Indonesia: Facing the Challenge

Since March 2000, East Asian share markets have fallen 21 per cent, wiping about US$1.2 trillion off their capitalisation. This fall in part reflects investor disillusionment with the slow implementation of East Asian post crisis reform programs and perceived lack of official commitment to them. 

When even the Republic of Korea, which recovered first from the crisis, is suffering from market scepticism, what are the lessons for Indonesia, the slowest recoverer? The obvious answer is that if East Asia is to regain past growth levels, reforms must go further and faster than many governments initially believed necessary; reform fatigue is not an option. 

Challenges facing Indonesia 

Sometimes looking beyond the media hype to make a calm analysis of an economy's prospects can be difficult. This is certainly the case for Indonesia. This morning I want to draw on the main theme of this report, and discuss what are the most important challenges facing Indonesia and how is it dealing with them? 

In broad terms its challenges are the same as those of any economy - The Indonesian Government recognises it must: 

• maximise sustainable growth by providing the right environment for new investment 
• ensure existing and new investment goes where it gets highest returns with the lowest risks 
• increase equity and provide security for its citizens, ensuring social stability. 

Since 1998, Indonesia has made some real progress towards achieving some of these objectives but still is not achieving others. 

Encouraging new investment 

The Indonesian Government has done most to lift investment, but still has not achieved sustained investment growth. On the positive side, sound macroeconomic policy has encouraged growth over the last 2 years. Growth is up and inflation is down

Slides

• In 1999, the Government did some modest pump priming, pulled in money supply growth and brought down real interest rates to reasonable levels. This underpinned economic recovery in 2000. 
• However, to refinance the banking system, government debt has risen dramatically, from 23 to 94 per cent of GDP since the start of the crisis. The World Bank and IMF believe servicing this much bigger debt should be manageable, but will require the Government to use the current oil price bonanza and proceeds of government asset sales to retire debt, scrap fuel subsidies and improve tax collection. 

Also a positive is the low rupiah exchange rate, which is supporting growth based on exports and import replacement. 

• Exports are growing strongly, and while imports are recovering, Indonesia still has a large balance of trade surplus equal to 11 per cent of GDP 

Slide

• Export oriented firms and SMEs, many of which are replacing imports, are growing rapidly due to the low rupiah. These sectors already are starting to undertake new investment including by attracting foreign investment. 
• However, many local exporters and SME’s cannot access bank capital, so may have limited ability to invest. 

Potentially positive are new lower foreign investment restrictions, which eventually should promote new investment. However, large inflows won’t occur until market confidence improves and asset sales accelerate at market clearing prices. At present direct investment outflows outweigh inflows. 

Slide 

Also potentially positive is that most banks are refinanced, their profitability is improving and some are starting to lend again. Bank lending rose Rp. 12 trillion (US$1.1 billion) in June and July 2000, or 6 per cent of bank assets. 

• However, this figure includes an undisclosed amount of restructured loans. 
• Genuine new lending is probably much lower, because of the poor viability of the corporate sector. This is holding back new investment 

Because of these problems, domestic investment grew modestly for the first half of 2000, but declined again in the third quarter of 2000. 

Slide 

Better quality investment 

It is not just important to encourage more investment: the lesson of the crisis is that investment must be good quality. Here again the Government has made some progress, but realises it still has a long way to go. 

On the positive side, new foreign direct investment FDI and trade reforms should promote more efficient investment. 

• For example, lower agricultural trade barriers should encourage Indonesian farmers to grow and export more commodities they produce competitively, and allow Indonesian traders to import more commodities they can’t . 
• Few areas of the economy now have protection or monopoly trading arrangements; this will increase investment efficiency significantly 
• Similarly, removing FDI restrictions should force domestic producers to raise efficiency to compete with foreign companies, and will encourage technology, marketing and management skill transfers. 
• Trade and investment reforms also will create opportunities for Australian exporters and investors. 

Other potentially positive developments for investment efficiency are legislative reforms to strengthen economic and corporate governance, including tightening financial sector prudential controls, the central bank independence act, and establishing anti-corruption commissions. 

• The Supreme Audit Board has issued important independent audits revealing significant failures by key bodies like Bank Indonesia and BULOG, the national logistics agency. 
• The Government has tightened the bankruptcy act, recently appointed ad hoc judges to some key bankruptcy cases, and rotated Jakarta judges to the provinces. 
• However, the Government has made little headway implementing other governance reforms, particularly anti-corruption measures. 

On the negative side, corporate debt workouts have been very slow. 

