by Hadi Soesastro

Until the onset of the 1997/98 economic and political crisis, the Indonesian economy has grown by an average of 7 percent per annum. The economy experienced a slowdown in the mid-1970s and again in the mid-1980s when the world economy was in a recession. Each time, however, the Indonesian economy was able to come out stronger, as the 'crises' forced the government to undertake the necessary reforms in order to sustain the country's economic growth.

Sustainable development as is understood in Indonesia is not only about economic growth. From the mid-1970s on it has been defined as involving three main elements, namely a sufficiently high economic growth, improved distribution of income and the fruits of development, and national (including economic) stability. This so-called 'trilogy of development' in essence proposes a kind of 'balanced development' in which growth will not be pursued at the cost of creating instabilities and a worsening in the distribution of income. Also, concern with distribution and equity issues should not lead to the adoption of policies that would result in economic stagnation. National stability is important but the pursuit of monetary stability, for instance, should not be at the expense of growth and welfare.

The strategy of development, nonetheless, is one that is growth oriented. It attempts to achieve growth with distribution and stability. Sound macroeconomic policies were adopted to achieve economic growth and stability. For many years, the government has strictly adhered to policy prescriptions that it has set for itself. These include the principle of a balanced budget, a current account deficit of no more than 2 percent of GDP, and a limit to external borrowing to maintain a debt-service ratio (DSR) of less than 20 percent. Distribution objectives were pursued through a policy of developing 'eight channels for more equal distribution' that is meant to improve access of the poor to basic health, education and training, job opportunity, credit, etc. A significant portion of the national development budget has been devoted to the agricultural sector, rural development and the provision of basic needs. It can be shown that progress has been made on many of these fronts. Most widely quoted has been the success in the reduction of the numbers of people living under the poverty line, from 70 percent in the late 1960s to 20 percent in the early 1990s. Gini-coefficients to denote relative income distribution have not seen a significant deterioration. Moreover, those indicators suggest that income distribution in Indonesia is better than in many other large developing countries.

The crisis of 1997/98, which is still ongoing in Indonesia, has led to a serious questioning of all these achievements. Were the achievements real? Why has it been that the crisis has hit Indonesia so hard? The Indonesian economy is expected to experience a contraction of 15 percent or more. Such severe contraction of the economy has not happened before. Inflation has reached 80 percent for the first eight months in 1998 and is expected to reach 100 percent for the whole year. Unemployment has increased to as high as 20 million, from about 6 million at the onset of the crisis. The number of people living under the poverty line is estimated to have risen to 80 million, or about 40 percent of the population. About half of them are faced with serious food security problems. Why have things gone so wrong? Is it because Indonesia has been pursuing a wrong development strategy?

Many have blamed the crisis on the premature opening up of the Indonesian economy, particularly of its financial sector. This strategy of opening up has not been adopted overnight, but began with a process of economic liberalisation since the late 1960s. Over the years, this process has been driven by various factors, both internal and external to the economy. This process has not been a smooth one, but whenever it achieved progress in terms of a further opening up of the economy it has been driven by the necessity to do so in order to sustain the country's economic growth and development. Indeed, as will be shown later, this process has not rested on some kind of a blueprint. The reforms have been based on pragmatism. It has been reinforced by regional and global commitments, such as through AFTA (ASEAN Free Trade Area), APEC (Asia Pacific Economic Co-operation), and the WTO (World Trade Organisation). The wave of competitive liberalisation that has emerged in East Asia has also been a positive factor in the adoption of open economic policies by countries in the region, including Indonesia. These developments have been widely praised, and countries in the region that have adopted this strategy are believed to being doing so largely in their own self interest. Yet, the question being raised today is whether this kind of strategy is sufficient in dealing with globalisation, particularly in regard to the huge and volatile flows of international capital.

A crisis, however, is pretty much in the eyes of the beholder. In April 1998 when the Indonesian students began to step up their demonstrations throughout the country, they demanded that President Soeharto make an end to corruption, collusion, and nepotism (CCN -- or KKN in the Indonesian vocabulary that has been adopted also by Malaysians), which in their view are the main source of the crisis. Demanding an end to CCN or KKN has become a shorthand for demanding 'good governance'. There is as yet no Indonesian word for governance, and until this crisis, the concept of governance has not been given sufficient attention to. Globalisation or governance has been often singled out as the main factor that has led to the East Asian crisis. There are some that have put the blame on either 'contagion' or 'conspiracy'. Yet, the crisis cannot be pinpointed to a single source.

There are many views and theories on the crisis in Indonesia as well as in the other East Asian countries. They can be clusters into three main themes. The first theme focuses on issues of financial fragility and the impact of volatile capital movements. Policy recommendations range from issues that are more or less of a technical nature, namely on how to strengthen prudential regulation and supervision of financial institutions, to those that involve complex policy choices regarding a country's capital regime, exchange regime and exchange rate system. The second theme stresses the importance of institutional development and institutional arrangements, either in the domestic context of enhancing governance practices and procedures or involving regional initiatives (regional surveillance mechanism) or multilateral, global co-operation (co-ordinated controls on short-term capital flows). The third theme addresses the issue of long-term growth strategy. As mentioned before, the prevailing development strategy based on international-oriented policies has been questioned. There is the view that incremental changes can be adequate, but others argue for the need for a totally new development paradigm.

In the case of Indonesia, the crisis has underlined the importance of governance and a strategy of development that can effectively respond to the challenges of globalisation. In policy terms, the challenge to Indonesia is how can it make a credible commitment to maintaining its open economic policies and to good governance. The next section reviews the process of economic liberalisation in Indonesia and efforts to make a credible commitment to open economic policies. This will be followed by a review of the governance structures, in terms of the broad institutional setting and policymaking processes in the economic field. The final section outlines the main issues that Indonesia has to address in responding to the challenges of globalisation.

