Indonesia: The Challenge of Sustaining the Economic Recovery -- Address by Anoop Singh
October 4, 2000Anoop Singh
International Monetary Fund
University of Indonesia
50th Anniversary Conference
October 4, 2000
1. With a much more stable macroeconomic environment, strong international support for Indonesia’s economic reforms, and an ongoing recovery, market confidence should be high. However, this is not the case, and the question on everyone’s mind is how best Indonesia can sustain the recovery. I am glad to have this opportunity to focus on some of the key macroeconomic, financial, and other challenges that lie at the heart of this question.
2. Let me touch on three topics
- First, it is useful to remind ourselves how far Indonesia has come since the depths of the crisis in 1998, and some of the economic policy lessons of the last two years.
- Second, the economic factors that are weighing down on market sentiment, especially the burden of the government debt and its implications for the growth prospects.
- Third, the approach in the economic program to address the problem of the government’s indebtedness and to assure sustained growth over the medium term.
I. Recovery from crisis
3. It is hardly necessary to recall the crisis conditions that prevailed in Indonesia just two years ago. By mid-1998, the exchange rate had collapsed, reaching a low of more than Rp 15,000 to the US dollar, compared with about Rp 2,500 before the crisis. Output was contracting sharply and, by the end of the year, had declined by about 13 percent—certainly the largest fall among the Asian crisis countries and, possibly, the largest single-year fall of any country in recent economic history. With rising food insecurity, the country was on the verge of hyperinflation. The banking system had virtually ceased to function and the corporate sector was weighed down by the recession, inflation, and its corporate debt. In short, Indonesia was in a vicious downward spiral.
4. Much of this now seems long ago and far away. Complacency may be the enemy of economic reform but it is also a measure of how much better shape the economy is in now. Let me quickly review the achievements of the past two years:
- Output has been growing steadily for about a year, broadly since late 1999, and there is substantial consensus that Indonesia’s growth could reach 4 percent in 2000. Confounding most observers, Indonesia’s recovery seems to have steadily broadened beyond its initial dependence on domestic consumption, and we have recently seen the beginnings of a recovery in, both, exports and domestic investment. Many forecasters are predicting solid growth for the year ahead.
- Inflation has been kept low over the past year. Indeed, before their recent increase, prices had been flat for a long period, benefiting from rice prices that had fallen by about 20 percent since their crisis peak.
- The rupiah has been much more stable, fluctuating in a range of Rp 8,000-9,000, which is lower and more volatile than justified by the fundamentals, but certainly much better than before.
- Short term interest rates are also in a much more supportive range although, here too, there is considerable room for further progress.
- Finally, the poverty rate—by most accounts—has fallen back sharply to well below its level at the peak of the crisis. Falling rice prices have been a major contributor to the decline in the poverty rate.
5. What explains these results? What stands out is the development and implementation of a sound macroeconomic framework, supported by successive measures to restore confidence in the banking system and rebuild key economic institutions, especially the following:
- Since mid-1998, there has been a radical reorientation of monetary policy focused on the targeting of base money. Through open market operations, Bank Indonesia (BI) has been able to sterilize past liquidity support and keep the growth in its net domestic assets and base money broadly in check.
- BI was allowed to freely adjust the interest rates as necessary and, since early 1999, BI has successfully brought interest rates down close to their pre-crisis level.
- Fiscal policy was allowed to become expansionary with the broadening of targeted social spending programs, such as the introduction of subsidized rice to poor families under the targeted rice distribution (OPK) scheme.
- Successive banking system reforms have been implemented, backed by a comprehensive guarantee on banking system liabilities, especially the closure of insolvent banks, and the recapitalization of virtually all the remaining banks.
6. Let me now turn next to discuss the challenges that lie ahead. The most immediate of these challenges arise from the volatility in market sentiment that has been evident for much of this year. Restoring market confidence in Indonesia’s economic prospects is crucial to reviving the investment and capital flows that will be necessary to deliver sustained growth.
