Developing Country Debt and Economic Performance, Volume 3: Country Studies--Indonesia, Korea, Philippines, Turkey (National Bureau of Economic Research Project Report)

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Developing Country Debt and Economic Performance

A National Bureau of Economic Research Project Report

Developing Countrv Debt and Economic Performance Volume

3

Edited by

Country StudiesIndonesia, Korea, Philippines, Turkey

Jeffrey D. Sachs and Susan M. Collins

The University of Chicago Press

Chicago and London

JEFFREY D. SACHSis the Galen L. Stone Professor of International Trade at Harvard University and a research associate of the National Bureau of Economic Research. SUSAN M. COLLINS is an associate professor of economics at Harvard University and a faculty research fellow of the National Bureau of Economic Research.

The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London 0 1989 by the National Bureau of Economic Research All rights reserved. Published 1989 Printed in the United States of America 98 97 96 95 94 93 92 91 90 89 5 4 3 2

1

@The paper used in this publication meets the minimum requirements of the American National Standard for Information Sciences--Permanence of Paper for Printed Library Materials, ANSI 239.48-1984.

Library of Congress Cataloging-in-PublicationData (Revised for Volume 3) Developing country debt and economic performance. (A National Bureau of Economic Research project report) Papers presented at a conference held in Washington, D.C. on Sept. 21-23, 1987. Includes bibliographies and indexes. Contents: v. 1. The international financial system-v.3. Country studies-Indonesia, Korea, Philippines, Turkey. 1. Debts, External-Developing countries-Congresses. 2. Developing countries-Economic conditions-Congresses. 3. International financeCongresses. I. Sachs, Jeffrey. II. Series. HJ8899.D48 15 1989 336.3'435'091724 88-20866 ISBN 0-226-73332-7(v. 1 : alk. paper) 0-226-73335-1(v. 3 : alk. paper)

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Contents

Preface

X

Debt, Policy, and Performance: An Introduction Susan M. Collins

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Book I

Indonesian Economic Policies and Their Relation to External Debt Management Wing Thye Woo and Anwar Nasution

17

1. Introduction and Summary

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2. Political and Economic Instability, 1950-65 3. The Political Economy Factors in Policymaking 4. The Fiscal System

32

5. Monetary Policy and Financial Structure 6. Exchange Rate Policy 7. External Debt Management 8. Conclusions and Prospects Notes References

Book I1

External Debt and Macroeconomic Performance in South Korea Susan M . Collins and Won-Am Park

56 67

83 96 114 130

140 146

151

1. Introduction

153

2. Historical Background: Economic Development Prior to 1962

159

vii

viii

Contents

3. An Overview of Korea's External Debt

170

4. Three Cycles of Debt Accumulation, 1960-86

182

5. Internal versus External Shocks

206

6. Introduction to Part Two 7. Korea's Rapid Growth

219

8. Savings and Investment

234

9. Exchange Rate, Trade, and Industrial Policy 10. Exchange Rates, Wages, and Productivity 11. Fiscal and Monetary Policy 12. Income Distribution 13. Lesson's from Korea's Experience: A Synthesis Data Appendix Notes References

Book I11

The Marcos Legacy: Economic Policy and Foreign Debt in the Philippines Robert S. Dohner and Ponciano Intal, Jr.

218

249 270 282 300 3 19 330 358 362

37 1

1. Introduction

373

2. Government Expenditure and Revenues

40 1

3. Trade Policy, Industrial Policy, and the Exchange Rate

433

4. Government Interventions and Rent Seeking

460

5. The Philippine Financial System and the Debt Crisis

48 1

6. External Debt and Debt Management

503

7. Debt Crisis and Adjustment

524

8. The Aquino Government and Prospects for the Economy Notes References

558 607

Book IV

615

Debt, Adjustment, and Growth: "hrkey Merih CelGsun and Dani Rodrik

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PARTI POLICY PHASES AND ADJUSTMENT PATTERNS 1. Turkish Economic Development: An Overview 2. Economic Boom and Debt Crisis. 1973-77

617 629

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Contents

3. Crisis Without Adjustment, 1978-79 4. Stabilization and Adjustment Policies, 1980-85 5. Performance and Adjustment Patterns in the 1980s

655 662 679

PARTI1 SELECTED ASPECTSOF DEBTAND ADJUSTMENT 6. External Borrowing, Real Wage Flexibility, and Equilibrium Exchange Rates: A General Equilibrium Analysis 7. Trade Regime and an Anatomy of Export Performance 8. The Public Sector: Fiscal Adjustment and Resource Mobilization 9. External Financial Relations and Debt Management 10. Conclusions and Prospects Appendix A. Political Chronology Appendix B. Statistical Appendix Notes References

702 716 73 1 750 76 1 768 77 1 797 804

Biographies

809

List of Contributors

810

Name Index

81 1

Subject Index

815

Preface

This volume contains four country studies that were prepared as part of a research project by the National Bureau of Economic Research on developing country debt. Studies of Argentina, Bolivia, Brazil, and Mexico have been collected in a separate volume. In addition to the eight country studies, this project includes eight papers that examine other debt crises that occurred before World War 11, the role of the banks during the current crisis, the effect of developed country economies on the debtors, as well as possible solutions to the debt crisis. These papers have also been published in a separate volume. A fourth book contains shorter and less technical summaries of all sixteen papers. The findings of NBER’s debt project were presented at a conference for government officials of lending and debtor countries, economists at international organizations, and representatives of banks and other private firms with interests in the debtor countries. The conference was held in Washington, D.C. from 21-23 September 1987. We would like to thank the Agency for International Development, the Ford Foundation, Mr. David Rockefeller, the Rockefeller Brothers Fund, the Starr Foundation, and the Tinker Foundation for financial support of this work. The success of the project also depended on the efforts of Deborah Mankiw, Yasuko MacDougall, Kirsten Foss Davis, Ilana Hardesty, Robert Allison, and Mark Fitz-Patrick. Jeffrey D . Sachs and Susan M . Collins

X

Debt, Policy, and Performance: An Introduction Susan M. Collins

For the developing countries, the 1970s were a time of growing external indebtedness but strong real growth. Borrowing seemed to be part of a sensible strategy of growth and development. In the 1980s, however, the role of foreign borrowing was much less innocuous. After 1982 the majority of heavily indebted countries found themselves in the midst of a debt crisis which was more severe and more persistent than most observers had predicted. Growth rates were stagnant and often negative. In many cases, per capita incomes in 1987 were below their 1980 levels. Fixed capital formation as a share of income declined precipitously, diminishing prospects for future growth. More troubling, the indicators of debt burden rose in a large number of countries. The debt crisis remains a long way from resolution. At the same time, there have been substantial differences in the experiences of the heavily indebted countries. Some countries announced debt moratoria while others avoided a crisis and countinued to repay their debts on, or ahead of, schedule. Some maintained relatively high growth rates and financial stability during the early and mid-l980s, while others wrestled with exploding inflation. These diverse experiences raise interesting and important questions about the roles of foreign borrowing and macroeconomic policy for small, open economies in an uncertain world environment. How did those countries which navigated the series of external shocks more successfully differ from those which are still struggling to “adjust”? Did they simply borrow more prudently? How are the differences in performance attributable to the The author would like to thank Geoffrey Carliner, Dani Rodrik, and Eliana Cardoso for comments and Donna Zenvitz for editorial suggestions. Of course, the author retains responsibility for the views expressed.

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SusanM.Collins

severity of external shocks as opposed to current and previous policy actions? How did external debt interact with political, social, and economic structure? The NBER country studies (volumes 2 and 3) examine in detail the policy and performance of eight heavily indebted developing countries: Argentina, Bolivia, Brazil, Korea, Indonesia, Mexico, the Philippines, and Turkey. The countries differ in many ways. Indonesia and Bolivia are low-income countries while the rest are middle income. Mexico and Indonesia are oil exporters, Bolivia exports natural gas and some oil, while the other countries are oil importers. Korea, Indonesia, and Turkey had relatively strong macroeconomic performance in the early to mid- 1980s, although foreign borrowing played a central role in their development. Brazil did relatively well during 1982-84, but emerged as a “problem debtor” by 1986. In Argentina, Bolivia, Brazil, and Mexico, price instability interacted with external debt to exacerbate the difficulties of stabilization and structural adjustment. In those countries and in the Philippines, improved external balance came at the expense of domestic investment and growth prospects. Thus, the allocation of domestic resources among investment, consumption, and net transfers abroad to service the debt remains a critical issue. Each study takes a broad perspective, examining the role of debt within the context of macroeconomic policy and performance. While there is no single model or approach, there are common elements throughout. In particular, the focus is on the debtor country’s perspective. Also, each study contains extensive data tables in the text and appendices. Finally, the authors have attempted to integrate social and political factors into their analyses and to emphasize the importance of historical context. The most striking aspect of these country studies is the similarities in their conclusions. It appears that countries which performed well in the 1980s differed from the other countries in three fundamental ways. First, they maintained stable and competitive real exchange rates. Second, they were successful in having a disciplined fiscal policy, containing budget deficits and maintaining a broad tax base. Third, they emphasized investment with incentives for capital accumulation in export sectors. While microeconomic policies, the trade regime, and the severity of external shocks all played a role (especially in the Philippines), these three macroeconomic policies stand out in explaining the range of performances. The next section provides a brief overview of the experience of each country. The third section turns to a cross-country comparison of the role of foreign borrowing and macroeconomic policy in the diverse performances.

External Debt and Macroeconomic Performance Three of the countries, Indonesia, Korea, and Turkey, maintained moderate to high real growth in the early to mid-l980s, with foreign borrowing playing a central role in each experience. In Indonesia, balance of

3

Introduction

payments difficulties erupted in 1966. They resulted in a debt rescheduling and a coordinated, long-term plan of official assistance. Turkey’s external crisis came in 1977, after the first oil price shock but well before repayment difficulties emerged in the other heavily indebted countries. Finally, Korea’s economic crisis began in late 1979 as a result of external shocks and internal political and economic factors. The crisis was relatively short, as performance had improved considerably by 1981. While Korea did not reschedule its debts, it did undertake a substantial shift in economic policies. The Philippines presents a stark contrast. Economic performance deteriorated sharply during the 1980s, and the economy remains far from a path of stable growth. In many respects, the Philippine experience was similar to Mexico’s. Both borrowed to finance capital flight and public investments which did not pay off in long-term growth or foreign exchange earnings. However, Mexico exports oil while the Philippines is an oil importer. In Argentina and Brazil the main economic problems revealed themselves in the form of inflation rather than as pressure on the external balance. However, debt played a central role both in fueling the inflation and in compounding the difficulties of debt reduction. South Korea South Korea is widely heralded as an economic success story. In 1987 real growth was 12 percent, inflation was just 3 percent, and the trade surplus had risen to nearly 9 percent of GNP. However, as Collins and Park emphasize, Korea was not always a high growth surplus country. On the contrary, it faced a severe crisis in 1980. Real output declined by 5 percent, inflation rose to nearly 30 percent, and the trade deficit mushroomed to 9 percent of GNP. Korea borrowed heavily to finance these deficits and by 1981 was the fourth largest debtor country in the world, behind Argentina, Brazil, and Mexico. How then was Korea able to combine external adjustment with real growth and price stability? A poor, war-devastated economy heavily dependent on foreign aid in the 1950s, Korea embarked on a new economic strategy of active export promotion and emerged as a newly industrialized country with growth rates averaging over 9 percent per year in the mid-1960s and 1970s. High rates of investment in exportables and competitive exchange rates, with credible and consistent incentives to exporters, are the key factors behind Korea’s growth. Fiscal policy was used countercyclically, but budget deficits were not allowed to become large. Initially, domestic saving rates were very low, and high rates of investment were financed by extensive foreign borrowing. A remarkable aspect of Korea’s development has been a trend rise in aggregate domestic savings from less than 6 percent of GNP in the early 1960s to over 30 percent by the mid-1980s. Korea’s economic strategy shifted during the early 1970s. Concerned about industrial deepening and building up military strength, policymakers launched the Big Push to develop heavy and chemical industries in 1973.

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Susan M. Collins

Investment was to be increased and concentrated in these sectors. However, the period coincided with the first oil price shock and slowdown in world growth. Korea decided to pursue the Big Push nonetheless and borrowed heavily to finance the investments. While fiscal policy was expanded to stimulate growth, the exchange rate was devalued and then fixed, and heavy taxes were imposed on petroleum products. World demand recovered during 1976-78, improving Korean export performance, and high growth rates resumed. Savings rose and the current account deficit was eliminated. However, a growing number of economic dislocations became apparent. The real exchange rate began to appreciate, export growth slowed, the current account deteriorated, and inflation surged. The government began to intervene more heavily in domestic markets, controlling prices, restricting imports, and rationing credit. As the other country studies make clear, this is the same pattern that emerged in countries which ran into difficulty. Korea differs in that these distortions were addressed before they became extreme. Policymakers became increasingly concerned about inflation and economic distortions. A new stabilization plan, announced in 1979, called for monetary and fiscal restraint, gradual reductions in price controls, and trade and credit market liberalizations. This policy shift was initiated before domestic authorities were forced to adjust since the oil shock had not yet hit, and foreign lending was still available. Interestingly, the initial program did not call for devaluation despite the fixed exchange rate and resulting appreciation. The exchange rate adjustment came in January 1980 in the midst of the crisis. Still, Korea’s overvaluation was corrected after the real exchange rate had appreciated by 25 percent. In contrast, Argentina experienced a real appreciation of over 80 percent between 1977 and 1980, before an adjustment was undertaken. Despite the severe shocks which hit Korea in 1979 and 1980, a full-scale debt crisis was avoided. However, the assassination of President Park, disastrous agricultural harvests, the rise in oil and commodity prices, higher interest rates, and the slowdown in world demand all contributed to very poor economic performance in 1980. Collins and Park point to four key elements which explain the impressive economic turnaround between 1980 and 1985. First, Korea was given breathing space by foreign creditors for the stabilization and structural adjustment. The devaluation did not generate an immediate export recovery. But fiscal policy was expansionary in 1980-81 to stimulate growth. Imports were contained, not through recession but because of the recovery in agricultural output which reduced food imports and boosted growth. Korea continued to borrow in the early 1980s to finance the (shrinking) current account deficits. The economy did not undertake a structural readjustment at the same time that austerity measures were used to improve external balance. Only in 1982, as output and export growth improved, did a fiscal contraction take place.

5

Introduction

Second, Korean policy was stable and consistent. The real exchange rate varied less than in most developing countries. Also, budget deficits were kept relatively small, averaging 2.7 percent of GNP during 1973-86 and ranging from 1.0 percent to 4.7 percent. Third, Korea persistently maintained high rates of investment throughout the adjustment (29 to 33 percent of GNP). These investments placed Korea in a prime position to take advantage of the revival in world demand. The final element is the dramatic rise in domestic savings. While Collins and Park show that a large part of the increase is associated with Korea’s rapid growth, much of Korean saving behavior remains unexplained. Turkey Turkey is unusual in that it experienced a debt crisis in 1977, before the second oil shock which caused most of the other indebted countries to have repayment difficulties. At the time, it was the most severe debt crisis of the postwar period. Turkey rescheduled its debts and undertook a comprehensive stabilization and liberalization program. By 1982, as the debt crisis was just erupting in most countries, Turkey had reestablished creditworthiness. In explaining the timing of events, Cellsun and Rodrik argue that it was not the 1973 oil shock and the policy response that differentiate Turkey. Instead, their analysis highlights the role of convertible Turkish lira deposits (CTLDs), a scheme for mobilizing short-term foreign loans. The Turkish episode had four phases. In 1963 Turkey launched the first in a series of five-year development plans. The plan embodied an import substitution strategy with emphasis on domestic, especially public sector, savings. The plans were successful in achieving moderate growth and in containing inflation. However, trade restrictions and increasing overvaluation discouraged exports. By the end of the 1960s, growth began to slow and attempts at reorientation, including devaluation and some trade liberalization, were not followed through. Turkey’s debt crisis erupted at the end of the second phase (1972-77). It began with a surge in worker remittances from abroad in 1972-73, which stimulated growth, generated a current account surplus, and removed the impetus for policy refocus. This reluctance to undertake macroeconomic adjustments distinguishes Turkish policy from policies in Korea and Indonesia in the late 1970s. With its large foreign exchange inflows leading to a debt crisis largely through macroeconomic mismanagement, Turkey’s experience parallels on a smaller scale what was to happen later in Mexico. Turkey embarked on an ambitious industrialization plan, concentrating on capital-intensive industries. As in Korea, the period saw rapid debt accumulation, growing price distortions, budget deficits, and exchange rate appreciation. Exports stagnated, and the current account deteriorated, especially during 1975-77 when public spending surged, financed through domestic credit expansion, financed in turn by foreign borrowing. Cellsun

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Susan M. Collins

and Rodrik argue that the dynamics of the CTLDs, which encouraged short-term private loans from abroad by protecting domestic borrowers from exchange risk, allowed the surge in spending to take place. The loans were converted to domestic currency, expanding the domestic money supply and providing credit to the public sector. As overvaluation increased, the current account deteriorated, foreign exchange reserves fell, investors lost confidence, and the scheme collapsed. During 1978-79, Turkey rescheduled some of its debt and initiated a series of stabilization programs. However, fiscal and exchange rate adjustments were too little, too late. The external balance improved through import compression, but investment and growth declined while inflation accelerated. This period of adjustment parallels the experiences of many other debtor countries. The case studies show no examples of programs that achieved stabilization with growth when the trade balance improvement came from import compression. From 1980 to 1982, Turkey launched a comprehensive stabilization plan. The initial policies were orthodox, export-oriented shock treatments, including devaluation and fiscal retrenchment. Real wages fell sharply, as did private spending, but Turkey managed to combine external adjustment with real growth. The key was surprisingly strong export performance. While real depreciation was important, Cellsun and Rodrik attribute the largest portion to “special factors,” including the strong demand in the Middle East associated with the Iran-Iraq war and hefty export subsidies. They also stress the importance of debt relief, together with substantial new lending from the IMF, the World Bank, and the OECD which reduced the need for import compression. These external factors clearly eased the difficult early stages of Turkey’s adjustment. Indonesia Indonesia’s debt crisis occurred in the mid-l960s, not during the 1970s and 1980s. Woo and Nasution emphasize Indonesia’s earlier political and economic crisis in explaining why macroeconomic performance was relatively strong in the 1980s. Prudent macroeconomic management, in particular fiscal and exchange rate policies, also explain why foreign exchange inflows from oil revenues did not lead to a debt crisis as they did in Mexico and Turkey. When General Soeharto took office in October 1965 following a military coup, Indonesia was in the midst of civil war and economic turmoil. There were growing budget deficits, external debt and inflation, overvalued multiple exchange rates, stagnant economic growth, and a shrinking export sector. One of the government’s first tasks was to stabilize the economy. A generous long-term plan of official assistance, including direct assistance and favorable terms for rescheduling existing debts, was coordinated by Western governments. This assistance enabled the government to raise investment,

7

Introduction

take advantage of a strong resource sector, and stimulate growth. In many respects, Indonesia’s growth strategy in the late 1960s paralleled Korea’s strategy. The government adopted a pro-export orientation and a balanced budget requirement. (Budget deficits could not be financed by domestic credit creation although they could be financed by foreign borrowing.) Woo and Nasution argue that the willingness to use active exchange rate policy to maintain competitiveness, along with incentives for agriculture and light manufacturing, arose from the desire to retain political support in rural areas. In any case, 1966 to 1971 was a period of strong growth in output and exports. The next phase in Indonesia’s macroeconomic history came with the fixed exchange rate during 1971-78. Strong export performance and then growing oil revenues led to a sizable current account surplus. By 1974 Indonesia had regained access to international financial markets. However, the foreign exchange inflows did not trigger aggressive debt accumulation leading to a debt crisis as occurred in Mexico and Turkey. Although the government increased investments and other expenditures and did not cut back on external borrowing as oil revenues rose, debt declined as a share of exports and of GNP. The government’s relatively cautious debt strategy was reinforced by the default of the state-owned oil company in 1975, which had borrowed extensively and was unable to roll over its large short-term debts. As a result, state-owned enterprises were denied direct access to international credit markets. In 1978 Indonesia devalued by 50 percent, marking the return to an active exchange rate management. The striking feature of this devaluation is that it was not triggered by a balance of payments crisis. Economic growth and the external balance were strong. Foreign exchange reserves were abundant. However, the real exchange rate had appreciated, hurting the competitiveness of nonoil exports. Nonoil exports responded strongly to the devaluation. As export receipts grew in 1979-81, public investment was increased further. Indonesia did run into some difficulties in 1982 and 1983 as oil prices slumped and world demand stagnated. Policymakers turned increasingly to quantitative import restrictions, exacerbating microeconomic distortions. Still, macroeconomic policies were the key to explaining Indonesia’s avoidance of a debt crisis. Strong export performance aided by active exchange rate adjustment, prudent debt management with relatively little short-term borrowing, and the favorable terms of their existing debt from the earlier rescheduling were the main elements of Indonesia’s success. The Philippines Philippine macroeconomic performance stands in stark contrast to the performance in the three other non-Latin American countries in the NBER group, and to expected performance in the late 1970s when the Philippines

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Susan M. Collins

was often grouped with the Asian tigers. In the 1980s, the Philippines became the only Asian country to declare a debt moratorium. Real growth, which had averaged 4.6 percent during 1980-81, averaged -5.2 percent during 1984- 85. In some respects, macroeconomic policies in the Philippines during the late 1970s were not dramatically different from policies in Korea or Indonesia. The real exchange rate appreciated at times during 1970-82, but by at most 15 percent. Korea’s real appreciation of the late 1970s was over 25 percent. Similarly, the Philippine budget deficit rose from 2 percent of GNP in 1978 to 6 percent in 1981. However, Korea’s budget deficit rose from 1 percent of GNP in 1979 to 5 percent in 1981. Both the real appreciation and the budget deficits were small when compared to 80 percent real appreciations and 18 percent budget deficits in Argentina. Why then did Philippine macroeconomic performance deteriorate by SO much? Dohner and Intal point to two factors. First, the magnitude of the external shocks was more severe for the Philippines than for most other developing countries. Unlike Korea, for example, the Philippines suffered a secular terms of trade deterioration. Some structural adjustments were required if the country were to maintain growth rates and a sustainable external balance, even without the two oil price shocks. Second, the political-economic environment under President Marcos was of critical importance. Individual favoritism in loan allocation and misallocation of other resources discouraged private investment, particularly in exportables, and encouraged capital flight. Government intervention became considerably more extensive than in Korea or Indonesia during the 1970s, exacerbating the difficulties of an overvalued exchange rate and growing budget deficits. The Philippine experience had five phases. In the first, from 1966 to 1969, Marcos borrowed heavily to finance a domestic expansion. The result was growing budget and current account deficits, leading to a balance of payments crisis. The external debt was rescheduled in 1970. Like Soeharto, Marcos had early experience with the potential pitfalls of foreign borrowing, but his caution lasted only until the late 1970s. The second period, from 1970 to 1972, included an economic stabilization plan supported by the IMF. Devaluation, together with tight monetary and fiscal policies, resulted in a sharp reduction in real wages and an increasingly violent political situation. However, strong export performance helped to revive economic growth. From 1972 to 1979, Philippine economic performance looked strong. Real growth rose to 6.2 percent per year, nontraditional exports increased, and investment boomed. However, these statistics mask underlying economic difficulties which help to explain the reversal after the second oil shock. In particular, total exports failed to grow as a share of GNP as traditional exports declined. Investments undertaken produced very poor returns and

9

Introduction

labor productivity actually declined. Much of the explanation for the system’s fragility comes from delayed exchange rate adjustments, disincentives for traditional export sectors, and the uncertainties and misallocations inherent in the government’s growing “crony capitalism” which favored certain industries and individuals for political reasons. The situation deteriorated during 1979-82. The Philippines was hit hard by the second oil price shock. However, unlike Korea and Indonesia which had undertaken stabilization measures even before the shock, the Philippines reacted with expansionary policies to counteract the contractionary effects. External borrowing soared to finance public investment projects, some of which never materialized. Increasingly, borrowing was short term. The value of exports fell sharply, budget and current account deficits continued to grow, and capital flight exacerbated the balance of payments difficulties. In October 1983, when reserves were nearly depleted, the Philippines declared a debt moratorium. During 1983-85, harsh austerity measures were undertaken. Inflation was reduced and the current account deficit nearly eliminated, but the output costs of stabilization were very large. Per capita income levels plunged to as low as those in the mid-l970s, and investment fell by more than half. The severe economic situation contributed to the defeat of Marcos in 1986. The new government of Corazon Aquino continues to struggle to revive growth. Many of the remaining problems are microeconomic. However, the case of the Philippines also points to the difficulties in achieving sustained growth in an economy where domestic residents have grown wary of investing their resources at home and where investment has been slashed to improve the trade balance. In contrast, Korea’s ability to reverse negative growth rates quickly is caused in large part by its history of consistent and credible policies and by the persistently high rates of fixed capital formation, even in the midst of the 1980 crisis. Mexico Mexico’s recent economic performance raises the question why a windfall in oil revenues should result in stagflation and a debt crisis. Buffie cites the “sustained bout of extraordinary fiscal indiscipline” as the major factor, and argues that the subsequent stabilization effort, which has contributed to the collapse of investment, is ill conceived. Again, microeconomic distortions are part of the story, but the keys are poor exchange rate and fiscal policies. Buffie’s analysis contrasts Mexico’s post- 1972 performance with the high growth, low inflation period (1958-72). In the earlier period, fiscal expansions were short lived and macro policy was managed with an eye to maintaining a stable exchange rate. Two cycles of expansion were followed by macroeconomic crises. The first was generated by rapid fiscal expansion, financed in large part by central bank credit. Initially the expansion

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stimulated growth, but then inflation accelerated, the real exchange rate appreciated, the current account worsened, and capital flight erupted, financed by rapid debt accumulation. The result was a balance of payments crisis in 1976. A large devaluation and an IMF program of monetary and fiscal austerity followed, but the down side of the cycle appeared in 1977 as inflation surged while employment declined. Recognition of Mexico’s oil wealth, together with easily available external credits, was used to launch an even larger fiscal expansion in 1978-81. As with the inflow from worker remittances in Turkey, the windfall was used to avoid, not to facilitate, a deeper structural adjustment. Again, the expansion generated strong growth in output and employment and high investment, but was unsustainable. Buffie points to three major flaws in the policy. First, public sector revenues, net of transfers of nonparastatals, declined despite the large oil revenues. The tax base was small and shrinking. Second, despite the dollar earnings from petroleum exports, the current account deficit deteriorated. Trade liberalization along with real appreciation generated an import boom and stagnant nonoil exports. At the same time, expected devaluation and lack of confidence resulted in large outflows of private capital. External debt was rapidly accumulated. A third factor in the program’s unsustainability was the growing concentration in short-term debt. Unfortunately, the debt did not primarily finance investments which could generate foreign exchange earnings and sustain growth. Much of the increase in public outlays went to current expenditure, while many of the investments in state-owned enterprises later proved unsound. As Mexico became unable to service its debts in 1982 and additional foreign loans dried up, the boom again turned to stagflation. Although the fiscal expansion continued and inflation soared, large real devaluations and trade restrictions cut imports, including intermediate inputs. Four years later, in 1986, Mexico’s real output was below its level at the beginning of adjustment. In 1982-84 a severe austerity program was put into place. The current account improved, and there was some reduction in the budget deficit. However, inflation remained high, real GDP fell substantially, and private investment collapsed. The investment decline in Mexico, as in Argentina, was caused by sharp reductions in available credit, together with high prices of capital goods and imported intermediates. There was no progress in reducing the budget deficit, as tax revenues remain stagnant and little effort was made to broaden the tax base. The deficits were financed largely by government bond sales, raising real interest rates, and contracting credit available to the private sector. The collapse of oil prices on the world market in 1986 brought renewed austerity. Again, output declined while inflation jumped. The severe terms of

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Introduction

trade deterioration compounded the difficulties of Mexico’s stabilization and structural adjustment. Argentina Dornbusch and de Pablo study the Argentine debt crisis from the perspective of the country’s long history of macroeconomic instability and political uncertainty coupled with the particular dynamics of debt, deficits, and inflation. They conclude that policy and economic structure eventually would have led to a debt crisis; the external shocks of the 1970s and 1980s merely brought the crisis on sooner. Again, both fiscal and exchange rate policies were central. A massive overvaluation in the late 1970s created a large external debt. Despite aggressive exchange rate management, the difficulties were compounded in the 1980s as the budget deficit mushroomed out of control. The late 1970s were a period of relative macroeconomic stability for Argentina. Finance Minister Martinez de Hoz had brought inflation down from 2,000 percent in 1975 to 100-200 percent in 1976. Similarly, the budget deficit had been reduced from 15 to 7 percent of GDP. In an attempt to reduce inflation further, Argentina introduced a new exchange rate regime in 1979. The exchange rate depreciation was to be preannounced, and capital markets were opened fully in the hope that international competition would discipline domestic price setters. While inflation did fall, the cumulative real appreciation exceeded 50 percent by the end of 1980. In anticipation of a maxidevaluation, there were massive capital outflows and accumulation of external debt. A series of large devaluations between 1981 and 1982 restored the real exchange rate to its 1976 level. However, the Argentine story differs strikingly from that of Indonesia, Korea, and Turkey, where large devaluations set the stage for rapid growth in exports and GNP, easing the burden of external debt repayment. Instead, Argentina’s economic performance deteriorated substantially during 1981-83. Despite the large exchange rate adjustments, external debt accumulation accelerated, real growth turned negative, and inflation soared. There are three main reasons why the devaluations did not generate export-led growth as had occurred in Turkey and Korea. First, Argentine exports did not respond quickly to the real depreciation as they had in Turkey because of sluggish world demand and a more fragmented export sector. Second, and more importantly, Argentina was not given the “breathing space” of continued capital inflows in the first years of adjustment which had eased the adjustments in Indonesia, Korea, and Turkey. Argentina was forced to reverse its current account quickly, from - 6 percent of GNP in 1980 to 3.6 percent of GNP during 1982-83. The

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improved external balance was achieved by cutting imports in half and through reduced investment and a domestic recession. Third, Argentina’s budget deficit more than doubled during 1981 -83, while Korea, Turkey, and Indonesia all undertook fiscal corrections. Reasons for the increase included the government’s unwise exchange rate guarantees, which deteriorated the budget as additional devaluations were required, and the military conflict in the Falklands. Dornbusch and de Pablo emphasize the interaction between the inflation explosion and the government budget deficit, which averaged 18 percent of GDP during 1981-83. Rising real interest rates and exchange rate depreciation increased the government’s debt service obligations and thereby the budget deficit, leading to additional money creation and fueling inflation. The process was exacerbated as institutional changes provided additional interest-bearing substitutes for money. As Alfonsin took office in 1984, large wage increases put further pressure on the budget and inflation accelerated. By the end of 1984, Argentina seemed to be headed toward hyperinflation. The Austral Plan, a heterodox shock treatment launched in June 1985, succeeded in bringing inflation down to 100-200 percent. The plan included a wage and price freeze, a promise not to create money to finance the deficit, and a rescheduling agreement with creditors. However, the budget deficit remained at 5 percent of GNP, while net private investment turned negative. Fiscal reform, especially broadening the tax base, remains an important issue on Argentina’s agenda. Brazil Brazil’s experience combines elements from Korea, Turkey, Mexico, and Argentina. Like Argentina, Brazil has a long history of inflation, debt, and macroeconomic crises and stabilization plans. Cardoso and Fishlow argue that external debt shifted from being part of the solution to attaining sustainable growth to being part of the problem. The years 1968 to 1973 were a period of strong growth. Import substitution coupled with some export promotion and financed by foreign borrowing seemed to be working well. When the first oil price shock hit, there was little political support for an orthodox policy response. Instead, Brazil elected to continue the expansion and embarked on a National Development Plan which stimulated public investment and stressed import substitution. It relied on external funds to avoid passing external price increases through to domestic consumers and to maintain domestic demand. Widespread indexation made the rising inflation tolerable. As the current account deteriorated, the government relied increasingly on direct market intervention and controls to restrict imports. While the real exchange rate was kept relatively constant, few incentives were created to encourage exports. Thus, when the second oil price shock hit, the Brazilian economy was in a precarious position.