Economic Liberalisation and Sustainable Development

Indonesia began with the liberalisation of its economy about thirty years ago, following a change of government in 1966. The program then was not called 'liberalisation'. That would have sounded too much like an undertaking inspired by 'liberalism', which until not too long ago was a dirty word in the Indonesian political jargon. Rather, the program was presented as a 'total correction' to the economic policies of the Old Order government. This new direction or re-orientation of economic policies was to move away from etatism, thought to be one of the main causes of economic disaster that had befallen the country.

The process of liberalisation that began with this total correction did not proceed on a linear track. Along the way there were periods in which the process slowed down, or came to a halt, or even experienced a reversal. Throughout the thirty years, there were three distinct periods of liberalisation, each being motivated by different events. The first period was between 1966 and 1972, during which the liberalisation measures were introduced to correct the economic policies of the previous government and to rehabilitate an economy that was at the brink of a collapse. These major corrective measures plus the significant reforms in other fields, particularly in the political field, provided the legitimacy for the new government. The second liberalisation period, from 1982 to about 1991, was essentially driven by necessity. The fall in oil prices forced the government to restructure the economy, away from its dependence on oil revenues towards an economy that is internationally competitive in a broad range of non-oil, manufacturing products. The third period, from 1994 onwards, has been driven primarily by the emergence of a dynamic regional environment that is characterised by competitive liberalisation. As suggested earlier, this was further reinforced by Indonesia's involvement in region-wide and global liberalisation initiatives through AFTA, the APEC liberalisation agenda, and the WTO.

In fact, the intervening periods in which the liberalisation process either slowed down, came to a halt, or experienced a reversal, are equally interesting to analyse. The identifiable periods of liberalisation trends and the intervening periods of increased protectionist policies are all closely linked to major economic and political changes (Pangestu, 1991). The story of Indonesia's economic liberalisation has not ended. This liberalisation agenda is far from being exhausted. Moreover, in an environment of competitive liberalisation this process tends to be 'ratcheted up'. In addition, a number of important areas have not been sufficiently touched by the liberalisation drive. The economic and financial crisis that has hit Indonesia so severely could have a significant effect on the way this liberalisation process will be unfolding in the years to come.

Although most attention is currently being given to resolving the crisis, a number of questions regarding the wisdom and process of liberalisation have been raised by the wider public. Some believe that to a large extent the liberalisation of the current and capital accounts, the latter in particular, has been responsible for the crisis. Others regard liberalisation as a manifestation of the globalisation process, which is largely being imposed on the nation without having the ability to resist it, and that this process might have gone too far. Still others would address the issue of liberalisation mainly in terms of the increased (and unchecked) role of the private sector in the economy. Finally there are those that link the issue of economic liberalisation with that of political liberalisation. These questions are not new but perhaps they have not been made very explicit before.

In undertaking the economic liberalisation Indonesia has never formulated any grand design to guide the process. It has been a process driven by pragmatism and by necessity. As such, the question of how far the process should go has never been made explicit. This is so because the government does not want to engage in a debate on whether the policy measures taken are in accordance with Article 33 of the 1945 Constitution and thus, to bring the issue to the level of 'high politics'. This is regarded as politically highly sensitive issue as it would open up a discussion about the 1945 Constitution with all its ramifications on national cohesion and political stability. It is believed, therefore, that the liberalisation policy should be kept at the level of 'low politics' (Soesastro, 1989). Since the mid-1980s the preferred label for the exercise is 'deregulation'.

Packaged as a total correction to the policies of the previous government, the new government had no difficulties justifying the policies and programs adopted during first period of liberalisation (1966 - 1972). In rehabilitating the economy the New Order government moved decisively on restoring macroeconomic stability and introduced market-oriented reforms. It eliminated the fiscal deficit and introduced the balanced budget principle as the cornerstone of macroeconomic management. A stringent monetary program was adopted to deal with hyperinflation. The multiple exchange rate system was unified in 1970 and a large devaluation was undertaken in 1971 to bring the exchange rate to a realistic level. The first major policy measure was to fully liberalise the capital account.

The market-oriented reforms involved changes in the trade and incentive regime. The import licensing system was abolished. Although in 1968 tariffs on some products (e.g. textiles) were increased to encourage domestic production, import protection was considerably reduced. The government also removed most domestic price controls. An open door investment policy was strengthened by the adoption of a Foreign Investment Law in 1967 which (initially) had no restrictions on foreign equity and employment of expatriates and allowed 100 percent foreign ownership.

These policies and programs were widely supported with great enthusiasm by the public because they were able to show immediate results. Growth was restored and inflation was brought down, private initiatives were promoted and foreign capital plus aid were coming back. However, many of these policies and programs were subsequently reversed, among other things in response to increased nationalist reactions to foreign direct investment (FDI). Investment regulations became more restrictive. All new FDI had to be in the form of joint ventures with Indonesian equity to be increased to 51 percent within a specified period. The list of sectors closed to FDI was extended and tax incentives were reduced.

In addition, the oil booms of 1973-74 and 1979-80 enabled the public sector to expand. Public enterprises began to take a dominant role in a number of sectors and public investments were increasingly directed into heavy industries, petrochemicals and mining. The civil service also expanded rapidly and bureaucratic interventions became rampant. Moreover, the incentive regime was made progressively more inward oriented. Investment licensing and credit allocation at subsidised interest rates had reinforced distortions in the trade regime (Bhattacharya and Pangestu, 1996). With the oil booms, the economy became heavily dependent on oil revenues and the government was faced with the 'Dutch disease' problem, i.e. the erosion of the competitiveness of the non-oil economy due to the rise in the real exchange rate. The drop in oil prices and world recession in the early 1980s opened up the way for the second period of liberalisation (1982-1990).

What lessons can be drawn thus far? First, compared to other large oil exporting countries, Indonesia did not squander its new wealth. Efforts were made to use the extra resources to reduce poverty, expand public education and health facilities, and promote rural development by allocating substantial resources to agriculture and rural infrastructure. Macroeconomic policies remain essentially sound. One could hypothesise that the very open capital account has imposed a discipline on macroeconomic management. Second, the liberalisation process had been largely influenced by events. One wonders whether this was due to the fact that there was no grand design for the liberalisation program. It is questionable, however, whether a blueprint for the process could have been drawn. In the final analysis, this process is political in its nature. It can be argued that reforms become less acceptable when the economy is doing well (or appears to be doing well).

