Briefing Notes for World Economic Forum ,1998 East Asia Economic Summit
Economic Briefing on Indonesia, October 12, 1998, 17.15-18.00
SOCIO-POLITICAL-ECONOMIC UPDATE
- National Income: Severe contraction due to collapse of domestic demand. Most dramatic contraction in Indonesia's experience and in post world war II experience world wide:
- Decline in growth began in mid 1997, leading to 4.5% growth in 1997 and contraction in first and second quarter of 1998 amounted to -7.9% and -16.5% or first semester contraction of -12.2 percent. Not clear whether hit bottom yet.
- Sectors most affected based on first semester 1998 figures are: construction (-37%); trading (-18%); transportation and communication (-6%); financial services (-17%); and manufacturing (-13%). Agriculture sector only one experiencing positive (but low) growth of 0.25% in first semester due to exports.
- Some sectors and provinces not as affected by crisis and even enjoying positive growth: agriculture, resource based such as mining, oil and gas. Certain provinces Sulawesi and Sumatra less affected because have plantation crops which are being exported and enjoying exchange rate advantage, and also less affected by trade financing problem since very little import content.
- Main Economic Indicators Exchange rate: After being in the Rp. 14,000-15,000 in June-July, Rp. 12,000-13,000 in the August-Sept. period, the exchange rate has stabilized at Rp. 10,000/US$ since the last week of Sept. and even reached Rp. 9000/US$ in the last few days as the US$ weakened vis a vis the yen. But sustainability at this rate in question because of continued political uncertainty, lack of resumption of private inflows, and less than robust exports.
Interest Rates: downward trend. The monetary authorities had responded by doubling interest rates in August 1997 in an attempt to prevent weakening of the rupiah, but interest rated declined again to around 20-22% for one month Bank Indonesia Certificates (SBI), and 25-30% for one month time deposits at state banks (interest rates on interbank and private national banks fluctuated). Interest rates of one month SBI have been increasing since March to 45%, in April to 50% and 58% in May under IMF auspices. Auctions of one month central bank paper (SBI) began around two months ago, and interest rates have been coming down with SBI one month rate of 70.58% in early September, 64.7% in first week of October and 60.03% in second week of October. Deposit rates are set 5% below SBI rates to be guaranteed by the central bank and thus, real interest rates are negative for now.
Money Supply: currency in circulation has increased substantially from Rp. 24 trillion in June 97 to Rp. 37 trillion in January 1998 and to Rp. 45 trillion by June 1998 (i.e. almost 100% p.a. increase) as a reflection of the lack of confidence in the banking system; M1 is growing at around 50% p.a. and M2 at around 70%; and reserve money at an annualized rate of close to 80%, but the growth rate of reserve money has been coming down in the last three months.
Inflation: - Inflation in 1997 was 11% with an upward trend already evident in the last three months of 1997. Inflation picked up dramatically in the first few months of 1998 with a record of 12.8% in February alone, as well as in the aftermath of the May riots and political upheaval, and a round of depreciation of the rupiah in the May-July period, so that inflation in July and August 1998 reached 8.6% and 6.3%.
- Main causal factors of inflation: high due to exchange rate (3-6 month lag effect), increased liquidity in first few months of 1998, and disruption of supply of basic commodities due to May riots, drought, and other factors.
- Inflation rates are beginning to come down with September figure of 3.75%, the lowest since January. Inflation January-September now at 73% and expected to be around 85-90% by year end.
Fiscal Policy: - After a series of revisions, IMF has shown greater flexibility on fiscal targets - shifting from 1% surplus with the first IMF package to -3.5% deficit in April 1998 and then -8.5% deficit in June 1998. fiscal deficit allowed equivalent to -8.5% of GDP (Rp. 81.5 trillion)
- The revised budget for 1998/99 of Rp. 264 trillion, is based on the assumption of contraction of 12 percent, inflation of 66 percent, exchange rate of Rp. 10,600 and oil prices of $13/barrel.
