Agenda for the new Indonesian Administration: a Rijsttafel of Policy Measures

David P. Loevinger
Deputy Assistant Secretary of Treasury for Africa, Middle East and Asia

Remarks Presented at the USINDO/DAI Conference Luncheon

Thank you for the opportunity to explain Treasury’s view on the new Indonesian government’s agenda.  The U.S. Treasury does not spend nearly as much time on Indonesia now as it did when I returned to Treasury from the IMF in January 2000 – and that’s a very good thing.  This is not because Indonesia is not as important but because Indonesia has made significant progress.

With over 250 million people – the world’s largest Muslim democracy – the path that the new government embarks on is important not only to Indonesia but to the United States and the world.  That’s why I’m here today.  Since I am a Finance Ministry official and many areas have already been covered this morning by others, I would like to focus my remarks on three issues Treasury views as critical for the new Administration to tackle early on: continued fiscal consolidation, the investment climate and banking reform.

Much Progress since 1998

First, it is worthwhile to take stock of the enormous progress achieved since the 1998 crisis.  Inflation, interest rates, the fiscal deficit and external debt levels are all down.

  • Year-on-year inflation dropped from a high of 70 percent in February 2002 to a low of 4.5 percent earlier this year, rising moderately to 6.2 percent in September.
  • External debt has been reduced by half to 60 percent of GDP.
  • After receiving one of the largest IMF programs at the time as well as Paris Club relief, Indonesia graduated from IMF financing and Paris Club rescheduling.  The IMF was much criticized and, admittedly, the IMF made some mistakes.  But in fairness and in hindsight, the IMF’s role in Indonesia should be viewed as one of great success.
  • Almost the entire banking sector had been nationalized; now almost all intervened banks have been returned to the private sector.
  • In 1997 there were almost 240 banks, with very little foreign presence.  Now there are about 100 fewer banks, and foreign banks have now grown to about one third of the banking system’s assets.
  • Much private sector debt was in arrears, now a significant share has been rescheduled.  IBRA recovered 163 trillion rupiah in assets by the time of its closure in February, a 28 percent recovery rate.  These proceeds greatly helped pay for IDR 650 trillion in public bonds issued to recapitalize the banking system.
  • Perhaps most importantly, after fits and starts, a disciplined economic policy team came into place that stayed “on message” and helped restore investor confidence.  Ministers Boediono and Dorodjatun deserve much credit.  I hope the new team will learn from their success.

Indonesian benefited from unusually benign environment

But Indonesia benefited from a favorable external environment.  Keep in mind that post-crisis Indonesia gained from a buoyant international financial environment, a tech boom that helped Indonesia’s major trading partners, the lowest global interest rates in a generation (that also spurred investor appetite for riskier debt), and a booming Chinese economy (which increased demand for and prices of Indonesian commodities).

Fiscal restraint played a key roll in restoring macroeconomic stability.  However, due to limited capital markets, past governments didn’t have the capacity to run large deficits, particularly with a broken banking sector.  While the government has now made good progress developing a liquid Treasury bond market, this gives future governments greater capacity to be less responsible.

The future environment may not be so forgiving and policy makers will need to focus on structural reforms to make the economy less vulnerable.  It is clear that consumption-led GDP growth of 3 to 5 percent, compared to the 6 to 7 percent pre-crisis, is too low to reduce high unemployment and poverty.  Peter Timmer of UC San Diego’s School of International Relations and Pacific Studies (IRPS) and Bill Foerderer from USAID spoke earlier in more detail about poverty in Indonesia, but it is worth noting that 7.5 percent of the population still earns less than $1 a day.  A much larger share is precariously one shock away from poverty – 110 million Indonesians make less than $2 per day.  Furthermore, high debt levels still leave the government and private sector vulnerable to exchange rate and interest rate movements.  I don’t like using the term “second generation” reforms, but this is what is currently needed in Indonesia.

Fiscal and Monetary Policy

With capital stock depreciating, increasing investment is needed to secure sustained growth and employment.  First, the authorities should build on the macroeconomic gains made since 1997 through further consolidation and by eliminating deficits, at least until debt falls to a level that will give the government capacity to run counter-cyclical fiscal policy without “spooking” investors.  The biggest enemy is complacency, as Argentina showed.   The IMF, Professor Carmen Reinhart at the University of Maryland, and others have done much recent research on debt intolerance.  Their research has produced three key conclusions:

  • Safe levels of debt are country specific, but Indonesia’s target level should be well below current levels.
  • Institutions matter: a country like Sweden can tolerate more debt because of its developed institutions.
  • Relying on growth alone is rarely sufficient to get out of the danger zone.  Thus, highly indebted countries need large primary surpluses.

Also, studies show that fiscal contraction in highly-indebted countries is not necessarily contractionary, as it might be in a less indebted country.  Moreover, Indonesia could partially offset the contractionary impact of further fiscal consolidation by making the composition of its spending more supportive of growth; reducing fuel subsidies (which mainly benefit higher income households and promote rent seeking); and devoting more resources to investments in health, education, and public infrastructure.

Bill Foerderer earlier spoke about the need to reduce the number of off-budget accounts.  In 1996, the U.S. Congress passed legislation, which had Indonesia in mind but which targeted all countries, requiring the United States to ensure that all revenues that fund military activities are audited and reported to civilian authorities before approving credits or grants from the international financial institutions.  By giving the Supreme Audit Agency authority to look into the finances of the military foundations, Indonesia made important progress, but much more could and should be done.