The liberalisation process has been conducted in a gradual fashion, taking full account of its political feasibility. Ali Wardhana (1989), one of the main forces behind the liberalisation drive in the 1980s, has argued that gradualism -as opposed to the 'big bang' approach-has the advantage of progressively winning over a new constituency for further reform. He pointed out that the extended period of weak oil prices during the 1980s had made the gradual approach to liberalisation a viable option and had enabled policy makers and implementors to work within their capacities to plan and execute reforms. Proponents of the big bang have argued that this approach would prevent vested interests from rallying forces to oppose further reforms. However, in a policy environment as in Indonesia where there is a great deal of doubt about the benefits of liberalisation, even within the government itself, gradualism is indeed the only viable option. The big bang approach is also considered more credible as it would send strong signals regarding the commitment of the government to the reforms. The gradual approach can be made credible if it starts with significant reforms that will then be followed by a clear action agenda and a timetable for further liberalisation. This has been the missing part in the liberalisation process of the 1980s.

As stated before, the liberalisation process in Indonesia has been driven largely by necessity and has been implemented pragmatically. It has been neither theory nor ideology driven. The universal trend in the 1980s towards economic liberalisation, deregulation, and privatisation may have provided an additional source of inspiration. Theories about the proper sequencing of the liberalisation or reform program have been devised, but they can be adopted only if they are politically feasible. The sequencing issue itself has been put forward because it would not be feasible or even desirable to undertake all reforms simultaneously. The accepted wisdom is that trade (current account) liberalisation be undertaken after having put in place or in conjunction with policies to ensure macroeconomic stability and exchange rate adjustment. The main objective of liberalisation of the trade regime is to improve resources allocation and economy wide efficiency by removing distortions as well as to earn foreign exchange and improve the balance of payments by increasing exports and fostering efficient import substitution (Pangestu, 1990). This would be followed by reforms in the industrial sector, including foreign investment regulations, the transportation sector, and domestic regulations. Administrative reform is key to the success of the program. Liberalisation of the capital account should come last. There are a number of arguments in support of this proposition. One concern is that capital flight during the reform process can aggravate or even stop the process. The other concern is that a liberalised capital account and reform of the financial sector that precede a reform of the real sector would only increase the flow of capital to sectors that are made attractive due to prevailing policy distortions.

In East Asia, Indonesia is the only country that began with the liberalisation of its capital account. This was instituted in the early 1970s with the clear objective of making the country attractive to foreign investment. Indonesia's experience has been cited as a 'successful' case of a reverse in the order of economic liberalisation. One is perhaps less sure today that indeed this is the case. In terms of the process of trade liberalisation, Indonesia has much in common with other East Asian countries. It has launched a series of export policy reforms before it undertook import reforms. In other words, it maintained import protection while promoting exports. Such facilities as duty draw back and export subsidies offset the high cost stemming from the protection system. This policy, which has been referred to as the double-distortion policy, could no longer be sustained under the present international trading environment. Import reforms have should ideally began with the removal of non-tariff barriers and replace them with equivalent tariffs that provide the same protection. This 'tariffication' would increase transparency and reduce rent-seeking activities in addition to improving the allocation of resources. Following this tariffication, the tariff system should be rationalised with the aim of reducing the level and variance of tariffs to a progressively lower and relatively uniform nominal and effective rate of protection.

The second liberalisation period in Indonesia was undertaken in response to the significant drop in oil revenues. It was been based on 'a simple chain of economic reasoning' (Wardhana, 1989): economic growth and development require export growth to pay for imports and to service debt; reliable export growth requires non-oil exports from agriculture and manufacturing; non-oil exports requires an efficient, productive economy, which needs a competitive domestic market; protectionist policies and government controls are inimical to this competitive domestic market, creating a high-cost economy; these policies need to be dismantled, i.e. the economy must be liberalised and deregulated. As a corollary, the government must develop non-oil revenues to be able to play a constructive role in development. The benefits of the liberalisation and the resulting economic growth must be widely and evenly spread, and development of the rural areas should receive continued emphasis.

The reform process so conceived did not proceed smoothly. Indeed, this second liberalisation period has been widely seen as consisting of two sub-periods (Sjahrir and Brown, 1992; Bhattacharya and Pangestu, 1996), the first half, from 1982 to 1985, being characterised by ambivalence (Pangestu, 1991) and partial reforms (Hill, 1997). Substantial reforms were undertaken only in the second half of this period, namely from 1986 to about 1990. During this entire period no less than 20 policy packages to deregulate and liberalise the economy were issued. However, the most significant of these measures were the trade liberalisation package of October 1986 and the financial liberalisation package of October 1988. The dramatic drop in oil prices in 1986, and the currency realignment following the Plaza agreement in 1985 that increased Indonesia external debt payments, appeared to have been responsible for precipitating and fuelling a sense of economic crisis that resulted in the more drastic measures. Earlier deregulation measures were not considered substantial because the trade deregulation failed to address the issue of non-tariff barriers that were affecting a large proportion of imports.

Some trade liberalisation measures were first taken in 1982 in response to the deterioration in the country's balance of payments. Measures affecting imports, such as export taxes and restrictions on trade with the Socialist bloc, were relaxed. A scheme for countertrade was also introduced. However, in an attempt to curb imports a licensing scheme was introduced in late 1982. The use of such import licensing proliferated rapidly. Until October 1986 close to 1,500 important items had come under some form of non-tariff barrier, usually a licensing restriction, which covered about 35 percent of the value of total imports. The system became a vehicle for rent-seeking activities that led to the emergence of what Mancur Olson called 'distributional coalitions'. The system was also misused to promote the development of industries of questionable economic viability. The October 1986 package was a first serious attack on this system. It included the dismantling of the plastic and steel import monopolies, which were seen as the symbol of the then emerging cronyism.