13

Introduction

In some respects, Brazil’s experience in 1974-78 paralleled the Korean experience. Korea also decided to borrow through the oil shock, without altering its plans to invest in heavy and chemical industries. As difficulties emerged, government intervention and import restrictions increased. However, there were also some important differences. Korea passed through the external price changes. Many more of Korea’s investments were in exportable industries, which would later generate foreign exchange to help repay debts. Also, Korean domestic savings rose during periods of strong growth, helping to finance the investments. Finally, Korea began to reduce government direct intervention and the size of subsidies to special interests before the crisis became serious. Brazil attempted to implement an orthodox program, including fiscal reform, in March 1979. However, the approach was labeled “recessionist.” A heterodox plan resembling the Argentine approach to inflation reduction through preannouncing the exchange rate devaluation was adopted instead, The program maintained real growth, inflation rose, the real exchange rate appreciated, and a massive current account deficit led to rapid debt accumulation. The plan was abandoned at the end of 1980 under pressure from foreign creditors. Thus, like Korea, Brazil suffered a debt crisis in 1980. Restrictive macroeconomic policies in 198 1 resulted in a recession along with a trade surplus, restoring Brazil’s access to international capital markets. However, Brazil’s policy lacked attention to medium-term structural adjustment, and an opportunity was lost to put the economy back on track. The public deficit rose, the real exchange rate appreciated, and exports declined, forcing Brazil to go to the IMF and reschedule its debts. Under a series of IMF programs during 1983-84, Brazil managed to overfulfill external balance targets and to revive growth of exports and output, but inflation persisted. Cardoso and Fishlow believe that the policies pursued to generate trade surpluses to service the debt also fueled inflation. They emphasize the switch from external debt finance of the budget to internal debt finance which pushed up domestic interest rates, feeding the budget deficit and lowering investment. At the same time, agressive devaluation fueled inflation in the highly indexed economy. Brazil’s inertial inflation differs strikingly from inflation in Korea and the Philippines. At the same time, the government was unable to raise tax revenues, a problem shared by Argentina, Mexico, and the Philippines. Fiscal policy played a central role in Brazil’s transition from a “successful debtor” in 1984 to a “problem debtor” by 1986. Internal problems, especially inflation, were the dominant concern, not external factors. Brazil also launched a heterodox plan to stop inflation in 1986. The Cruzado Plan did stop inflation initially, but the gains were short lived. As November elections approached, fiscal policy became expansionary and monetary growth accelerated. When the price freeze was no longer

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capable of containing the repressed inflation, the entire program fell apart and inflation reached 800 percent by mid-1987. Cardoso and Fishlow again emphasize the need for budget corrections and for revived investment expenditures, if Brazil is to achieve growth with financial stability.

Common Themes There are many similarities between countries which did relatively well and those which are still struggling to resume growth with low inflation. Even Korea, Indonesia, and Turkey (the “high growers”), which grew at moderate to high rates and avoided rescheduling in the 1980s, have been forced to readjust economic policies in the face of external shocks and poor economic performance. Strikingly, external shocks were not the primary cause of economic difficulties in either the high growers or the debt reschedulers. Nor do the differences in the magnitudes of those shocks differentiate between the two groups. In all of the countries studied, problems emerged because domestic policies were ill suited to cope with external conditions. In Korea’s 1979-80 crisis, external (and internal) shocks were compounded by heavy imports, overvaluation, and increased fiscal deficits associated with the Big Push of the 1970s. In Turkey and Mexico, a foreign exchange windfall, not negative external shocks, set the stage for unsustainable fiscal expansion, real appreciation, and debt accumulation. In contrast, foreign exchange inflows in Indonesia led to a fiscal expansion, but not to a surge in foreign borrowing. Six Lessons There are six important differences between those countries which rescheduled in the 1980s and those which did not. First is the importance of the breathing space which some countries had at the initial stages of the adjustment. None of the three high growers undertook a structural adjustment at the same time that it converted its external deficit to a surplus. In all three cases, financing was available to maintain investments and to stimulate growth while the current account deficit was reduced. Indonesia received generous official assistance in the mid- 1960s. Turkey received substantial foreign inflows after its 1977 crisis. Korea continued to borrow heavily in international capital markets during 1979-81. These countries all ran into difficulties before the magnitude of the crisis became evident and before lending to developing countries contracted in 1982. Second, the successful countries maintained high rates of capital formation. They avoided cuts in investment and encouraged investment in export industries. When world demand conditions were favorable, they were in a prime position to expand their exports rapidly. Of course, high rates of investment are not enough to ensure high rates of growth, especially if there

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Introduction

are severe microeconomic distortions. The Philippines during 1979- 83 provided a stark example of very high incremental capital output ratios when capital accumulation was concentrated in industries with low or negative value added at world prices. Third, the successful countries maintained stable and competitive real exchange rates. Indonesia’s aggressive exchange rate policy kept nonoil exports competitive. Korea maintained a relatively stable and competitive real exchange rate. Devaluations in Brazil, Indonesia, Korea, and Turkey were successful in expanding exports, although sometimes with a lag. Fourth, the importance of fiscal discipline and a strong tax base stands out from the country experiences. In Korea, budget deficits above 4 percent of GNP were considered very large and lasted for no more than two consecutive years before being reduced to 1-2 percent of GNP. Revenues were maintained and increased through the introduction of a value-added tax and other taxes. Korea’s public sector also contributed to a high saving rate. In contrast, Argentina has not had a budget deficit below 4 percent of GNP since 1970. The deficit reached 18 percent of GNP during 1981-83. In both Argentina and Brazil, the budget deficit played a central role in debt accumulation and rising inflation. How to broaden and deepen the tax base has plagued these two countries as well as Bolivia, Mexico, and the Philippines. The timing of policy response to external shocks is a fifth important factor. Indonesia and Korea initiated adjustments because of undesirable domestic performance even before a crisis emerged. Arguably, Brazil could have avoided much of the 1981-83 recession if it had undertaken policy adjustments in 1979. Finally, both Korea and Indonesia have enjoyed trend increases in domestic (especially private) savings. The rising saving rate enabled these countries to finance high rates of investment with declining reliance on foreign borrowing. It is not clear, however, how much of the saving behavior is attributable to government policies and how much to social and political factors. Tradeoffs in Economic Policy A final theme which runs throughout the country case studies is how to allocate domestic resources among consumption (public and private), investment, and net resource transfers abroad. In the years preceding a debt crisis, the typical pattern has been an inflow of resources from abroad allocated to a combination of higher domestic consumption and higher investment. In Korea, the resources went primarily to investment. In Mexico and the Philippines in the early 1980s, a large part of the resources went to increased consumption. Difficult policy decisions arise when the net resource transfer must go in the other direction, to repay debts. If consumption is to be squeezed, it also

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matters how the transfer is achieved. Alternatives include inflation, as in Argentina, Bolivia, Brazil, and perhaps Turkey in the late 1970s, income taxes, and cuts in government expenditures. The alternatives can have widely different distributional consequences. However, for political as well as economic reasons, there are limits to the amount consumption levels can be squeezed in already poor countries. This perspective highlights differences in the adjustments across countries. Initially, Korea and Indonesia were able to maintain investment because the net resource inflow continued. Over time, real growth stimulated domestic savings, reducing private consumption as a share of GNP. The “lower” consumption substituted for net inflows from abroad by freeing resources for investment. In Argentina, Bolivia, Brazil, Mexico, and the Philippines, the reversal of net resource inflows led to cuts in investment and private consumption to contain imports. Growth slowed and there was no rise in private savings to ease the transfer burden. Thus, there are strong arguments for reducing debt repayments in order to stimulate investment and growth. The tradeoffs involved in allocation of domestic resources are at the heart of the debates over schemes for debt reduction. The lesson which emerges strongly from the NBER country studies is that, while capital inflows are no panacea and need not lead to investment and growth, it is unrealistic to expect countries to revive growth without some “breathing space” while they initiate structural adjustments.

I

Indonesian Economic Policies and Their Relation to External Debt Management Wing Thye Woo Anwar Nasution

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1

Introduction and Summary

1.1 Introduction Our aim is first to explain why Indonesia did not experience an external debt crisis in the 1982-84 period as did most of the Latin American countries, and then on the basis of the analysis make recommendations to deal with Indonesia’s present debt situation. We hope that the lessons drawn will be useful as well in the design of adjustment policies for other countries experiencing debt-servicing difficulties. While a great deal of this monograph is about the conduct of economic policies and their consequences, our study goes beyond the normal economic analysis by giving detailed attention to the Indonesian historical and political setting within which decisions about policies are made. Specifically, the questions we are interested in are: What were the economic policies adopted, and what have been the results? What are the different strategies for economic development considered by the Indonesian government? What is the political and economic basis for each strategy and what is its distributional implication? What are the reasons a particular strategy was chosen and then subsequently superceded? Finally, even though the actual combination of strategies warded off a debt crisis in 1982-84, how likely is an external debt crisis in the near future, taking into account the present economic policies and the political dynamics in Indonesia? In the course of answering these questions, we conclude that the major reason for the absence of a debt crisis was the satisfactory management of the exchange rate. This task was made easier because there were neither burgeoning budget deficits nor extended periods of loss of control over monetary growth. The absence of protracted exchange rate overvaluation from 1979 onward was fundamental in maintaining a strong nonoil tradable sector. The nonoil tradable sector was able to earn enough foreign exchange 19

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to service Indonesian debts when the external shock of high interest rates increased debt-service payments and the recession in industrialized countries lowered the price of oil. We also want to emphasize that the absence of extended exchange rate overvaluation kept the external debt down by not encouraging capital flight. We ascribe this use of the exchange rate to protect the tradable sector as much to the existence of an influential political constituency consisting of (comparatively) neoclassical economists, Javanese peasantry, and Outer Island residents, as to balance-of-payments considerations. This monograph is organized as follows: chapters 2 and 3 explore the historical and political dimensions of economic policymaking, and chapter 4 verifies the veracity of our political economy approach by analyzing the distributional consequences of the fiscal system. Chapter 5 reviews the conduct of monetary policy and finds that the choice of the monetary control mechanism in the 1970s was influenced by political economy considerations. Chapter 6 shows how exchange rate management since November 1978 has been sensitive to both the economic viability of the agricultural export sector and the balance-of-payments position. The difficulties that political economy considerations imposed on external debt management are illustrated by the Pertamina crisis discussed in chapter 7. Chapter 8 identifies three factors-concessional loans, prudent debt management, and export orientation-responsible for the non-crisis outcome in 1982-84, and then discusses the role for policy in ensuring a non-crisis outcome in the medium run. In the remainder of this introductory chapter, we give a summary of each of the succeeding chapters.

1.2 Political and Economic Instability, 1950-65 An understanding of the economic conditions prior to the establishment of the New Order government in 1966 is important because the economic policies of the 1950-65 period left a very strong imprint on the institutional memory of the new government, especially insofar as it resides in the person of President Soeharto. During this period, the Indonesian government was preoccupied with domestic political and military problems, with the restoration of sovereignty on West Irian, and with political recognition in world forums. Little attention and resources were devoted to economic development. An increasingly difficult budget situation made inflation a major problem. Taxes on trade were the major source of government revenue, but the overvalued multiple exchange rate system was reducing the profitability of the tradable sector, causing it to shrink. The twin rebellions on the islands of Sumatra and Sulawesi in 1958 constituted a simultaneous supply and demand shock to the budget. The rebellions forced big increases in military expenditure, at the same time reducing the government revenue base since

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both of these islands were important sources of export tax revenue. The monetization of the budget deficits raised the average 1958-61 inflation rate to 25 percent from the 1950-57 average of 17 percent. The budgetary pressures grew steadily worse, resulting in a period of even higher inflation in 1962-65. Between 1962 and 1964 both money supply and the cost-of-living index roughly doubled every year, and by the end of 1965 they were doubling every few weeks. Economic growth slowed to 0.8 percent per year in this turbulent period. The evolution of the export/GDP ratio tells the story of economic decline very well; it fell from 8.7 percent (1951-57) to 6.8 percent (1958-61), and then to 1.1 percent (1962-65). The internal political struggle culminated with the abortive coup by military personnel sympathetic to the Indonesian Communist Party (Purtai Kommunis Indonesia or PKI) on the night of 30 September 1965. The political instability aggravated the economic instability. The increasing economic difficulties speeded up the transfer of authority from President Soekarno to the anti-communist General Soeharto in the following year.

1.3 The Political Economy Factors in Policymaking The economic chaos of the 1958-65 period left such a deep impression that the new Soeharto government has had a “balanced” budget rule since 1968. In reality, this rule amounts to refusing to finance the deficit through money creation and limiting the deficit to the availability of foreign loans, which are officially described as foreign “revenue.”’ Another consequence of the chaos was the recognition that the exchange rate is an extremely potent policy instrument that can effect large-scale, economy-wide resource reallocation and income redistribution. President Soeharto has been in power since October 1965 and has not faced any serious challenges to his rule since the 1974 riots. The Indonesian political system can be described as a corporatist-authoritarian state. We were able to identify three political concerns that have significantly influenced his choice of economic policies. The first is to avoid conditions favorable to the revival of the PKI. Since the PKI was primarily a Javanese peasant-based movement, the policy implication is that conditions in the rural area must be improved. The second concern is to display equitable treatment of the Outer Islands, given their long history of secessionist movements. Since the economy of the Outer Islands depends heavily on tree crop exports, this further strengthens the case for promoting agricultural development. It must be added that Soeharto, because of his peasant origin, has consistently shown a strong personal commitment to eliminating rural poverty. Soeharto’s third concern is one common to all politicians: the maintenance of his power base. Political patronage has often taken the form of trade restrictions to benefit specific groups. It would not be correct, however, to attribute all trade restrictions to rent-seeking motivation. Ideology also plays an important

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role. Soeharto, like most members of the 1945 generation who fought in the bitter war for independence from the Netherlands, is influenced by an economic nationalism which is congruous with Indonesian political nationalism. Dutch economic policies were seen as designed to impose a plantation economy on Indonesia to serve the need of Dutch manufacturing industries for raw materials. In reaction, the generation of 1945 regards industrialization as synonymous with economic development. The policy translations of economic nationalism are high trade barriers to induce the development of a manufacturing sector and foreign investment laws more strict than those of neighboring countries. The primary reason Indonesia sometimes pursues a contradictory mix of liberal and protectionist policies is the above political, ideological, pecuniary, and personal elements working themselves through two groups of contending presidential economic advisors, popularly referred to as the technocrats and the technicians. The technocrats are neoclassical economists who subscribe to the comparative advantage principle. This has meant a favorable treatment of the agricultural sector because it supplies about 80 percent of nonoil exports. Exchange rate devaluations, rather than the removal of trade restrictions on imported inputs, are used to promote exports because the technocrats control the ministries that oversee macroeconomic policies but not the Ministry of Trade and the Ministry of Industry which have authority over trade restrictions. Their policies find favor with the president because they address his political concerns for raising rural income and for maintaining equitable treatment of the main islands. The second group of economic advisors, the technicians, is an amorphous collection of technicians-turned-managers, military advisors, and economists with structuralist inclinations. The technicians are united by their common belief in the general validity of the infant industry argument and by their common rejection of foreign capital ownership. The technicians’ push for import-substitution industrialization has won them the support of the army, the most powerful constituency in the country. Thanks to the dual function (dwifungsi) doctrine which legitimizes military participation in economic development, the expansion of state enterprises translates directly into more managerial positions for senior military personnel. It must be noted that since most of the import-competing industries are set up in urban Java, the higher prices of manufactured goods represent an implicit tax on residents of the rural sector and the Outer Islands. In looking at the political setting within which policies are chosen, we have identified an important political coalition of technocrats, Outer Islanders, and rural residents which favors a policy package emphasizing the maintenance of a competitive exchange rate. Since a debt crisis occurs when a government runs out of foreign reserves-either to service its guaranteed external debts or to permit private residents to convert their domestic currency to service private external debts-such a policy package reduces

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the probability of a debt crisis by keeping the (foreign exchange earning) nonoil export sector healthy.

1.4 The Fiscal System The most notable feature of the 1970s is the central government’s increasing reliance on oil as its chief source of revenue. Oil revenue as a share of total federal revenue rose from 26 percent in 1969/70 to peak at 71 percent in 1981/82. Nonoil revenue normalized by GDP fell from the 1969-71 average of 8 percent to the 1980-82 average of 6 percent. The fiscal danger of such a narrow tax base was brought home dramatically in 1982 when the global recession caused oil prices to collapse. Oil revenue (in 1980 rupiahs) fell from Rp 7.8 billion in 1981182 to Rp 6.9 billion in 1982/83, causing real total revenue to fall for the first time since the Soekamo years. It was clear that greater internal resource mobilization was necessary. A completely revised personal and corporate income tax code came into force in January 1984, a value-added tax in April 1985, and a consolidated property tax in 1986. The result was that real (1980 prices) nonoil revenue rose from Rp 3.6 billion in fiscal 1983 to Rp 4.7 billion in fiscal 1986. It is important to note that the oil revenue contributed to “undertaxation” in a subtle way which led to greater external debt accumulation. The two OPEC price increases encouraged undertaxation by giving Indonesia access to external credit on very favorable terms. The examination of the fiscal system supports our claim that the technocrats favor an economic strategy which leads to resource transfers to the Javanese rural areas and to the tree crop industries in the Outer Islands. This favorable tax treatment of the agricultural sector improves the rural-urban terms of trade and hence encourages the production of tradables, the presence of which determines a country’s ability to service its debts. In examining government expenditure, we surmised from fragmentary evidence that government spending was more likely to display a rural rather than an urban bias. Because of better data, stronger evidence could be garnered to support the hypothesis that budget allocations were very sensitive to inter-island equity. There is in fact evidence that inter-island equity takes precedence over rural-urban equity. This is consistent with our conjecture that concern for rural development stems more from a desire to eradicate poverty than to narrow the rural-urban gap. The analysis in chapter 4 sets the stage for our discussion in which we determine that political economy factors have been important in determining the debt outcome. To the extent that people are consistent in their actions, the fact that the technocrats implemented, with Soeharto’s approval, a fiscal policy favoring the tradable sector means that they would also advocate a

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similarly-oriented exchange rate policy. Such an exchange rate policy, as we will see, yields side effects that are salutary to external debt servicing.

1.5 Monetary Policy and Financial Structure While the balanced budget policy of the Soeharto government effectively ended the creation of money to finance budget deficits, it could not prevent monetary policy from moving in tandem with fiscal policy during the 1970s. This is because the main instrument for monetary control prior to April 1974 was the extension of central bank credits to the banking system, state enterprises, and private companies. Since these credits were extended for a contracted time period, the government was not in a position to engineer quick increases or reductions of the money stock. This meant that with the maintenance of a fixed dollar-rupiah exchange rate, the conversion of oil revenue from dollars to rupiahs in order to finance expanded government expenditure automatically increased the money supply. Thus, when the price of oil quadrupled at the end of 1973, encouraging the government to increase its spending, the monetary authorities lost control of the money supply. Reserve money grew 57 percent in 1974 and the inflation rate for that year was 41 percent. The central bank responded to this monetary anarchy by setting lending ceilings on the banking system in April 1974. It is understandable to use lending ceilings as a short-run, stopgap measure to control monetary growth, but Indonesia continued to rely upon them for monetary control until June 1983, despite their well-known deleterious effects. The reason is that credit ceilings gave the government an additional instrument to consolidate its political base. Over time, Bank Indonesia was instructed to introduce detailed ceilings by type of credit for each bank through an extensive selective credit system featuring subsidized interest rates to achieve other goals. For example, banks were assigned a civic function insofar as they restricted certain credit only to pribumis (indigenous people) and made establishing credit for them a priority in order to enhance pribumi participation in economic activities. The highest priority items were financing rural participation in the government’s rice intensification program and financing the scheme to stabilize the price of rice. Since most priority credits were handled by state banks, the policy of ceilings with selective credit became one of the major tools protecting the state banks from competition with private banks. Since state banks also had a wider network of branch offices than the private banks, the result of choosing this mechanism of monetary control was the preservation of the dominant position of the state banks. In the absence of pressures to innovate in order to be more efficient, the Indonesian financial system remained underdeveloped. One of the policy responses to the external shocks of the 1980s was an overhaul of the financial structure which was announced in June 1983. The financial refom package included partial deregulation of interest rates,

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elimination of credit ceilings, and reduction in the scope of Bank Indonesia's subsidized credits to state-owned banks. To increase the number of central bank instruments for open market operations, Bank Indonesia began reissuing Debt Certificates (SBIs) in February 1984 and introduced Money Market Instruments (SBPUs) in January 1985. It is clear that the financial instruments SBI and SBPU still did not provide sufficient control over monetary aggregates. This is evident in the way the money supply had to be contracted in response to a speculative run on the rupiah in June 1987. The minister of planning, in addition to asking Bank Indonesia to sell Rp 800 billion of open market instruments, ordered the state enterprises to withdraw Rp 1.3 trillion from state banks to be put into central bank securities. This action reveals that the market for both SBI and SBPU was still too shallow. It may be difficult to increase their role if the financial markets remain underdeveloped. Financial deepening is an important priority, but not only because of the need to enhance the effectiveness of the monetary instruments. Financial deepening would also better mobilize (and maybe increase) domestic saving, reduce dependence on external credit, and improve the overall allocation of capital within the economy. A boost to financial deepening would be the privatization of some of the state-owned enterprises, and an easing of external debt service would be achieved if foreigners were allowed to buy into these enterprises. 1.6

Exchange Rate Policy

Indonesian exchange rate policy is characterized by three distinct phases during the 1966-87 period. In the first phase, from October 1966 to July 1971, there was a steady dismantling of the multitiered exchange rate system into a unified exchange rate. This phase revealed a readiness to have medium-sized devaluations at short intervals in order to restore the competitiveness eroded by higher inflation in Indonesia. In the second phase, from August 1971 to October 1978, there was a fixed exchange rate. The reason for this remarkable stability is straightforward: the balance of payments was very strong throughout the period. The rapid development of the oil sector together with the 1973 OPEC price increase caused Indonesian oil exports to grow as follows (in U.S.$ billion): 0.4 in 1969, 0.9 in 1972, 5.2 in 1974, and then 7.4 in 1978. The result was a swelling of the nongold reserves, measured in the number of weeks of imports they could support: 8.1 in 1969, 19.1 in 1972, 20.2 in 1974, and 20.4 in 1978. The macroeconomic conditions also did not warrant any additional stimulus which a devaluation would bring. The sustained high income growth rates of this period-7.9 percent per year-were achieved with substantial overheating of the economy. The average 1973-78 inflation rate was 22 percent compared with 8 percent in 1970-72.

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The third phase involved three large devaluations in November 1978, March 1983, and September 1986, separated by moderately long periods of gradual exchange rate depreciation. There are two mutually compatible explanations for the 50 percent devaluation in 1978. The first explanation views the November 1978 devaluation primarily as an anticipatory action to the inevitable dropoff in oil export earnings due to resource depletion. The second explanation emphasizes the economic difficulties and political tensions associated with the reallocation of resources being forced upon the economy by the overvalued exchange rate. The overvaluation of the rupiah was the result of maintaining the exchange rate at 415 rupiahs to the dollar despite the large domestic inflations from 1974 to 1977. This meant that Indonesian producers of tradables were experiencing a profit squeeze. The prices of their output were fixed by international competition, but the prices of their domestic inputs were being driven up by the double-digit inflation. The result was reports of increasing unemployment in the tradables industries, particularly in the labor-intensive agricultural export sector. Indonesia was suffering from the “Dutch disease”.* In this second explanation, the 1978 devaluation was as much due to political concern about worsening conditions in the countryside as to economic concern about the desirability of the resulting composition of economic activities. After all, the level of reserves in 1978 could sustain the existing amount of imports much longer than was possible at any time during the 1969-76 period. It must be stated that the deleterious effects of the Dutch disease on the nonoil export sector are not obvious. Nonoil, non-liquified natural gas (LNG) exports, whether measured in physical units or in dollars or in the units of imports for which they can be exchanged, show steady growth throughout 1972-78. The production disincentive faced by the nonoil export industries is clearly seen only when the local purchasing power of their exports is measured. Even though nonoil exports were bringing in increasing amounts of foreign goods, the steady real appreciation of the exchange rate meant that the nonoil export industries were not being paid a greater number of baskets containing the mix of goods typically consumed by Indonesians. In terms of foreign purchasing power, these industries increased their revenues by 32 percentage points between 1973 and 1978, but their revenues were unchanged if measured in terms of local purchasing power. More direct evidence of the production disincentive experienced by the nonoil export sector is the movement of prices of tradables relative to prices of nontradables, PT/PN. Our three proxies of PT/PN show an average decline of 29 percent between 1973 and 1978. The 50 percent nominal exchange rate devaluation caused FT/PN to increase by 29 percent, almost restoring the profitability of the tradable sector. The speed and size of the response of nonoil, nonLNG exports were impressive. Export volume went up by 36 percent in one year, raising dollar earnings by 52 percent. The 32 percent growth in foreign purchasing power in 1979 translated into a domestic purchasing power increase of 78 percent.