• The large majority, maybe 70 per cent, of Indonesian corporates are insolvent, tying up valuable assets. Few of these firms are being liquidated. Most of their owners cannot borrow fresh funds as they are not servicing their existing debts. 
• Bankruptcy courts mainly have failed to implement new bankruptcy laws, though creditors have had some important recent wins. 
• Also, until recently, the Government has provided inadequate support for Indonesian Bank Restructuring Agency, IBRA or Jakarta Initiative debt workout processes, and political interference continues. 
• Failure to liquidate insolvent companies and bailouts like the recent Texmaco case also create major moral hazard problems. Failed entrepreneurs continue to run their companies. This could set the scene for another financial crisis in the foreseeable future. 

Particularly negative for investment efficiency is IBRA’s slow rate of selling bank and other corporate assets 

• IBRA, the government agency established to sell recently acquired assets holds bank, corporate and loan assets with a face value of about US$60 billion, 57 per cent of GDP. 
• However, its year 2000 asset sales target is only US$2 billion. IBRA claims it wants markets to recover before more sales; this is stalling restructuring. 
• IBRA controls 12 previously private banks which it has announced will be sold, including to foreigners. 
• To avoid another crisis it is important to sell these banks to efficient private sector operators. But this is not occurring. 
• The Bank Bali scandal put an end to Standard Chartered’s bid for that bank. 
• The mid 2000 sale of Bank Central Asia shares was smooth and transparent, but in October the parliament postponed more share sales in BCA and Bank Niaga till 2001. 
• The Government recognises the large inefficient state banks also need to be privatised, but no timetable has been announced. 
• Alas, sales of other state enterprise assets are progressing very slowly due to political resistance. 

Overall, despite some gains the Government has made limited progress in increasing investment efficiency. 

What About Social Equity and Stability 

Some gains have been made here, but generally the outlook for equity and social stability also is negative, at least in the short term. 

• On the positive side, trade reforms and rupiah depreciation should increase equity, encouraging employment in labour intensive manufacturing and agriculture. 
• Indonesia's new democratic institutions promise more equity in future. However, since the crisis, poverty has increased and the Government has made little progress in developing a basic social safety net. Higher government debt service costs are reducing spending on education and social services. (Fuel subsidies are greater than development expenditure). 
• New fiscal decentralisation reforms may exaggerate income inequalities, as resource rich provinces like E. Kalimantan and Irian Jaya will receive a large share of their extensive mineral and energy royalties. 
• Also a negative is the security situation. In some regional areas the transition from military to civilian police authority is proving difficult, reducing the capacity to maintain law and order. 

So, in summary post crisis governments have made very mixed progress on investment efficiency, social equity and security outcomes. 

What Does All this Mean for Business? 

The Government’s rather limited success to date at implementing these needed economic reforms is likely to reduce growth below long term potential levels - which is about 6.5 to 7 per cent per year. 

• To explore what this means for growth, the report considers 3 growth scenarios developed by the Centre for Strategic and International Studies in Jakarta for this report. These are compared to a base case without the crisis which involves growth of 6.5-7 per cent. 

Slide 

• The slow growth scenario is the most likely if the present pace of reform and restructuring is maintained. This scenario would involve only 3-4 per cent GDP growth up to 2006, recovering to 5-7 per cent after that. 
• However, if asset sales and meaningful corporate restructuring accelerates, trade and investment reforms already achieved could generate the fast growth scenario, or about 6-7 per cent GDP growth till 2010 
• The least likely but still possible scenario, another smaller crisis, and a W shaped recovery, could occur if significant backtracking occurs on reforms. This would reduce growth to -3 to 3 per cent for most of the decade, and reduce real GDP to about half the no crisis scenario level. 

Hence rapid reform and restructuring will pay big growth dividends. 

What does this mean for business? 

• The report explores many detailed sectoral opportunities for Australian business. However, in summary: 
• Businesses supplying markets dependent on domestic demand growth may need long time horizons when going into the Indonesian market, they will need to look beyond short term difficulties 
• However, many trade opportunities are emerging supplying export oriented sectors, agricultural and autos markets and services like education, IT, finance, insurance and business services where trade and investment barriers are now lower. 
• Investment opportunities also are encouraging in export and SME sectors 
  • For example, a recent survey of export oriented, mainly foreign firms in an industrial estate outside Jakarta found output had risen 50 per cent since the crisis, and production was highly profitable. 
• If investors do consider investing in government or other distressed corporate assets, they will need to undertake careful market assessment, due diligence and risk management to guard against downside risks.