(25 January, 2001)Introduction
The consensus at the end of December 2000 about the economic prospects for 2001 is that developments will be "more of the same" as in the previous year (Hadi Soesastro, TEMPO, 25 December 2000 - 7 January 2001). Economic growth is projected at about 4 to 5 percent. It is felt that to achieve a 4 to 5 percent growth would not be "a big deal" (Tony Prasetiantono, Kompas, 20 December 2000). The 2001 budget was drafted, and endorsed by the parliament (DPR), on the basis of that growth projection, an inflation rate of 7.2 percent, an average exchange rate of Rp 7,800 per US$, and an interest rate (SBI, the Central Bank's certificate) of 11.5 percent. While the growth projection is widely viewed as realistic, the projected inflation rate is seen as too low, the exchange rate as too strong, and the interest rate as somewhat on the low side. Inflation may increase to about 9 percent with another round of upward adjustments of administered prices (fuel and electricity) in 2001 and in view of the continued weak currency, which may settle at about Rp 8,500 per US$, and the SBI interest rate may have to be raised to and stay at about 15 percent.
What does this projection mean for Indonesia? This projection is consistent with the "muddling through" scenario for Indonesia, which many view as the most likely scenario for Indonesia. The implication of this scenario is that it will take Indonesia much longer to return to the pre-crisis per capita level of incomes. The more optimistic view, as espoused by Indonesia's Coordinating Minister for Economic Affairs, Rizal Ramli, in a recent interview in TEMPO (25 December 2000 - 7 January 2001), predicts that the economy could grow by 6 to 7 percent in 2001. Based on a structural approach to development Minister Ramli proposed to achieve this growth rate by promoting the development of infrastructure, agriculture, marine resources, and tourism. The more pessimistic view points to the dangers of another crisis looming large on the horizon. One possible source of such a crisis is the continued vulnerability of the banking sector. Another possible source is the unsustainability of the fiscal sector.
Yet another source of a "second" crisis is the continued bickering within the political elite that can lead to disastrous economic policy decisions. There is an emerging view, however, that after more than three years of political uncertainties many economic agents no longer seem to bother too much about political developments. In other words, businesses appear to have become more resilient to political developments. A "decoupling" of economics from politics seems to be taking place. But such decoupling can happen, and in fact has been the case, in the part of the economy that does not rely much on the government. It is this "healthy" part of the economy that has grown rapidly in the past year and has been the economy's driving force. The other part of the economy, the "sick" economy, has been relying on government favors and its recovery depends on government's involvement. The handling of this sick economy is politically a sensitive issue and as such is prone to political interventions. This explains why the sick economy is recovering very slowly and poses a drag to the economy as a whole. Perhaps the sick economy has been growing by 2 to 3 percent while the healthy economy manages to grow by 6 to 7 percent already. This emerging dualistic structure will be discussed later.
This paper begins with a review of recent developments. It then discusses the challenges for the Indonesian economy over the short and medium term, and examines the likelihood of a "second"crisis to arise in the near future.
Recent Macroeconomic Developments
Growth. The three quarters in 2000, up to the end of September, saw a steady increase in economic growth, from 4 percent (year-on-year) in the first quarter, to 4.5 percent in the second quarter, and 5.1 percent in the third quarter. In terms of the industrial origin of growth, the first quarter has been driven by a resumption of activities in the construction sector that continued to grow above 10 percent into the second quarter. In addition, the transportation and communication sector also grew by more than 10 percent in the first two quarters. The growth rate of both sectors declined to about 8 percent, respectively. Manufacturing experienced growth of 6 to 6.5 percent in the first two quarters, but the growth also slowed down to 4.4 percent in the third quarter. Trade, hotel and restaurant and the financial sector were growing by between 5 and 6 percent throughout the three quarters with a tendency to slowing down but only slightly. It has been the agricultural sector that pulled up the overall growth rate with the sector growing by a strong 6.5 percent in the third quarter from a negative 5.8 percent in the first quarter and a negative 3.2 percent in the second quarter.
In terms of expenditure, total consumption grew more rapidly in the third quarter, reaching 2.9 percent (year-on-year), up from 1.6 percent and 1.7 percent in the first two quarters, respectively. The third quarter growth of consumption was driven primarily by government consumption expenditures. Gross fixed capital formation, namely investments, grew strongest in the second quarter by close to 17 percent, and the growth rate declined to about 13 percent in the third quarter. The same trend occurred in the export sector which grew strongly by 21 percent in the second quarter but declined to about 18 percent in the third quarter.