27

IndonesidChapter 1

We interpret the quick and large response to the devaluation as proof of the Dutch disease, the mounting severity of which since 1974 caused an increase in excess capacity in the traditional export industries. Small producers of tree crops were spending more and more of their time in nontradable activities. Meanwhile, the real prices of their agricultural products sank as a constant nominal exchange rate was maintained in the face of big domestic price increases. The March 1983 and September 1986 devaluations were undertaken to boost nonoil exports in the face of big declines in oil export earnings. Manufacturing exports grew very rapidly after the March 1983 devaluation. They jumped (in U.S.$ million) from 850 in fiscal 1982 to 1,480 in fiscal 1983, and then to 2,166 in fiscal 1984. The strong export responses to the 1978 and 1983 devaluations indicate that export-oriented industrialization is a real possibility as long as favorable relative prices are maintained through appropriate exchange rate and trade policies. While it is clear that negative external demand shock had a role in worsening the balance of payments from 1983 to 1986, we want to point out that there were also internal developments during this period that caused substantial movements in relative prices which were unfavorable for the tradable sector. Specifically, we are refemng to the widespread use of quantitative restrictions (QRs) in the 1980s. Of the 5,229 items imported in 1985, 1,484 required import licenses and 296 were under quotas. The import licenses were usually given to only two or three traders or to the few firms producing the competing goods domestically and thus conferred a monopoly position to their holders. The range of activities that were protected by import licenses accounted for 32 percent of total domestic value added, excluding construction and services. If the petroleum sector, which requires no protection, is also excluded, then the coverage is 53 percent of total domestic value added. The implication of this microeconomic distortion for exchange rate management is profound. The intrusion of this distortion since late 1982 and its quick metastasis across the tradable sector renders invalid trying to draw conclusions about production incentive by examining the movements of the macroeconomic proxies for FT/PN. Output prices of tradables are set by international competition, while output prices of nontradables (which are generally very labor-intensive) are set by the domestic cost structure, the level of which is primarily determined by domestic wages on the supply side and domestic macro conditions on the demand side. Hence, the introduction of a quota on an imported input to the tradable sector will reduce the profitability of the tradable sector without any change in PT/PN. The point we want to emphasize is that although the Morgan Guaranty competitiveness index in predevaluation 1986 shows almost the same value as in postdevaluation 1979 (110 versus I l l ) , it does not indicate that the August 1986 exchange rate was not overvalued. In order to have the 1986 nonoil export supply schedule in the same position within the familiar

28

Wing Thye Woo and Anwar Nasution

Marshallian price-quantity space as in 1979, a devaluation was warranted, particularly in light of the shrunken gap between output and input prices. It is of course an empirical question how much the additional nonoil export earnings would have been in the absence of QRs, especially in comparison to the fall in oil export earnings. The current account deficit would still have widened in 1986, but not to the same extent.

1.7 External Debt Management The Soeharto government is no stranger to external debt management, having inherited an external public debt of $2 billion. It cut its teeth on the economic stabilization and rehabilitation program of 1966, within which rescheduling the Soekarno debts and arranging for new capital inflows to support the balance of payments were key components. Given the desperate situation of Indonesia, the Western countries set up the Inter-Governmental Group on Indonesia (IGGI) to ensure a long-term coordinated plan of official assistance. IGGI was generous both in the amount and the terms of assistance. In the 1967-70 period, it gave an average of $477 million a year, with a repayment period of 25 years, including 7 years of grace, and an interest rate of 3 percent. The mix of generous external assistance and corrective economic policies undertaken by the Soeharto government imparted a new dynamism to the Indonesian economy. The annual average growth rate from 1968 to 1972 was 8.2 percent compared to the average rate of 1.2 percent in the preceding five years. By 1974 the international credit markets had rescinded whatever credit restrictions they had imposed on borrowing by the Indonesian government in the aftermath of Soekamo’s economic Armageddon. The reasons for this change were threefold: one, the avalanche of oil revenue increased the creditworthiness of the Indonesian government; two, there was a boom in commodity prices in the early 1970s; and, three, lending opportunities decreased in OECD countries whose medium-term economic prospects were rather bleak after the 1973 OPEC price increase. On consumption-smoothing grounds, readmission into the external credit market resulted in a net gain to Indonesian national welfare. This welfare gain was not without its price: Indonesia was now exposed to two new risks. The first risk is systemic in nature and threatens every country with external debts. The second is the possibility of imprudent borrowing by Indonesia. This danger was realized in February 1975 when the state oil company, Pertamina, could not roll over a $400 million short-term loan and defaulted. It could be cogently argued that the Pertamina crisis was a blessing in disguise. The government, by denying all state-owned enterprises direct access to the external credit market after the Pertamina embarrassment, did not have as large a publicly-guaranteed external debt as it otherwise would have had at the beginning of 1982.

29

IndonesidChapter 1

While the Pertamina crisis was a deep one, it was still manageable. Real interest rates were low and Indonesian exports were in high demand. The collapse of oil prices since 1982 and the subsequent collapse of commodity prices have made external debt management more difficult. 1986 was a particularly bad year for Indonesia. The price of oil dropped precipitously from $28 per barrel in January 1986 to $10 in August 1986. The yen, in which more than a third of Indonesian public external debt is denominated, appreciated 21 percent against the dollar. The result was that the public debt-service ratio shot up to 29 percent at the end of 1986. The Indonesian government has shown itself to be prepared to make significant policy changes to ward off an external debt crisis. The rupiah was devalued by 38 percent in March 1983 and by 45 percent in September 1986. In October 1986 and January 1987, the input costs to the export sector were lowered by abolishing a substantial number of import restrictions. Nominal state expenditure for fiscal 1986 was reduced 8 percent from the previous year. In fact, real government expenditure has been steadily lowered since fiscal 1983. Real expenditure has declined more than the drop in real revenue, reducing the amount of real borrowing (in 1980 prices) from Rp 2.8 billion in 1983 to Rp 2.1 billion in 1986. Mobilization of domestic resources was also undertaken to slash foreign borrowing, with the income tax system completely overhauled in December 1983 and a value-added tax introduced in April 1985, followed by a more comprehensive land tax in June 1986. These tax increases, however, have not been able to make up for the fall in oil royalties. Nominal revenue in 1986 was Rp 1.4 billion lower than in 1985.

1.8

Conclusions and Prospects

As pointed out earlier, a debt crisis occurs not only when the government does not have the reserves to service the loans it has guaranteed, but also when it does not have the reserves to enable private domestic residents to convert their service payments on nonguaranteed debts from domestic currency to foreign ~ u r r e n c yTo . ~ take the second cause of a debt crisis into consideration, we define the total external debt service to be the sum of external short-term debt and the debt service on all external long-term debt, publicly-guaranteed and private nonguaranteed. We include short-term debt in our definition because we are interested in the financial resilience of a country to sudden protracted credit squeezes in international credit markets which make short-term borrowing extremely expensive, if not occasionally impossible. After all, the 1973-74 credit crunch did precipitate the 1975 Pertamina debt crisis in Indonesia. Since the reserve position of a country is crucial for avoiding debt crises, it is not appropriate to assess a country’s ability to pay by looking at the total external debt service with respect to its income. A more appropriate

30

Wing Thye Woo and Anwar Nasution

indicator is the debt-service ratio, DSR-the total external debt service normalized by the level of exports-because the official reserve position is determined primarily by the ability of the export sector to earn foreign exchange. By comparing the DSRs of Indonesia, Mexico, and Brazil, we identified three factors that explain why Indonesia did not experience a debt crisis in 1982-84 as did Mexico and Brazil. These factors are concessional loans, high export orientation, and prudent management of the maturity structure. Concessional loans. A high proportion of Indonesia’s external debt was borrowed at fixed concessionary rates from IGGI. This “IGGI effect” explains why the effective interest rate on Indonesian long-run debt averaged 16 percent against the 20 percent paid by Mexico and Brazil. Another result was that only about one-third of Indonesian debt was denominated in dollars compared to 90 percent of Mexican and Brazilian debt. This meant that the large appreciation of the dollar from 1979 to 1982 did not raise the effective interest rate for Indonesia as much as it did for Mexico and Brazil. High export orientation. The availability of significant amounts of other tradables prevented Indonesia’s debt-servicing capacity from collapsing as did Mexico’s when the price of oil dropped in early 1982. Appropriate exchange rate policies by Indonesia, exemplified by the 1978 devaluation, ensured a diversified export bundle as well as a high export orientation. The average 1980-82 export/GNP ratio was 27 percent for Indonesia, but only 14 percent for Mexico and 9.5 percent for Brazil. Indonesia’s political concern to keep the agricultural sector vibrant no doubt helped to maintain the observed export orientation. Prudent management of the maturity structure. This was evident in that only 14 percent of Indonesia’s debt in 1981 was short-term compared to the 19 percent for Brazil and 32 percent for Mexico. The shock of the Pertamina crisis caused official borrowing in Indonesia to take place very cautiously with regard to exposure in the short-term credit market. We can also call this third factor the Pertamina legacy. To quantify the relative importance of the three factors in explaining the absence of an Indonesian debt crisis, we calculated what the total DSRs in the 1980-82 period would have been if Indonesian debt was paying the same effective interest rates as Mexico, as well as bearing the same maturity structure, and if the Indonesian exporVGNP ratio was identical to Mexico’s. The average values of the six possible decompositions of the effect of each factor and the range of values achieved are reported in table 1.1. The decomposition identifies the export orientation of Indonesia as the most decisive factor in why Indonesia’s total debt-service/export ratio was so low compared with Mexico’s. Export orientation explained 31 of the 54 percentage point difference, accounting for 57 percent of the gap. The Pertamina legacy was of moderate importance. It contributed 18 percentage points, accounting for almost a third of the gap. Concessional interest rates

31

IndonesidChapter 1 Average Values and Range of Values Achieved

Table 1.1

Average Value Hypothetical 1980-82 average total debt-service ratio when Indonesia had all 3 Mexican features Contribution of (in percentage points):

IGGI Maturity management Export orientation Actual 1980-82 average total debt-service ratio

Range of Values for Each Factor

84.4 5.8 11.1 30.8

3.7-8.4 12.0-23.8 23.6-31.8

30.1

and currency composition of debt played only a minor role in reducing the DSRs, explaining less than 6 percentage points. Our finding that the IGGI effect contributed so little toward the reduction of the 1980-82 debt-service/export ratio is surprising because many of the informed observers we talked to cited foreign concessionary loans as the primary reason for the absence of an Indonesian debt crisis. The $1 billion saved annually in reduced debt service during 1980-824 is a large sum of money, but this amount would have been easily swamped by a Mexico-style loss of reserves if the Indonesian government had tried to prop up an overvalued exchange rate and was then forced to finance capital flight. Similarly, if exports were 12 percent below actual value because of an overvalued exchange rate, as suggested by the 1965-68 experience, the loss in foreign reserves would have also greatly exceeded this $1 billion saving. Our conclusion is that the Indonesian exchange rate policy was the most important reason Indonesia was able to meet its debt commitments in the 1982-84 period. The conduct of this exchange rate policy was greatly facilitated by the existence of a political lobby that promoted exchange rate protection and by the memory of the economy-wide negative effects of exchange rate overvaluation. While the decline of oil prices in early 1982 did make debt management more difficult-the total DSR rose from 26 percent in 1981 to 39 percent in 1982-it was still far from a crisis situation. The subsequent collapse of agricultural commodity prices and the rapid descent of the price of oil in 1986 produced a more ominous situation. The fall in export earnings from $21 billion in 1982 to $15 billion in 1986 caused the total DSR to soar to 68 percent. The 68 percent appreciation of the yen against the dollar between 1985:lQ and 1987:1Q caused debt-service payments to jump. While our analysis would place great emphasis upon an aggressive competitive real exchange rate policy to reduce the probability of a debt crisis through its effects on exports and capital flight, we strongly feel that there are a number of other policies which must be implemented

32

Wing Thye Woo and Anwar Nasution

immediately if a debt crisis is to be avoided in the medium run. We recommend the following policies: 1. Cut budget deficits by controlling spending and increasing taxes. This

would keep fiscal policy consistent with exchange rate policy. 2 . Maintain an anti-inflationary posture in monetary policy. 3. Amend the balanced budget rule to allow internal financing of government deficits. The deepening of the domestic market in government securities would make open-market operations by the central bank easier. The addition of this monetary tool to SBI and SBPU would tend to enhance monetary control, and thus macroeconomic stabilization efforts, tremendously. 4. Accelerate the development of the domestic financial system. Financial deepening could be boosted by the privatization of many of the state-owned enterprises. The debt situation would be improved if the government were to allow foreigners to purchase shares in the former state enterprises. 5 . Liberalize controls on foreign investments in the manufacturing and agricultural sectors, especially in industries that produce primarily for export markets. In short, state and private enterprises should issue equities instead of bonds to foreign investors when financing their capital expenditure. 6. Eliminate the wide array of monopoly import licenses. The growth of manufactured exports, spurred by access to cheaper inputs, would not only increase foreign exchange earnings but would also diversify the export bundle, hence reducing the sensitivity of the DSR to the prices of a few key commodity exports. 7 . Expand the tree crop sector. In addition to earning more foreign exchange, the strategy of accelerating the growth of agricultural export industries would also promote a more equitable, rural-urban-as well as inter-island-growth pattern, and ease population pressure on the urban areas.

2

Political and Economic Instability, 1950- 65

2.1 Introduction Indonesia achieved formal recognition of its political independence in December 1949 after a bitter, four-year struggle against the Dutch. President Soekamo was the dominant political figure in the 1950-65 period. The years

33

IndonesidChapter 2

from 1950 to 1959 are usually referred to as the period of liberal democracy when President Soekarno shared power with elected representatives. He was the only durable presence, however; the extreme fragmentation of political opinions brought about twelve cabinet changes in ten years. The corollary of this constant reshuffling of ministerial portfolios is that government policies toward economic development were in a constant state of flux. Needless to say, the continuous jockeying for power by various coalitions diminished public respect and support for parliamentary democracy. In June 1959 President Soekarno, with the support of the army, centralized political power in his hands by dismissing the elected representatives. The parliamentary seats were reassigned to representatives of regional interests and of “functional” groups. Examples of the latter are youth and women’s groups, and religious, labor, and peasant organizations. This form of “guided democracy” lasted until October 1965 when the armed forces took over after suppressing a communist coup. During the 1960-65 period Indonesia continually faced fiscal and trade problems, in addition to unemployment problems resulting from a high rate of population growth. The root of the fiscal problem was ever-increasing budget deficits. Since tax revenues could not rise as fast as expenditures and governments were unable to curtail spending, the deficits had to be financed by money creation. Government revenue was heavily dependent on the taxing of international trade. These trade taxes reduced profitability in the trade sector, cut real wages, and increased (disguised) unemployment, at least in the short run. High inflation and high domestic costs of production made exports uncompetitive in international markets. Occasional bans of some export commodities to stabilize their prices in the domestic market and the trade breaks with Singapore and Malaysia since 1963 made Indonesia an unreliable source of traded goods. All of these factors made Indonesia unable to translate its export potential into actual earnings.

2.2 The Course and Causes of Inflation The episodes of economic development in Indonesia during 1950-65 can be divided into three phases, 1950-57, 1958-61, and 1962-65. Despite the political instability and destruction during the Pacific War and the Revolution, the economy performed quite well during the first phase. Measured at 1955 constant market prices, the average annual growth rate was a respectable 5.4 percent per annum, and the average inflation rate was 16.5 percent per year (table 2.1). The trade sector was badly hit by a decline in the terms of trade after the Korean War boom. Despite that, the average current account deficit during this period was less than 1 percent of the national income. Table 2.1 shows that 1951 was the only year the government ever had a budget surplus. Since then, the budget has always been in deficit. The average amount of this deficit during 1951-57 was 1.5 percent of the

Table 2.1

Selected Economic Indicators, 1951-69

1951

1952

1953

1954

3.1 31.2 6.0 -27.6

8.8

6.5 13.4 5.6 - 10.1 - 19.3

6.9 48.5 6.4 3.1 - 17.7

5.8 10.0 35.0 9.1 .3

2.6 9.5 - 1.5 -2.0 36.3

17.4 15.7 I .7 .9 5.0 7.3

14.6 17.9 -3.3 -3.5 12.9 12.7

15.3 17.7 - 2.3 - 1.4 9.9 10.8

9.7 11.0 - 1.3 - .4 5.9 8.2

11.2 12.8 -1.6 .9 5.7 8.5

3.8

11.4

11.4

11.5

500.8 11,402.0 495.8

266.7 9,736.0 460.4

192.5 7,571.0 495.0

14.5

14.4

12.6

Growth rates National income Money supply Inflation Exports' Imports'

6.3 16.9

64.1 61.4 98.4

As percentage of national income Government revenue Government expenditure Government deficitb Current account Imports Exports Exchange rate (Rp/US$)' Prices of export goodsd Rubber (USelkg) Tin (US$/metric ton) Coffee (US$/kg) Income velocity of money

1955

1956

1957

1958

1959

7.1 41.2 54.9 3.0 -6.6

-4.1 55.3 18.0 - 17.2 - 32.3

2.4 18.8 13.2 17.7 - 11.4

12.2 13.3 -1.0 - 1.2 6.5 7.0

11.7 14.6 -2.9 - .5 5.2 6.3

12.7 19.2 -6.5 .8 3.4 5.0

11.5

11.5

11.5

200.0 7,619.0 678.5

326.0 7,713.0 537.4

268.6 7,923.0 595.3

13.1

10.9

11.8

1960

1961

1962

2.0 37.1 20.0 -9.7 19.9

5.1 41.4 95.2 -6.3 37.8

2.4 100.9 155.9 - 15.8 - 18.7

13.9 20.1 -6.2 .9 2.5 4.9

13.7 15.5 -1.8

5.5 9.1 -3.6

6.1 9.7

13.2 18.8 -5.6 -4.4 7.6 1.5

11.5

45.3

45.3

45.3

45.3

239.6 1,429.0 503.2

211.9 7,109.0 404.6

275.4 7,701.0 354.8

288.2 7,652.0 345.0

218.2 8,380.0 329.0

201.7 8,320.0 303.0

10.9

7.6

6.9

9.4

8.1

13.1

-.I

- .7

2.2 2.3

Annual Averages 1%3

1965

1964

1966

1967

1968

1%9

1951-57

1958-61

1%2-65

1951-65

Growth rates

National income Money supply Inflation Exports' Imports'

-2.4 93.8 128.8 5.2 - 19.4

As percentage of national income 5.1 Government revenue Government expendihm 10.3 Government deficitb -5.2 Current account - .3 Imports .7 Exports 1.0 Exchange rate (Rp/US$)' -

Prices of export goodsd Rubber (USGlkg) Tin (US$/metric ton) Coffee (USe/kg)

.o

3.8 156.3 135.3 3.8 30.4

.O 282.5 594.5 -2.3 2.2

2.3 763.5 635.4 -4.1 - 24.2

2.3 131.8 112.2 8.0 35.1

121.3 84.8 13.1 3.2

7.1 61.1 17.4 14.1 19.7

5.5 24.4 24.4 5.3 14.3

1.4 38.2 36.6 - 3.9 3.5

4.0 9.6 -5.6 -.l .4

3.9 10.7 -6.8 - .2 - .6 .6

4.1 9.3 -5.2 -6.1 -33.4 40.0

7.1 10.3 -3.2 -4.1 - 13.1 12.5

7.5 9.3 - 1.8 -3.2 -11.9 12.4

9.4 12.8 - 3.4 - 3.9 -11.5 11.5

13.2 14.7

13.4 18.4

- 1.5 - .7 7.3 8.7

5.1 6.8

1.1

10.9 14.4 -3.5 - .7 4.9 6.2

235.0

235.0

235.0

300.1

326.0

10.4

36.9

70.1

33.4

.5

-

11.1

-5.0 - .9

1

158.4 253.6 -2.3 - 1.4 4.6 9.9 -5.3 - .3 .7

3.2 63.8 88.8 .8 7.2

191.8 8,586.0 299.0

177.9 11,436.0 361.1

184.0 12,977.0 356.3

164.0 11,492.0 336.0

140. I 10,608.0 294.3

132.7 10,019.0 301.0

168.9 10,451.O 302.4

284.9 8.484.7 537.9

248.4 7,710.5 358.4

188.9 10,329.8 329.9

249.6 8,770.3 434.6

16.1

15.2

14.6

26.8

23.0

24.1

18.3

12.6

8.0

14.8

11.9

Income velocity of money

Sources: BPS, Statisticul Pocketbook of Indonesia. 1960-71 editions. Bank Indonesia, Report of the Governor, various issues covering financial years 1950151 through 1960/65, IMF and World Bank databases. Note: Dash indicates that data were not available. 'In foreign currency (US $). bMinus sign indicates a deficit. Wfficial exchange rates at Jakarta. 1980 constant US. dollars.

36

Wing Thye Woo and Anwar Nasution

national income. The Bank Indonesia Act of 1953 restrained the use of deficit financing to a level equal at most to five times the amount of the nation’s gold and foreign exchange reserves. Inflation during this phase was largely due to positive external shocks. The rise in exports because of the Korean War boom in 1950-51 increased domestic income as well as the monetary base. As shown in table 2.1, the rates of growth of the money supply and inflation rates fluctuated sharply during 1950-57, reflecting the efforts of various governments to check the inflation rate. The exceptional rate of growth of the money supply in 1954 was related to the rising campaign expenditures of various political parties for the general election in 1955, the first to be held after achieving independence. The incumbent government expanded bank credit and used the trade licensing system to, in essence, buy political supporters. Inflation during the second phase, 1958-61, was primarily related to a combination of a supply shock and a sharp increase in government expenditures. These simultaneous adverse events were the result of, first, the twin rebellions in 1958 on the wealthy, export-earning islands of Sumatra and Sulawesi and, second, the nationalization of foreign-owned firms and expulsion of expatriate managers and technicians in 1957-58. The combination of inflation, widespread trade licensing, and unrealistic multiple exchange rates reduced profitability in the traded sector, thus creating disincentives for the transfer of productive resources in that direction. As shown in table 2.la, the margin between official and market exchange rates became wider over time. The fall in production and exports eroded the tax base and reduced government tax revenue, both in real and nominal terms. At the same time, the rebellions created pressure for an expansion of military expenditures to restore political unity. The size of the budget deficit increased dramatically, and expenditure allocation for investment purposes was reduced substantially. The combination of supply shocks and pressure for higher budget expenditures accelerated during 1962-65. The political conflict with Singapore and Malaysia in 1963 led to a break of trade which further reduced exports. This was because Singapore and Penang were important entrepdt ports for Indonesian exports. As shown in table 2.1, the ratio of exports to GDP declined from 8.7 percent (1951-57) to 6.8 percent (1958-61), and then to 1.1 percent during the third phase (1962-65). The 1962-65 period was marked by an intensified contest for power among the president, the army, and the PKI. The contest was reflected in the making of policy, the exercise of patronage, and control over financial resources. As the struggle for budget allocation became more of a political dispute than a technical one, the political and administrative control of the Ministry of Finance declined. Since 1959 many ministries maintained extra budgets which were not reported in the budget document. The president and

37

IndonesidChapter 2

Table 2.la

Exchange Rates (rupiahRT.S. dollar)

Year

Market Rates

Year

Market Rates

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957

2.7 2.7 2.7 3.8 3.8 3.8 11.4-1 1.7 11.4-1 1.7 11.4 11.4 11.4- 13.6= 22.7" 28.4-42.6b 56.8-78.1' 30.3' 37.9-56.gb 75.8-104.2' 36.P 45.0-67Sb 90.0-135.0'

1961

45.0' 45 .Oa- 72.Ob 200.W 45.0-173.0' 45.0-270.0b 900.0- 1 ,170.OC NA

1958

1959

1960

45.0'

45.0-72.0b 200.w

1962

1963 1964 1965

1966

1967

1%8

I969

NA

235.06 235.V 235.0' 235.0' 235.F 235.0' 235.06 235.0' 153.7' 326.0' 326.0' 300.1' 326.e 326.05 326.6

Source: International Financial Statistics, various issues. aF'rincipal export rates. bPrincipai import rates. 'Other import rates. 'The end-of-period national currency value of the SDR. 'Refers to end-of-period market exchange rates for countries quoting rates in units of national currency per

U .S . dollar.

'Refers to period averages of market exchange rates for countries quoting rates in units of national currency per U.S. dollar. NA: not available.

his cabinet ministries controlled the so-called Revolution Fund which was financed separately from the reported government revenues. The use of this fund was not reported to anybody but the president. During the later part of the term of President Soekamo, the government did not even bother to submit its draft budget proposal to get approval from the parliament. The supply of money and the inflation rate accelerated during 1962-64. In this period, both the money supply and the cost-of-living index roughly doubled every year, and by the end of 1965 they were doubling every few weeks. In May 1957 the government enacted Emergency Law No. 14 which freed Bank Indonesia from its obligation to maintain the 20 percent cover on gold and foreign exchange reserves. In 1965 Bank Indonesia merged with three of the four existing state commercial banks and the sole state-owned savings bank to form Bank Negara Indonesia. With these changes, the

38

Wing Thye Woo and Anwar Nasution

government budget deficits were automatically financed by credit from the central bank. The government made some effort to finance its budget deficits by selling bonds to the general public in the early 1950s. The Jakarta stock exchange, which was closed during the Pacific War, reopened on 4 June 1952. However, because of the public’s unfamiliarity with the stock exchange and because of their preference for other forms of assets, the government was not able to raise any significant amount of funds through the stock exchange. The erosion of real value by high inflation helped make financial assets, including government bonds, unattractive.

