Since March this year, 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.

The Indonesian Government has done much 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.

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.

As recovery proceeds, reducing debt will be necessary to
ensure government demand for funds does not push up interest rates and squeeze
out private sector investment. 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.

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.

It is not just important to encourage more investment, but
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.

New foreign direct investment 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 produce competitively. Other potentially positive
developments for investment efficiency are legislative reforms to strengthen
economic and corporate governance, including tightening financial sector
prudential controls, introducing the new bankruptcy act, competition policy
legislation, the central bank independence act, and establishing anti-
corruption commissions. The Government has appointed ad hoc judges to some key
bankruptcy cases, and rotated Jakarta judges to the provinces. However, the
Government has made less headway implementing other regulatory and legal
reforms, particularly anti-corruption measures. On the negative side,
corporate debt workouts have been very slow. The large majority, maybe up to
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.

Post crisis governments have made very mixed progress on
improved equity outcomes. 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. Higher government
debt service costs are threatening spending on education and social services.

The Indonesian Government's relatively modest success to
date in implementing these economic reforms is likely to reduce growth below
long term potential levels - which is about 6.5 to 7 per cent per year.

A 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 could 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.

Dr Frances Perkins is Executive Director of the East Asia
Analyitcal Unit, in the Department of Foreign Affaires and Trade and Brendan
Berne, is acting Director, EAU. The Unit's report Indonesia - Facing the
Challenge was released yesterday.