- Main policy dilemma: ensuring fiscal discipline, optimizing and running effective social safety net programs (i.e. targeting subsidies) and minimizing inflationary impact of fiscal deficit; this means avoiding populous programs that are introduced as the present government attempts to maintain power and popularity, and in the run up to elections. Due to disruptions in government due to political changes, the disbursement of these programs have been below target and need to be stepped up.
- Out of the deficit of -8.5 percent of GDP allowed, 6.2 percent of GDP is allocated for subsidies (i.e. Rp. 58 trillion), and out of that amount 61.2 percent is for electricity and fuel, and only 23.5 percent is for subsidizing food (i.e. rice, sugar, soybeans, wheat flour, corn etc.) and 1.5 percent for medicine. Need to rethink how to implement targeted subsidies more optimally
- Further adjustments to administered prices, especially fuel and electricity will also be undertaken in this as well as next fiscal year. A mechanism for regular adjustments to administered prices will be introduced in 1999/2000.
Balance of Payments: - Current account deficit declining to -1.4% of GDP by 1997/98 with non oil export growth still being sustained at 17% p.a. but oil exports declining by 19% so that export growth was only 8%; imports already declining by 6%. Since then, non oil export growth appears to have declined to 5% in January-May period compared with previous period and projected to grow at only 5% in the 1998/99 period. Despite exchange rate advantage, non oil export growth not as robust due to problems with trade financing experienced due to the banking sector problems and sluggish markets. Oil exports also projected to decline by 20% in the 1998/99 period due to the fall in prices so total export growth projected only at 0.5%. Import growth has slumped with a 37.4% decline in the January-May 1998 period compared with the same period in 1997, and projected to decline by 38% p.a. by end 1998/99
- Capital outflow - net outflow of $7.6 billion in 1997/98 out of which $11.8 billion net private capital outflow compared with $13.5 billion net private capital inflow in the previous year. Net outflow result of repatriation of portfolio investment, outflow of capital due to confidence problems, decline in new investment and credit. For the next two years, the source of capital inflows will be mainly official.
- At the end of October 1997, Indonesia received a pledge for loans amounting to US$42 billion from these various sources, with the first commitments amounting to US$23 billion and the remaining being defined as second line to be used only if needed and which further approval from sources and domestic governments still needed.
- In addition to the IMF led package, the Indonesian government will also receive the usual CGI (Consortium for the Government of Indonesia) annual loan which was approved in July at $8 billion or higher than the usual amount of $4-5 billion.
External Debt: one of the crucial vulnerabilities of the crisis countries has been the large debt overhang, especially of the private sector. In the case of Indonesia, as of March 1998, the total external debt amounted to $138.02 billion, out of which $65.56 billion is public sector debt (i.e. government and state enterprises) and $72.46 private sector.
Stock Market: the Jakarta Stock Market Index has slumped along with the exchange rate, coming down from 730 in July 1997 to close to 330 in January 1998, recovery to around 500 in the February-April period and hovering around 450 between May-early August. Since early August the index has declined precipitously to only around 250 by end of September due to fluctuations in exchange rates, uncertainties in economic and political outlook, and problems in privatization. Only in last week good news of exchange rate strengthening led to a surge in the exchange of 8.4%. Social Indicators
Unemployment figures: government estimate of unemployment continues to rise from 14 million earlier in the year to 18 million at present, and estimated to be 20 million by end 1998 out of labor force of 90 million. If numbers under employed included, the picture is grimmer.
Poverty nos.: according to government numbers, 79.4 million people fall below the poverty line due to rising prices and declining incomes.
Declining Buying Power: - Increase in food prices amount to more than 100%; 60% of average consumption basket comprises food, beverage and tobacco whose prices have risen by 100% and meanwhile wages increase not compensate (e.g. average manufacturing wage up by 20% only), people have lost jobs or taking pay cuts.
- Per capita income has declined in dollar terms from $1,055 in 1997 to an estimated $436.3 at present (using exchange rate or Rp. 10,600/US$). In rupiah terms per capita national income increased from Rp. 3 to Rp. 4.6 million over the pre crisis 1997 level to the present situation but because the increase is lower than inflation, this implies a decline in per capita real purchasing power.