2.3 The Government Budget None of the coalition governments during the period of liberal democracy (1950-59) had an adequate mandate to take bold measures, nor survived long enough to implement an economic stabilization program. The key element in the contest for power within the coalition was the budget allocations. For example, one of the prime ministers, Wilopo, failed to prune back the personnel budget in 1952 because of strong political opposition from all over, including from his own party. The series of secessions between 1957 and 1965 led to greater military expenditures. In addition, President Soekamo, who had the dominant political position between 1959 and 1965 and who was not interested in economic issues, also demanded higher expenditures for his pet projects. Table 2.1 shows that the ability of the government to raise revenue declined from an average of 13 percent of GDP in 1951-61 to 5 percent in 1962-66. However, the average ratio of annual government expenditures to GDP rose from 14.7 percent (1951-57) to 18.4 percent (1958-61). This ratio dropped to 9.9 percent in 1962-66, in line with the decline in the government’s ability to tax.The ratio of budget deficit to GDP has risen from 1.5 percent in the first phase to around 5 percent in the second and third phases. The size of the government budget from 1950 to 1969 is given in table 2.2. Column (5) of the table, which gives the budget deficit as a percentage of gross expenditures, shows an exceptionally low percentage in 1956 (7.7 percent). This was due to extensive deregulations introduced by Professor Sumitro Djojohadikusumo, minister of economic affairs in the short-lived 1955 cabinet of Burhanudin Harahap. To combat inflation the government had liberalized imports and then released extra foreign exchange reserve to finance them. The increase in imports and exports raised revenue from the tax on foreign trade which, in turn, moderated the budget deficit. Table 2.3 depicts the major components of government expenditures and their rates of growth. The table shows that roughly half of government expenditures were for personnel and other current expenditures. Some of the

39

IndonesidChapter 2

lbble 2.2

Year (1) 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1%2 1963 1964 1965 1966 1967 1968 1969 1%9/70

Government Budget 1950-69

(in

billions of rupinhs)

Gross Revenue

Gross Expenditure

Total Budget Deficits

Deficits as 96 of (3)

(2)

(3)

(4)

(5)

7.00 11.80 12.30 13.60 12.50 14.20 19.20 20.60 25.30 30.50 49.82 62.20 75.00 161.00 282.10 960.77 13.14 60.2 149.8 45.9 251.6

8.70 10.60 15.00 15.70 15.40 16.30 20.80 25.60 35.50 44.30 58.34 88.50 122.1 329.80 681.30 2,526.32 29.43 87.55 185.3 58.6 342.7

- 1.7 1.2 -2.7 -2.1 -2.9 -2.1 - 1.6 -5.0 - 10.2 - 13.8 -8.5 -26.3 -47.1 - 168.8 -399.2 - 1,565.6 - 16.3 -27.3 -35.5 12.7 -91.1

-

- 19.5 11.3 - 18.0

- 13.4 - 18.8 - 12.9 -7.7

- 19.5 -28.7 -31.2 - 14.6 -29.7 -38.6 -51.2 -58.6 -62.0 -55.3 -31.2 - 19.2 -21.7 -26.6

Source: Bank Indonesia, Annual Reporr, various issues; World Bank sources. 1966 on: data in new rupiahs (1 new = 1,ooO old). 1969: Jan-Mar. 1%9/70 fiscal year that begins 1 April 1969.

current expenditures were subsidies for public utilities and state-owned enterprises. The next biggest expenditure item was for defense, which accounted for between 20 to (nearly) 47 percent of the budget throughout 1950-65. The share of defense outlays as a portion of total expenditures markedly increased during 1958-62 and again in 1965 to meet the security crises in these periods. Increases in the shares of current and defense expenditures reduced the shares of outlays for economic and social services, as well as for investment. Since 1963 the share of investment expenditure rose significantly, mainly to finance pet projects of the president such as the Senayan Sport Complex, the National Monument, the massive Istiqlal mosque, and the giant Ganefo complex. As shown in the lower section of table 2.3, the annual average growth rate of government expenditures increased from 15.8 percent in 1950-57 to 36.3 percent in 1958-61, and then jumped to 275 percent during 1962-66. During the first phase, the rate of growth of government expenditures was roughly equal to the average annual inflation rate at 15.8 percent. Since 1958, however, the rate of growth of government expenditure has consistently been higher than the inflation rate. The structure of government revenue, as shown in table 2.4, was heavily dependent upon taxing foreign trade (import and export taxes). As a result, tax revenue was quite sensitive to foreign trade activities and to government

40

Wing Thye Woo and Anwar Nasution

Table 2.3

Year

Major Components of Government Expenditures, 1951-66 (in millions of rupiahs)

Defense

Economic Service

Social Service ~

1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966”

3,269 3,032 3,892 3,327 3,937 4,075 6,051 11,085 14,071 22,431 41,607 57,438 97,900 195,200 1,009,100 2,260

(30.8) (20.2) (24.9) (22.0) (24.1) (20.4) (23.6) (31.4) (31.7) (38.5) (46.5) (46.6) (29.7) (28.7) (40.0) (9.3)

313 1,758 1,579 1,844 1,483 984 1,082 1,404 1,927 3,036 6,218 5,615 53,600 40,700 193,800

1,034 1,435 1,245 1,436 1,564 2,120 2,334 2,884 3,124 5,083 6,945 6,816 23,000 41,400 108,Mx) 18,400

Other Current Expenditure ~~

(9.7) (9.6) (8.0) (9.5) (9.6) (10.6) (9.1) (8.2) (7.0) (8.7) (7.8) (5.5) (7.0) (6.1) (4.3) (75.5)