Similarly, the financial deregulation initially addressed only problems of the state banks and not the liberalisation of the financial market as a whole. The October 1988, which has been widely regarded as the most sweeping reforms during this period, aimed at increasing competition within the sector by removing some of the barriers to entry. State enterprises that hitherto had to use only state banks were now permitted to deposit up to 50 percent of their funds in private banks. New foreign (joint venture) banks and domestic banks were allowed and foreign banks could open branches outside Jakarta. This liberalisation resulted in a dramatic growth of the financial sector. It has changed the market structure and competitive situation facing the banking sector. The number of banks increased from 61 in 1988 to close to 120 in 1991, and to 230 in mid-1990s. The growth of assets and credits of private banks expanded rapidly and resulted in a dramatic increase in the role of private banks, especially domestic banks, at the expense of state banks.

This rapid growth in credits may have been responsible for the overheating of the economy in the late 1980s and the subsequent tightening of liquidity, which led to an increase in foreign borrowing that was facilitated by the open capital account. Leakage from abroad meant that despite the tight monetary policy money supply growth continued to be high and inflationary pressures increased. In 1991 the government began to take measures to manage offshore borrowing by setting a ceiling on the borrowing for government-related projects and borrowing by banks. The ceiling was put at about US$ 5 to 6 billion for the next five years. Borrowing by the private sector could not be directly controlled but the government indicated that an amount of up to US$ 2 billion annually could be acceptable. As it turns out, private sector external borrowing increased rapidly with the accumulated debt amounting to over US$ 70 billion in mid-1997.

Concerns were expressed about the possibility that the rapid expansion of bank credits could lead to financial distress and financial instability (Pangestu, 1993), in view of increased problem loans and bank failures. The open capital account was not at issue as it has been in place for some time. Rather, the concern is with the ability of the authorities to supervise the rapidly expanding banking sector. Efforts to strengthen bank prudential regulations were made in 1992 and in subsequent years. However, they appear to be far from adequate. Over the years the sweeping reforms in the financial sector of the late 1980s were evaluated with increased caution, but the prevailing attitude was that of allowing for a learning period on the part of both the new private banks and the Central Bank.

Although the process of liberalisation in the 1980s was widely supported in its broad outline, economists from the University of Indonesia expressed some concern over the widespread, simplistic notion that the reforms could provide a panacea for overcoming the high-cost economy and its many ills and inefficiencies. First, if the liberalisation of the current account is singularly pursued to promote non-oil exports, new distortions could be introduced. Second, a heavy focus on reforming the manufacturing sector can result in a bias against the agricultural sector. Third, the overall impact of the liberalisation has been positive primarily in psychological terms. Fourth, a closer examination needs to be undertaken on the impact of the reforms at the sectoral or industry level (Anwar and Aziz, 1988). In essence, these concerns relate to the issue of the gainers and losers in the process, which will be addressed in the following section.

From 1991 to about the middle of 1994 the country experienced a 'reform fatigue' (Iqbal, 1995) or a policy inertia (Hill, 1997). Efforts to further liberalise the current account appeared to have come to a halt. The average rate of nominal tariffs remained at the same level during much of this period. Things began to change in the middle of 1994 with the issuance of liberalisation measures in the investment field. This marked the beginning of a process that was driven by the need to compete with other countries in the region that characterised the increased competitive liberalisation in East Asia.

The investment liberalisation of June 1994 allows for 100 percent foreign ownership to increase the attractiveness of Indonesia's investment regulation due to increased competition for investment from China, Vietnam and other countries in the region. The government took note of the fall in investment approvals in 1993 and the slowdown in growth of non-oil exports. In addition, nine sectors that were previously closed for FDI, including ports, power generation, shipping, air transport, railways, telecommunication, and initially even mass media, were opened up. In the trade field, a liberalisation package was issued in May 1995 which included a timetable for the reduction of tariffs of most tariff items up to the year 2010. This was the first time the government came up with such a timetable for liberalisation. This unilateral liberalisation measure was clearly issued in response to the competitive liberalisation environment in the region. In addition, this liberalisation measure was to be understood as the government's determination to implement its commitments under AFTA, APEC and the WTO. These measures were further improved in June 1996. However, while on the whole significant progress has been achieved in reducing tariffs, a few sectors remain highly protected. The dismantling of the protection given to these sectors has become a difficult political question. It no longer involves a competition of ideas between different ministries in the government. Rather, it became a struggle to dismantle the cronyism that has become so rampant and entrenched.

The crisis that hit Indonesia in the second half of 1997 was seen a providing an opportunity to redress this problem. The agreement with the IMF to resolve the crisis includes a structural reform program that is widely understood as a renewed attempt to tackle the problem of cronyism that has become a major obstacle to the liberalisation process. The inclusion of this program in the IMF-supported reforms carries a risk in that the reforms would not be implemented in good faith. The dilemma, however, is that its exclusion would take away the credibility of the reform package (Soesastro and Basri, 1998). It remains to be seen whether this reform package could ensure that the structural reforms would continue to be undertaken in the years ahead.

The issue of who gains and who loses from the liberalisation has become important because the future of the liberalisation process will depend on its assessment by the body politic and the public at large. No longer will it be sufficient to show the overall favourable impact of the process. There is an urgent need to study this issue in some depth in order to be able to respond to popular beliefs or myths about the impact of liberalisation and globalisation.

Hill (1997) noted that some of these popular beliefs are that the liberalisation (and deregulation) process has led to the creation of conglomerates and monopolies, increasing inequality and poverty, widening of regional disparities, and the demise of small firms. Hill gave an assessment on each of these propositions based on available empirical evidence to suggest that simplistic conclusions are faulty. A survey of perceptions in Indonesia, as reported in Rinakit and Soesastro (forthcoming), indicated that liberalisation and globalisation are primarily seen as causing problems because of the increased domination of foreign enterprises in the economy and a weakening of small and medium enterprises. A study by Iqbal (1995), examined the effects of the reforms upon firms according to the size distribution of firms. Realising that there is the common perception that deregulation only benefits larger firms, he examined the probabilities of growing larger, or becoming smaller, or of exit for the different categories of firms during the two periods, 1980-85 and 1986-91. The conclusion is that during the 1980s both large and small firms appear to have benefited from the reforms.