Rice crisis and increased social unrest: - Drought conditions, a disappointing second harvest, disruptions on distribution due to a change in the system as well as subsidized prices which in fact led to increased smuggled exports, and some panic hoarding, led a rice shortage problem in July-August and rice prices increased again, making the total rice price increase of more than 100 percent since the beginning of the year.
- The government with IMF support has a seven point strategy for rice: flood the market with rice, release at less than market price, increase direct deliveries to retailers and cooperatives, VAT on rice (and other essential commodities) temporarily suspended, expand provision of rice at very subsidized prices to poor households to 2 million households with help from provincial governors and is planned to be extended further to 7.5 million poor families by October, close new import contracts to ensure stocks remain adequate, and allow private traders to import rice.
- Increased rice prices and unemployment, have in turn led to worsening social unrest with increased reports of looting and, crime. The worsening social conditions are evident from the increased frequency of street children, malnutrition, and children being taken out of schools.
- Implementation of Stabilization and Recovery Measures, Structural Reforms and Policy Direction
Indonesia has been on the IMF program since October 31st 1997 and since then there has been several revisions of targets and policies to be implemented due to political changes as well as a change in IMF approach. In all the packages there are several main components: macroeconomic stabilization and policy along with targets; structural policies in trade, investment, banking restructuring, and privatization; social safety net; and other policies such as the competition policy. Macro targets are more or less on schedule for the latest revision of the IMF package, with IMF more willing to be flexible on fiscal policy and easing off on pressuring higher interest rates; shift attention to inflation control. However, targets of exchange rate of Rp. 10,600, lowering of inflation, targeted subsidies, and positive growth by 2000 still clouded by uncertainty.
The progress on structural and other reforms can be summarized as follows.
Trade and Investment: - Reduce tariffs and remaining quantitative import restrictions and non tariff barriers by 2003/end of IMF program; reduce export taxes on logs, sawn timber, rattan and minerals to a maximum of 30% by April 15, 1998; 20% end December 1998, and 15% by end December 1999, and 10% by end December 2000 - phase in resource rent taxes on logs, sawn timber, rattan and minerals; eliminate all other export restrictions.
- Removal of import subsidies on wheat, sugar, and soybeans was eliminated on September 2nd 1998 and opening up of imports of wheat, wheat flour, soybeans and garlic; sale or distribution of flour; and importation and marketing of sugar. The removal of subsidies will also mean that export bans, except for rice, will be eliminated. It is not clear whether there will be large price increases as a result of the removal of subsidies as there are two forces at work: removal of the exchange rate subsidy on the one hand and supposedly increased efficiency and competition on the other.
- Lift restrictions on foreign investment in wholesale trade-done but delayed due to revisions in implementing regulations.
Banking Restructuring: Nature of the problem: - After the closure of the 16 banks as part of the first IMF package in October, there was a run on private domestic banks (remaining 143 national private banks out of 221 banks) which continued in the following months as confidence declined due to deterioration of the political and economic situation. As a result the central bank has had to give a large amount of liquidity support to these banks. Despite the introduction of a guarantee on deposits in February, confidence in the banking system was not restored, and in May during the riots there was another run which affected the largest private bank most due to its close connections with the Suharto family.
- The liquidity support provided by the central bank to the banks, mostly domestic private banks, increased from Rp. 14.6 trillion in June 1997, to Rp. 23 trillion at the end of 1997, Rp. 72 trillion by March 1998 and to Rp. 124 trillion by June 1998. The amount of liquidity support represents an increase from 35% to 228% of capital equity of the commercial banks, and 3.4% to 12.2% of total assets of the commercial banks over the June 1997-June 1998 period.
- Of course many of these banks were also severely weakened by the crisis whether because of their over exposure to dollar loans directly or indirectly through the corporations they loaned to, and the impact of the deterioration of the economic situation on their non performing loans. Many also violated the legal lending limit, with an average of 60% of loans being given to own group in the case of the banks closed under IBRA.
Restructuring program under IMF and implementation: - Indonesian Banking Restructuring Agency was set up in January, and after two weeks of establishment 54 banks were put under IBRA based on capital adequacy less than minimum standard of 5% and use of liquidity support from BI which exceeded 200 percent of stored up capital.