On monetary policy, Bank Indonesia should establish a much more transparent inflation-targeting regime.  BI’s current policy is too eclectic and it is unclear whether they are targeting base money, interest rates, the exchange rate or other indicators.  As part of this, Indonesia should have less “fear of floating” – though Indonesia fares much better on this than the rest of Asia.

Improving the Business Climate

Others at this conference have already spoken at length about the micro efforts to improve the business climate, but I would like to highlight that investors still complain of unfair treatment by local courts, corruption, lack of transparency and high costs to starting a business.  It is impossible to overestimate how damaging high profile cases are.  CEOs who read the Wall Street Journal have a hard time justifying investment in Indonesia to their boards.

Governance continues to be a big challenge and was a key reason that Indonesia was not selected to be eligible for the U.S. Millennium Challenge Account funds in 2004.  In the previous seminar, Peter Timmer noted that Indonesia could be five years away from passing the control of corruption indicator.  The corruption indicator is the only MCA indicator which the Board is singularly required to look at when assessing a country’s prospect for achieving MCA-eligible status.  I would like to point out that the MCC Board can use its discretion if it believes that a country is making significant progress and that the numbers used in the calculation may not reflect current conditions.  In the first year of the MCA, for example, Bolivia was just at the median for the corruption criteria and not above as is required by the rule but was still nominated as an MCA candidate by the Board.

The top priority for the new administration will be to send strong signals that corruption, particularly in the judiciary, won’t be tolerated.  We understand reforming the judicial system takes time and it is much easier said than done given that it will require educating an entire corps of lawyers and judges.  We also understand that judicial independence is a step forward.  Furthermore, it is much easier to design IFI conditionality on macro indicators (such as reserves, deficit, and asset sales) than on judicial reform.  But at the same time, allegations of judicial corruption need to be investigated and, if discovered, dealt with unambiguously.   There are still far too many stories about judicial decisions being sold to the highest bidder.  Recent passage of the bankruptcy law and the establishment of the Anti-Corruption Committee are welcome moves in this direction.

We’ve been talking today about the need to improve the investment environment and eliminate bureaucratic red tape, but I think it’s important to look at the numbers to truly understand the situation in Indonesia.  According to the World Bank, it’s not pretty:

  • It takes an average of 151 days to start a business in Indonesia, compared to a regional average of 52 days and 8 days in OECD countries.
  • The cost of starting a business is 131 percent of per capita income, compared to 47 percent in the region and 8 percent in the OECD.
  • Firing costs are 3 years of wages in Indonesia, compared to one year in the region and 40 weeks in the OECD.
  • The cost of enforcing a debt contract is 127 percent of the contract, compared to 57 percent in the region and 11 percent in the OECD.
  • Resolving bankruptcies takes 6 years on average with a recovery rate of about 11 percent, compared to 3 ½ years and 30 percent in the region and 1 ½ and 72 percent in the OECD.

Passage of an adequate investment law is also critical to allow full repatriation of profits, reduce restrictions on foreign investment and simplify taxes and duties.

Banking Sector Reform

Continued reform of the banking sector would also help increase the efficiency of financial intermediation, and therefore boost growth, while reducing the risk of another build up of contingent liabilities.  Moreover, the “movie” of credit boom-fueled growth, which we are seeing in Indonesia and throughout Asia, is one we’ve seen many times before.  The question is whether this time there will be a happy ending.  And we won’t know until growth slows.

While there have clearly been improvements in governance in the banking and corporate sectors, it is hard to know how much the quality of intermediation has improved, particularly credit assessment and risk management, though the fact that a significant part of credit growth is coming from state banks is cause for concern.  We also won’t really know whether creditors’ rights are stronger until they’re really needed.  Developing a credit bureau system now should be a key priority.

State banks remain a key systemic risk.  Their average ratio of compromised assets is four times the level of private banks.  The government needs to get out of the commercial banking sector.  We had seen time and again in Indonesia and elsewhere that large state-owned commercial banks are fiscal time bombs.

Treasury Support

Treasury’s Office of Technical Assistance has provided several advisors on a variety of issues to Indonesia and sent a tax advisor in February.  Treasury works with the multilateral development banks as they coordinate their programs in Indonesia.  Treasury is also working with Indonesia to combat money laundering activities and prevent the financing of terrorism.  This is critical, most importantly for Indonesia which has suffered greatly from terrorist attacks. As we know, there are terrorist groups in Indonesia using the financial sector.  While some progress has been made, getting off the FATF non-cooperative list will require demonstrable signs that enforcement is improving.

Treasury is also very supportive of Indonesia’s White Paper, which provided inspiration for the Policy Monitoring Arrangement (PMA) proposed by the United States and being considered by the IMF Board of Directors.  It is a new type of IMF engagement based on enhanced surveillance, not lending.

Conclusion

In conclusion, the new president has a strong mandate to embrace a broad reform agenda, strengthen substantially the investment climate, raise potential growth and create jobs.  I hope that the new government will shift into high gear and make economic reform one of its top priorities for long-lasting benefits to the economy and to the Indonesian people.

Thank you. I look forward to a vigorous debate.