Investment

~~~~

Total

~~

5,343 7,726 8,005 7,401 8,302 11,642 15,078 18,646 23,279 23,962 27,678 48,880 47,000 144,900 354,000

(50.3) (51.4) (51.1) (48.9) (50.9) (58.2) (58.9) (52.8) (52.5) (41.1) (30.0) (39.7) (14.3) (21.3) (14.0)

-

-

(6.3) 666 (7.1) 1,074 (6.0) 938 (7.5) 1,133 (6.3) 1,030 (5.9) 1,180 (4.2) 1,065 (3.7) 1,294 (4.4) 1,949 (6.6) 3,824 (7.9) 7,051 (3.7) 4,510 108,300 (32.8) 259,100 (38.0) 860,200 (34.1) 3,700 (15.2)

~

10,625 15.025 15,659 15,141 16.316 20,001 25,610 35,313 44.350 58,336 89,499 123,259 329,800 681.300 2,525.700 24,360

Averagc Annual Rates ot Growth

Defense Economic Cervicr Social \ervice Other current expenditure Investment Total expenditure Inflation rate

1951-57

193-6 I

I962 66

I95 I -66

10.8 23.0 14.5 18.9 81 15.8 24.4

55.4 64.2 34.0 14 I 76.0 36.3 36.6

150.5 225.6h 620.8 93.P 435.2 274.9 330.0

54.6 22.5’ 92.0 34.9’ 77.7 67.5 123.0

~

Source Biro Pusat Statistik

N o w . Dash indicatec that data were not available. Figures in parentheses are expenditures as a percentage of the total. “In new rupiahs beginning 1966 ( I new rupiah equals 1,000 old rupiahs). ”Avcrage growth ratea for 1962-65 ‘Average growth ratch for 1951-65.

policies toward the trade sector. Tax collection from the foreign trade sector was easy to administrate and faced practically no political opposition since the taxes were paid by foreigners (Dutch trading firms until 1958) or by the Chinese who dominated foreign trade activities. Revenue from the external sector was also raised by instituting different exchange rates for exports and imports. The result of multiple exchange rates was an upsurge in smuggling exports and imports. This illegal trade reduced the government’s tax revenue. At the same time, the high inflation rate and the inefficiency of domestic tax administration eroded revenue from personal and business income taxes. The share of nontax revenue increased steadily from 1959 on as there was an increasing contribution to the treasury of profit from the newly nationalized state enterprises.

41

IndonesidChapter 2

Table 2.4

Sources of Government Revenue 195169 (in percentages) ~~

~

Year

Personal Income Tax

Business Income Tax

on Income"

Tax on Consumption

Import Tax

Export Tax

Nontax Revenue

1951 1952 1953 1954 1955 1956 1957 I958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969

6.6 8.6 9.0 12.4 12.1 9.5 9.9 10.4 8.6 6.6 5.3 8.4 8.0 10.1 4.7 4.9 3.7 5.1 3.6

6.4 9.3 11.1 15.7 17.5 10.0 10.3 9.9 10.9 10.3 13.5 15.2 12.4 14.5 9.2 4.6 12.7 18.9 19.1

.3 .3 .4 .5 .7 .3 .3 .4 .3 .4 .4 .2 .6 .5 15.2 4.1 3.4 3.6 4.6

17.1 20.5 22.5 28.8 25.1 19.4 26.2 25.9 20.2 21.7 19.8 30.7 26.1 27.2 27.8 37.1 17.2 15.6 15.1

53.6 35.9 32.6 25.7 28.6 43.6 25.7 23.2 28.3 18.9 10.8 6.5 8.1 12.0 5.6 28.1 19.9 23.4 22.0

12.7 18.8 10.3 9.9 10.6 4.0 19.2 20.3 20.9 13.3 5.4 6.6 1.1 .3

3.3 6.7 13.2 6.9 5.4 13.2 8.8 9.8 10.6 27.4 29.4 30.3 43.4 34.7 37.5 6.2 1.5 2.6 .9

Other Tax

.o 15.0 12.5 11.7 7.4

~~

Development Revenue

.o .o

.o .o .o

.o .o .o .o 1.3 15.6 2.1 .3 .8

.o .o 29.1 19.2 27.2

Source: 1951-65: Bank Indonesia, Annual Reporr. 1951-52 through 1960-65 issues. 1966-69: Bank Indonesia, Indonesiun Financial Statistics. monthly bulletin, July 1969. "Includes land tax.

2.4

The Monetary Purges

The government of the newly independent Republic of Indonesia in January 1950 inherited two types of money in circulation. Each of the local governments of the Republic of Indonesia during the war for independence issued its own currency as legal tender in any temtory under its control. The Republican government issued currency known as Uang Republik Indonesia (URI) and the Dutch military authority issued currency notes popularly referred to as the Nica or "Red" money. At the end of 1949 the amount of URI of all types that was in circulation was estimated at about Rp 6 billion, and the amount of Dutch currency in circulation amounted to over Rp 3.3 billion. To bring monetary order and restore stability of the rupiah, the government decided upon the first monetary purge in April 1950. The Nica money and any Java Bank notes higher than Rp 2.50 were literally to be cut into two pieces. The right-hand side was to be exchanged for 3 percent government bonds and the left-hand side was to be exchanged for new Java Bank notes. Currency denominated at Rp 2.50 or less was excluded. Half of time and demand deposits over Rp 400 were to be exchanged for government bonds to be redeemed in installments within a forty-year period. The URI money with a denomination of Rp 50 or more could be exchanged for the

42

Wing Thye Woo and Anwar Nasution

new Java Bank notes at rates that varied from one region to another. URI money of smaller denomination could be deposited with the Bank Negara Indonesia. Monetary stability brought about by the monetary purge did not remain for long due to the way the government financed its budget deficit and to transmission of international inflation into the domestic economy during the Korean War boom. Lack of confidence in government domestic economic policy after the monetary purge raised the income velocity of money which, in turn, aggravated inflationary pressures. The lack of confidence was also due to an unequal distribution of the burdens of the monetary purge and inflation. The purge had sharply reduced the cash position of the business sector as shown by a 1.2 percent reduction in demand deposits in 1951 (table 2.5). To restore normal business operations, bank credit had to be expanded to the business sector. By September 1950, six months after the purge, the total money supply exceeded the amount in circulation before the purge. Inflationary pressures again rose to an alarming level in 1959. This was due to rapid growth of the money supply to finance the budget deficit, a Money Supply and Its Composition, 195(c67 (in billions of rupiah)

Table 2.5

Year

Currency (C)

Demand Deposit (DD)

Total Money (M)

1950 1951 1952 1953 1954 1955 1956 1957 1958 L959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969

2.58 3.33 4.35 5.22 7.47 8.65 9.37 14.09 19.87 26.38 34.08 48.54 102.28 175.46 447.00 1,811.00 14.36 34.10 74.68 115.70

1.73 1.71 2.26 2.27 3.64 3.59 4.02 4.82 9.49 8.50 13.76 19.10 33.62 87.90 278.00 761.00 7.85 17.37 39.21 67.74

4.31 5.03 6.60 7.49 11.12 12.23 13.39 18.91 29.37 34.88 47.84 67.64 135.90 263.36 725.00 2,572.00 22.21 51.47 113.89 183.44

Rate of Growth (96)

Percent of Total

Currency

Demand Deposit

59.9 66.1 65.9 69.7 67.2 70.7 70.0 74.5 67.7 75.6 71.2 71.8 75.3 67.0 61.6 70.4 64.7 66.2 65.6 63.1

40.1 33.9 34.1 30.3 32.8 29.3 30.0 25.5 32.3 24.4 28.8 24.7 33.0 38.4 29.6 35.3 33.8 34.4 36.9 38.2

Currency

Demand Deposit

Money Supply

Income Velocity ofMoney

47.4 29. I 30.6 20.0 43.1 15.8 8.3 50.4 41.0 32.8 29.2 42.4 110.7 71.5 154.8 305.1 692.9 137.5 119.0 54.9

10.9 -1.2 32.2 .4 60.4 -1.4 12.0 19.9 %.9 -10.4 61.9 38.8 76.0 161.5 216.3 173.7 931.5 121.3 125.7 72.8

30.2 16.7 31.2 13.5 48.5 10.0 9.5 41.2 55.3 18.8 37.2 41.4 100.9 93.8 175.3 254.8 763.5 131.7 121.3 61.1

14.5 14.4 12.6 13.1 10.9 11.8 10.9 7.6 6.9 9.4 8.1 13.1 16.1 15.2 14.6 26.8 23.0 24.1 18.3

-

Source: BPS, Srarisrical Pocketbook of Indonesia, various issues. Notes. Income velocity of money is defined as Y r / [ l / z ( [ M t - 11 money supply at time t .

New rupiah since 1966. Dash indicates that data were not available.

+ M I ) ] ,where Yr = GDP at time f and Mr

=

43

IndonesidChapter 2

reduction in exports as a result of the nationalization of foreign firms in 1957, as well as the closing of non-Indonesian Chinese rural stores. The black market value of the rupiah responded to the surge in inflation by dropping sharply from Rp 100 to Rp 150 per U.S. dollar between April and July 1959. On 25 August 1959 the government undertook a monetary purge for the second time. Bank notes with a value of Rp 500 or Rp 1000 had their face values reduced by a factor of ten. Ninety percent of all bank deposits of Rp 25,000 or more were frozen. The purge reduced the volume of currency in circulation from Rp 34 billion to Rp 21 billion overnight. The government also devalued the rupiah by almost 300 percent and increased taxes on trade. A 20 percent tax was put on all exports, and imports were classified into six categories with tariffs ranging up to 200 percent. The price stability brought by the second monetary purge and the tax increases again did not last long. Government expenditures on prestige projects financed by money creation started up again in 1961. To induce external aid as a way to contain the renewed inflation, in May 1963 the government implemented a stabilization program designed by the IMF. The program was a combination of budget austerity, relaxation of price controls, introduction of new foreign exchange regulations to encourage exports, and tight money policy. The effects of the stabilization program were dramatic but short-lived. The availability of foreign aid and loans increased imports and flattened out the general price index between June and August. In September 1963 Indonesia entered into a political conflict with Malaysia. The resulting increase in military expenditures widened the budget deficit so much that the stabilization program was undermined. Diversion of resources and transportation facilities from the civilian sector for military use reduced the productive capacity of the economy. In April 1964 the IMF stabilization program was formally abrogated. The government reverted to money-financing the budget deficits and reimposed extensive price controls. The money supply increased by 156 percent in 1964, 283 percent in 1965, and 764 percent in 1966. Under such circumstances, price controls were unable to curb the inflation rate. 2.5

The Foreign Sector

The Indonesian economy was heavily dependent on the export of a narrow range of primary products such as rubber, crude oil, tin, palm oil, and coffee. Rubber, for example, accounted for about 45 percent of the total value of Indonesia’s exports in 1955 and in 1960 (table 2.6). Export of petroleum amounted to 23 percent of the total value of exports in 1955 and 26 percent in 1960; copra accounted for nearly 4.5 percent of the total export proceeds in 1955 and 4 percent in 1960. The figures for tin were 6 percent in 1955 and in 1960.

Table 2.6

Export by Commodity as Rercentage of Total Exports (1951-69) ~~

~~

~

~

1951

1952

1953

1954

1955

I956

1957

1958

1959

Rubber Petroleum and petroleum products Tin and tin ore Copra and copra cakes Coffee Tea Tobacco Palm oil and palm kernels Other

50.6

44.9

33.0

30.5

45.4

40.1

36.0

34.6

45.0

14.3 6.3 10.3 1.7 2.8 1.8 2.9 9.4

20.5 9.2 6.0 1.9 2.5 2.5 3.3 9.3

24.5 9.9 7.8 3.7 2.9 3.0 4.1 11.2

26.2 7.1 6.7 4.6 4.6 3.8 3.5 13.1

22.8 6.3 4.5 1.7 3.3 2.9 2.8 10.3

25.5 7.2 5.1 3.4 3.4 3.3 3.5 8.7

33.3 5.6 4.4 3.0 3.1 3.5 3.1 8.0

37.4 5.0 2.8 2.4 3.3 4.0 3.7 6.9

30.7 3.9 3.6 2.0 3.2 2.6 2.6 6.4

Rubber Petroleum and petroleum products Tin and tin ore Copra and copra cakes Coffee Tea Tobacco Palm oil and palm kernels Other

7.8

7.2

5.5

5.8

5.8

5.0

3.6

3.7

69.1 0.5 6.1 0.2 0.4

76.5 0.5 4.2 0.2 0.3 0.1 1.5 9.5

78.7 0.4 3.4 0.3 0.2 0.1 1.4 10.0

84.6 0.4 3.4 0.3 0.3 0.2 1.4 3.7

79.5 0.4 3.2 0.2 0.2 0.1 1.3 9.4

80.8 0.4 3.0 0.4 0.3 0.1 1.3 8.8

86.8 0.2 2.4 0.3 0.2 0.1 0.9 5.6

86.8 0.2 1.5 0.2 0.2

0.1

1.3 14.6

Source: Bank Indonesia, Annual Report, various issues.

0.1

1.1 6.1

1960

1961

1962

1963

1964

I965

1966

1967

1968

1969

By Value 44.9 39.0

43.8

35.2

32.6

31.4

32.9

25.3

24.0

26.5

31.7 5.1 2.7 1.8 3.0 2.4 3.1 6.5

38.6 2.7 2.5 2.9 2.6 2.7 3.4 9.5

36.9 4.4 3.9 3.7 2.4 3.0 4.3 9.0

38.5 5.7 2.6 4.5 1.8 2.7 4.5 8.5

30.0 4.7 2.2 4.8 2.5 3.5 5.5 13.8

36.2 7.8 2.0 6.8 1.5 2.2 4.1 14.1

42.2 5.6 3.5 6.2 2.2 2.0 3.3 10.9

44.9 4.8 2.3 7.0 1.1 0.6 3.3 9.6

4.7

3.3

3.3

3.6

3.7

3.0

2.8

2.2

85.0 0.2 1.4 0.4 0.2 0.1 0.7 7.4

86.6 0.1 0.6 0.5 0.2 0.1 0.6 8.0

88.6 0.1 0.9 0.3 0.2 0.1 0.7 5.8

88.1 0.1 1.3 0.5 0.2 0.1 0.8 5.3

86.9 0.1 1.4 0.5 0.2 0.1 1.1 6.0

87.1 0.1 1.3 0.6 0.1 0.1 0.8 6.8

87.1 0.1 1.2 0.3 0.1 0.0 0.7 7.5

82.3 0.1 I .9 0.5 0.1 0.0 0.5 12.4

26.3 33.1 6.0 4.2 5.1 4.1 1.6 1.8 3.3 3.3 3.4 3.1 2.9 3.1 7.6 7.4 By Volume 4.9 3.6 3.6

84.7 0.2 1.0 0.3 0.2 0.1 0.7 8.0

86.1 0.2 1.0 0.3 0.2 0.1 0.7 7.2

86.2 0.1 1.3 0.4 0.2 0.1 0.7 7.5

45

IndonesidChapter 2

Table 2.7 shows an almost continuous deficit in the goods and services account during 1951-66. As has been pointed out earlier, since economic policies had been subordinated to political maneuvering, government expenditure could not be cut. The only adjustment measures that could be taken by the government were to reduce private consumption and private investment expenditures. To achieve the reduction in private spending, the government used a mixture of devaluation, tariff, trade restrictions, and export-inducement certificates. Devaluation gives a price incentive in domestic currency to factors of production in the traded sector. The price incentive is expected to encourage the movement of factors from the nontraded to the traded sector, thereby changing the structure of the economy to a more efficient one. The growth in output and the structural change in the economy, however, did not happen in Indonesia due to political instabilities and extensive dirigisme. Undoubtedly, quantitative import restrictions are more effective in restraining imports than a devaluation or a tariff, since their effects can be felt immediately. However, the resulting distortions decrease the efficiency of the economy and ultimately its growth potential. The first system of export-inducement certificates was introduced on 11 March 1950. In this system, exporters were required to sell their export proceeds to the Foreign Exchange Fund, LAAPLN (Lembaga Alat-Alat Pemabayaran Luar Negeri). In addition to the countervalue in rupiah at the official exchange rate (Rp 3.80/U.S.$), they received a certificate to buy foreign exchange equal to 50 percent of the rupiah value of the foreign exchange they turned in. The export certificates could be sold in the free market at a pegged price which was equal to 200 percent of the official rate. The buyers who wanted to use foreign exchange were required to turn in certificates equal to the full countervalue of the foreign exchange. In this system, therefore, exporters received 200 percent of the official exchange rate, importers paid 300 percent, and the government collected the difference as tax revenue. However, the constant need for additional government revenue made sustained export promotion efforts impossible. On 4 February 1952 the government imposed “additional export duties” on a wide range of export products to supplement the existing 8 percent general rate. The so-called strong products, such as rubber and copra, were subject to an additional 25 percent export tax, while the “weak products,” such as tin, palm oil, petroleum, and coffee, were subject to an additional 15 percent export tax. And finally, in February 1953 the export certificate system was abolished. The Burhanudin Harahap government introduced a major economic policy reform on 1 September 1955. To encourage exports, the authorities introduced a new export certificate, the BPE (Bukti Pendorong Ekspor) system. Export premium in the new system was given in foreign exchange, unlike in the old one which gave it in local currency. The percentage amount

Table 2.7

Indonesia’s Balance of Payments, 1950-69 (in millions of U.S. dollars)

Goods and services Merchandise Exports Imports Nonmonetary gold movement Foreign travel Transportation Insurance Investment income Government n.i.e. Miscellaneous Oil Companies Donations Private Official Total current transaction Private, exclusive banks Long-term loans Oil companies investment Other long-term loan movements Short-term loans Long-term improvements Short-term improvements Government and banks Long-term loans Short-term loans Liabilities to IMF & IBRD Other short-term loan movements Long-term improvements Short-term improvements Foreign exchange & gold holdings Foreign exchange holdings Monetary gold holdings Total movements of capital, foreign exchange & monetary gold Transirory items

1950

1951

1952

1953

1954

1955

1956

1957

1958

1959

174.0 250.4 629.1 -378.7 0.0 - 8.7 -21.5 - 10.0 -24.1 - 26.5 14.4 0.0 39.1 N.A. N.A. 213.2

164.2 401.6 1254.6 -853.0 0.0 -7.1 -5.8 -7.7 -42.3 -25.6 -43.4 - 105.5 0.4 N.A. N.A. 164.7

-265.4 -90.9 890.5 -981.4 0.0 -9.3 -11.1 - 12.1 -38.0 - 18.6 -32.3 -53.1 1.3 N.A. N.A. -258.2

- 135.8

-40.6 61.1 769.8 -708.7 0.3 -6.8 -7.7 -9.7 -70.3 -7.5 0.0 0.0 2.7 0.6 2.1 -44.1

102.2 251.0 877.4 -626.4 0.1 -7.1 -13.3 -12.4 - 107.6 -8.5 0.0 0.0 1.3 0.4 0.9 103.5

- 157.6

-42.7 23.2 425.6 -402.4 0.0 -5.2 -4.7 -4.6 -42.6 - 8.8 0.0 0.0 6.0 0.2 5.8 - 36.7

- 96.9

-48.6 845.7 -894.3 0.1 -9.7 -11.7 - 12.7 - 64.0 -11.0 0.0 0.0 1.4 0.6 0.8 - 156.2

83.6 961.2 - 877.6 0.0 -9.9 -20.2 -5.9 - 102.0 -42.5 0.0 0.0 280.4 0.3 280.1 183.4

25.2 234.8 816.9 -582. I 0.0 - 10.0 -53.7 -3.2 -71.5 -15.1 -50.1 0.0 16.7 0.2 16.5 41.8

-4.7 0.0 0.0 0.0 0.0

8.2 0.0 0.0 -0.1 0.0 0.0

7.9 0.0 0.0 0.0 0.0 0.0

-0.4 15.8 -16.2 -0.8 0.0 0.0

0.4 25.6 -25.2 0.7 0.0 0.0

0.1 2.3 -2.2 0.8 0.0 0.0

0.8 1.5 -0.7 0.0 0.2 0.6

5.7 7.8 - 2.0 0.0 0.2 1.2

1.4 0.0 1.4 0.0 -0.3

- 39.4

-78.4 0.0 0.0 0.0 0.0 0.0 0.0 - 181.1 -44.2 -295.7 37.5

-2.4 0.0 14.9 0.0 0.0

- 15.9

0.0 0.0 97.6 8.9 - 103.5

-2.5 0.0 0.0 22.9 - 1.7 0.0 0.0 12.1 2.7 35.1 1.7

- 3.4

0.0

-11.0 0.0 27.5 36.9 1.2 0.0 0.0 60.8 37.1 153.4 2.7

120.9 0.0 -9.1 8.7 0.0 -21.3 0.0 - 124.2 4.8 - 18.9 -22.8

0.0

7.6 161.4 0.0 0.0 0.0 0.0 116.0 0.0 0.0 194.7 18.4

0.0 0.0 0.0

0.0 0.0 0.0

76.6 -70.6 115.9 48.7

66.1 853.5 -787.4 1.7 -7.9 -13.1 - 12.9 -54.3 - 16.1 -44.4 -54.9 3.3 N.A. N.A. - 132.5 1.6 0.0 0.0 -0.1 0.0 0.0

-1.2 26.1 0.0 0.0 0.0

0.0 0.0 89.6 5.6 115.5 16.9

0.0 -22.6 55.3 44.1 0.0

0.0 0.0 0.0

0.0

0.0

0.0

0.0 11.2 - 17.9 0.0 0.0 - 170.9 2.2 - 171.8 -11.6

0.0

Goods and services Merchandise Exports Imports Nonmonetary gold movement Foreign travel Transportation Insurance Investment income

Government n i e . Miscellaneous Oil Companies Donations Private Official Total current transaction Privare, exclusive banks Long-term loans Oil companies investment Other long-term loan movements Short-term loans Long-term improvements Short-term improvements Governmenr and banks Long-term loans Short-term loans Liabilities to IMF & IBRD Other short-term loan movements Long-term improvements Short-term improvements Foreign exchange & gold holdings Foreign exchange holdings Monetary gold holdings Total movements of capital, foreign exchange & monetary gold Transitory items

1960

1961

1962

I963

1964

1965

1966

1967

1968

1969

-83.5 132.2 881.2 -749.0 0.0 -7.6 -50.7 -3.2 -67.0 -10.3 -76.9 0.0 24.5 0.8 23.8 -58.9

-523.5 -289.9 766.1 - 1056.0 0.0 -7.5 -65.6 - 3.4 -86.3 - 15.5 -55.2 0.0 60.0 0.3 59.7 -463.5

- 248.4

-227.8 54.4 616.4 -562.0 0.0 -5.6 -39.7 -3.2 -97.5 -50.8 -85.4 0.0 26.4 0.4 25.9 -201.5

-229.8 41.8 631.5 -589.8 0.0 -6.5 -44.1 - 1.2 -92.6 -52.7 74.4

- 248.0

- 132.0

- 282.0

39.0 634.0 - 595.0 0.0 8.0 -11.0 -60.0 -95.0 -52.0 -61.0 0.0 24.7 0.0 24.7 - 222.8

110.0 714.0 -604.0 0.0 - 18.0 -7.0 -63.0 -47.0 -35.0 -72.0 0.0 15.0 0.0 15.0 - 117.0

-35.0 770.0

-251.00 41.0 872.0 -831.0 0.0 - 14.0 - 3.0 -92.0 - 78.0 -23.0 - 82.0 0.0 26.0 0.0 26.0 -225.0

-361.00 2.0 995.0 -993.0 0.0 - 10.0 3.0 - 107.0 107.0 - 18.0 -118.0 0.0 47.0 0.0 47.0 -314.0

18.3 18.7 -0.4 0.0 0.1 1.8

- 11.7 - 12.5

25.1 25.0 0.1

18.0 18.0 0.0 0.0 0.0 0.0

- 16.0 - 16.0

- 10.0

0.0 0.0 0.0

9.4 9.7 0.4 0.0 0.0 0.0

0.0 0.0 50.0 0.0

2.0 28.0 66.0 0.0

3.0 -3.0 6.0 12.0 35.0 0.0

31.0 31.0 0.0 8.0 12.0 0.0

119.5 0.0 - 19.0 38.5 0.0 - 22.2 0.0 -42.6 - 25.4 68.8 -9.8

349.6 0.0 34.0 -42.0 0.0 -2.7

45.7 0.0 21.3 43.5 0.0 3.1 0.0 130.5 -0.7 255.9 -44.1

85.3 0.0 20.0 25.3 0.0 0.7 0.0 89. I 8.6 239.2 -37.7

78.8 0.0

5.8 0.0 0.0 222.7 0.0 -0.8

51.0 30.0

0.0 12.5

0.0 5.0 0.0 126.0 -9.0

187.0 4.0 0.0 0.0 0.0 0.0 0.0 -6.0 0.0 284.0 -30.0

179.0 12.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 229.0 -4.0

290.0 8.0 0.0 0.0 0.0 0.0 0.0 35.0 0.0 279.0 35.0

0.7

0.0 0.0 0.6

0.0 119.6 15.0 462.4 1.1

-25.4 710.8 - 736.2

0.0 -3.0 -51.8 -2.3 - 100.8 -23.8 -41.2 0.0 36.5 0.2 36.3 -211.8 12.5 11.5 0.9

~

Source; Bank Indonesia, Annual Report. various issues. Nore: N.A. = data not available. n.i.e. = not included elsewhere.

-

0.0 24.0 0.4 23.6 - 205.7

0.0 0.0 0.0

0.0 50.1 0.0 0.2 0.0 5.5 33.2 192.8 12.9 ~

-

0.0

0.0 0.0 0.0

0.0 258.3 -35.5 ~~~~

- 805.0 0.0 -4.0 - 9.0 -86.0 -63.0 -23.0 -62.0 0.0 28.0 0.0 28.0 -254.0

- 12.0

~~

-

-

48

Wing Thye Woo and Anwar Nasution

of export premium was divided into eight groups ranging from 2 to 20 percent. The BPE certificate could be sold in the free market within three months. In early September 1956 the free market value of the BPE certificate was 260 percent of the official rate. On 20 June 1957 the Monetary Board replaced the BPE certificate with the BE (Bukti Ekspor) certificate. The BE certificates, valued in rupiah at the official exchange rate (Rp 11.40), could be sold in the free market within two months. Purchase of the BE certificates was restricted to holders of import permits and licenses and of transfer permits. A 20 percent levy known as PBE (Pembuyuran Bukti Ekspor) was collected by the government from exports of goods and services. The market price of the new BE certificate immediately soared to 220 percent of the official rate. At the end of 1957 it rose to 250 percent and then to 332 percent in March 1958. In April 1958, however, the government ended the market determination of the BE exchange rate by fixing its value. The BE system was officially ended in August 1959. The vacillating treatment of the export sector described above characterizes very weil the inability of the government to conduct consistent economic policies within any reasonable time horizon. The on-again and off-again use of export incentives continued until the end of the Soekarno regime: the SIVA (Surat Zjin Vulutu Asing) export certificate in March 1962, the Additional Export-Inducement certificate and Special Export certificate in May 1963, and the SPP (Surat Pendorang Produksi) export certificate in April 1964. None of these export certificate schemes lasted long because the tension between taxing exports in order to reduce the budget deficit and promoting exports in order to attenuate the balance-of-payments deficit was never resolved.

2.6 The End of the Soekarno Regime The internal political struggle culminated with the abortive coup by the communists on the night of 30 September 1965. The political instability aggravated the economic instability. A combination of drastic devaluation and a third monetary purge on December 13 had no effect in controlling inflation. The increasing economic difficulties due to those measures speeded up the transfer of authority from President Soekarno to General Soeharto in the following year.

Appendix Table A2.1

Private consumption Government consumption Gross capital formation Exports Imports

1960

1961

1962

I963

311.4

335.8 (7.8) 42.0 (-6.9) 44.1 (43.6) 56.7 (9 0 ) 66.0 (34.7)

359.2 (7.0) 33.8 ( - 19.5) 40. I (-9.1) 51.8 ( - 8.6) 64.7 ( - 2.0)

345.0 (-4.0) 34.0 (.6) 30.6 (-23.7) 48.7 (-6.0) 47.5 (-26.6)

347.7 (.8) 40.0 (17.6) 34.8 (13.7) 54.5 (11.9) 51.7 (8.8)

356.0 (2.4) 29.0 ( - 27.5) 36.2 (4.0) 56.2 (3.1) 47.5 (-8.1)

390.2

412.6

420.2

410.8

425.3

390.2

470.1

1,335.1

3.208.8

7l.237.5

45.1 30.7 52.0 49.0

GDP at constant prices GDP at current prices Source:

Expenditure on GNP at Constant 1960 Prices (in billions of rupiahs)

Biro Pusat Statistik.

Note; Figures in parentheses are growth rates

1964

I965

I966

1967

1968

1969

350.8 1.5) 40.3 (39.0) 40.7 (12.4) 55.6

396.3 (3.8) 37.2 (3.9) 46.3 (39.5) 61.3 (10.5) 62.3 (6.9)

442.0

45.5 (-4.2)

381.8 (8.8) 35.8 (-11.2) 33.2 (~ 18.4) 55.5 ( - .2) 58.3 (28.1)

429.9

441.9

448.0

478.8

531.0

23.823.4

419.5

945.2

2.102.9

2,830.7

(-

( - 1.1)

(11.5)

42.0 (12.9) 52.0 (12.3) 70.0 (14.2) 75.0 (20.4)

Table A2.2

Rrcentage Distribution of National Income by Sector of Origin, 1953-69.

Sector

1953

1954

1955

Agriculture

57.0

58.0

56.0

55.0

36.2 7.9 4.5 4.2 3.0 2.3

36.9 7.9 3.8 4.9 2.9 2.2

36.2 8.0 3.8 4.6 2.9 1.4

36.6 7.1 3.5 4.5 2.8 1.4

1.1

.6

.9

.9

43.0

42.0

44.0

12.0 23.1

11.8 22.5

12.2 23.2

7.9

7.7

8.6

Peasant food crops Peasant export crops Estate crops Livestock Forestry Fishery Minus: export duties and statistical tax Nonagriculture Industryb Services Trade & financial Other Government

1956

1957

1958

1959

52.6

56.0

35.5 6.7 3.4 4.2 2.6 1.3

40.4 3.6 3.2

1966

55.4

58.7

38.0 5.7 2.6 2.8 2.3 4.0

35.8 9.1 3.6 3.5 .9 5.8

-

42.1 12.2 26.2 15.6 10.6 3.8

1961

55.2

53.9

47.9

59.0

57.9

3.0 1.6

35.3 7.7 3.1 4.7 2.2 2.0

34.4 7.2 3.3 4.8 2.4 1.9

27.3 7.2 2.9 4.7 2.5 3.4

42.8 5.4 2.6 3.6 1.4 3.1

37.7 6.8 2.3 3.7 1.2 6.1

.9

.8

-

-

-

-

-

45.0

47.4

44.0

44.8

46.1

52.1

41.0

12.5 23.4

14.7 23.1

11.0 19.3

9.1

10.2

13.7

16.5 23.2 11.8 11.4 5.0

14.4 27.2 15.3 11.9 4.5

15.4 31.0 18.7 12.4 5.6

11.1 27.3 16.1 11.3 2.5

5.0

Source: 1953-58: Biro Perancang Negara (1960, 101) 1959-66: BPS, SfafisticalPocketbook of Indonesia,various issues Nofe: Dash indicates that data were not available.

"Based on current prices. bIncludes mining, manufacturing, construction, and utilities.

1962

1965

1960

1%3

1964

1967

1968

1969

53.3

53.9

51.0

49.3

33.8 5.9 2.6 2.6 .8 7.7

35.5 5.4 2.3 3.9 .7 6.2

34.6 6.3 2.2 2.5 1.7 3.6

30.3 7.3 2.5 3.3 2.2 3.7

-

-

-

-

-

44.6

41.3

46.7

46.1

49.0

50.7

17.2 24.6 14.5 10.2 2.7

11.9 25.8 13.2 12.6 3.6

11.1 30.4 19.5 10.9 5.1

12.1 29.2 18.0 11.1 4.8

15.2 28.2 17.5 10.7 5.6

17.2 28.5 18.3 10.2 5.0

51

IndonesidChapter 2 Expenditure Composition of National Income (GDP), 1960-69 (in percentages)

lsble A2.3

1960 1961 1962 1963 1964 1965 1964 1961 1968 1969

private Consumption

Government Consumption

Investment

Export

Import

19.8 82.0 88.4 85.0 80.4 81.1 12.3 83.2 84.2 81.2

11.6 11.8 6.2 7.1 7.0 5.6 6.6 6.6 6.8 7.0

1.9 10.2 5.6 8.2 11.9 6.1 3.4 1.2 8.5 11.2

13.3 9.6 5.2 9.1 12.1 5.3 9.6 1.9 10.8 11.6

12.6 13.6 5.4 9.3 12.9 5.1 16.6 15.1 15.5 15.0

Source: Biro Pusat Statist&.

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LEI'

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091' 828' 8PO' 510' 8SZ. 6EE' ZEZ' E59'Z 811.01 098'1 LL9'PI

PPE'5I

KO' IPZ' LIL' 820' 86L'Z 655'51

PZO' E69'Z OIE'91

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SPZ' SIP' ZEZ'

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801'

EOE 858' 1EO' 8E9'Z 028'21 S91' 98L'

Em' EIO'

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6EO' WZ'

PIS' KO' Z9P'Z 818'11

991' ZS8' PPO' 910' L9Z' 9PE' LOZ' 868'1 LIE'6 I L6' I ZEP'PI

OZO' ELI'

006' 9EO' IPOO'Z

E18'OI 691 ' 81L' LPOO' PIO' 882'

oop' 882' IlI'Z 695'6 OZL'Z 190'51

ZZO' 051' L68' PEO' E9L'I 19Z'OI 091' 029' LEO'

ZZO' 60E' 90E' POZ. 9Ll.Z ES6'8 518.1 t.9o'Pl

600' PPE' 696' 9EO' 6LE'l EZS'8 9PI' 8SP' LPO' €10' 662' 982' L91' 262'2 5ES.L 8E9' I ELL.ZI

0 ZW' 898'

IEO' EIO'I 660'8

IZI' 8ZP' 9mO'

ZIO' 612' 9LZ' P61'

EOE. I EEI'L 86E'I 896'1 I

Agriculture (million kgs) Paddy Maize Cassava Sweet Potatoes Peanuts Soya beans Rubber Coffee Tea

sugar Palm oil Mining (billion kgs) Crude petroleum Natural gas Tin in ore Coal Bauxite Manganese ore

1961

I962

1963

I964

1965

1966

1967

1968

1969

15.900 2.283 11.190 2.464 ,252 .426 .231 .019 ,034 ,643 ,146

17.111 3.243 11.386 3.680 ,261 ,397 ,218 ,013 ,047 .592 .142

15.276 2.358 11.679 3.070 .235 .350 ,218 ,019 ,039 .664 ,148

16.192 3.769 12.262 3.958 ,261 ,392 .234 .008 ,046 .655 .161

17.072 2.365 12.643 2.651 ,244 ,410 .228 ,020 ,044 .775 .I57

17.960 3.717 11.233 2.476 ,264 ,417 ,217 ,013 .612 ,174

17.398 2.369 10.747 2.144 ,241 ,416 ,205 ,019 ,034 ,666 ,174

20.032 3.102 11.268 2.282 ,273 ,389 ,215 ,014 ,042 ,603

20.464 2.271 10.845 1.904 ,257 ,416 .223 .016 ,047 .628 ,189

21.287 3.314 ,019 ,549 ,420 ,013

22.747 3.491 .Ol7 ,471 ,461 ,050

22.231 3.610 .013 ,650 ,506 ,001

26.851 3.524 .016

27.955 3.156 .015 ,281 ,688 .052

26.778 3. I62 ,013 ,320 ,701 .001

25.311 2.776 ,013 ,207 ,912 0

34.946 3.287 ,017 ,176 ,879 0

.446 ,648 ,005

,040

Sources: BPS, Statistical Yearbook of Indonesia, various issues. Bank Indonesia, Yearly Report, various issues

,188

43.086 2.604 ,017 ,191 ,765 0

54

Wing Thye Woo and Anwar Nasution

Table A2.5

Population of Indonesia, 1930-76 Population (millions)

Java-Madura Rural Urban Total Outer Islands Rural Urban Total Indonesia Rural Urban Total

Annual Growth Rate ( 0 )

1930

1961

1971

1976

1930-61

1961-71

1971-76

-

53.2 9.8 63.0

62.4 13.7 76. I

67.9 15.1 83.0

-

1.6 3.4 I .9

1.7 2.0 1.9

29.5 4.6 34.0

36.0 7. I 43.1

40.2 8.6 48.8

-

2.0 4.4 2.4

2.2 3.9 2.5

82.7 14.4 97.0

98.4 20.8 119.0

108.1 23.7 131.8

-

1.8 3.7 2.1

1.9 2.6 2.0

-

41.7

-

18.9 -

60.6

Note: Dash indicates that data were not available.

I .4

-

1.9

-

I .5

Table A2.6

Distribution and Size of Work Force in Indonesia, 19-76

(in percentages)

Indonesia

Java-Madura

Outer Islands

Sector

1930

1961

1971

1976

1930

1%1

1971

1976

1930

1961

1971

1976

Agricultural Manufacturing Trade Services Total Total number (millions) Annual growth (percent)

68.8 10.6 7.7 12.9 100.0 20.9

73.6 7.8 8.9 9.7 100.0 34.8

66.2 9.9 13.5 10.4 100.0 44.1

62.0 10.1 17.3 10.6 100.0 51

64.3 11.6 8.5 15.6 100.0 14.4

69.4 9.1 10.2 11.2 100.0 22.7

61.4 11.4 15.9 11.3 100.0 28.8

58.7 11.3 18.9 11.1 100.0 33.2

79.5 8.3 5.7 6.5 100.0 6.2

81.6 5.2 6.6 6.6 100.0 12. I

75.4 6.9 9.0 8.7 100.0 15.3

68.4 7.9 14.1 9.5 100.0 17.8

Source: David 0. Dapice (1980)

1.7

2.4

3.0

I .4

2.4

2.9

2.2

2.4

3.1

56

3

Wing Thye Woo and Anwar Nasution

The Political Economy Factors in Policymaking

3.1 Introduction The economic chaos of 1958-65 left such a deep impression on the institutional memory of the new Soeharto government that it has followed a “balanced” budget rule since 1968. In reality, this rule amounts to refusing to finance the deficit through money creation and limiting the deficit to the availability of foreign loans, which are officially described as foreign “revenue”. Another consequence of the chaos was the recognition that the exchange rate is an extremely potent policy instrument which can effect large-scale, economy-wide resource reallocation and income redistribution. The aim of this chapter is to show how the institutional memory has interacted with political economy factors to shape Indonesian economic management since 1965. In short, this chapter attempts to illuminate how the dead hand of history sets the constraints within which the invisible hand of economics operates. An emphasis on political factors should certainly be an important part of any discussion about external debt management. In the final analysis, it is these political considerations which determine whether a country will continue austerity measures in order to service its debts or will choose to repudiate its debts. In the case of Indonesia, an understanding of the political alignment and economic interests of the different constituencies is necessary in order to make sense out of the seemingly contradictory policies of the 1980s. For example, in March 1983 when it was clear that oil prices would be unlikely to soon recover, the Indonesian currency was devalued by 38 percent against the dollar in order to promote nonoil exports. The devaluation was followed by several fundamental reforms with the stated goal of liberalizing the economy in order to improve resource allocation which would then lead to higher long-term growth. The financial sector was thoroughly deregulated; the traditional instruments of monetary control-interest rate ceilings and credit rationing-were abandoned for more market-oriented financial instruments. The tax system was completely restructured: the tax code simplified, the tax base broadened, and marginal tax rates slashed. Economic liberalization was nevertheless not the overall thrust of Indonesian economic policies. At the time that the liberalizing measures were introduced, an avalanche of import restrictions was imposed. The new import restrictions generally took the form of monopoly licensing. The right to import was granted either to an individual, to a small group of firms, or to import-competing firms. The stated aim was the same as that for the liberalizing reforms-to achieve higher long-term growth. The means in this

’

57

IndonesidChapter 3

case were industrialization and the development of sectoral linkages. Furthermore, since many of the monopoly licenses were for important industrial materials which were inputs to many export industries, these new trade policies ran counter to the purpose of the March 1983 devaluation. Given that all of the policies adopted in 1983 were drastic departures from past norms, one may be puzzled by the absence of a clear direction in the new economic strategy. We attribute this curious mix of liberalizing steps and protectionist decrees to two factors: one, the existence of two groups of economic advisors who represent very different interests and ideological perspectives; and, two, the delicate role of the president in Indonesian politics as the supreme arbiter of the distribution of economic benefik2

3.2 The Dead Hand of History Indonesia is an authoritarian state which practices implicit corporati~m.~ President Soeharto has been in power since October 1965 and has not faced any serious challenges to his rule since the Malari riots of January 1974. Parliament is dominated by the government party, GOLKAR, which is an umbrella organization of civil service unions, trade associations, and youth, veteran, and women’s groups. GOLKAR was created by Soeharto and hence it does not formulate the national agenda to be implemented by the president. The opposition parties are in such disarray that they actually receive annual government subsidies in order to maintain their operations. The plight of the opposition parties is as much due to government intimidation as to their record for ineffectiveness and squabbling during the early days of the Republic. Although Soeharto is a former army general and the army is the backbone of GOLKAR, Indonesia is not a military state. The military does not have “important centers of power independent of the central authority” and the president does not engage in “a continuous process of bargaining with other officers” (Sundhaussen 1978, 78). The army supports Soeharto but it, like GOLKAR, does not set the national agenda. We pay particular attention to Soeharto’s preferences because of the unusual degree of decision making concentrated in, and the broad executive powers granted to, this one individual. Since the authoritarian nature of the state renders the medium-run accountability of the president’s actions to be very low, and there are substantial differences in interests and ideology within the implicit coalition, Soeharto must be considered an independent force rather than merely the compromise byproduct of competition among the elite groups. One way of describing the economic policymaking process is the following: The different lobbies and advisory groups propose policy initiatives, and the president adopts those which are either compatible with his innate preferences or vital to maintaining his position as the overarching

58

Wing Thye Woo and Anwar Nasution