The declining growth rates of GDP by industrial origin, outside of agriculture, may suggest that the "easy" growth phase for the economy is over. Idle capacity that was available during the years of the crisis is now nearly fully utilized. Capacity constraint may characterize the economy in 2001 unless new investments are being undertaken. No new investments are likely to come into the sick economy unless serious restructuring efforts are undertaken. A large portion of the healthy economy has financed its activities from retained earnings and savings or own equity. As such, investments in these activities are not likely to increase rapidly. This part of the economy also operates largely on cash and thus, it is less efficient than it could have been if it has access to bank credits. Export-oriented activities and joint-venture or FDI companies rely to a large extend on funds from abroad. Banks have begun to channel new credits since the beginning of 2000, but a survey conducted by Bank Indonesia (BI) shows that banks believed that credit growth may slow down in the last quarter of the year. It is likely that most of these credits was not directed to the healthy economy, including small and medium enterprises (SMEs).
Inflation. For the first eleven months in 2000, inflation reached 7.26 percent (year-to-date) or 9.12 percent (year-on-year). During the month of December inflation may be around 2 percent or more due to the festivities, resulting in an annual inflation rate of more than 9 percent, which is higher than BI's inflation target of 7 to 8 percent and the government's budget assumption of 5 to 7 percent. Decomposed into tradable and non-tradable goods, prices have increased about twice as fast for non-tradables than for tradables. Across commodities, the rise in inflation is most pronounced for processed food, beverages and tobacco, housing, and transport. Prices of foodstuff, which began to decline in August, were again on the rise since October.
Several factors have contributed to the rise in inflation. These include the increase in fuel prices by an average of 12 percent in October 2000 as part of the government's policy to eliminate fuel subsidies over a period of three years or so. Depreciation of the Rupiah was another cause for the higher inflation. For the eleven month until the end of November the Rupiah depreciated by about 28 percent. But perhaps the source of inflation that causes the greatest concern is the slack in monetary policy. Money supply continues to grow beyond the target. The targeted annual growth of base money is around 12 to 13 percent. The base money at the end of November stood at Rp 100.2 trillion, significantly above the Rp 90 trillion target as agreed upon with the IMF. The main contributor to the growth of base money is the large increases of currency in circulation. Miranda Goeltom, one of BI directors that have recently resigned, argued that it has been difficult for Bank Indonesia to control base money growth because of the high demand for currency in line with the increase in economic activities and failure of the banking sector to perform its intermediation function (TEMPO, 25 December 2000 - 7 January 2001). This problem relates to the growth of the cash-based economy mentioned before.
BI is in the process of negotiating with the IMF to revise the base money target.
However, BI has adopted a tight-bias monetary policy based on open market operations that focuses on SBI auctions. This has resulted in upward pressures on SBI interest rates from about 11 percent in June 2000 to 14.2 percent at the end of November. BI has been concerned that the increase in interest rates could have a significant effect on prolonging the recovery period as well as on increasing the burden on government finances. The interest cost of the huge amount of bonds, which the government has issued to finance the recapitalization of the banks and to refinance BI's liquidity support (BLBI), has to be serviced through the budget. A one percent increase in interest rate would add Rp 6 trillion to the government's burden.
Political pressures on the monetary authority to adopt a loose monetary policy are prevalent. Despite the proclaimed independence of BI from the government, it has been difficult for BI to insulate itself from such political pressures. Economist Mari Pangestu has strongly argued for a depolitization of monetary policy and proposed that BI and monetary policy should focus on price stability as a target and should allow interest rates to rise. In her words, "[m]onetary policy should not be concerned with considerations of the rising cost of servicing the government debt at the cost of price stability; the issue of servicing the debt is the purview of fiscal policy management." (The Jakarta Post, 21 December 2000).
Balance of Payments. Indonesia's balance of payments has been strong as the surplus continued to rise. Foreign reserves have steadily increased and now amount to about nine months of imports. This favorable development has been caused mainly by the strong export performance although imports have been on a rapid rise as well. Oil export revenues have increased significantly to the continued high oil prices. Non-oil (and gas) exports up to October 2000 increased by 24.5 percent (year-on-year) while imports had risen by 27.9 percent. Imports of raw materials and intermediate goods have continued to increase since the beginning of the year, suggesting that recovery has been on the way. Imports of capital goods have increased in the first half of the year, while imports of consumer goods have declined.
The growth of exports has been driven by ten commodities that account for 60 percent of total non-oil exports. These include machine/electricity equipment and machinery/mechanical machinery that have grown fastest by more than 100 percent compared to the same period (January to September) in the previous year. Wood and wood products, textiles and garments, and footwear are still important export items but their growth had declined. The main destination of non-oil exports remains the United States, Japan, Europe, Singapore, Malaysia, China, and Korea.