II. Market Confidence and fiscal sustainability
7. Despite the macroeconomic achievements to which I have just made reference, and the successful conduct of last year’s Parliamentary and Presidential elections, market confidence has been volatile in 2000. This volatility is beginning to affect the macroeconomic achievements. For example, inflation has begun to creep up. Although there was virtual price stability for much of the first half of this year, the 12 month inflation rate has now reached about 7 percent, largely a result of the more depreciated level of the rupiah. In an environment of already large risk premia, investors continue to adopt a wait and see attitude, and flight capital has still to return. Such an environment has already put renewed pressure on nominal interest rates and also makes it difficult for much delayed corporate restructuring to take place. There must be high priority given to reversing present sentiment.
8. There are many reasons for the decline in market sentiment. I do not want to go into all the possible reasons, and I am sure many of you here today will know more about the interplay of political developments and market confidence. Instead, I would like to focus on some of the major economic factors that are weighing down on market sentiment. One of these factors is, certainly, the slow progress Indonesia has made in asset recovery or restructuring, relative to the large size of the problem. Indeed, Indonesia’s relatively large debt burden makes it all the more imperative to make progress in asset recovery. Thus, concerns about fiscal sustainability may well dominate the economic factors that are weighing down market confidence. These concerns will remain—likely come into fuller exposure—when the other factors—those of a more political nature—have been addressed.
9. What do I mean by fiscal sustainability? It means that the government is in a position to repay its debts, both now and in the future, in an orderly way—without resorting to extraordinary measures. A simple measure of sustainability is a declining trend in the debt-to-GDP ratio. Such an outcome generally requires the rate of economic growth to exceed the real interest rate. Without this condition, the burden to run a fiscal surplus increases.
10. Markets worry about fiscal sustainability in Indonesia for a number of reasons. Among them are the following:
- External public debt amounts to almost $70 billion equivalent to around 45 percent of the country’s GDP, while domestic debt amounts to around Rp 650 trillion, accounting for another 45 percent of GDP. So, in all, the government’s debt amounts to around 90 percent of its annual output, which is one of the heaviest debt burdens in the region. By comparison, Malaysia’s and Thailand’s government debt are below 65 percent of GDP, and Korea’s below 40 percent of GDP.
- A high government debt—as I have said—places a direct burden on the budget. For example, the payment of interest on the government debt is already absorbing about one third of government revenue. The bulk of this will be paid on the bonds that have been issued to recapitalize the banking system. In the coming years, without offsetting measures, the budgetary burden will rise as the bank recapitalization bonds begin to fall due.
11. Given this background, it is very important for markets to be reassured about the government’s ability to meet its debt servicing burden in an orderly way. As long as investors doubt this ability, interest rates will have to remain high; this is the counterpart of the risk premium demanded by investors to compensate them for the higher perceived risks of holding the government debt. And, as we all know, higher interest rates impose a heavy burden on the economy. For one, they reinforce the weight of the debt on the budget, thereby forcing the government to seek offsetting savings elsewhere. Perhaps more important, they discourage new investment spending, thereby directly detracting from growth. There are many international examples of countries where concerns about fiscal sustainability kept interest rates well above the inflation rate, and contributed to low growth.
12. Therefore, it is imperative to prevent Indonesia from experiencing the same prospects. Now that the economy is stable, and a recovery underway, the next important step is for the government to take measures to reassure markets of its commitment to bringing down the debt burden over the medium term, thereby maintaining fiscal sustainability. I will now briefly discuss the elements in the government’s approach to support this objective.
III. The Strategy for Fiscal Sustainability and Growth
13. The importance of fiscal sustainability—of bringing down the debt burden in an orderly way—was well recognized by Parliament last year, when it enunciated the Guiding Principles for State Policy. The present economic program builds the framework to accomplish this reduction in the government’s indebtedness, and seeks to do so in an orderly way. The basic strategy relies on maintaining a favorable macroeconomic environment, making progress with fiscal consolidation, and driving asset recovery. All of these factors would have a mutually reinforcing effect on stimulating new productivity-enhancing investments and capital flows, reducing real interest rates, and raising growth, thereby satisfying the conditions for reducing the debt ratio. Setting in train—and entrenching—such a virtuous cycle is the fundamental aim of the economic program. If fully achieved, our projections point to the government debt ratio falling to about 67 percent by 2004.