- In April out of the 54, 7 were frozen (i.e. those using liquidity support amounting to more than 500 percent of stored up capital) and 7 others had its management taken over by IBRA.
- After the May riots, BCA which experienced a substantial rush on their deposits was also put under IBRA.
- The implementation of IBRA has been slow due to the changes in Ministers and the head of the institution, but since June it has been running under a new and professional management team. The asset management unit is under IBRA.
- On August 21, after the international audit was completed, resolution of seven major banks taken over by IBRA and seven frozen by IBRA was announced. Owners were given until September 21 to come forth with the payment of the liquidity support they received from Bank Indonesia as well as for lending given to their own group. The debt is to be paid through the sale and pledge of their assets. After the September 21, 1998 deadline passed, IBRA has now given the owners another month to come up with a plan to realize the value from their assets to be paid back to the Central Bank. The asset realization can be done over a period of five years, and meanwhile interest payments have to be made.
- As for the remaining banks, an international audit will be undertaken and a recapitalization plan laid out for those which are still viable by various criteria, including capital adequacy. Others will be asked to merge or inject new capital, or be closed down.
- Four state banks will be merged into one, and two remaining ones allowed to continue.
- Changes in banking law also needed to facilitate restructuring process such as allowing speedy transfer of assets to its asset management unit, reform bank secrecy laws, and eliminate legal restrictions on foreign ownership of listed banks (plan to be passed October 20).
- The strengthening of the banking system involves a total restructuring and tightening of regulations as well as improving supervision. The problems are complex and it will be a true test of IBRA's independence and authority to act if all the rules and regulations can be implemented fully, and write down of share holders equity and take over of their assets can take place fairly.
Privatization - There has been a revision with revenue target of the sale of state owned enterprises (SOEs) due to problems encountered in privatization and the absorption capacity of the market; it is likely that the plan to divest seven SOEs by end of March 1999 is likely to be revised. Problems encountered are clear from the Krakatau Steel and Semen Gresik experiences, indicating conflicts between the existing bureaucracy and the Ministry of SOEs, as well as the objective of maximizing revenues and nationalism.
- The framework for privatization has also not been made clear despite the end of September 1998 deadlines for the privatization of state owned enterprises (SOEs): a framework for reform of all state enterprises, including a transparent sale process; action plans for all 164 SOEs; and develop plan for dealing with unlivable SOES. According to the IMF target, by year end there will be an international audit of the state oil company, Pertamina; state electricity company, P.T. PLN; BULOG and the reforestation fund. Also preparations for a number of cases including cement, some areas of telecommunications, mining, plantations and infrastructure are supposed to be well advanced.
- The uncertainty has certainly had its toll on the stock market, with part of the decline in recent weeks being caused by dumping of shares in SOEs previously thought to be on offer.
- The process is likely to be slower than scheduled due to the complexities, lack of complete framework, market absorption capacity and low investor interest in emerging markets.
Competition Policy - By end of December 1998, Indonesia should introduce draft of competition law. A draft exists and will be submitted to the House of Representatives by year end. An independent body like the Fair Trade Commission will be created to implement the law and regulations. The press reports indicate that the law will include specific quantitative definition of market dominance which constitutes a "monopoly"; it could be 40-75%. Exceptions to monopoly based on cooperatives or small and medium sized enterprises or type of sector (i.e. natural monopoly) still being discussed - likely to be by government.
Bankruptcy Reform - Government regulation instead of bankruptcy law of 1905 was introduced in April and announced will be effective as of August 20 1998. The four months interim was used to prepare the court and its judges; the court is supported by technical assistance by the IMF and other contributors. The changes introduced, with clear deadlines linked to actions to be taken, are meant to ensure that the court proceedings are efficient, transparent and predictable. In the past there were very few bankruptcy petitions (33 in all the years) and took a long time to reach a decision and even longer to foreclose. Examples of 5-15 years are not uncommon.
- Special Commercial Court opened as schedules on August 20 and has received and registered a number of bankruptcy petitions.