The expansion of export has been based on existing capacity that was underutilized. For export capacity to expand in the future availability of finances will be critical. The slow resumption of bank loans, including for working capital, poses a major constraint. Export activities have been driven by self-financing exporters. Due to political instabilities, export orders are based on short-term contracts. There have been reports of cancellation of orders. Yet, the very competitive exchange rate and regional economic recovery have given a strong boost to exports. There are concerns that export demand may weaken in 2001 as a result of a cooling down of the American economy.
As of September 2000 Indonesia's external debt stood at US$ 140.8 billion, which was about US$ 8 billion less than the position in December 1999. During January to September debt service payments amounted to a total of US$ 21.4 billion, which was mostly related to private debt service payments. The external debt of domestic private companies at the end of December 2000 could have been reduced to US$ 25 billion. An additional US$ 25 billion may be owed by foreign companies operating in Indonesia. Further progress in corporate debt restructuring could also increase the demand for foreign exchange that in turn exerts pressures on the exchange rate.
Indonesia's economic recovery during 2000 was at best still fragile. Sustainability of the recovery is the issue. The recovery has thus far been driven by domestic consumption, exports and some increase in investments. Each of these "growth engines" has not been very strong. There have been signs of a weakening of domestic consumption. There is the danger that exports will weaken due to both internal and external factors. Investments have been made largely by domestic investors and the amounts per project are likely to be small. Foreign investments have not come back. Transactions by foreign investors in the Jakarta Stock Exchange now amount to 21 percent of total, compared to 60 to 70 percent in the 1994-1996 period. The trend in foreign direct investment since 1998, exhibiting a negative net FDI inflow, has not been reversed. To date there is little fresh equity capital injection into the economy. Without resumption of investment growth will be positive but continue to be modest. With the country's recovery agenda far from completed there is a small prospect that the country will soon see large inflows of investments from abroad that would help sustain the recovery and growth.
Unfinished Recovery Agenda
Despite the signs of recovery, macro stability remains fragile and confidence is still low. The Rupiah has substantially weakened since August 2000 and has remained close to breaking the "psychological" level of Rp 10,000 per US$ at the end of the year. The stock market index has declined since the middle of the year. The weakening of the Rupiah is partly due to the strengthening of the US dollar and the rise in US interest rates. In addition, it has also been caused by the continued political bickering and the attempts to unseat President Abdurrahman Wahid. Investor confidence is at a low point with concerns about security, political and economic uncertainties, and the lack of clear policy directions. Maintaining confidence and macro stability continue to be a major challenge for Indonesia.
However, it is in regard to structural reforms that Indonesia's score card is still much in the red. The agenda for reform and recovery is largely unfinished three years after the first IMF-supported program had been in place. The lack of progress is not for lack of understanding about what to do. The list of urgent tasks has been with us for some time. These include speeding up the reforms, accelerate the disposal of assets that are under IBRA, the Indonesian Banking Restructuring Agency, strengthening of the banking system, corporate debt restructuring, privatization of a number of state-owned enterprises, strengthening of institutions, including at the local levels to enhance capacity to implement regional autonomy, improve governance and address corruption, strengthen the rule of law and the legal system. This is, indeed a tall order. It is the lack of systematic and serious implementation that is the main bottleneck. Confidence remains low so long as no single major corruption case is brought to court and successfully dealt with and so long as Tommy Soeharto cannot be put in jail.
As of the end of October 2000, about 12 percent of bank loans that have been transferred to IBRA has been restructured. IBRA's performance in disposing of assets has been lagging that of similar agencies in the region with a recovery rate of about 24 percent. In particular, since mid-November a series of restructuring agreements have been reached with some of the large debtors. However, the quality of these restructuring agreements has been criticized as they imply a disproportionate shift of debt burden and risk to the government. In addition, there appears to be a lack of level playing field in terms of treating the different debtors with some receiving greater concessions than others. On paper, by the third week of November about 81 percent of the debt of 21 largest debtors had been restructures. Since mid-November IBRA has been speeding up the sale of assets and reports suggest that by the end of the year it will reach the budget target. Yet the task for IBRA will be more difficult once it has disposed of the good assets. IBRA's transparency and accountability remain questionable and need a lot of improvement to enable itself to being insulated from political intervention.