Perceptions are powerful and they have to be taken into account. There is an urgent need to study the impacts of the liberalisation and globalisation process in some depth in order to be able to respond to popular beliefs or myths about these impacts. The question of whether liberalisation has gone too far or has been undertaken too fast cannot be answered and addressed by studying its differential impacts on different sectors or segments in the society. There will always be a difference in impact, and that there will be winners and losers. Identifying them would help devise the necessary institutions and develop the required policy instruments to deal with the negative impacts of liberalisation.

Governance and Sustainable Development

As reviewed above, immediately after assuming power in the mid-1960s the Soeharto government began to liberalise the economy with the aim of restoring stability and promoting growth. It inherited an economy that was in shambles. The measures taken were based on pragmatic considerations but guided by a conscious decision to steer the economy away from etatism towards market-oriented measures and to deregulate the economy in order to promote private sector activities. This 'total correction', away from a state-led economy, was based on a decision by the Provisional People's Consultative Assembly (MPRS) in 1968. The implementation of this re-orientation was fully entrusted upon the government. President Soeharto, assisted by a team of economists - the technocrats, was given the full mandate to take the necessary measures.

Having successfully restored economic and political stability, in 1969 the country embarked on its first Five Years Development Plan (Repelita). The plan is an indicative one, and not an elaborate, centrally managed type of plan. In this plan, the government outlines the broad directions of economic development and structural change, and defines the areas in which the government will involve itself directly through its annual budgetary outlays. In the earlier years, the government's role was dominant as shown by the government's share in total capital outlays of around 75 to 80 percent. The private sector is free to fill in the gaps between the overall development agenda as outlined in the plan and the areas of activities reserved for the government. This overall structure of economic management remains largely intact throughout the past 30 years, but in later years the role of the private sector increased to about 75 percent of total capital outlays. What is remarkable is that throughout this entire period the development of the economy has been overseen, supervised, and largely directed by one person, namely President Soeharto, who is unofficially called the Father of Development (Bapak Pembangunan).

In view of the dominance of the state, the strong role of the government, and the central position of the president, the economic and political environment has been largely influenced by changes in government policy. These changes have also influenced the role of the government in the economy, but by and large this remains dominant. Structural changes in the economy, from an agrarian, traditional economy into an industrialising, modern one, have brought about a host of new institutional challenges. After 30 years of development, the institutional setting remains largely underdeveloped. This fundamental deficiency in the development process, however, has not been sufficiently appreciated in Indonesia, and perhaps also elsewhere, so long as the economy continues to perform well. It is only recently, particularly in relation to deep economic and financial crisis that has befallen Indonesia since the second half of 1997, that attention is being given to issues of institutional arrangements and development. Some do believe that the underdeveloped institutional setting has been partly responsible for the crisis.

A review of the process of deregulation, and economic liberalisation in general, that has taken place in Indonesia over the past 30 years also provides a venue for understanding the evolution of the institutional setting. The study by Bhattacharya and Pangestu (1996) referred to before is thus far the only comprehensive one on the institutional aspects of the deregulation process over the entire period. Analyses covering a shorter time period in the 1980s, in which sweeping reforms in a number of areas were undertaken, can be found in Soesastro (1989) and Sjahrir and Brown (1992). These studies have shown that the process of deregulation has brought about new institutional challenges and that this process will be seriously hampered if insufficient attention is given to institutional development, in both the narrow and the broadest sense of the word as applied in this book.

In the earlier period of the deregulation process in Indonesia there was progress in institutional development. The earlier period saw a qualitative shift from the use of informal, ad-hoc, and irregular mechanisms of economic policy making as well as for the implementation of policies to the use and strengthening of more formal, structured, and coherent ones. It needs to be remembered that the new government had to undertake the task of economic stabilisation and rehabilitation without having the necessary institutions in place since the bureaucracy no longer was functioning as a result of the ideological and political conflict during the Old Order. It subsequently began to gradually rehabilitate the bureaucratic structure and build new institutions around it. Institutional development also took place in other fields of life, including in the political field. The direction of institutional development and the establishment of more normal and regular processes of government and 'governance' have resulted in the emergence of what has been called a 'corporatist' state system, which is characterised by the strong role of the bureaucracy in directing the economy.

The later period saw clear stagnation in the process of institutional development, perhaps even an 'institutional involution' as institutions were progressively losing their independence and became part of a system of government and governance that increasingly became more 'patrimonial' in nature. Over the years, the economy has become more liberalised, i.e. more open to the world, but much of the economic activities are now conducted under a patrimonial system that centres on the president. The change did not occur abruptly. Perhaps this explains why it was not immediately recognised and why it did not have an immediate, negative impact on the economy.

Left with an economy that was on the verge of collapse, the new government moved swiftly and decisively to restore marcroeconomic stability and introduce market-oriented reforms. The first measure taken was to bring about a discipline in the budget as government expenditures were way out of control resulting from the heavy burden of military manoeuvres in the struggle for the return of West Irian and the adventurous policy of 'Konfrontasi' towards the immediate neighbours. In 1967 the government adopted a balanced-budget policy which has become one of the important cornerstones of the New Order's economic management. This policy prohibits domestic financing of the budget in the form of either debt or money creation. To bring down inflation the government also adopted a stringent monetary programme. Through a series of large devaluation the exchange rate was adjusted to realistic levels. The multiple exchange rate system was unified in 1970, and following a further devaluation in 1971, the capital account was fully liberalised. This was a daring step as the capital account in most developing countries is usually the last to be liberalised. Yet, the open capital account has become another important cornerstone of the New Order economy.