patron. It is, therefore, only natural that we begin the task of explaining the choice of economic strategy in Indonesia by studying the events and forces which shaped Soeharto’s views on economic management. Indonesia was in a state of total economic chaos when Soeharto assumed formal executive power in March 1966. The economy had grown unsteadily at an annual average rate of 1.8 percent between 1960 and 1965. Since the annual population growth rate was 2.5 percent, per capita income declined over this period. The inflation rate was also accelerating. It was 128 percent in 1963, 135 percent in 1964, and 595 percent in 1965. In addition, Indonesia had defaulted on its external debts in 1965. The economic stagnation was inevitable given the many microeconomic distortions and the huge macroeconomic imbalances. An exchange rate that was overvalued for a prolonged period of time had caused the decline of the export industries, the most productive sector of the economy. The import-competing industries, kept alive by high tariffs, were notoriously inefficient. Extensive price controls which discouraged production, a complex tax system with high marginal rates, and a corrupt administrative structure also helped to cripple economic growth. The high inflation rate was the result of the monetization of the swingeing budget deficits and the government-ordered extension of central bank credit to state enterprises and to favored members of the private sector. Central government expenditure was 103 percent larger than its revenue in 1963, 140 percent in 1964, and 163 percent in 1965. The rapid expansion of money (Ml) in circulation reflected this fiscal mismanagement. The money stock increased 94 percent in 1963, 156 percent in 1964, and 283 percent in 1965. The inflation rates in 1963 and 1965 were actually higher than the money growth rates, 129 percent and 595 percent, respectively, producing a situation where money was rapidly losing its function as a medium of e~change.~ On 3 October 1966 the new Indonesian government announced a stabilization and rehabilitation program5 The central plank of the stabilization program was an unequivocal commitment to end the printing of money to finance government budget deficits. The government pledged that it would adhere to a “balanced” budget policy from 1967 on. In official Indonesian usage this meant that government expenditure was limited to the sum of domestic revenue and external loans. Since the Indonesian government was shut off from the external private credit market in 1966, such a budget rule was effective in limiting government expenditure because of the inelastic supply of foreign concessionary loans. Furthermore, central bank credit to state and private enterprises was severely curtailed and placed under strict supervision. The trend toward a demonetized economy was immediately reversedprices in 1967 rose only 112 percent when the currency stock went up by 132

59

IndonesidChapter 3

percent. After two years of balanced budgets and continued credit restraint, the restoration of confidence in the rupiah was complete. In 1969 prices rose only 17 percent in the face of a 61 percent increase in the currency stock. Inflation reached the extraordinarily low rate of 4 percent in 1971 despite a nearly 30 percent rise in the amount of currency in circulation. Soeharto obviously understood his first lesson in macroeconomic management because the balanced budget principle has never been compromised during his administration. To Soeharto, a prudent fiscal policy is the prerequisite for preventing runaway inflation, and fiscal prudence is understood to mean a “balanced” budget. The rehabilitation part of the October 1966 program was to allow market forces a greater (but by no means unrestricted) role in resource allocation. To reverse the trend toward subsistence fanning in the agricultural sector and, in particular, to improve the balance of payments, the government devalued the rupiah from 10 rupiahs/dollar to 100 rupiahs/dollar.6 Price controls on many commodities were removed to encourage their production. The government subsequently showed no reluctance to allow the rupiah to depreciate according to market conditions. The rupiah stood at 326 to the dollar at the end of 1968. Real nonoil exports (measured in foreign purchasing power) increased by 12 percent between 1965 and 1968.7 This is an underestimate because there was a large upsurge in smuggling to evade unauthorized taxes levied by corrupt officials who attempted to scoop some of the gains of the devaluation for themselves (see Penny and Thalib 1967). This export growth is still impressive, however, because this was a period of slow growth in the industrialized economies.* The surge in agricultural exports came from increased production by the small holders rather than by the estates. The production of farm nonfood crops increased by 19 percent compared to a 7 percent increase in estate output (World Bank 1975, table 2.2). The rehabilitation program really took effect in 1968 when real GDP increased by an unprecedented 11 percent. There was an annual average growth rate of over 8 percent from 1969 until the 1973 OPEC price increase. The distributional aspects of the devaluation are clear. Since the prices of commodities are set in dollars, a devaluation of the rupiah translated directly into increased income for the small agricultural producers. It would belittle Soeharto’s ability if we were to believe that he was not aware of either the political economy of the 1966 devaluation or its effectiveness as a policy instrument. Since then, devaluation has been a frequently used instrument; the rupiah was devalued in 1978 even when there was no balanceof-payments crisis ! Competitive exchange rate management alongside the balanced budget are the two constants in Soeharto’s economic policymaking, and they directly result from the memory of the economic chaos of the Soekamo years and of the 1966 economic program.

60

Wing Thye Woo and Anwar Nasution

3.3 Agrarian Radicalism, Separatism, and the Peasant Background of Soeharto It would be helpful at this point to use the issue of exchange rate management to lay out the political environment within which decisions are made about the goals of economic policies and the choice of instruments with which to implement them. The considerations that render Soeharto immune to a commitment to a strong (read “overvalued”) currency are the same ones that dictate budgetary choices during times when total spending has to be restrained to match lower revenue growth. Soeharto’s attitude to the exchange rate after observing the distributional impact of the 1966 devaluation is rooted in two political concerns and a strong personal commitment. The first political concern is to avoid conditions favorable to the resuscitation of the PKI. In 1965 Indonesia had “the strongest communist party outside the communist bloc, with a membership of over three million and affiliated mass organizations of farmers, workers, women, and students that claimed over 20 million followers” (Dake 1973, 1-2). The fact that its members were largely landless peasants in Central and East Java indicates that any prolonged impoverishment of the rural heartland could lead to the resurgence of the PKI. Soeharto is personally opposed to the communist ideology, and he has had two bloody encounters with the PKI. The first run-in was the internecine Madiun Affair in 1948 when the PKI tried to hijack the leadership of the independence movement. The second showdown was the 1965-66 aftermath of the abortive communist coup of September 30.9 The official casualty figure for the latter event is half a million, though unofficial reports of the period put it at one million. The political lesson is clear: the spectre of communism can be exorcised only by improvements in the lives of the rural population. Soeharto’s second political concern is the diversity of the ethnic groups which live in the 13,000 islands which make up Indonesia-“There are over three hundred different ethnic groups in Indonesia, each with its own cultural identity, and more than two hundred and fifty distinct languages are spoken in the archipelago. Religious beliefs, too, are varied” (Geertz 1963, 24). This diversity resulted in numerous secession attempts in the 1950s. Soeharto was personally involved in squashing a rebellion in Sulawesi in 1950. The sense of alienation in the Outer Islands has not been helped by the fact that the inner circles of the government have been dominated by the Javanese since independence in 1949. It has, hence, been necessary to assuage feelings of discrimination among the non-Javanese by proffering to them tangible economic benefits. The government has had to do more than raise living standards as it did in rural Java, it has also had to make it clear that inter-island (regional) equity is a primary goal of the Soeharto government. This has meant that spending for regional development has

61

IndonesidChapter 3

been a high priority, reinforcing Soeharto’s readiness to devalue the currency. Most of the import-substitution industries, whose products are practically nontradables because of cost inefficiency, are located in Java, and a devaluation always turns the regional terms of trade in favor of the agricultural-commodity-exporting Outer Islands. On the personal level, Soeharto has never downplayed his peasant origin.” From the earliest days of his presidency, he has consistently emphasized the need to improve the living standard in rural areas. Even if one were to dismiss Soeharto’s avowed commitment to alleviating rural poverty as political opportunism, the critic must concede that all this symbolism testifies to the importance which Soeharto places on rural development.” It may have been more than “mere” symbolism that the agricultural sector was singled out for attention in the first development plan, Repelita 1. This agricultural emphasis has been continued in subsequent development plans. It is the combination of the three factors-oncem about the traditional peasant base of PKI, experience with secessionist movements, and a personal commitment to rural development-that explains a great deal of the observed allocation of government expenditure in particular, and the conduct of economic management in general. The first and third concerns imply the need to improve the absolute level of the standard of living in rural areas, while the second concern implies the need to improve (or bring to par) the relative standard of living in the Outer Islands. Together these three factors focus attention on development of the agricultural sector, that is, rice in Java and agricultural commodities in the Outer Islands. l2 The general INPRES programs (development funds funneled directly at the president’s discretion through decrees, Znstruksi Presiden, to the local level), fertilizer subsidies, irrigation projects, and maintenance of a competitive exchange rate are the most explicit manifestations of the high priority placed on developing the agricultural sector.

3.4 Economic Nationalism, Political Patronage, Priburni-ism, and the Military Background of Soeharto Attention to its agricultural sector does not mean a strong overall agricultural bias in Indonesian economic policies. Rather, the bias is toward the industrial sector. There is widespread popular sentiment for, significant intellectual support of, and powerful special interests clamoring for the rapid development of a large and diversified industrial base. The president himself is sympathetic to this view because of his experience in the war for independence. As we explained in chapter 1, Dutch economic policies were seen as designed to impose a plantation economy on Indonesia to serve the needs of Dutch manufacturing industries for raw materials and to drain

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Indonesia of its wealth through profit repatriation. In reaction, the generation of 1945 regards industrialization as the key to economic prosperity because technological advancements were, supposedly, less likely to occur in the agricultural sector. They see the repatriation of profits to Holland as an additional reason for the absence of investment in manufacturing. So it is understandable that economic nationalism in postcolonial Indonesia took the form of state support for industrialization programs and intolerance for foreign ownership of capital (except in extractive industries in the Outer Islands where the capital requirements were immense). The policy translations of economic nationalism are high trade barriers to induce the development of a manufacturing sector and foreign investment laws (which still are) stricter than those of neighboring countries. It is Soeharto's economic nationalism which explains the vacillating attitude toward laissez-faire. The simultaneous introduction in 1983 of liberalizing measures, such as financial deregulation, together with interventionist measures, such as additional nontariff barriers, illustrates this ambiguity. Setting up inefficient industries behind trade barriers may reflect more than the fact that the army is the bastion of economic nationalism or the belief that industrial development is the long-run solution to rural poverty. An institutional legacy from the past may have been equally important. During the war for independence, the various army units were selfsupporting by circumstances, as there was no functioning central government to make budget allocations. In the Soekarno years, army generals were expected to continue supporting their troops by raising outside revenue to supplement their budget allocations. Joint business ventures involving senior army generals and the private sector were common. This practice has been expanded under the Soeharto regime, and the use of army personnel in business management has been justified by the doctrine of dwifungsi.'3 The imposition of trade barriers to give a monopoly position to manufacturing enterprises with army connections thus serves the dual purpose of catering to the army's economic nationalism and providing additional funds to the armed forces.14 The second purpose is an important reason Indonesian manufacturing industries are oriented toward internal rather than external markets. Competition in external markets may make production more efficient, but it also makes funding for the army more uncertain. This also helps to explain why quotas rather than tariffs are the favored form of import restriction.15 The granting of quota rights is a faster way of transferring funds to selected groups like the army, bypassing the laborious budgetary process. The result is that the budget understates the revenue and expenditure of the public sector. The widespread use of monopoly import licensing since 1982 serves in most cases the same transfer-of-funds function as quotas. Since the license holders are usually family members of government officials and political supporters, it is clear that the trade barriers were erected more for

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rent-seeking purposes than for infant industry reasons. l6 What is being revealed is the political patronage side and not the economic nationalist side of the Indonesian state. It has been argued that this privatization of public funds was actually a form of privatization of public works rather than the fruits of political patronage. According to Bustanil Arifin, the minister of cooperatives, the profits of the monopoly import licensing system are “being used to develop small industries, build mosques and churches and run public health program^."'^ The point is that given the considerable overlap of personnel in the public and private sectors (a practice sanctioned by dwifungsi), the line between these two sectors is blurred in Indonesia. Since private firms are expected to contribute for nonbudgeted public projects, it is perhaps not surprising that when the biggest cement company, Indocement, ran into financial difficulties in July 1985, the government reciprocated by spending over U.S. $325 million to bail it out. The ways in which Soeharto’s background has influenced his style of economic management have presented occasional problems for the budget. Perhaps, being a military man, it is natural that Soeharto shows impatience at the bureaucratic implementation of government programs. What is surprising is that instead of trying to streamline the bureaucracy, he regards its inefficiency as endemic. Two events reveal this attitude very clearly. Through INPRES since 1969, a sizable amount of development spending is directly channelled to the village and county levels, bypassing the usual disbursement mechanism. More recently, in 1985, the entire Indonesian customs service, well known for its corruption and delay, was put on indefinite paid leave. A private Swiss firm (SociCtC GCnCrale de Surveillance S.A. of Geneva) was hired in its place to clear the goods at their foreign ports of departure. In the eighteen years of his rule, Soeharto had plenty of time to revamp the customs service but he chose not to. And when he did respond to its inefficiency, the action reflected his pessimism about bureaucratic reform. While Soeharto highly valued the advice of his capable economic technocrats, he saw their penchant for detailed financial assessment and accountability as a drag on the pace of development. Soeharto’s appointments of, first, General Ibnu Sutowo, and then Technology Minister Habibie, as the czars of national industrialization, arise from his perception that the problems of a desperately poor country like Indonesia are obvious and what is needed are quick, decisive actions initiated and enforced by a capable and dedicated individual. Quick actions necessarily dictate that the individual be unconstrained by the usual bureaucratic checks which, after all, are meant only for men of lesser talent and dedication. Soeharto’s practice of allowing the “dynamiser” a free rein follows from his own experiences as the Central Java regional commander in the 1950s. Again, it was a time when military commanders had to generate substantial

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revenue to supplement the budget allocation in order to maintain the army units, the force that was preventing the disintegration of the new country into regional republics. Soeharto met this challenge with a series of very successful business ventures. In addition to the usual transportation and trading activities, Soeharto’s military command was the only one with a Development Contribution Fund financed by levies on the local business community. Soeharto’s style of granting broad discretionary powers to his industrialization czars resulted in the Pertamina crisis in February 1975. General Ibnu Sutowo, who in 1966 became head of the state oil company, Pertamina, expanded its nonoil investments tremendously. To finance this proliferation of activities, Pertamina borrowed heavily in the international credit market. A significant portion of Pertamina’s external debt was in short-term borrowing because the technocrats resented the evolution of Pertamina into an independent development agency and had, with the help of major aid donors, pressured Soeharto to restrict Pertamina’s borrowing in the medium-term credit market. It was this borrowing in the short-term market which precipitated the Pertamina crisis. In 1973 and 1974 Pertamina found itself paying higher and higher interest payments on the debt it was continually rolling over. (The interest rate rose because the central banks in the industrialized countries were stomping on their monetary brakes in order to dampen aggregate demand to offset the supply-side inflation caused by the OPEC-1 price increases.) The increased debt-service burden proved too much for Pertamina. In February 1975 it defaulted on a short-term loan, and Bank Indonesia had to take over Pertamina’s debt. Bank Indonesia’s foreign exchange reserves fell from $1.6 billion in January 1975 to $0.5 billion in September 1975, while at the same time its foreign liabilities rose from (nearly) zero to $0.8 billion, a reflection of the tremendous external borrowing required to meet Pertamina’s obligations during those seven months.” The big diversion of resources led to the scaling back of development expenditure in 1976/77 and 1977/78. It would be wrong to attribute the fiscal problems arising from the Pertamina affair entirely to Soeharto’s predilection for getting things done quickly. Special interests and ideology were also important in shaping events. The huge revenue generated by rapid development of the petroleum sector was very important to the Soeharto government in the early days of its administration because it obviated the unpopular steps of raising taxes to pay for routine government expenditures. l9 Since the Ministry of Finance had no knowledge of the amount of oil taxes and royalties that Pertamina had collected on the Ministry’s behalf, Pertamina retained part of the revenue for extrabudgetary activities. These activities helped to consolidate Soeharto’s power base by channelling resources to key constituents to meet what Karl Jackson (1978b) has called their “nonservice goals.” It is highly likely that

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the armed forces, which had their official budget capped in order to convince external aid donors of the commitment by the Indonesian government to development, were a big recipient of extrabudgetary allowances from Pertamina. Given these extra functions, it was no surprise therefore that Sutowo adopted a management style which “ensured that few people apart from himself even had a rough overall picture of the finances of operations of the company” (McCawley 1978, 5). Nothing illustrated this attempt at obfuscation better than the fact that Pertamina had six uncoordinated accounting departments.*’ Ideology also plays an important role in explaining the Pertamina affair because there was a sizable group of intellectuals who concluded that the establishment of more quasi-state conglomerates a la Pertamina was essential for political stability. An underlying resentment among many indigenous Indonesians (pribumis) was that the Chinese Indonesians (peranakan and totok) wielded economic power disproportionate to their 3 percent share of the population. It was widely felt that this state of affairs originated from the victimization of the pribumis by Dutch colonial policies.21 This resentment against the Chinese led to occasional mob destruction of Chinese property. These intellectuals were pessimistic about the ability of laissez-faire to change this inequality drastically and quickly enough to be politically acceptable. They proposed that Chinese domination of business be reduced by launching large, state-sponsored enterprises, each headed by one of the small number of talented pribumi entrepreneurs in existence. By regarding these Indonesian zaibatsu as holding their capital in trust for the pribumis, the share of indigenous ownership of capital would be considerably increased very rapidly.22 This method of defusing racial tension received enthusiastic support from the economic nationalists within the army, the key constituency in Soeharto’s regime, making it easier for Soeharto to follow his preference for quick action.

3.5 The Embodiment of the Different Concerns at the Policymaking Level The primary reason Indonesia sometimes pursues a contradictory mix of liberalizing and protectionist policies is because of these ideological, pecuniary, and personal elements working themselves through two groups of contending presidential economic adivsors, popularly referred to as the technocrats and the technician^.^^ The technocrats are mostly economists of neoclassical persuasion who work at the Ministry of Finance and the National Planning Body (BAPPENAS). Their acceptance of the comparative advantage principle leads them to emphasize the development of nonoil export industries, particularly agricultural commodities and labor-intensive manufactured goods. This has meant a favorable treatment of the agricultural sector because it supplied 82 percent of nonoil exports in 1970 and 75

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percent in 1980. Exchange rate devaluations, rather than the removal of trade restrictions on imported inputs, are used to promote exports because the technocrats control the ministries that oversee macroeconomic policies but not the Ministry of Trade and the Ministry of Industry which have authority over trade restrictions. The technocrats do not have much of a domestic constituency outside of the universities. Consistently strong sources of support for their marketoriented policies are the foreign aid donors, the World Bank, the International Monetary Fund, and IGGI.24This foreign backing helped in the early years to establish the role and power of the technocrats because of Indonesia’s dependency at that time on foreign concessionary This aspect was very well illustrated by the strategy the technocrats adopted to rein in Pertamina when it was intruding upon the economic policymaking turf.26In March 1972 the minister of finance chose to enter into another standby agreement with the IMF, even though in the agreement document the IMF had concluded that: [the] proposed fiscal and credit policies, the recent depreciation in the effective exchange rate of the rupiah, the expected substantial increase in net receipts from crude oil exports should make possible the achievement [of the Indonesian goals which were] to achieve a higher rate of economic growth in conditions of relative price stability, and to increase net international reserves. (emphasis added) The result of this extreme aversion of the Ministry of Finance to the possibility of a balance-of-payments crisis led to the IMF setting a ceiling on medium-term external borrowing of $145 million for 1972/73 as part of the standby agreement. A decree was issued in October 1972 requiring all state bodies to seek approval from the Ministry of Finance before contracting medium-term foreign loans. When Pertamina ignored this decree, the United States (the biggest donor) suspended its aid. Pertamina then started borrowing in the short-term market to finance its long-term investments. As noted earlier, this switch led to the 1975 Pertamina debt crisis, after which the firm was taken over by army personnel sympathetic to the technocrats. Despite the big decline in the importance of foreign aid after the oil boom, the technocrats have maintained their influence on economic policies because of their proven competence. They designed and implemented the 1966 stabilization program, restructured Pertamina’s debts, and introduced a new professionalism into economic management. This explains why the president remains their patron. The second group of economic advisors, the technicians, is an amorphous collection of technicians-turned-managers, military advisors, and economists with structuralist inclination^.^^ The technicians are united by their common belief in the general validity of the infant industry argument and by their common rejection of foreign capital ownership. They see state enterprises

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like Pertamina (until its downfall) as vehicles to achieve these two objectives.’’ This position allies the technicians with members of the intelligentsia who see state enterprises as the way to counterbalance Chinese domination of the corporate sector. The technicians’ control of the Ministry of Trade has allowed them to encourage domestic production of manufactured goods, including airplanes. Given the strong sense of economic nationalism in Indonesia and the widespread belief that only industrialization (regardless of whether it is import-competing or export-oriented) holds the key to a higher standard of living, the technicians enjoy popular support among the Indonesian elite. Furthermore, their import-substitution industrialization has won them the support of the army, the most powerful constituency in the country. Thanks to the dwifungsi doctrine, the expansion of state enterprises translates directly into more managerial positions for senior military personnel. It must be noted that since most of the import-competing industries were set up in urban Java, the higher prices of manufactured goods represented an implicit tax on residents of the rural sector and the Outer Islands. In looking at the political setting within which policies are chosen, we have identified an important political coalition of technocrats, Outer Islanders, and rural residents which favors a political package emphasizing the maintenance of a competitive exchange rate. The fact that there exists a strong institutional memory about the economically destructive effects of an overvalued exchange rate means that the government is naturally disposed to the arguments for a competitive exchange rate. Since a debt crisis occurs when a government runs out of foreign reserves, this emphasis on avoiding prolonged exchange rate overvaluation reduces the probability of a debt crisis by keeping the (foreign exchange earning) nonoil export sector healthy and capital flight low. We shall show in subsequent chapters how these political and economic factors have influenced the setting of economic policies and, hence, the performance of the economy.

4

The Fiscal System

4.1 Introduction

The two arguments we are developing in this monograph are that appropriate exchange rate management was fundamental to why a debt crisis did not appear during 1982-84 and that the exchange rate policy was heavily influenced by political considerations. The aim of this chapter is to test the

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validity of the second argument by examining the fiscal system to see if its functioning is in accord with the political concerns to prevent impoverishment of the rural sector and to show equitable treatment of the main islands. We picked the fiscal system because it is largely controlled by the technocrats, and we have claimed in chapter 3 that the technocrats favor an economic strategy which has as its side effects (if not as its aims) the alleviation of rural poverty and the reduction of regional differences. We will discuss the control and performance of the overall fiscal balance in chapter 7 where the subject of external debt management is explored in detail. A comparative analysis of external debt due to cumulated budget deficits is done in chapter 8. It is more natural to examine the accumulation of external debt due to fiscal deficits together with the management issues involved.

4.2 The Revenue Structure, 1969-83 In assessing the tax system before the December 1983 tax reform, it is important to keep in mind that the collection of taxes did not usually correspond closely to the tax laws. The shortage of competent personnel made enforcement of the highly complicated Indonesian tax code impossible. The result was “that the tax revenue targets published in the budgets determined the amounts which administrators felt obliged to collect” (Booth and McCawley 1981b, 136). Since the amount of taxes actually paid was nearly always a negotiated outcome, annual changes in income taxes bore little relation to the marginal tax rates. In short, the vertical and horizontal equity aspects of the income tax system cannot be accurately gleaned from the pre-1984 tax code. Furthermore, the tax burden owed to the state was consistently understated by the total amount of revenue collected. This is because of widespread petty corruption and occasional unauthorized levies on business transactions by administrative and military personnel. The data in table 4.1 show the revenue structure of the central government, and they differ from the official classifications in three ways. Our total revenue figures from fiscal 1969 to fiscal 1971 are greater than the official figures by the amount of IPEDA because IPEDA was not included in central government revenue figures prior to 1972. (IPEDA stands for Iuran Pembangunan Daerah which means Contribution to Regional Development.) IPEDA is revenue which belongs to the provincial authorities and is collected on the provinces’ behalf by the central government. The “tax on nonoil income” category differs from the official definition in that it covers only personal income, corporate income, and withholding taxes; the “other taxes” subcategory under the official definition has been added to the “tax on nonoil domestic consumption” category in the table.’ The third difference is that we have constructed a “tax from oil sector” category by combining official subcategories-the “tax revenue from oil corporations”

Table 4.1

Revenue Structure, FY1969 to FY1983 (in billions of Rupiahs) 69/70

Total revenue Tax on nonoil income Tax on oil and gas Tax on nonoil domestic consumption Tax on international trade Tax on property, IPEDA Nontax receipt Share of total revenue (%) Tax on nonoil income Tax on oil and gas Tax on nonoil domestic consumption Tax on international trade Tax on property, IPEDA Nontax receipt Share of nonoil revenue (%) Income tax Domestic consumption tax International trade Property tax Nontax receipt Indicative ratios (%) Total revenue/GDP Oil and gas tax/ GDP Nonoil income tax/GDP Property tax/GDP Nonoil income tax/ domestic consumption tax Nonoil export tax/ total revenue Memo items Tax on nonoil exports Nominal GDP GDP deflator (1980= 100)

70171

71/72

72/73

73/74

74/75

75/76

76/77

77/78

78/79

79/80

80181

81/82

6.696.8 10,227.0 12,212.6 12,418.3 14,432.7 736.5 1,045.3 1,279.3 1,605.2 1,784.3 4,259.6 7,019.6 8,627.8 8,170.4 9,520.2

251.6 42.9 65.8

354.7 52.8 99.2

440.0 67.4 140.7

590.6 84.6 230.5

%7.7 135.4 382.2

1,753.7 217.8 957.2

2,241.9 287.2 1,248.0

2,906.0 359.8 1,635.3

3,534.4 475.8 1,948.7

4,266.1 581.2 2,308.7

50.8 81.0 8.0 3. I

61.8 117.8 10.0 13.1

72.5 119.9 12.0 27.5

92.1 133.7 15.1 34.6

133.3 247.5 19.5 49.8

184.3 299.8 28.0 66.6

253.6 308.1 34.6 110.4

328.9 421.3 42.2 118.5

432.1 481.7 52.5 143.6

534.7 587.0 63.1 191.4

599.0 843.0 71.4 187.3

811.1 948.1 87.2 315.7

986.7 887.9

17.1 26.2

14.9 28.0

15.3 32.0

14.3 39.0

14.0 39.5

12.4 54.6

12.8 55.7

12.4 56.3

13.5 55.1

13.6 54.1

11.0 63.6

20.2 32.2 3.2 1.2

17.4 33.2 2.8 3.7

16.5 27.3 2.7 6.3

15.6 22.6 2.6 5.9

13.8 25.6 2.0

11.3 13.7

11.3 14.5

12.2 13.6

12.5 13.8

1.5

1.5

1.5

1.5

5.1

10.5 17.1 1.6 3.8

4.9

4.1

4.1

23. I 27.3 43.6 4.3 1.7

20.7 24.2 46.1 3.9 5.1

22.5 24.2 40.1 4.0 9.2

23.5 25.6 37.1 4.2 9.6

23.1 22.8 42.3 3.3 8.5

27.3 23.1 37.6 3.5 8.4

28.9 25.5 31.0 3.5 11.1

28.3 25.9 33.2 3.3 9.3

9.3 2.4 1.6 .3

11.0 3.1 1.6 .3

12.0 3.8 1.8 .3

12.9 1.9 .3

14.3 5.7 2.0 .3

16.4 8.9 2.0 .3

17.7 9.9 2.3 .3

84.4

85.4

93.0

91.9

101.6

118.2

2.8

7.0

6.4

5.5

7.1

28.1 32.7 3,672.0 4,564.0 16.3 18.5

68.6 6,753.4 24.6

7.0 25.0 2,718.0 3,238.0 13.9 15.4

Nore: New GDP series used from 1978 onward.

5.1

82/83

83/84

336.4

1,266.5 835.4 105.2 435.6

1,560.3 916.0 132.4 519.5

10.2 68.6

10.5 70.6

12.9 65.8

12.4 66.0

4.5

8.9 12.6 1.1 2.8

7.9 9.3 .9 3.1

8.1 7.3 .8 2.8

10.2 6.7 .8 3.5

10.8 6.3 .9 3.6

30.0 27.2 30.4 3.3 9.1

29.7 27.3 30.0 3.2 9.8

30.2 24.6 34.6 2.9 7.7

32.6 25.3 29.6 2.7 9.8

35.7 27.5 24.8 2.6 9.4

37.8 29.8 19.7 2.5 10.3

36.3 31.8 18.6 2.7 10.6

18.8 10.6 2.3 .3

18.6 10.2 2.5 .3

17.8 9.6 2.4 .3

19.5 12.4 2.1 .2

20.9 14.4 2.1 .2

20.9 14.8 2.2 .2

19.8 13.0 2.6 .2

19.6 12.9 2.4 .2

113.2

109.4

110.1

108.7

123.0

128.9

129.7

126.7

114.4

4.0

2.7

2.1

2.3

3.9

5.8

3.0

1.1

.7

.7

70.3 10,708.0 36.2

61.6 12,642.5 40.7

61.7 15,466.7 46.6

94.5

104.0 128.4 389.1 82.5 305.0 80.2 166.2 19,033.0 24,002.5 34,344.7 48,913.5 58,421.3 62,646.5 73,697.6 58.4 77.4 52.7 100.0 111.2 119.6 136.3

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item from the direct tax category and the “other oil revenue” from the taxes on domestic consumption category. The second subcategory is zero after 1977/78 because the government stopped taxing the domestic use of oil and started subsidizing its use instead, changing what was formerly a revenue item to an expenditure item. Taxes on domestic consumption consist primarily of sales tax (which after 1984/85 includes value-added taxes) and excises. Prior to 1986 the property tax consisted only of IPEDA, the land tax. Nontax receipts are mainly the profits of state-owned enterprises. The most notable feature of table 4.1 is the central government’s increasing reliance on oil as its chief source of revenue. Oil revenue as a share of total federal revenue rose from 26 percent in 1969/70 to 55 percent in 1974/75, and peaked at 71 percent in 1981/82. The fiscal danger of such a narrow tax base was brought home dramatically in 1982 when the global recession caused oil prices to collapse. Oil revenue (in 1980 rupiahs) fell from Rp 7.8 billion in 1981/82 to Rp 6.9 billion in 1982/83, causing real total revenue to fall for the first time since the Soekarno years. The continued real revenue decline in the succeeding years as oil prices began their free fall from $36/barrel to $18/barrel wreaked havoc with the financing of expenditure, especially of development projects. It is, hence, only natural that since December 1983 the government has passed several tax reforms to broaden the tax base. The need for action is well illustrated by the fact that nonoil revenue normalized by GDP has fallen from the 1969-71 average of 8 percent to the 1980-82 average of 6 percent. The fact that Indonesia was adhering to its balanced budget rule and the inflow of oil revenue had been enormous does not justify the decision to allow the tax base to shrink. The government could have broadened the tax base and still adhered to its balanced budget rule. All it had to do was reduce its foreign borrowing. Foreign borrowing obviated the introduction of unpopular measures to make tax collection broader and more effective. Since the ease of external borrowing was no doubt helped by the existence of substantial oil reserves, we can attribute the absence of base broadening largely to the two oil booms. It appears that the “tax-negotiating’’ form of tax collection in the 1969-83 period did not undermine the spirit of progressiveness which the pre-1984 Indonesian tax code aspired to achieve. The fact that the nonoil-income-tax/GDP ratio exhibits a slow, rising trend indicates that the actual marginal rates are mildly progressive. Indirect evidence suggests quite strongly that progressivity increased in the 1969-83 period. This statement is based on the common belief that direct income taxes are progressive and indirect consumption taxes are regressive. The Indonesian ratio of direct income tax to indirect consumption tax has been increasing over time. Income taxes were only 84 percent of consumption taxes in 1969/70, but averaged over 120 percent in 1980-83.