Of critical importance is banking restructuring. Indonesia's banking system remains fragile even after the costly recapitalization. As argued by Lin Che Wei from SG Securities, Indonesia's banking structure today is not different from what it was pre-crisis (Kompas, 20 December 2000). Therefore banks remain vulnerable to an economic crisis. Firstly, there is yet no clear division between bank owners and user of the bank's funds and services. This is because the Indonesian banking system consists of up to 80 percent of banks of the conglomerates and state-owned banks. Bank owners whose main business is banking is still in the minority. Although BI's supervision of banks has seen some improvements in preventing the violation of legal lending limits, but back-to-back lending can still happen. State-owned banks are equally vulnerable to government-directed lending and political intervention. Secondly, the banking system is still too fragmented. There are still 153 banks and only a few have reached sufficient economies of scale. The large number of banks increased systemic risk in the banking system. Ideally, Indonesia should have 20 to 30 banks. Thirdly, bank capital is still a major problem. Bank recapitalization, through the issuance of bonds, has increased the banks capital but only in legal terms and not in economic terms. Recapitalization through bonds has enabled banks to gain positive spread and a breathing space for recovery. Only injection of fresh capital can strengthen the banking system. There has been only very little of this injection since the crisis. The unsuccessful acquisition of Bank Bali by Standard Chartered Bank has been a bad precedence Fourthly, privatization of state-owned banks is absolutely critical to preventing future crises as most of the outrageous banking scandals have been committed by state banks. Fifthly, banks intermediation function need to be restored, but this should not be achieved through forced measures. Banks should provide loans on a commercial basis. There are still so much distortions that prevent banks from providing loans on a commercial basis.
Failure to strengthen the (national) banking system could become a trigger for another crisis.
The government's fiscal situation is another source of major concern. This is not an immediate problem but fiscal sustainability becomes a real issue in the period 2004 to 2008 when the repayment of government bonds through the budget would reach more than Rp 100 trillion annually, with a peak of close to Rp 150 trillion in 2006. This problem is particularly very serious if the government fails to develop a secondary bond market.
The 2001 budget has passed the parliament with some modifications. Total government expenditures are projected to be about Rp 305 trillion while domestic revenues are projected to reach Rp 263 trillion. The deficit of about Rp 42 trillion is around 2.9 percent of GDP, lower than initially set at about 4 percent of GDP. The deficit in the 2000 budget was also lowered from the budget target of 4.5 percent of GDP to 3.2 percent of GDP. This has been achieved because of the higher revenues from oil. The 2001 budget assumes an average oil price of US$ 24 per barrel. Oil and gas would contribute about 25 percent of total domestic revenues. Non-oil taxes are projected to be about 10 percent of GDP. This is low in comparison to other developing countries in the region. However, this projection has been regarded by many observers as being somewhat too optimistic in view of the narrow tax base that is focused on corporations and activities that are largely within the sick economy.
On the expenditure side, of the total expenditures, about two-thirds will be allocated to repayment of debt (26 percent), subsidies (16 percent), and resource transfers to the region within the framework of fiscal decentralization (25 percent). Central government development expenditures comprise now only 11 percent of total expenditures. A failure on the part of the government to sharpen its development priorities would lead to a rapid deterioration in physical infrastructure and human capital that would affect the country's longer term growth performance and its sustainability.
About three-fourths of the budget deficit is to be financed by the sale of assets by IBRA (Rp. 27 trillion) and the proceeds from privatization (Rp. 5 trillion). The remaining one fourth will be covered by foreign assistance. It is the policy of this government to limit foreign borrowing to finance the budget in view of the huge foreign debt overhang. In order to assure fiscal sustainability the way out is to "grow"out of the debt (foreign and domestic). The burden of financing the budget will increasingly rests on the other sources of financing. The prospect is not all too bright given the great resistance and opposition to accelerating the disposal of assets and their sale to foreign investors as well as to privatization.
An open debate on this matter needs to be conducted by lying down all the options for policy. In fact, the options are limited: continued and increased reliance on foreign assistance or risking another economic crisis that will be triggered by a fiscal crisis.
Concluding Remarks
The muddling-through scenario is still the most likely one for Indonesia in 2001 and beyond. Economic growth will be modest and economic reform will be slow. There is an inherent risk in this scenario. The risk is that of a "second" economic crisis that can be triggered either by a banking crisis or a fiscal crisis.
Since there is no alternative to the muddling-through scenario, the task is to assure that the reforms, albeit slow, would proceed on the right track. Political reforms towards democratization are of critical importance. A return to a strong and authoritarian government will not be acceptable even under the pretext of restoring confidence, law and order. As Mari Pangestu has proposed, "[m]ost of us still felt that the muddling through solution was still the one that would safeguard democracy, and to some extent worth the social and economic costs once one took a long-term view of a better outcome in the future." (The Jakarta Post, 21 December 2000).
In this muddling through process there are bright spots. The healthy part of the economy that is emerging demonstrates that there is resilience in the economy and that there is a lot of entrepreneurial drive if it is allowed to express itself. But this economy relies on self-financing and its transactions are largely cash-based. Therefore, it cannot grow much faster than the rate it has achieved thus far. The activities are mostly undertaken on a small and medium scale. The prolonged problems of the sick economy in fact provides space for this emerging economy to blossom. If they become stronger in a few years hence, a more balanced economic structure may develop. This, in turn, helps consolidate Indonesia's democratization process.
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