The early years of the Soeharto government were marked by a style of economic management that resembled the operations of an army unit that was given the task to mobilise resources and control those resources in achieving a particular objective. Soeharto, himself an army commander, was at the helm and immediately began to organise groups to undertake specific tasks of mobilising resources. He himself retained full control of those mobilised resources. In addition to macroeconomic stabilisation, the technocracts were given the tasks of mobilising foreign aid with the help of the World Bank and the IMF. Various persons were dispatched as Soeharto's personal envoys to lobby foreign governments for increased aid and to develop links with foreign companies to attract investments from abroad. He placed a few of this army colleagues as head of important state enterprises to restore their functioning and economic health but at the same time also to mobilise resources for various non-budgetary expenditures. It has been known that as head of the state oil company, Pertamina, General Ibnu Sutowo was also given the task to provide supplementary resources for the armed forces whose resources from the budget had been drastically reduced.

Formally, Soeharto himself chaired the Economic Stabilisation Council, formed in 1968, to oversee the economic rehabilitation program. In later years, under more normal conditions, the main forum for economic policy co-ordination was the regular cabinet meeting on economic affairs. The extent to which policies are discussed and debated among cabinet members and the president in these meetings has been questioned. It is believed that a change has occurred in later years as policies were increasingly decided in bilateral meetings between the president and the respective minister or ministers and only subsequently reported at the cabinet meeting prior to a public announcement.

This structure of centralised economic policy making seems to have worked well. The key to the success lies with the organisation of policy inputs to the president who makes the final decisions. The technocrats, who were initially recruited as economic advisers to Soeharto as acting president, became ministers in the cabinet and were given the most important portfolios. Working as a group under the leadership of Prof. Widjojo Nitisastro they were able to propose coherent policies that received the full backing of the president. Being in charge of the most important economic ministries and working as a cohesive group they were able to implement the policies even though the bureaucracy was very weak. The enormous challenge to stabilise and rehabilitate the economy allowed the technocrats to formulate policies without having to face political pressures and interference, even from the military. As stated before, supplementary resources to meet the financial needs of the military were separately organised by the president from non-budgetary sources. This helped to guarantee that the economic policy making process was largely 'insulated', an important factor for the success in economic development that Indonesia shares in common with many other East Asian economies (Campos and Root, 1996). Another factor in ensuring that economic policy remained largely insulated was the visible and quick results that the reform programmes delivered. The economy grew rapidly, initially as a result of increased efficiency in the utilisation of existing production facilities and subsequently due to the increased inflows of aid and foreign investment. Inflation was controlled and food production increased. With such a record no other groups could effectively provide an alternative input to the president. The technocrats' development agenda, however, did not remain unchallenged for long.

Within a few years, the country was seen to have opened up its door too widely to foreign investment, particularly Japanese foreign investment, arousing nationalist sentiments that culminated in riots during the visit of Japan's Prime Minister, Tanaka, to Indonesia in January 1974. The extent of the riots, which were compounded by internal political struggles among competing factions within the political elite, came as a shock to the leadership. A series of policy measures, including in the economic field, were introduced in response to demands that were strongly expressed in the public, particularly on foreign investment. The regulations on foreign investment were amended and became more restrictive.

A further change in the direction of development resulted from the oil bonanza of 1973-74. With the increased availability of resources, public enterprises began to take a dominant role in a number of sectors and public investments were increasingly directed into heavy industries, petrochemicals and mining. The civil service also expanded rapidly and bureaucratic intervention became rampant. To promote import substitution in government-initiated upstream industries the incentive regime was made progressively more inward oriented. The oil boom directly increased the amount of resources at the disposal of Pertamina and were used to finance the development of heavy industries (Krakatau Steel), air transport (Pelita Air), rice estate in Sumatra, hotels throughout Indonesia, and other big projects. In addition, a new division of advanced technology was set up within Pertamina, headed and developed by Habibie, and was the embryo of what became the Agency for Research and Application of Technology (BPPT). It was believed that over time Pertamina retained an increasing portion of the central government's oil revenues. With the increased resources at hand, Pertamina's head, Ibnu Sutowo, began to challenge the technocrats with an alternative vision of development. However, Pertamins's rapid expansion, including the development of its own fleet of tankers led to a severe financial crisis when oil prices began to weaken in 1975. Apparently Ibnu Sutowo did not inform President Soeharto about the tanker deal. Ibnu Sutowo was dismissed as head of Pertamina and the president called upon the technocrats to resolve the crisis. A supervisory board that included several technocrats as members was instituted to oversee Pertamina's operations.

For a while, the structure of economic policy making was back to what it was. However, new challenges arose. The economy became heavily dependent on oil revenues and suffered from the 'Dutch disease' problem, i.e. the erosion of the competitiveness of the non-oil economy due to the appreciation in the real exchange rate. The government devalued the currency in September 1978 by about 30 percent, but another, even larger, oil boom followed in 1979-80. The appreciation of the real exchange rate led to pressures to protect the newly developed industries. A host of non-tariff barriers (NTBs) was introduced. This included an import licensing system, import bans and quotas, and various informal quantitative restrictions.

The import licensing system was introduced with the intention of promoting import substitution in such basic goods as cement, fertilisers, chemicals, synthetic fibres, and iron and steel. The number of products requiring an 'approved-importer' license was continuously increased, but the number of approved traders was reduced to as few as two or three companies. Initially, the approved trader status was mainly given to state enterprises. In the years to come, these were increasingly given to private companies with strong links to the political power. Quotas and import bans were used as an instrument to raise the local content of various domestic assembly activities. These included initially motor vehicles, tractors, diesel engines, and motorcycles, but were subsequently extended to construction equipment, diesel engines, home appliances, and electronic goods.