- First decision is disappointing - the new bankruptcy court threw out its first important case on a technicality. The case involves creditors including American Express Bank, Fuji Bank Indonesia, and Bank Negara Indonesia, and involve PT Ometraco Corp., a company with interests in poultry, pharmaceuticals, electricity distribution. Due to technicality the case was deemed not to belong in the bankruptcy court, but should be dealt with under the normal court procedures, which are deemed to be ineffective and not timely.
Corporate Debt Restructuring on Voluntary Basis - The corporate debt problem remains unresolved despite the introduction of various mechanism to resolve it. For large corporations 2/3 of their debt estimated to be foreign and 1/3 to be domestic. Therefore solving external debt problem is key. The magnitude of the problem becomes large at today's exchange rate or around 60-70% depreciation and with an uncertain outlook ahead to be able to project cash flows. The availability of foreign exchange is not sufficient of a carrot, there probably needs to be some sort of debt relief built in, as well as an effective stick, such as a well functioning bankruptcy and foreclosure procedures.
- Present mechanisms on paper:
- The Frankfurt agreement and the creation of the Indonesian Debt Restructuring Agency (INDRA) is aimed at providing the needed foreign exchange for corporations to be able to pay their debt. However, it requires that debtors and creditors negotiate a schedule of repayment and amount of discount if any on the loan before registering to INDRA, which will then pay the creditor in foreign exchange while the debtor pays INDRA in rupiah. The debtor will have to start payment immediately and pay an interest in rupiah which is calculated as 5 percent real interest (i.e. some inflation rate figure plus 5 percent).
- The Jakarta Initiative was introduced on 9th September which sets out principles that will facilitate out of court corporate restructuring to apply to both domestic and foreign creditors. The principles are intended to promote the availability of interim financing to companies being restructured and the provision of information by these companies so restructuring can be evaluated by their creditors. A government task force (the Jakarta Initiative Task Force) has also been set up with Jusuf Anwar from the Capital Markets Monitoring Agency (Bapepam) as the executive chairman. The task force will also provide a forum for one stop facilitation of regulatory applications for restructuring plans. While the initiative was supported by the IMF and the World Bank, there is as yet no mechanism or carrot-stick package to put pressure on creditors-debtors negotiations.
Policy Direction: ambivalence?
Despite implementation of IMF reforms and apparent stabilization due to IMF funds disbursement, the direction of policy remains ambivalent due to the lack of credibility of the present government and the continued lack of confidence in its ability to manage the crisis. The feeling of insecurity post the May riots remains, and the growing crisis against the authorities is evident with increased frequency of crime, disturbances, and societies taking the law into their own hands in judging local officials misconduct. There are also signs of politicizing of many economic policy decisions, with conflicts evident between the technocratic/IMF approach and having to accommodate for:
- popular or populist policies in the name of helping the poor and the weak/small enterprises - which is often translated as using cooperatives as the vehicle to ensure that the well being of the people are taken care of;
- nationalist sentiments;
- anti-large or anti conglomerate sentiments.
- Political Developments: Continued uncertainty for next 14 months
- Political uncertainty likely to continue until Presidential Selection. President Habibie has outlined the national agenda: Special General Session of the Peoples Consultative Assembly (MPR) on November 10, 1998; general party elections in May 1999; and General Session of the MPR in December 1999 to select the new President.
- November 10 Special session will layout basic guidelines for various changes in political laws pertaining to elections, formation of political parties, terms of Presidency, structure of Peoples Consultative Assembly and House of Representatives, and establishing legitimacy of President Habibie.
- Main issues of new laws and regulations: proportional representation vs. district; simple majority vs. absolute majority to determine the winning political party; mechanism overseeing the elections; proposed rules for participation of political parties in elections which right now favor existing parties due to requirements for district and provincial representation in more than half of the districts and provinces; limitations on the term of the presidency; role of Armed Forces; and allocated seats for "functional groups".
- While there maybe moves to unseat President Habibie as transition leader or pressure to change his cabinet, in the absence of a stronger group within the existing members and continued support of the President by the Armed Forces, it is difficult to see any change in the immediate term.