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Indirect taxes increased more slowly than direct taxes as real per capita income doubled in the same period. It may be true that the rich did not pay the high taxes required by the tax code, but in light of the two preceding indicators of vertical equity, it cannot be said that this was done at the expense of the poor. We are unable to analyze the incidence of taxes along rural-urban and regional divisions because the revenue data is not disaggregated enough to permit such an examination. There are two items in table 4.1, however, that permit us to make a partial assessment of our hypothesis that an agricultural bias existed in Indonesian fiscal policy. The first item is the ratio of IPEDA land tax to nonoil income tax which has shown a secular decline since 1969/70; IPEDA is paid almost entirely by landowners in rural areas, while income tax is paid by urban residents. This ratio, together with the increasing direct tdindirect tax ratio, suggest that the tax burden in the rural sector has not increased at the same pace as in the urban sector. The second item suggestive of agricultural sector bias is the large decline in revenue from nonoil export taxes (see memo item in the table) and from import taxes. As pointed out earlier, nonoil exports are largely agricultural products like rubber, palm oil, timber, coffee, tea, and spices. In April 1976 the export duties on most agricultural exports were reduced from 10 to 5 percent, and subsequently to zero. While there is no doubt that the large decline in export tax revenue is a big transfer to the agricultural sector, the almost equally dramatic phasing out of import taxes did not result in the same degree of transfer.2This is because the import tariff in some cases was replaced by nontariff barriers such as quotas and monopoly import licenses. It is reasonable to believe that the government would not have allowed part of this import tax revenue to be transferred as economic rents to certain segments of the industrial elite if the treasury were not awash with oil revenue. This is the second instance of tax base erosion permitted by the oil boom, the first being the postponement of tax reforms because of easy external credit.

4.3 The 1984 Tax Changes and Their Aftermath With the onset of the worldwide recession in 1982, there was an across-the-board fall in Indonesian exports. The severity of this external shock caused the real GDP growth rate to fall from 6.8 percent in 1981 to 0.1 percent in 1982. The oil sector was particularly badly hit, with oil export earnings plummeting from U.S. $18 billion in 1981 to U.S. $15 billion in 1982. Because oil taxes accounted for 70 percent of domestic revenue in 1981, the collapse in oil exports exerted severe financial pressures on government spending. The Indonesian government reacted swiftly against the financial crisis and the low level of economic activity: the rupiah was

72

Wing Thye Woo and Anwar Nasution

devalued by 38 percent against the dollar in March 1983 to boost nonoil exports, and some forty-seven capital-intensive projects were postponed indefinitely. It was clear that greater internal resource mobilization was necessary to make up for the immediate revenue shortfall and to broaden the tax base to prevent the reoccurrence of major financial crises arising from overreliance on one revenue source. There were a number of hopeful signs that a lot more revenue could be extracted from the nonpetroleum sector if better enforcement were undertaken. The most hopeful sign was that only 60 percent of the taxpayers who had filed returns in 1979/80 did so again the following year. In December 1983 the Indonesian government announced a drastic revision of the personal and corporate income taxes which would take effect on 1 January 1984. The complicated and steeply progressive income tax structure was simplified to three rates-15 percent, 25 percent, and 35 percent-which applied to both personal and corporate taxpayers. To make enforcement easier, the cutoff point beyond which people had to pay income tax was doubled to render only 10 to 15 percent of the population eligible for income taxation. Greater attention was put on withholding as the way to collect personal income taxes. Corporations were required to withhold 15 percent of interest, rents, royalties, and dividends to domestic residents and 20 percent of these payments to foreigners. The time-consuming practice of collecting corporate taxes by negotiating individually with the firm concerned was replaced with complete self-assessments by the firms themselves. These self-assessments were subject to selective audit by the government to prevent abuses. The commitment to efficiency in the reform measures was emphasized by laying down specific time limits for the government to refund excess taxes and to respond to appeals against its rulings. Later on in 1984 the Indonesian government sought to increase the tax rolls by announcing that taxpayers who registered by June 1985 were eligible for a pardon of past unpaid taxes. The broadening of the tax base was impressive-there were 995,000 registered income taxpayers at the end of 1985 compared to the 550,000 registered in March 1984. The tax amnesty program resulted in adding Rp 52 billion to 1985186 revenue (IMF 1986a). It needs to be noted, however, that while the procedural reforms and simpler tax code reduced the administrative burden and the incentive to cheat, the biggest bugbear of the Indonesia tax system still remains: shortage of trained personnel. Until this outstanding personnel problem is resolved, nothing can be done about the fact that in 1985 only 50 percent of registered corporate taxpayers and 70 percent of registered personal-income taxpayers actually filed returns. In April 1985 the complicated sales tax with seven different rates was replaced with a value-added tax (VAT) of 10 percent. Like the response to

73

IndonesidChapter 4

the earlier income tax reforms, there was a surge in the number of registered VAT taxpayers40,OOO in December 1985, up from 25,000 in March 1985. The disappointing aspect,, as with the income tax case, is that only 41 percent of the registered VAT payers are filing the required monthly returns. In January 1986 a new property tax law that consolidated IPEDA with six other property taxes was introduced and the stamp duty laws were revised. The revenue-raising ability of the tax reform has been impressive (see table 4.2). Real nonoil income tax rose from 1.3 trillion rupiahs in fiscal 1983 to 1.7 trillion in fiscal 1986. The success of the VAT was even more impressive: it boosted the revenue from domestic consumption by 94 percent in the first year of its introduction. A further rise of 30 percent is expected

Table 4.2

Revenue Structure, FY1982 to FY1987 (in billions of rupiahs)

7ixal revenue Tax on nonoil income Tax on oil and gas Tax on nonoil domestic consumption Tax on international trade Tax on property, IPEDA Nontax receipt Share of total revenue (%) Tax on nonoil income Tax on oil and gas Tax on nonoil domestic consumption Tax on international trade Tax on property, IPEDA Nontax receipt Share of nonoil revenue (%) Income tax Domestic consumption tax International trade Property tax Nontax receipt Indicative ratios (%) Total revenueiGDP Oil and gas taxiCDP Nonoil income tax/CDP Property tax/GDP Nonoil income taxi domestic consumption tax Nonoil export taxitotal revenue Memo items Tax on nonoil exports Nominal GDP GDP deflator (1980= 100)

82/83

83/84

84/85

85/86

86/87

12,418.3 1,605.2 8,170.4

14,432.7 1,784.3 9,520.2

15,905.5 2,121.0 10,429.9

19,252.8 2,313.0 11,144.4

17,832.5 2,880.5 9,738.2

17,236.1 3,315.9 6,938.6

1,266.5 835.4 105.2 435.6

1,560.3 916.0 132.4 519.5

1,648.2 861.9 157.2 687.3

3,478.6 657.8 167.5 1,491.5

3,317.1 658.8 284.0 953.9

4,481.4 732.6 274.0 1,049.3

12.9 65.8

12.4 66.0

13.3 65.6

12.0 57.9

16.2 54.6

19.2 40.3

10.2 6.7 .8 3.5

10.8 6.3 .9 3.6

10.4 5.4 4.3

18.1 3.4 .9 7.7

18.6 3.7 I .6 5.3

26.0 4.3 I .6 6.1

37.8 29.8 19.7 2.5 10.3

36.3 31.8 18.6 2.7 10.6

38.7 30.1 15.7 2.9 12.6

28.5 42.9 8.1 2.1 18.4

35.6 41.0 8.1 3.5 11.8

32.2 43.5 7. I 2.7 10.2

19.8 13.0 2.6 .2

19.6 12.9 2.4 .2

18.2 11.9 2.4 .2

20.0 11.6 2.4 .2

17.6 9.6 2.8 .3

16.0 6.4 3.1 .3

126.7 .7

114.4 .7

128.7 .6

66.5 .3

86.8 .4

74.0 .4

82.5 62,646.5 119.6

104.0 13,697.6 136.3

91.0 87,535.5 152.6

50.5 96,132.4 165.8

78.8 101,491.2 170.9

70.9 107.672.0 176.0

1.o

87/88

Note: GDP deflator assumed to rise 3.1 percent in 1986 and 3 percent in 1987. Real GNP assumed to rise 2.4 percent in 1986 and 3 percent in 1987.

74

Wing Thye Woo and Anwar Nasution

for fiscal 1987, increasing (real) consumption taxes by almost two and half times over their fiscal 1984 value. The reduction of the maximum marginal rate from 50 percent to 35 percent did not decrease the progressiveness of the income tax system. Nonoil income taxes as a proportion of GDP rose from 2.4 percent in 1983/84 to 2.8 percent in 1986/87, and were expected to reach 3.1 percent in 1987/88. Progressiveness in income taxes was enhanced because the income tax reform greatly increased the number of people paying taxes. Furthermore, with the doubling of the threshold for tax eligibility, the majority of these new taxpayers are people who have incomes substantially above the average. It seems however that the overall effect of the whole tax reform package may not be a progressive one. This is because the regressive taxes on nonoil domestic consumption (sales tax, VAT, excises, and stamp duties) were raised much more than progressive taxes on income. The ratio of income taxes to consumption taxes fell by 50 percent in fiscal 1985, the year that VAT was introduced.

4.4 The Structure of Central Government Expenditure Table 4.3 shows the allocation of state expenditure according to function. Expenditure is divided into two categories: routine and development. Routine expenditure represents what is necessary to maintain the level of existing government services, while development spending represents capital deepening which expands the productive capacity of the economy. In the case of Indonesia, the official designation of development expenditure does not in many instances correspond to its economic definition. The biggest misnomer is generally believed to be the payment of salary supplements from the development budget to government employees for development-related activities. There is great incentive for government workers to initiate many minor development projects because the average salary in the public sector is rather low and the criteria for supplement awards is quite broad. Salary supplements are paid to civil servants for engaging in “development” activities such as serving on the steering committee of a new project, doing exercises in project evaluation, and travelling to inspect construction projects. The result is that many members of the bureaucracy receive regular supplements which amount to significant portions of their salaries. The worst feature of this scheme is that it encourages neglect of operations and maintenance activities in favor of starting new projects. Other items of routine expenditure that are included in the development budget are fertilizer subsidies and military expenditure. The former is clearly an input to the current production process, and the latter contributes to capacity creation only in the broadest sense that viable economic growth is

Table 4.3

Expenditure Structure of the Central Government Budget FY1969 to FY1987 (in billions of rupiahs) 69/70

70171

71/72

Total expenditure

342.7

467.8

Total routine expenditure Personnel Debt service External debt service Internal debt service Subsidies to regions Food subsidy Oil subsidy Other routine expenditures

216.5 103.8 14.4 12.7 1.7 44.1

288.2 131.4 25.6 23.6 2.0 56.2

.o .o

.o .o

54.2

75.0

72.4

100.4

265.1

179.4

325.7

Total development expenditure Regional development Fertilizer subsidy Agriculture & imgation, excluding fertilizer subsidy Industry & mining Electric power Transportation, tourism & communications Manpower & transmigration Education & culture Health & social welfare Housing & water supply General public services Government capital participation Other items Unknown allocation of project aid

126.2 12.6

179.6 43.5

207.9 49.6

298.2 55.7

.o

.o

.o

.o

450.9 70.1 33.0

961.8 136.0 227.2

1,397.7 173.0 134.0

25.0 5.8 4.1

32.1 1.8 7.1

46.6 8.1 14.1

39.6 4.7 16.2

45.0 5.3 21.6

74.8 71 .O 79.0

25.3 .1 9.1 4.5 1.2 11.8

17.7 1.o 8.9 3.5 2.6 14.6

42.4 .7 10.9 4.6 2.4 11.9

44.0 .3 16.2 7.3 4.4 16.0

57.0

124.0

.o

5.0

29.9 14.4 5.3 78.0

.o

Memo item GDP deflator (1980= 100) (continued)

72/73

73/74

74/75

75/76

76/77

77/78

78/79

557.0

736.3

1,164.2

1,977.9

2,730.3

3,684.3

4,305.7

5,299.3

349.1 163.3 46.6 37.2 8.4 66.8

438.1 200.4 53.4 44.1 83.9

713.3 268.9 70.7 62.6 11.1 108.6

.o .o

.o .o

1,332.6 593.9 78.5 71.7 6.8 284.5 50.0

1,629.8 636.6 189.5 165.1 24.4 313.0 39.0

2,148.9 893.2 228.3 220.9 7.4 478.4

.o .o

1,016.1 420. I 73.7 67.3 6.4 201.9 141.0

.o

.o 451.7

65. I 483.9

2,743.7 1,001.6 534.5 525.7 8.8 522.3 43.5 197.0 444.8

2,054.5 190.0 107.0

2,156.8 251.0 32.0

2,555.6 275.0 83.0

123.0 124.0 128.0

249.0 195.0 218.0

348.0 139.0 223.0

367.0 205.0 272.0

47.0 25.0 7.0 49.0

312.0 12.0 114.0 38.0 13.0 72.0

429.0 27.0 136.0 48.0 30.0 114.0

355.0 61.0 211.0 71.0 90.0 123.0

413.0 95.0 251.0 79.0 56.0 225.0

5.3

.o

.o

.o

1

.9

1.2

7.0 1.6

24.7 1.9

.O .O

98.0 19.0

115.0 40.0

225.0 87.0

190.0 63.0

162.0 73.0

25.8

44.6

8.0

67.2

91.3

.o

.o

.o

.o

.o

13.9

15.4

16.3

18.5

24.6

36.2

40.7

46.6

52.7

58.4

Table 4.3

(continued) 79/80

SOB1

81/82

82/83

83/84

84/85

85/86

86/87

87/88

Total expenditure

8,076.0

11,716.1

13,917.6

14,355.9

18.31 1.0

19,380.8

22,824.6

21,42 I .6

23,583.2

Total routine expenditure Rrsonnel Debt service External debt service Internal debt service Subsidies to regions Food subsidy Oil subsidy Other routine expenditures

4,061.8 1,419.9 684.1 647.6 36.5 669.9 124.9 534.9 628.1

5,800.0 2,023.3 784.8 754.0 30.8 976.1 281.6 1,022.0 712.2

6,977.6 2,277.7 931.0 915.0 16.0 1,209.4 224.0 1,316.0 1,019.5

6,996.3 2,418.1 1,224.5 1,204.7 19.8 1,315.4 1.o 962.0 1,075.3

8.41 1.8 2,757.0 2.102.7 2,072.9 29.8 1,546.9

11,951.5 4,018.3 3,323.1 3,303.1 20.0 2,489.0 374.2 1,746.9

13,125.6 4,212.6 4,223.2 4.183.2 40.0 2,639.7 .O 142.4 1.907.7

15,826.6 4,316.9 6,805.4 6,765.4 40.0 2,649. I

928. I 1,077.I

9.428.9 3.046.8 2,776.5 2.737.2 39.3 1,883.3 0.0 506.7 1,215.6

Total development expenditure Regional development Fertilizer subsidy Agriculture & irrigation, excluding fertilizer subsidy Indusuy & mining Electric power Transportation, tourism & communications Manpower & transmigration Education & culture Health & social welfare Housing & water supply General public services Government capital participation Other items Unknown allocation of project aid

4,014.2 336.0 85.0

5,916.1 482.0 283.0

6,940.0 616.0 371.0

7,359.6 711.0 420.0

9,899.2 749.0 324.0

9,951.9 791.0 732.0

10.873.1 850.0 477.1

8,296.0 939.0 672.0

7,756.6 873. I 203.5

423.0 356.0 376.0

646.0 491.0 431.0

583.0 827.0 530.0

511.0 913.0 758.0

589.0 2,153.0 660.0

967.0 839.0 911.0

660.9 1,189.0 1,447.0

434.0 737.0 788.0

977.2 349.9 1,008.9

466.0 162.0 362.0 142.0 117.0 473.0

780.0 326.0 575.0 218.0 191.0 700.0

807.0 417.0 726.0 286.0 166.0 800.0

876.0 436.0 703.0 259.0 151.0 785.0

1,527.0 456.0 1,032.0 279.0 221.0 899.0

1,428.0 422.0 1.231.0 320.0 224.0 927.0

1,484.0 665.0 1,413.0 398.0 335.0 977.0

1.063.0 394.0 1,146.0 312.0 333.0 722.0

1,288.I 156.6 1,021.5 207.7 412.0 569.4

466.0 250.0

389.0 404.0

389.0 422.0

281.0 556.0

234.0 776.0

292.0 868.0

221.0 758.0

202.0 554.0

191.1 497.0

.o

.o

.o

.o

.o

.a

.o

.o

.o

77.4

100.0

111.2

119.6

136.3

152.6

165.8

170.9

176.0

.o

.o

.o .o 2,055.2

Memo item GDP deflator (1980= 100)

77

IndonesidChapter 4

not possible without deterrence of foreign aggression. In the absence of more information, it is not possible for us to eliminate the discrepancy between the official and economic definitions of development expenditure. The allocation of official development expenditure by program is given in table 4.4. The general INPRES programs are funds channelled to local authorities to finance public works projects chosen at their own discretion. The INPRES village program was started at the very beginning of the Soeharto era to alleviate rural unemployment and to rebuild the rural infrastructure that had been allowed to deteriorate under Soekamo. With the growth of the oil sector in the early 1970s, the INPRES district and province programs were started partly to handle projects which affected more than one village and, partly, because the village administrators were not able to absorb more funds. This decentralized decision making in the public works projects of the general INPRES programs is very much in line with what we have earlier identified to be one of Soeharto’s traits-impatience with the bureaucracy. While efficiency was clearly an important concern, what may have been equally important was the political symbolism of commitment to rural development. With the increased inflow of oil revenue, sectoral INPRES programs in primary education, health, reforestation, market and road construction were started and funding to existing INPRES programs was increased. In real terms (1980 prices), the cost of INPRES programs rose from Rp 276 billion in fiscal 1973 to Rp 714 billion in fiscal 1980. The government also expanded its industrialization program: annual government capital participation rose from Rp 166 billion to Rp 477 billion in the same period, a 16 percent annual rate of increase. Given the easing of the budget constraint, it was only natural that subsequent spending was much broader in coverage.

4.5 Preferences as Revealed by the Expenditure Pattern In the discussion on political considerations in chapter 3, we identified a goal of the Soeharto government to be the improvement of the livelihood of the Javanese peasants. This goal is based on the fear of the reemergence of the PKI in its traditional rural stronghold. It must be emphasized that the logical policy translation of this primary policy concern is to reduce rural poverty and not the degree of rural-urban inequality. The policy emphasis is on the absolute standard of living rather than on the relative standard of living. Given the history of separatist movements and the fact that the Javanese dominated key government positions, we also identified regional equity to be another of Soeharto’s primary political concerns. The policy translation in this case is the attenuation of differences in the standard of living across islands. Finally, we argued that the technocrats, because of their belief in comparative advantage, would strive to maintain and improve the economic

Table 4.4

Distribution of Development Expenditure by Programs FY1972 to FY 1987 (in billions of rupiahs) Actual

1. Departments 2. General INPRES programs Subsidies to provinces Subsidies to kabupatens Subsidies to villages 3. Sectoral INPRES programs primary schools Health Markets Replanting/ afforestation Roads 4. IPEDA 5. Irian Jaya and East Timor Subtotal of transfers to lower levels of govemment (2-5) 6. Fertilizer subsidy 7. Government capital participation (PMP) 8. Others Total (1-8) 9. Project aid Total (1-9)

72/73

73/74

74/75

75/76

76/77

150.0 39.3 20.8 12.8 5.7 .O

.O

167.3 48.7 20.8 19.2 5.7 19.2 17.2

.o

.o

221.6 101.3 47.4 42.5 11.4 25.0 19.7 5.3

384.9 129.0 54.0 59.1 15.9 65.1 49.9 15.2

590.9 143.7 61.5 62.4 19.8 94.1 57.3 20.8

.o .o

16.0

77/78

78/79

79/80

80/81

81/82

82/83

83/84

84/85

2,533.2 336.8 166.7 119.4 50.7 377.2 249.8 50.4 2.5 48.6 25.9 87.2 6.4

2,724.6 448.1 215.0 162.6 70.5 584.5 374.5 78.8 6.0 70.4 54.8 94.5 6.8

3,260.9 535.3 253.0 193.9 88.4 444.2 267.4 80.3 4.5 49.6 42.4 105.2 5.7

3,219.5 538.8 253.1 194.1 91.6 771.2 549.3 87.3 10.6 59.4 64.6 132.4 5.2

3,474.4 540.4 253.0 194.6 92.8 824.4 572.0 64.6 25.5 61.2 101.1 157.2 4.2

4,466.5 2,087.7 574.5 599.7 287.3 280.0 188.6 220.8 98.6 98.9 753.7 715.5 526.1 417.2 110.6 114.5 11.5 4.4 42.5 42.3 70.1 130.0 167.5 255.6 6.9 7.2

807.6 283.6

1,133.9 371.4

1,090.4 420.1

1,447.6 324.2

1,526.2 731.6

1,502.6 477.1

252.8 476.5 480.9 336.6 591.7 128.5 326.7 448.7 291.0 385.5 565.3 75.1 1,568.3 2,697.9 4,486.4 5,276.1 5,434.7 6,031.7 987.3 1,316.3 1,429.7 1,663.9 1,924.9 3,867.5 2,555.6 4,014.2 5,916.1 6,940.0 7,359.6 9,899.2

336.1 474.9 6,543.2 3,408.7 9,951.9

851.0 181.6 86.8 70.9 23.9 176.0 111.8 26.9 1.3 36.0

.o

.o

.o

.o .o .o

.o

.o

.o

15.2 3.3

19.5 3.3

28.0 4.0

34.6 5.5

42.2 5.0

52.5 9.0

63.1 10.4

1,480.3 218.8 100.7 87. I 31.0 252.0 155.8 30.0 12.4 40.8 13.0 71.4 6.6

57.8 .O

85.7 33.0

158.3 227.2

234.2

285.0 107.3

366.2 31.8

431.1 82.6

548.8 125.0

22.5 5.6 235.9 62.3 298.2

40.8 10.0 336.3 114.1 450.9

91.1 67.7 765.9 195.9 961.8

217.9 108.7 64.0 79.8 926.3 1,280.9 471.4 773.6 1,397.7 2,054.5

166.9 109.8 1,419.2 737.6 2,156.8

.o .o

.o .o

134.5

.o

744.5 167.7 75.4 69.1 23.2 137.0 85.0 26.3 1.2 24.5

Budget 85/86

86/87

87/88 752.2 604.9 280.0 226.0 98.9 326.3 100.8 76.3 3.0 16.2 130.0 246.6 5.0

1,578.0 671.5

1,182.8 203.5

412.3 207.4 511.2 243.7 7,369.7 4,788.3 3,503.4 3,507.7 10,873.1 8,296.0

83.4 109.0 2,330.9 5,425.7 7,756.6

79

IndonesidChapter 4

incentives to produce Indonesia’s traditional exports, primary commodities. Since the production of primary commodities is confined to rural Java and the Outer Islands, the thrust of the technocrats’ economic program addresses two important political objectives of the government. It is impossible to conclude from tables 4.3 and 4.4 whether a rural bias exists because only a few of the items in them can be easily classified either as pro-rural or pro-urban. The obvious pro-rural items are “fertilizer subsidy” and “agriculture and imgation” in table 4.3 and most of the INPRES programs in table 4.4. The obvious pro-urban items are “food subsidy” and “housing and water supply” in table 4.3. Examination of these items shows that the pro-rural items tended to be financed first after the 1973 and 1979 OPEC price increases, and that they also tended to suffer smaller cuts when future revenue prospects turned gloomy as in 1977/78 and 1983/84. The 1986/87 fertilizer subsidy allocation provides a striking example of rural income maintenance. In the 1986/87 recession, while total nominal spending by the government fell by 7 percent in response to lower domestic revenue, fertilizer subsidies actually rose by 20 percent in an attempt to check the fall in rural Javanese income. What is really noteworthy about this is that the peasants were encouraged to grow more rice at a time when BULOG, the state rice agency which guarantees the floor price, was on the verge of bankruptcy because of the runaway costs of storing the excess rice from the bumper harvests of previous years! Another indication that the commitment to rural development is genuine is that the first two programs started right after the 1973 oil price increase were targeted toward the rural sector. Fertilizer subsidies benefited the agricultural sector directly, and the first sectoral INPRES program, by focusing on primary schools, benefited the rural sector disproportionately. The fact that food subsidies, which benefited urban residents disproportionately, were started in 1974/75 after the 1973 oil price increases does not overturn our hypotheses of rural bias in government policies. The history of food subsidies clearly shows the lack of a systematic urban bias. Food subsidies were considered dispensable. During 1977/78 when Pertamina needed a cash infusion of Rp 86.4 billion to meet its debt obligations, food subsidies were eliminated that year. With the weakening of oil prices in 1982, food subsidies were drastically reduced in 1982/83 and completely ended in 1983/84. Table 4.5 ranks the provinces by their nonmining regional gross domestic product (RGDP) and details the amount of central government expenditure under each program by province. Despite several sizable deviations, the central feature is that government outlay systematically varied inversely with the income of the province. The average total central government spending for the poorest one-third of the regions is 26 percent of RGDP, for the middle one-third, 21 percent, and for the richest one-third, 17 p e r ~ e n t . ~

80

Wing Thye Woo and Anwar Nasution

Table 4.5

Per Capita Budgetary and Central Government Direct Development Expenditures 1980181 1980 Nonmining RGDP Per Capita (in thousands Rp)

INPRES Grant Rp/cap

South East Sulawesi West Nusa Tenggara East Nusa Tenggara D.I. Jogyakarta Central Java West Java Lampung Jambi East Java Central Sulawesi Bengkulu West Sumatra Bali Aceh South Sulawesi West Kalimantan South Kalimantan North Sulawesi Irian Jaya North Sumatra Maluku South Sumatra Riau Central Kalimantan DKI Jakarta East Kalimantan

87 97 97 I19 127 131 146 I46 I47 I47 148 153 I53 I57 I58 I68 181 I96 I97 205 223 228 250 270 448 740

Indonesia

167

Province

Central Subsidy Rpicap

Central Development Expenditure Rp/cap

Total Spending & Nonmining RGDP

13,523 5,692 5,704 4,697 2,830 3,015 4,629 9,497 3,022 10,896 14,185 5,653 6,889 6,849 4,968 8,339 7,804 7,920 1 1.365 5,034 8,801 6,507 7,292 13,075 2,042 10,431

10,177 6,536 11,406 9,084 6,305 6,353 7,038 7,541 5,479 8.973 8,106 7,563 8,220 8,069 7.045 8,267 10,266 13,609 27,191 8.530 8,998 5,276 10,187 11,359 6,690 10,431

36.618 10,342 9,805 10,801 4,967 8,176 8,293 26,864 4,902 20,110 34,319 17,400 12,288 19,467 9,754 12,754 22,712 16,364 28,016 10.908 16,275 18,131 23,557 2 1,794 94.03 I 25,354

72 23 21 22 II 13

17 23 19 34 12 IS 13 16 17 23 6

4,465

7,111

9,961”

13

13

30 9 27 38 20 18 22 14

Source: World Bank (1984, 133) a Excluding DKI Jakarta. The figure including Jakarta is 13,661. The high figure for Jakarta reflects the substantial level of spending on the apparatus of the Central Government rather than on the development of Jakarta itself.

Examining the big outliers to the practice of awarding more aid to the poor provinces yields a very interesting finding. Four Javanese provincesJogjakarta, Central Java, West Java, and East Java-rank fourth, fifth, sixth, and ninth in terms of poverty, yet only Jogjakarta received aid higher than the average level of 13 percent. In Jogjakarta’s case, its higher aid level may have less to do with its poverty than with the fact that its sultan played an important role in Soeharto’s rise to power (he was Soeharto’s first vice president). East Java’s RGDP is indistinguishable from those of Lampung, Jambi, Central Sulawesi, and Bengkulu, but its aid level is only 9 percent while the others receive 13 percnt, 30 percent, 27 percent, and 28 percent, respectively.

81

IndonesidChapter 4

We interpret this Outer Island bias as a deliberate attempt to lessen the seemingly big differences in the absolute amount given to each island. As it is, three Javanese provinces (Central Java, West Java, and East Java) already account for Rp 119 billion of the total amount of Rp 313 billion spent, i.e., 38 percent. If Jakarta and Jogjakarta are included, then Java is receiving 61 percent of total budgetary transfer and direct development expenditures while contributing only 47 percent to total national income. It was, apparently, necessary to tolerate inequities toward these three Javanese provinces in order to have some semblance of regional (inter-island) equity. The political message of table 4.5 is clear: the top echelon of the Soeharto government may be dominated by Javanese, but the government is committed to improving the standard of living in the Outer Islands. This political message is the legacy of the many secessionist movements in the 1950s and early 1960s. Table 4.6 focuses on a number of welfare measures in order to provide an alternate way of determining the thrust of Indonesian economic policy, especially its fiscal policy. We have limited the welfare measures to those which particularly apply to the poorest segment. This is because the provision of services to meet the basic needs of the poor is heavily dependent on government expenditure. Part A of the table divides the population along rural-urban lines. In 1971 only 58 percent of rural children aged seven to twelve attended school compared with 73 percent among urban children. In 1980 the figures were 81 percent and 90 percent, respectively. In the same period the ratio of rural to urban infant deaths declined from 5.5 to 4.6. The surprising finding here is that the rural poor may actually eat better than the urban poor, 1,47 1 calories per day in the rural sector as against 1,433 in the urban sector. Together, these three basic-needs indicators paint a picture of improvement in the social services being provided in the countryside and imply that the Indonesian government does not neglect the rural population. Part B of table 4.6 provides a number of regional welfare measures to serve as a consistency check on the conclusions drawn from table 4.5. The most notable difference is that the provision of health care in the Outer Islands appears to be more pervasive. The minimum average number of health centers in the Outer Islands is at least one and a half times more than in Java. The basic health conditions appear to be at least as good in the Outer Islands as in Java; the infant mortality rate and life expectancy are almost indistinguishable across the main islands, except for the Eastern Islands. The primary school enrollment also saw uniform improvements-a 33 percent improvement in every region. It is clear that the expenditure of the INPRES primary school program was quite evenly spread among the islands. Perhaps the same could be said about the regional division of government programs in general because the poverty rate fell by approximately 17 percentage points in both Java and the Outer Islands.

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Table 4.6

Indicators of Distribution of Government Expenditures on Basic Needs Part A: Rural-Urban Equity

Ratio (ruraYurban) of number of infant deaths School enrollment ratio for 7- 12 year olds

1971 5.5

I976 4.6

51 73

81

Rural 1,471

Urban 1,434

Rural Urban Daily calorie intake among the poorest 40 percent of sector in 1976

90

Part B: Inter-Island Equity

Java

Sumatra

32

24

36

71

48

140 105

138 104

139 93

139 106

149 108

Indonesia Health centers per million people 1980 Infant mortality rate 1971 1980

Kalimantan

Life expectancy 1969 1978 (years increase)

46.7 52.9 (6.2)

47.1 53.1 (6.0)

47.0 55.4 (8.4)

46.8 53.8

Primary school enrollment ratio 1971 1980

60 84

59

64

85

84

Java

Outer Islands

Indonesia Poverty rate 1970 1980 Per capita consumption index, Indonesia = I00 1970 1980

4.6

40

57

65 47

43 28

100 100

88 97

130

Sulawesi

Eastern Islands 50

NA NA

(7.0)

45.2 52.3 (7.1)

42.7 41.8 (5.1)

60 71

62 82

63 84

105

A Summing Up

The examination of the fiscal system supports our claim that the technocrats favor an economic strategyy which leads to resource transfers to the Javanese hinterland and to the tree crop industries in the Outer Islands. The secular decline in trade taxes and low taxation of land relative to income reflect Soeharto’s political concern with communism and secession, as well as the technocrats’ neoclassical inclination toward the comparative advantage doctrine. This favorable tax treatment of the agricultural sector improves the rural-urban terms of trade and hence encourages the production of tradables, the presence of which determines a country’s ability to service its debts.

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In examining government expenditure, we surmised from fragmentary evidence that government spending was more likely to display a rural rather than an urban bias. In the absence of more detailed data, disproportionate weight was given to the budget allocations for fertilizer subsidies, irrigation projects, rural school programs, the INPRES village programs, and food subsidies. Because of better data, stronger evidence could be garnered to support the hypothesis that budget allocations were more sensitive to inter-island equity. There is in fact evidence that inter-island equity takes precedence over rural-urban equity. This is consistent with our conjecture that the concern for rural development stems more from a desire to eradicate poverty than to narrow the rural-urban gap. The analysis of this chapter sets the stage for our forthcoming discussion on the importance of political factors in determining the debt outcome. To the extent that people are consistent in their actions, the fact that the technocrats support, and Soeharto approves of, a fiscal policy which favors the tradable sector means that they would also advocate a similarly-oriented exchange rate policy. We will show in chapter 6 that exchange rate management has been tempered by political considerations, and will quantify in chapter 8 that this exchange rate policy resulted in Indonesia avoiding a debt crisis during 1982-84.

5

Monetary Policy and Financial Structure

5.1 Introduction

The purpose of this chapter is to analyze the conduct of monetary policy and the development of the financial sector since 1966. Along with other economic measures, financial policies have been actively used by the government to pursue its macroeconomic objectives. During the period of prosperity in the 1970s, mainly due to the two oil booms in that decade, there was no incentive for the government to reform the underdeveloped tax and banking systems which were inherited from the Dutch colonial administration. Major reforms to the financial system in order to mobilize domestic saving were initiated only after the bust of the second oil boom. In contrast to the 1966-67 reforms which accomplished a total turnaround of the economy in a relatively short period of time, recent reforms cannot produce quick results.