The attempt by the Department of Industry to establish a system of administrative guidance failed because it became apparent that fair deals cannot be reached as more and more of the import monopolies were related to the powers that be. The bureaucracy was in no position to facilitate a process that involved powerful business groups. Fair rules of the game cannot be formulated on this basis. In any case, this import licensing system created a high-cost economy. Gradually, however, some exporters that were being seriously injured by the import protection scheme began to campaign for the dismantling of the system. As observed by MacIntyre (1992) they later became a valuable ally of the technocrats in undertaking the reforms that were instituted to assault on the high cost economy, which was the main objective of the second period of deregulation.
In the late 1980s, the minister of trade, Arifin Siregar, proposed the creation of a formal mechanism for government-business relations. It was unfortunate that the initiative was presented in terms of the idea of 'Indonesia Incorporated'. This was strongly opposed by many quarters as it was seen as giving legitimacy to the practice of government-business collusion, which by then has become very visible (Soesastro, 1989).

In addition to dealing with the excesses of rent-seeking activities, in the latter half of the first period the technocrats were trying to limit the damage caused by the adoption of the policy of inward-oriented industrialisation. They made maximum use of three important disciplining devices as their only weapon in dealing with their colleagues in the government that were in favour of large, capital intensive upstream projects, and high technology ventures. Those disciplining devices were the balanced budget, the open capital account, and a rule of thumb to set a limit on the use of foreign capital so as to maintain a debt-service ratio (DSR) of 20 percent at the most. With the help of these disciplining devices the technocrats were able to maintain sound macroeconomic policies and prevent a financial disaster as experienced by other large oil exporting countries (Nigeria, Venezuela). The Pertamina financial crisis, earlier in 1975, was another powerful reminder.

Nevertheless, they also felt that the high-cost economy resulting from rampant rent-seeking activities would make it increasingly difficult for them to hold the ford. The weakening of oil prices in 1982 came as a blessing in disguise. As described in the previous section, the severe effect on the economy, which has become so dependent on oil, created a sense of crisis that was sufficient to set into motion a new round of reforms.

Increased pressures on the country's balance of payments that began to be felt in 1982 had led to a few measures on the trade front. However, the government appeared to have been more concerned with the import side than with the export side. As shown earlier, attempts to curb imports resulted in the creation of an import licensing system that became so entrenched. This system was also misused to promote industrialisation through a combination of import-substitution policies, regulation of investment, and state ownership. Vested interests behind this industrialisation drive also became very strong.

In view of the strong resistance in deregulating trade and industry, the technocrats were left with the financial sector to launch the process of deregulation. They could begin with the financial sector because they were in charge of the central bank and the ministry of finance. But it was also felt that financial reform itself was long overdue. This decision to liberalise the financial sector was also a daring move and has been characterised by the wrong order of sequence. Indonesia's first major liberalisation measure was to fully open up its capital account in the early 1970s and it undertook financial sector liberalisation before real sector liberalisation. With this very open capital account, it was the continuous threat of capital flight that helped to induce the deregulation of trade and industry.

The continued weak oil prices helped to keep the pressures for reform. More substantial deregulation was introduced in 1985. An across the board reduction of import tariffs was announced in March. In addition, with the issuance of a presidential decree the Indonesian customs service was subcontracted to a Swiss-based private surveying company, SGS. This was a radical step and run counter to Indonesia's strong nationalist instinct. Yet, even so observers felt that the measures did not go far enough as the assault was not directed to the core of the problem, namely the rampant rent-seeking activities of the import monopolies.

In May 1986 the government introduced its first package of trade and industrial deregulation. The measure allowed major exporters to procure imported inputs directly without going through licensed importers. It also replaced an export subsidy program with a duty drawback. But the import monopolies remained untouched. In October 1986 a first step to dismantle the complex import licensing system was undertaken by abolishing the import licenses. This was followed by an announcement in January 1967 of a further round of tariff reductions and the removal of NTBs to imports, including the dismantling of the monopoly on steel and plastic imports which were seen as the symbol of the then emerging cronyism.

The technocrats might have realised that they have reached the limits of what can be achieved since it became clear that any further major surgery in this field would face great resistance from the president himself. As a result they again turned their attention to the financial sector. The previous section has described the deregulation of the financial system undertaken in October 1988 as the most sweeping initiative thus far in the financial sector. Soon, there were concerns about the possibility that the rapid expansion of bank credits could lead to financial distress and financial instability in view of growing problem loans and bank failures. Indeed, in 1990 some banks had a run on their deposits following rumours of their difficulty. In August 1990 it became public that one of the largest domestic foreign exchange banks, Bank Duta, incurred losses of US$ 400 million in foreign exchange dealings. It was also revealed that at the time the bank went public earlier in the year the losses had already been incurred, but this was not evident from the bank's financial statement. The open capital account was not at issue as it had been in place for a long time. Rather, the concern was with the ability of the authorities to adequately supervise the rapidly expanding banking sector. Efforts to strengthen bank prudential regulations were made in 1992 and in subsequent years. Yet, confidence in the banking system remained shaky at best.

The remarkable thing about the Bank Duta case was the manner in which it was rescued. As the bank was partly owned by a number of foundations that have been set up by President Soeharto over the years to raise funds for various social and religious activities, the president himself organised the rescue operation. He requested one of his close business-associate to provide fresh capital to be injected to the bank in the shortest time possible. The request was favourably responded too, and within a few months later it was reported that this close business associate was being granted a license to build one of the largest petrochemical complexes that could enjoy the privileges of foreign direct investment and subsequently was given tariff protection.

This episode illustrates the direct involvement of and intervention by the president in business affairs, bypassing institutions and ignoring rules and regulations that are in place. The past few years have seen an increase in such behaviour, and that it continues to be unchecked. The larger, equally worrying, picture suggests the gross lack of independent and effective institutions, including legal institutions. In fact, what appears to be puzzling is that this type of governance - or the lack of it - has not resulted in a situation where the country is seen to have priced itself out of international investments. MacIntyre and Ramli (1997) have addressed this issue. They listed the many problems with the formal legal system as well as systemic cronyism and corruption in the administration of government. They also noted that the business community in Indonesia has largely abandoned the notion that the legal system is an effective vehicle for arbitrating commercial disputes. How, then, can it be explained that this weak legal guarantee of property rights and widespread corruption have not discouraged private foreign investors from coming into the country?