- Therefore change can only come about through the election process, and it will be important for the elections to be held in a fair and transparent manner. It would appear that whatever the new rules set up, as long as there is a reasonably fair election, then the government party Golkar is unlikely to gain an unchallenged majority and it is likely that a coalition will have to be formed between the major parties Megawati's PDI, NU based parties, and a combination of other Moslem based parties such as the existing PPP, and the rainbow coalition party of Amien Rais. For now it is difficult to predict who would emerge as a leader under such a scenario and how decision making with regard to policy will be conducted, however, it is clear that accommodations will need to be made for the different interests.
PROSPECTS
Worse yet to come?
Full effects of downward spiral not felt yet - will worsen before get better due to economic and political developments. Economic uncertainty with regard to banking and corporate debt restructuring, and ambivalence in policies due to interactions with political development will continue to affect confidence levels and therefore resumption of private flows. Political uncertainty can be expected until end of next year as Indonesia muddles through a process of nascent democracy.
Economic stabilization and recovery?
There are some signs of temporary stabilization:
In the 1960s crisis, it took three years to reach stabilization and normal growth from the time of a change in regime. The prospects beyond 1998 are very difficult to assess. At best positive growth will only be achieved at the earliest in the year 2000, with negative growth still being expected in 1999 since one may have to wait until the end of 1999 for there to be certainty with regard to the political leadership and policy management. It will then take another two to three years, that is by 2002-2003 before normal growth of 5-6 percent will be reached (gradual V-shaped recovery), given that no sharp turn around is expected based on domestic or external factors. Furthermore, it will take at least 8-10 years to get back to the real level of income of 1997 and even longer to reach the real level of per capita income of 1997 (used as a rough measure of real purchasing power).
Note that basis of recovery still relatively strong: a well established industrial and agriculture base where there are segments which are competitive internationally; relatively high domestic savings; and existence of human and fixed capital base. Main issue in emergency and short term response is to prevent the erosion of this basis of recovery so when turn around occurs, will be shorter period rather than longer, and ensuring protection of the most vulnerable class in society.
Exchange rates are targeted by the government to reach an average of Rp. 10,600 by March 1999 and this maybe attainable given the disbursement of IMF funds leading up to that period, but may not be sustainable thereafter given elections in May and possible riots in the coming months. Exchange rate stabilizing at Rp. 9000-10,000 can only be sustained with resumption of private capital inflows and exports. Inflation rates are coming down although pressure on prices will continue in the coming months from further removal of subsidies and controlled prices (especially electricity and fuel); wage increases which have not been fully adjusted; price increases to the extent there is further fluctuations in exchange rates and supply of basic goods. Interest rates are unlikely to fall any further without a strong trend of inflation falling and greater confidence about exchange rate stability. Expect little change in the next six to 12 months.
Political Uncertainty will Continue to Cloud Recovery
The political outlook is even more difficult to predict. It is possible that the country will embark on real political reforms after the necessary changes in the political laws and regulations, and a coalition of sorts will emerge out of the elections in May. While the management of the crisis may experience problems due to the need to accommodate different needs of the coalition, in the medium term the process of democracy that results will be important for the sustainability of Indonesia as a nation. However, there is also the other possibility that the political and economic situation will continue to deteriorate and the government will be powerless to do much, and there could be another transfer of transition power before the elections.
It may be a muddling process in the next 14 month or so, with all the economic and social costs. However, there is not much choice but to undergo the process and try to avoid total chaos.
In the medium term Indonesia will hopefully then emerge as a stronger nation based on:
open political system and democratic and participatory processes to ensure good governance; it is hoped that the desire for freedom after 32 years of repression will be translated into real democracy and not be captured again by special interests with an agenda that will not benefit the nation as a whole.
credible and workable commitment to openness of the economy and good governance
more autonomy and decentralization of its regions
there will be a natural process of selection whereby the ownership of Indonesian corporations, Indonesian Chinese and non Chinese, will be changed dramatically with a likelihood of increased foreign ownership as well as state ownership and in such a case the focus must be pragmatic. Dominant foreign ownership is acceptable if it can create jobs, know-how, linkages and are good corporate citizens who do not exploit the environment and follow or even set the example for good corporate governance.
medium term prospects for Indonesia remain positive given natural resource base and size of market.
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