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5.2 Performance of Monetary Policy in the 1970s As we mentioned earlier, the balanced budget policy of the Soeharto government effectively ended the creation of money to finance budget deficits. This did not mean, however, that monetary creation in the 1970s was truly independent of the state of the government budget. This is because the money stock was also affected by changes in the foreign asset position of the central bank, Bank Indonesia. This balance-of-payments linkage to the monetary supply was what made the stance of monetary policy move in tandem with that of fiscal policy. As will be explained, when fiscal policy was expansionary in the wake of the two oil booms, it induced monetary policy to be expansionary too. The result was a big inflation spurt in the 1970s that had nothing to do with money-financing of government budget deficits, but rather with the lack of instruments to end the balanceof-payments linkage between government spending and the money supply. Prior to the introduction of ceilings on lending by the banking system in April 1974, the main instrument for monetary control was the extension of central bank credits to the banking system, state enterprises, and private companies. Since the central bank credits were extended for a contracted time period, the government was not in a position to engineer quick increases or reductions of the money stock. This reserve method of monetary control was shown to be grossly inadequate for stabilizing the economy when a large fiscal stimulus occurred, financed by increases in oil revenue. The reason for the synchronization of fiscal and monetary policy during the 1970s lies in the balance of payments. With the rapid development of the oil sector since 1970, government revenue from oil accelerated (see table 5.1). It climbed from Rp 99 billion in 1970 to Rp 141 billion in 1971, and then to Rp 231 billion in 1972 oil revenue was actually denominated in U.S. dollars). Since the primitive nature of the Indonesian financial system ruled out the possibility of open-market operations, the maintenance of a fixed dollar-rupiah exchange rate meant that the conversion of oil revenue from dollars to rupiahs in order to finance the expanded government expenditure automatically increased the money supply. This is clearly seen in 1972 when oil revenue increased by 90 billion rupiahs over the previous year. The conversion of this oil revenue (231 billion) led to a 122 billion rupiah increase in the reserve money base because of the monetary authorities’ inability to quickly sterilize the monetary consequences of foreign-exchange market transactions to peg the value of the exchange rate. The 1972 growth rate of reserve money was 46 percent compared to the 29 percent of the previous two years. The price of oil then quadrupled at the end of 1973, encouraging the government to increase its spending. In fact, the government augmented its expenditure well beyond the increase in oil revenue. This was possible because the creditworthiness of Indonesia soared along with the price of oil.

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Table 5.1

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Oil and Gas Tax”

Budget Deficit

Foreign Assets of Central Bank as Proportion of Total Assets

65.8 99.2 140.7 230.5 382.2 957.2 1,248.0 1.635.3 1,948.7 2.308.7 4,259.6 7,019.6 8,627.8 8,170.4 9,520.2 10,429.9 11,144.4 9.738.2

91.1 113. I 117.0 145.7 196.5 224.2 488.4 778.3 771.3 1,033.2 1,379.2 1,489.1 1,705.0 1,937.6 3,878.3 3,475.3 3,571.8 3,589.1

18.3% 21.3 17.7 38.9 41.7 49.0 12.0b 22.7 31.2 32.3 39.3 46.1 39.6 28.4 34.5 39.0 39.8 32. I

Change in= Reserve Money

M1

60.0 47.0 60.0 122.0 153.0 308.0 282.0 248.0 340.0 165.0 593.0 897.0 545.0 187.0 1,031.0 563.0 1,020.0 1.449.0

67.0 67.0 69.0 155.0 197.0 271.0 332.0 327.0 405.0 482.0 828.0 1,695.0 1,463.0 646.0 456.0 1,005.0 1,543.0 1,507.0

Rate of Growth of Reserve Money 60.0% 29.4 29.0 45.7 39.3 56.8 33.2 21.9 24.6 9.6 31.5 36.2 16.1 4.8 25.1 11.0

17.9 21.6

M1

Inflation

57.8 36.6 27.6 48.6 41.6 40.4 35.2 25.7 25.3 24.0 33.3 51.1 29.2 10.0 6.4 13.3 18.0 14.9

17.4% 12.3 4.4 6.4 31.0 40.6 19.1 19.8 11.0 8.1 20.6 18.5 12.2 9.5 11.8 10.5 4.7 5.8

”In billions of rupiahs. ?he low ratio of foreign assets to total assets in 1975 is because of the bailing out of Pertamina by Bank Indonesia.

External credit, euphemistically referred to as “external revenue,” was pretty much available on demand. This is evident from the large jumps in the budget deficit; it rose from Rp 224 billion in 1974 to Rp 488 billion in 1975, and then to Rp 778 billion in 1976. The constantly increasing amount of oil revenue caused the monetary authorities to lose control of the money supply. Reserve money grew 57 percent in 1974, and the inflation rate for that year was 41 percent. The central bank responded to this monetary anarchy by setting lending ceilings on the banking system. The government tried to control the inflationary effects of this massive foreign wealth transfer by increasing imports in order to reduce the inflow of foreign reserves. Imports by the public sector were increased by restructuring budgetary expenditures toward those which were import-intensive. The private sector was encouraged to import more through a general tariff reduction and the removal of the ban list. In addition, the government built up stockpiles of imported commodities such as foodstuffs and basic materials. We want to emphasize that the expansion of government expenditure was not in any way a logical consequence of the balanced budget practice. The government need not have increased expenditures at all; it could have decreased its external “revenue” (external borrowing) in step with the

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increase in oil revenue. With access to external credit markets, the Indonesian balanced budget practice was neither a restraint on government spending nor a check on the growth of the money stock. The key point we want to make from the 1973-75 experience is not that the increase in government spending was undesirable, but that the instruments available for controlling monetary aggregates were grossly inadequate. Loan ceilings were a highly inefficient way to solve the problem. The need for better monetary instruments was again demonstrated in 1979 and 1980 after the doubling of oil prices. The great inflow of oil revenue via the balance of payments caused the monetary authorities to briefly lose control of the money supply. Reserve money grew 32 percent in 1979 and 36 percent in 1980, pushing inflation up to 20 percent in these years.

5.3 Financial Structure The structure of the organized financial system is shown in table 5.2.' The dominance of the banking sector in the system is evident from the data. At the end of 1985 the banking sector (Bank Indonesia and commercial banks) held more than 90 percent of the gross assets of the organized financial system. Table 5.2

Structure and Growth of the Organized Financial Sector, 197MQ

Gross Assets (in billions of rupiahs)

Number in 1982

1986

Bank Indonesia 1 Deposit money banks 113 National foreign exchange banksb 15 11 Foreign banks Other commercial banksC 50 Development banks 28 Nonbank financial institutionsd 13 Savings banks' 3 Insurance companies 83 Leasing companies 34 Other credit institutions' All institutions 6,106

Annual Growth of Assets (%)

Shares in Assets (5%)

1978

1982

1985

1978-82

1983-85

1978

1985

1 113

5,368 5,277

13,707 15,952

23,285 33,758

26.4 31.8

19.3 28.3

48 48

55

15 11 59 28

4,115

26,469 2,245 2,342 2,702

32.6 23.4 29.5 33.1

27.6 24.1 48.1 26.5

37 5 2

43 4 4

401

12,724 1,172 720 1,336

4

4

14 3

195 37 159 26 57 1 1,077

805 452 528 114 86 31,615

2,073 1,290 694 693 30 61,879

42.6 86.5 35.0

37.1 41.8 9.5 82.5

2

4 2 I

-

73 20 6,120

505 256

44.0

14.6 30.0

Source: Bank Indonesia, Indonesian Financial Sfatisfics.various issues. Note: Dash indicates data were not available.

"Annual compound rates. bFive state banks and ten national private banks. 'National private banks doing only domestic currency business. dNine investment finance, three development finance, and two other finance companies. 'One state savings banks and two private savings banks. 'Village banks, rural paddy banks, and government-owned pawnshops.

-

1

-

38

1

-

_

_

25.1

100

100

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IndonesidChapter 5

About 70 percent of the assets and credit of the banking system are owned and provided by the seven state-owned banks, including Bank Indonesia itself. Until March 1984 Bank Indonesia provided credits directly to economic units, particularly to state-owned enterprises and to quasigovernment institutions. The rest of the bank credit is divided evenly between the foreign and joint venture banks and about seventy domestic private banks. The latter include twenty-seven Regional Development Banks (RDB) owned by provincial governments. Each province has an RDB restricted to operating within its own jurisdiction. In reality, RDBs operate like commercial banks. There are now twelve nonbank financial institutions (NBFI) operating in Jakarta, all established between 1972 and 1974. Nine of them are investment finance companies, and three are development finance corporations. The first type of NBFI acts as an intermediary and underwriter of financial paper and finances medium- and long-term investments. The second type, development finance corporations, concentrates only on medium- and long-term financing and equity participation. The state commercial banks and the central bank are the majority shareholders of nearly all NBFI. The minority owners are domestic and foreign private companies. An NBFI is required to have at least three foreign partners, each from a different country, with at least one partner an investment bank. Bank Indonesia is a major shareholder in two of the investment finance companies and in all three of the development finance corporations. The investment finance companies have one big advantage over the commercial banks: they are subject to only two regulations, a debtlequity ratio of 15 and a ceiling on foreign borrowing. The absence of other regulations has permitted the investment finance companies to adapt more rapidly and effectively than the banks to changes in the economic environment. In fact, these companies were used by the state banks and Bank Indonesia to extend credit and to invest in sectors and activities which banks could not service under the old credit regulations. The Jakarta stock market started operations on 4 June 1952, but it was closed in 1958 due to political and economic instabilities. It was reopened on 10 August 1977. Trading has been virtually inactive. As of September 1986 there were twenty-four equity stocks and three bonds listed in the infant Jakarta stock exchange. Sixteen of the listed companies issuing equity shares were foreign companies and eight were domestic privately-owned firms. The companies issuing bonds were public enterprises. All of the new share issues took place during 1981-84. The main motivation of foreign companies to go public was to comply with the “Indonesianization” process which is required after operating for a certain period of time in the country. Through their overseas networks,these companies had access to international markets. They really did not need to raise money in the small, fragmented, and high-cost Indonesian money market. In other words, raising capital was not

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the main reason for foreign companies to issue equity shares in the Jakarta stock exchange. Going public for a foreign company was like “paying an entrance fee” to the Indonesian market. At the same time, these companies derived benefits from the tax concessions offered for going public under the 1983 tax system. The tax benefits actually exceeded the value of the sale of shares! This tax concession has since been rescinded. On the supply side, there are many reasons why the supply of marketable securities is so limited in Indonesia. The government has never floated bonds in the domestic market because its budget deficits since 1968 have always been financed by foreign aid and loans. Only four of the 220 state-owned enterprises have floated bonds in the Jakarta stock exchange, and none of them has issued equity share. The capital needs of these public enterprises have been financed by direct government investment, foreign loans, and subsidized bank credit. For domestic private companies, debt financing was less expensive relative to the costs of raising and servicing equity because credit from the state banks carrying subsidized interest rates was plentiful and could be easily rolled over. During the period of high international inflation rates and low nominal interest rates in the 1970s, it was not hard to tap foreign financial centers such as Singapore and Hong Kong. Working capital could be obtained by issuing promissory notes to the NBFIs (merchant banks). In a country where the data base on taxpayers is poor, tax administration is inefficient, and the legal and accounting systems are underdeveloped, tax evasion is an important source of internal financing. For all of these reasons, the opportunity costs of going public (disclosure, regulation, tax liability, dividend payout, dilution of ownership and control) for corporations is too high. On the demand side, the general public is still unfamiliar with the function of modem financial institutions, including the stock exchange, and the benefits to be derived from them. This, and a history of financial instability and repression, have made investment in stocks unattractive. An example of financial repression in the Jakarta stock exchange is the excessive controls by PT Danareksa (the National Investment Trust), a public company, in stabilizing the stock prices. In order to avoid large capital losses, PT Danareksa stabilizes the share prices within a narrow band (4 percent daily maximum variation) to make a share similar to a fixed price (fixed coupon) marketable asset like a time deposit or bond.

5.4 Financial Repression of the 1970s The financial system in Indonesia was repressed for almost a decade after April 1974, up until the financial reforms of June 1983. To control the increase in money supply resulting from monetization of government oil revenue denominated in dollars, Bank Indonesia set ceilings on bank credits and other domestic assets. The original purpose of the credit ceilings was to

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directly control the expansionary impact of the oil boom in the 1970s since a reserve management approach was shown to be insufficient. Then the government realized that this rationing method of monetary control could also be used to address several important items on its political agenda. Over time, Bank Indonesia was instructed to introduce detailed ceilings by type of credit for each bank through an extensive selective credit system featuring subsidized interest rates. For example, banks were assigned a civic function insofar as they restricted certain credit only to pribumis and made establishing credit for them a priority in order to enhance pribumi participation in economic activities. With the allocation of credit in mind, the Bank of Indonesia set up complicated rediscount financing, rediscount rates, and state banks’ loan rates. For Bimas (a government rice-intensification program) and foodrelated activities, Bank Indonesia provided 100 percent of the funds loaned by state banks. For this rediscount financing the state banks act as agents of the government to finance its program. For other sectors, rediscount percentages range from 20 to 80 percent of the state banks’ loans. The higher the priority of the sector, the higher the percentage of financing. (Discount facilities for nonpriority sectors were subsequently made available in January 1978.) To encourage state banks to extend credit to the priority sectors, Bank Indonesia ensured them adequate profits by charging low rediscount rates ranging from one-fourth to one-half of their loan rates. High rediscount percentages and low rediscount rates increased the rate of return on state banks’ own funds. Because the discount facilities were primarily available to state banks, these facilities were another form of subsidy to their operations. The true subsidy was higher, taking into account the government’s share in the burden of bad debts of state banks. The bad-debt ratio of state banks was quite high. For example, of the Bimas loans made by Bank Rakyat Indonesia (BRI) in Java (85 percent of the total for Indonesia) during 1970-74, around 7 percent remained unpaid two years after the loans were made. Loans were supposed to be due at most seven months from disbursement. The proportion of unpaid debts rose to 13 percent for the 1974-75 crop and 22 percent for the 1975 dry season crop. Approximately Rp 7 billion (U.S. $17 million) was written off or rescheduled during 1974-77 because of crop failures. Risk-bearing in the Bimas loans was shared by Bank Indonesia and Bank Rakyat Indonesia (25 percent each) and the rest (50 percent) by the government. According to Bank Bumi Daya’s 1976 annual report, about 28 percent of its loans were rescheduled and 8 percent had to be written off in that year. The Bank Bumi Daya is the biggest state bank, and most of its unrepaid loans were investment credits. Since most priority credits were handled by state banks, the policy of ceilings with selective credit became one of the major tools protecting state

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banks from competition with private banks. In addition, state banks and RDBs are depositories for government institutions and state enterprises. Since they also have a wider network of branch offices than private banks, state banks and RDBs have great advantages in tapping domestic savings. These institutional features discouraged competition, preserved the status quo, and guaranteed the dominant positions of the state banks. Discrimination in access to Bank Indonesia’s liquidity credit by bank ownership has encouraged the banking system to hold excess reserves, both in rupiah and in foreign currencies. With their loans financed primarily through liquidity credit facilities, most of the funds generated by state banks contributed to excess reserves. With the secured loan refinancing, there was little need for state banks to mobilize domestic saving. On the other hand, savings were not attracted to these banks where deposit rates were set by authorities at levels which usually lagged behind inflation. Many RDBs also had excess reserves. The excess reserves of state banks and RDBs, channelled through the interbank market in Jakarta, have been an important source of funds for private banks and NBFIs. In theory such credit policies add to the distortion of resource allocation and preserve fragmentation in the financial market (see McKinnon 1973, Gablis 1977, Nasution 1983). An extensive ceiling is similar to credit rationing, i.e., a ceiling on what customers can borrow, regardless of their willingness to pay higher interest rates. It is hard to judge whether Indonesian authorities succeeded in allocating credit according to their original design. For one thing, there are no detailed data on how credit was allocated according to various government objectives or a scale of priorities. Second, there were too many simultaneous objectives the government had wanted to achieve with the selective credit policy: to redress racial, sectoral, firm size, and technological imbalances; to equalize distribution of income, increase employment, stabilize prices of basic commodities; and so forth. If not accompanied by other policies, these objectives were not likely to be achieved since their number is much greater than the number of instruments available to use in pursuing them. For example, without any talent, skills, or experience, a person cannot be turned into an entrepreneur overnight by credit provision alone. Also, real resource allocation might not be similar to the credit allocation. In order for selective credit policies to be effective, the degree of banks’ credit fungibility would have to be zero. This means that long- and short-term credits from the banking system are exclusively utilized by business firms to finance fixed assets and working capital, respectively. Fungibility in this context is defined as the ability of business firms to borrow credits for a particular purpose but to effectively use it for another. Another type of fungibility is when business firms use low-cost funds from the banking system to finance (bank-) approved uses, thereby releasing their own funds for purposes that otherwise could not be pursued without the

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availability of bank credit. For example, BRI provides low-interest credits for the purchase of hand tractors, and a farmer who receives such credit uses it for that purpose and uses his own funds to buy a color TV set. Although easily evaded by big borrowers such as Pertamina and the multinationals, credit ceilings are thought to have contributed to slowing the rate of growth in the Indonesian money supply (Amdt 1979). There is one extremely interesting puzzle in the credit ceiling experience, and most of the answers to it are rather damning to the dominant presence of the government in the financial sector. The puzzle is that state banks, unlike the private banks, seldom used up all of their prescribed ceilings and had to lend out their excess reserves in the interbank market. One can speculate, first, that the demand was actually high but bad bank practices by the state banks made them unable or reluctant to reach out to small customers because it involved cumbersome operations and low profit per customer. Second, it could be the inability of the officers of the state banks to select projects which were acceptable both economically and politically. Third, the officers may have demanded too high side payments from prospective borrowers (to divide the implicit rents from a negative, zero, or low real interest rate). It has been suggested that the graft could have been as high as 15 percent of the volume of the loan granted (Gray 1979). This would have resulted in the real cost of interest rates from state banks becoming too high either for prospective borrowers or to be competitive with interest rates at private banks. If the interest rates at state and private banks were about equal, borrowers would have preferred to borrow from the latter, especially from branches of foreign banks or NBFIs, to avoid long delays and harassment from state banks. All of these factors could have reduced the rate of growth of credit expansion to less than the permissible ceiling without necessarily satisfying demand.

5.5 Financial Sector Reform in the 1980s A series of negative external shocks began in 1982. The world recession and the first wave of weakness in the world oil markets was worse than had been expected. Economic recovery in the OECD countries since 1983 does not appear to have helped economic growth in Indonesia significantly. The price of oil dropped from $35 per barrel in 1982 to $25 in 1985, and then to $12 in 1986 (figure 5.1). This dismal picture was repeated for the prices of Indonesia’s nonoil exports. The worst is still to come. Nonoil export prices are expected to continue falling, bottoming out only in 1988 when they would be 25 percent of the 1982-84 level (figure 5.2). The decline in the terms of trade has been aggravated by the sharp currency realignment in 1985-87. Most of Indonesian exports are priced in terms of the U.S. dollar, but a large proportion of its imports and foreign debts are denominated in the appreciating currencies. The dollar depreciation worsened the current

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account deficit, added to the burden of foreign debts, and cut Indonesia’s real budgetary expenditures. The decline in the terms of trade plus the big reduction in government real nondebt budgetary expenditures produced a sharp decline in economic growth. The annual average real GDP growth since 1982 has declined to one-third to one-half of the level in the 1970s. In short, the end of the oil boom in 1982 made financing the investment-saving and foreign exchange gaps much harder. In response to the external shocks, the government adopted several economic programs, among which was an overhaul of the financial structure. The financial reforms since 1 June 1983 fall into two major categories. The first category comprises partial deregulation of interest rates, elimination of credit ceilings, and reduction in the scope of Bank Indonesia’s subsidized credits to state-owned banks. The second category consists of piecemeal measures. Direct Bank Indonesia intervention in the day-to-day operation of state banks was reduced significantly, and its direct lending to quasigovernment bodies and state-owned enterprises was replaced by state bank lending financed by Bank Indonesia’s liquidity credits. At present there is no treasury debt that can be used for open market operations because the government financed its budget deficits solely through foreign aid and foreign loans. To increase the number of central bank instruments for open market operations, Bank Indonesia began reissuing

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IndonesidChapter 5

160 140

120 100

80 60 40 44 48 52 56 60 64 68 72 76 80 84 88

Year 1979-1981 = 100 Fig. 5.2 Primary product prices. Index of nonoil commodities (in constant dollars).

Debt Certificates (SBI) in February 1984 and introduced the Money Market Instruments (SBPU) on 28 January 1985.* The SBI had first been issued on 12 March 1970. However, issue ceased during the oil boom era in the 1970s as the authorities encouraged banks to invest their excess reserves in foreign assets in order to sterilize the inflow of oil money. At the beginning the interest rates on SBIs were set by Bank Indonesia at levels higher than the rates paid on excess reserves held at the central bank, but over time the sales of SBIs shifted to an auction system. Since 1984 the frequency of SBI auctions has increased, and rediscounting can be done either at Bank Indonesia or at Ficorinvest, an investment finance type of NBFI largely owned by Bank Indonesia. Bank Indonesia guarantees to rediscount the SBIs at their original auction prices, irrespective of their remaining maturities. Despite promotional efforts by Bank Indonesia, SBIs are not yet well accepted by the financial sector. The SBIs can be resold to the nonbank public. So far, however, the secondary market for SBIs is nonexistent. To maximize their profit from holding SBIs, financial institutions usually purchase a large volume of long-maturity SBIs and hold them for a short period before rediscounting.

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SBPUs are contingent liabilities of the bank of NBFI that first endorsed them. There are three types of SBPUs, namely: (1) promissory notes by eligible banks and NBFIs; (2) promissory notes issued by customers of eligible banks and NBFIs when borrowing from them; and (3) bills of exchange issued by third parties and endorsed by eligible banks and NBFIs. Initially the maturity of SBPUs was set between one to three months. However, on 7 August 1985 the upper limit was raised to six months. In reality, 98 percent of the SBPUs are in the form of promissory notes with maturity dates ranging form one to fourteen days. Only institutions which have signed repurchase contracts with Ficorinvest are eligible to endorse an SBPU. The repurchase contract prescribes the upper limit of each institution in rediscounting SBPUs. There are no data available on the total volume of SBPUs in circulation. However, the growth in the market for SBPUs must have been rapid since there is a high rate of growth of Bank Indonesia’s claims on banks arising from the use of the central bank’s rediscount facility on these instruments. As it now stands, the SBPU system is only beneficial for large financial institutions, especially the foreign exchange banks. Its eligibility standards discriminate against small private banks whose customers are mainly small and medium-sized firms. It is also discriminatory against unit banks which operate outside the capital city, since Ficorinvest has no branch office outside Jakarta.

5.6 Evaluating the 1983 Financial Sector Reform Our first observation is that the financial instruments SBI and SBPU still do not provide sufficient control over monetary aggregates. This is clearly seen in the way that the money supply had to be contracted in response to a speculative run on the rupiah in the first half of 1987. Capital flight began in earnest in the second quarter of 1987 when a higher than expected current account deficit was reported. (This overreaction was mostly due to nervous bankers and investors who had suffered losses in the two closely spaced devaluations of May 1983 and September 1986.) In June 1987 the minister of planning, Dr. Sumarlin, after concluding that open market operations would not be able to raise interest rates quickly enough, ordered state enterprises to withdraw Rp 1.3 trillion from state banks to be placed in central bank se~urities.~ This action, together with the sale of Rp 800 billion of open market instruments to banks during the month, sharply reduced bank liquidity and forced the banking system to sell its foreign assets in order to meet rupiah funding requirements. Other domestic corporations began repatriating capital to meet current operating needs. This severe credit squeeze succeeded in convincing private agents that the government was prepared to adjust other policies in order to ensure the viability of the existing exchange rate, and the speculation against the rupiah came to an end.

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Our second observation is that the response of long-term financial intermediation to liberalization of the financial sector is a slow one, and its initial reaction may even be perverse. While the response by depositors has been very favorable, the response by financial institutions has not been so. The volatility of sources and costs of funds forced the banking industry to adjust its lending terms in order to minimize interest rate risks. This resulted in an increasing share of short-term fixed rate assets and a large proportion of credits canying adjustable rates. Since interest rate volatility also increases borrowing risks, the banks have become more cautious in extending credit. The third observation we want to make is that the deregulation should have been preceded by institutional reforms in the state enterprise system. The bureaucratization of the state-owned banks in the protected climate of past credit policy raised their overhead cost and subsequently their cost of intermediation. High arrears in all sectors and all credit schemes is a reflection of high credit risks which resulted from the inadequate selection and supervision of customers. These deficiencies were largely due to the fact that all of their lending risks were passed on to the government. After the reforms, the opportunity cost of funds increased while the cost of intermediation and credit risks remained high. The high cost of intermediation was also caused by the state banks being prohibited from reducing personnel. These are additional reasons why the lending rates of state banks rose after deregulation. Our fourth observation is that the initial balance sheet conditions of the financial institutions should not have been overlooked. The present newly competitive market requires capital bases stronger than those of many of the financial institutions. Due to the past credit policy of subsidized interest rates, a large proportion of the assets of state-owned banks were extended at negative real interest rates. The weakness of the capital base of the private national banks is clearly shown by several recent bank failures. The final observation we want to make is that deregulation of the financial sector should have been accompanied by greater supervision of the banking system. The banking system is not insulated well enough in practice from the fortunes of individual clients. This is because the interconnections of family ownership closely link many of the private national banks to the performance of sister companies. Indeed, some of these banks have been established mainly to secure funds for the nonbank business ventures of their owners. 5.7

Concluding Remarks

The emphasis on the development of two open market instruments, SBI and SBPU, is a long overdue step toward better control over monetary growth. An important obstacle to improved macroeconomic management seems to be that open market operations have been mainly geared to keep interest rates constant. Monetary policy was particularly unresponsive to

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external interest rate developments. One reason for the capital outflow prior to July 1987 was that Bank Indonesia had kept the SBI rate flat for a relatively long period, causing domestic interest rates to diverge from international interest rates. In a financially open economy like that of Indonesia, it is essential to recognize that external shocks will frequently make tradeoffs among interest rate stability, domestic income stability, and exchange rate stability inevitable. It is clear from the manner in which the monetary contraction of June 1987 had to be implemented that the market for both SBI and SBPU was still too shallow. It may be difficult to increase their role if the financial markets remain underdeveloped. Financial deepening is an important priority, but not only because of the need to enhance the effectiveness of the monetary instruments. Financial deepening would also better mobilize (and maybe increase) domestic savings, reduce dependence on external credit, and improve the overall allocation of capital within the economy. One of the first steps that could be undertaken to boost development of the financial sector would be to privatize some of the state enterprises. It would certainly ease Indonesia’s external debt burden if a minority portion of these state enterprises were sold to foreigners. The possible increase in efficiency of these enterprises would be an added bonus.

6

Exchange Rate Policy

6.1 Introduction In chapter 3 we identified an important political constituency (technocrats, Javanese peasants, and Outer Island residents) which is opposed to the maintenance of an overvalued exchange rate. We will show in this chapter that this constituency has been successful in influencing exchange rate policy, with the result that there is an asymmetry in policy response to changes in the balance of payments. It makes good economic sense to devalue the real exchange rate when a balance-of-payments deficit occurs, but due to the existence of this constituency it makes good political sense not to allow the real exchange rate to revalue when a surplus occurs. The fact that the institutional memory was impressed by the potency of the exchange rate in effecting economy-wide resource reallocation and income redistribution during the 1966 economic rehabilitation program helps to strengthen the economic argument for a devaluation whenever the balance-of-payments situation demands it. This exchange rate policy, as we will argue in chapter 7, played a crucial role in helping Indonesia to avoid a debt crisis in

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1982-84 because it maintained a large and healthy tradable sector and discouraged capital flight. Given the crucial role of the exchange rate in external debt management, we focus on exchange rate management in some detail. The statistical profile of the rupiah-dollar exchange rate in figure 6.1 is characterized by three distinct phases. The first phase, from October 1966 to July 1971, saw a steady dismantling of the multitiered exchange rate system into a unified exchange rate, revealing a readiness to have medium-sized devaluations at short intervals. In the second phase, from August 1971 to October 1978, there was a fixed exchange rate. The third phase occurred from November 1978 to March 1987 and was a time of large devaluations separated by moderately long periods of gradual exchange rate depreciation. Since these three phases reflect policy responses to changes in the external environment and to developments internal to Indonesia, we will use them as a convenient way to organize our discussion of Indonesian exchange rate management. The discussion of phase 3 will revolve around the November 1978, March 1983, and September 1986 devaluations.

6.2 Phase 1, Pre-August 1971 When the New Order government of General Soeharto took power in October 1965, it inherited a system of multiple exchange rates.' This system not only allowed corruption because of the discretionary element inherent in

60 50 40 30 20 10 0 -1[

68 69 70 71 72 73 74 75 76 78 79 80 81 82 83 84 85 86 Fig. 6.1 Rupiah-dollar exchange rate changes (%), 1968-86

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its administration, it also made smuggling an extremely profitable business. Since the array of exchange rates was set to promote domestic industrialization and extract revenue for the government, the exchange rate system discriminated against the traditional agricultural commodity exports. The fact that the whole exchange rate structure had become increasingly overvalued because of chronic high domestic inflation meant an acceleration in the pace of resource shift away from export activities. Many rural residents abandoned the cultivation of tree crops for subsistence farming. The Soeharto regime made the maintenance of a competitive exchange rate and the simplification of the exchange rate system a key element in its economic rehabilitation program. A unified exchange rate was achieved in April 1970 when the government set its major import exchange rate (Bonus Ekspor, BE