14. It should be recognized at the outset that this is no easy task for at least three reasons:
- For one, the pace at which fiscal stimulus is withdrawn needs to be carefully managed. Stimulus has been appropriate for initiating the ongoing recovery and, as in other Asian countries, needs to be scaled back with due care, protecting the poor.
- Second, a strong political consensus for maximizing asset recovery—especially IBRA’s—is essential for the process to move forward. This has been the experience in other countries and is also needed in Indonesia. Here it will be very important to hold firm against vested interests in the form of recalcitrant debtors who might try to further delay asset sales, compromise the quality of restructurings, and regain control over their assets—all with lasting effects on the government’s ability to deal with its indebtedness.
- Third, a number of institutional weaknesses will need to be overcome. For example, a bond market needs to be developed in Indonesia, virtually from scratch, to facilitate roll-overs of maturing debt, and attract a wider group of investors who need the assurance of a well-functioning secondary market.
Let me now go on to discuss in more detail the principal avenues available to the government to bring down the debt ratio in the next few years. Many of these avenues will tend to—indeed are necessary to—raise efficiency and factor productivity at the same time.First, adjustment in the government budget.
15. During the crisis, Indonesia’s budget balance moved into deficit because of the need to support domestic demand, cushion the output decline, and expand support for the poor. Now that recovery is underway, it is appropriate that the process of scaling back the fiscal deficit should begin. As I have already mentioned, this will not be an easy process. Many parts of the expenditure budget have already been squeezed, and there is still substantial need for infrastructure and social safety net support. That is why a strong political consensus will be needed on how best to pursue fiscal consolidation and to make the necessary choices:
- During the crisis, government spending on subsidies increased. Of these, those on oil are quantitatively the most significant. However, much of the budgetary subsidies are not of a targeted nature, and there is no assurance that the benefits accrue to the poor. Such untargeted subsidies presently amount to as much as 3 percent of GDP, almost equal to the entire international support for the budget.
- Civil service reform is another avenue for budgetary savings—and greater efficiency. The government has, commendably, already made clear its intention to rationalize its work force, eliminate unnecessary and obsolete jobs, and refocus the civil service on the new priorities of a democratically elected government. Indeed, there is considerable room to do so. Because of successive and large wage increases over the past two years, the government’s wage bill—as a ratio to GDP—has risen to above 5 percent of GDP which is above that of many similarly placed countries.
- There is also considerable scope to strengthen the revenue base of the government. Again, the government has already expressed its intention to rationalize the large number of exemptions and tax holidays which have reduced the revenue base, in many cases, without commensurate benefits. Also, in the past, significant revenues that would otherwise have accrued to the government have been diverted into a proliferation of off-budget accounts, thereby escaping the scrutiny of Parliament. Changing these practices will strengthen the revenue base without imposing new burdens on the Indonesian people.
Second, implement fiscal decentralization without adding to the budget deficit.
16. The government is currently preparing to implement fiscal decentralization in 2001. There is much international experience that is guiding the government in its efforts. The international experience clearly points to the risk that the general government deficit could rise following decentralization. If this were to happen, it would make it all the more difficult to bring about a reduction in Indonesia’s burden of government indebtedness.
17. For this reason, the government is taking a number of actions to preserve fiscal neutrality during the decentralization process. Perhaps the most important enabling condition is to ensure that expenditure functions are transferred to local authorities to match the revenues that they are receiving. If this is not done, an additional burden would be placed on the government budget, at a time when it can least afford it. In short, finance should follow function, and not the other way around.