MacIntyre and Ramli offer three explanations for this puzzle. First, high rates of return to investors would make them accept some increased costs associated with bribery and some increased risk associated with the uncertainty of formal property rights. Their second explanation has to do with the nature of governance. They argue that in Indonesia's political architecture that centralises power around the presidency, President Soeharto's position is much like that of a unified monopolist. In that position he has the ability to monitor and control that the pricing of bribes by the various agencies would not drive down investments. Yet, how can it be assured that the strong leader would not reverse its decision? MacIntyre and Ramli proposed the third explanation. In order to make a credible commitment to the investment community, the government has effectively tied its own hands. This is provided by the open capital account, which creates a powerful early warning system of investor discontent that would exercise a powerful discipline on government behaviour.

The current financial crisis shows that this disciplining mechanism should not be relied upon as markets (and investors) can react so abruptly. Particularly, this is the case with portfolio investment and short term capital flows rather than foreign direct investment. Nonetheless, recent developments suggest that ultimately it is good governance, including the development of solid legal institutions, which should be relied upon. Will the issue of good governance become a priority in Indonesia's national agenda? Indeed, as posed by Goodpaster (1997), why would a country such as Indonesia, which has been able to achieve political stability and economic growth with little regard to the state of its laws and legal system, all of a sudden become convinced that rule of law and rule-based behaviour would be necessary to ensure the sustainability of its development efforts?

It may not be too difficult to find the answer to this question. One is the fact that successful development itself creates a more complex society that requires a rule-based social ordering system to provide social stability, harmony, enhanced personal freedom, economic growth and even democratisation (Goodpaster, 1997). MacIntyre and Ramli offer a similar argument when suggesting that change is imperative because the political underpinnings of the present system will give way. The other reason is that in an increasingly integrated global economy, Indonesia cannot allow itself to maintain a system in which transaction costs are excessive because of a lack of rule-based behaviour. This may not be self-evident as yet to many Indonesians, but this understanding was brought home by the emergence of an environment of competitive liberalisation in East Asia. As described before, this was followed by a period of 'reform fatigue'. During the early 1990s the average rate of nominal tariffs stayed at the same level and no efforts were made to eliminate NTBs. Things began to change in 1994 following a poor non-oil export performance and a marked decline in approvals of foreign direct investment. It was felt that Indonesia was beginning to lose out in the competition for foreign direct investment to such countries as China, Vietnam and India. In addition, it also began to experience declining export competitiveness, which was another possible reason for the slowing down of foreign investments.

Instead of an overall improvement, the 1990s saw a rapid deterioration in governance. As mentioned before, as a quid pro quo for rescuing Bank Duta, the president granted a special license to the rescuer to build and operate a large petrochemical complex, Candra Asri, which was also given tariff protection. Having recently embarked on the ASEAN Free Trade Area the granting of protection to this new project was seen as a violation of the spirit of the exercise. It was all the more awkward because the announcement was made only a few days after President Soeharto successfully engineered the APEC Bogor Declaration to achieve free and open trade and investment in the region, which was enthusiastically received by most governments in the region. The minister of finance, Mari'e Mohamad, ex officio head of the Tariff Board (Tim Tarif) as stipulated by the law, was removed from the position because he was not in favour of granting tariff protection to Chandra Asri.

By the mid-1990s the technocrats were no longer in the favourable position that they had before in advising the president. Faced with the deterioration in governance, they pulled their remaining strengths to make the liberalisation of the economy a regionally binding commitment. They could not state this in the open, but that was what they aimed for by supporting the idea of forming an AFTA, which until not too long ago was not supported by Indonesia, including the technocrats themselves. The technocrats were also behind the efforts that produced the APEC Bogor Declaration. Following this, in May 1995 and in June 1996 further trade liberalisation packages were introduced. However, while on the whole significant progress has been achieved in reducing tariffs, a few sectors would remain highly protected for an extended period. The new deregulation packages have exposed these protected sectors, such as steel, chemicals, automotive, and agriculture. The dismantling of protection in these sectors becomes politically very difficult. The struggle is no longer a matter of competing concepts of development and industrialisation between different ministers in the government. Rather, it has become a struggle for the dismantling of cronyism that has become so rampant and entrenched.

The crisis that hit Indonesia in the second half of 1997 was initially seen as a another blessing in disguise as it could provide a new opportunity to redress the problem and to continue with the deregulation process that has come to a halt. The government began to introduce fiscal and monetary measures to cope with the crisis quite early. A large number of large government-sponsored and private infrastructure projects were cancelled for balance-of-payments reasons. Many of the projects involve businesses of the cronies and the president's children.

Having introduced these measures the currency remained unstable and continued to depreciate, in part due to the contagion effect. This led the government to seek the assistance of the IMF. An agreement was reached involving an IMF-organised financial package of US$ 43 billion in support for a reform programme to be undertaken by the government of Indonesia. The reform programme included a structural reform agenda that would begin to make an end to the monopolies. The inclusion of this structural reform agenda carries a risk because the entire reform program could be entangled into complex and sensitive political problems.

The agreement with the IMF not only stipulates a continuation of the deregulation measures but it also focuses on institutional development to promote greater transparency and competition, more institutional autonomy, and stronger legal and regulatory environment. It is ironical, for instance, that it needs an agreement with the IMF for the Indonesian government to make a pledge to give autonomy to the central bank, Bank Indonesia, in formulating and implementing monetary policy. But who will monitor this? Will we have to rely on the IMF? The agreement also suggests a number of laws that needs to be improved and that needs to be introduced. On paper, there is no shortage of meaningful laws, including those that could help promote corporate governance. The Banking Law of 1992 could promote prudential supervision of banks, if it was enforced. The Corporate Law of 1995, which came into operation in 1996, clearly stipulates the new duties of directors, the rights of shareholders, and disclosure requirements that are of 'high standards'. However, the critical issue is their enforcement. The weak enforcement of the law has a lot to do with the patrimonial nature of the system of government and governance. However, the Indonesian themselves will have to work out a way to change this system

NEXT