18. The government is also considering other measures that would contain the macroeconomic risks of fiscal decentralization and ensure that the overall debt reduction strategy remains on track:
- International experience strongly suggests that borrowing by sub-national governments should be subject to strict limits, particularly in the early stages of decentralization. Most importantly, bank lending to sub-national governments should be tightly controlled or even prohibited.
- The overall budget framework of the central government needs to retain some flexibility in case some of the risks do materialize. This is commonly done, in many countries, by creating a margin within expenditures that is maintained as a contingency against unexpected risks.
Third, pursue recovery from publicly held bank and nonbank assets
19. Asset recovery is of the highest priority in the economic program, and not only because of its considerable potential to help bring down the government’s debt. Of equal importance is the role that asset recovery can play in sustaining the recovery. As is well known, IBRA controls a very large amount of assets—whose book value has been measured to be close to one-half of annual GDP—and needs to be put back in the private sector where they would be more efficiently deployed. The longer the assets remain in the hands of the government, and despite the best intentions of IBRA, the assets are likely to deteriorate. The same with asset sale prices—waiting with asset sales for their prices to firm usually produces the opposite result. These are the clear lessons from every country that has been faced with this task, and they are also the emerging lessons from Indonesia’s own experience. In contrast, accelerating asset recovery would jump start the revival of foreign investment into Indonesia and raise factor productivity, both of which are crucial for sustaining growth, while also helping strengthen the rupiah closer to its fundamentals.
20. Overall, over the next few years, bank asset recovery and the proceeds of nonbank privatization could be as important as the adjustment in the budget deficit in their contribution to reducing the debt ratio. All the institutions concerned need to play their part—especially IBRA and the JITF where there is considerable need for coordination of function—as well as the government as owner of the state-owned enterprises.
Fourth, safeguard public resources from being used for additional bank recapitalization
21. The principal reason why Indonesia’s government debt has risen so much during the crisis is because of the need to recapitalize the banking system. Indeed, there were previous episodes of bank recapitalization at public expense in the 1990s. For this reason, it is critical to ensure that—once the present recapitalization is completed—the government does not need to lead another bank recapitalization in the future. However, such an assurance is still not at hand. The restructuring process for the recapitalized banks is still underway and needs to be carried to completion, and private capital more vigorously encouraged. The process entails the following priorities:
- Enhanced supervision of the banking system is paramount to protect against the abuses that have occurred in the past. The economic program contains a wide-ranging program to accomplish this, and improve governance of the state banks.
- Transformation of Indonesia’s banks into genuine intermediators of the financial savings of the community. For far too long, the banks have been the vehicles of directed lending, of one sort or another, and this was the true heart of Indonesia’s financial crisis. Nothing short of a culture change is at stake, and I have been impressed by so many of Indonesia’s own bankers who have made this point to me. Achieving such a culture change—so that credits are extended on the basis of proper appraisals and risk analysis—is another challenge.
- Privatization of the large state share in the banking system. Such a process, as observed elsewhere in Asia, will not only bring in much needed new capital into the banking system and strengthen their ability to extend new credits, but also build up the financial and competitive strength of the banking system. Because of the resolution process in response to the crisis, the government’s share of ownership in the banking system has risen to above 70 per cent, much above its historical level, and also above the level of other Asian countries. Reversing this situation is a necessary part of the process of reducing the government debt, increasing efficiency, and sustaining growth.
IV. Concluding Remarks
22. I have stressed today that a coordinated strategy to reduce the government debt is an essential part of the process of restoring market confidence and sustaining the emerging recovery. Of course, this is not the only part of the process, but it may well lie at the heart of it. The international community is fully committed to helping Indonesia meet the challenges that are involved in this task. Just recently, the IMF Executive Board completed the second review of Indonesia’s Fund supported economic program, and I speak on the eve of an important meeting of the Consultative Group for Indonesia. Our role—that is to say, of the international community—is to give technical assistance, policy advice, and financial support for the implementation of the economic program. The program itself, as repeatedly emphasized by Coordinating Minister Ramli, is very much that of the government. We are there to support it.