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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Wing Thye Woo and Anwar Nasution

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.

95

IndonesiaChapter5

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

96

Wing Thye Woo and Anwar Nasution

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

97

IndonesidChapter 6

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

98

Wing Thye Woo and Anwar Nasution

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) to be the same as that of the then free market exchange rate (Devisa Pelangkap, DP) of 378 rupiahs to the dollar.2 The government in this period displayed no reluctance to change the exchange rate whenever it seemed that a balance-of-payments problem was appearing. Exchange rate realignments were quite frequent, with medium-sized devaluations undertaken at short intervals in order to preserve the competitiveness of Indonesian goods in the face of high domestic inflation rates. A good example is the August 1971 devaluation which brought the exchange rate to 415 rupiahs to the dollar. This devaluation was clearly implemented in response to the worsening of the current account deficit, which widened from 3.4 percent of GDP in 1970 to 4.0 percent in 1971 (see table 6.1). The deterioration in the balance of payments was partly the result of a slowdown in world economic growth and partly the result of the real appreciation of the rupiah caused by the relatively higher inflation rate in Indonesia during 1969 and 1970.

6.3 Phase 2, August 1971 to October 1978 The exchange rate remained at 415 rupiahs/dollar for a record seven years. The reason for this remarkable stability was straightforward: the balance of payments was very strong throughout the period. The current account deficit during phase 2 stayed below the 1971 figure of 4 percent of GDP (see table 6.2). The largest current account deficit occurred in 1975, 3.6 percent of Table 6.1

Background to the August 1971 Devaluation (in percentages)

Current account balance to GDP Industrial countries’ GDP growth rate Industrial countries’ inflation rate Indonesia’s inflation rate

I969

1970

1971

1972

-4.0 4.9 4.1

- 3.4

-4.0 3.5 5.2 4.4

-3.0 5.2 4.6 6.4

17.4

Source: International Financial Sfatistics, 1986 yearbmk.

2.7 5.6 12.3

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IndonesidChapter 6

Table 6.2

Economic Conditions During Rriod of Fixed Exchange Rate, August 1971to November 1978 ~~

Current balance as %of GDP Current account receipts as % of GDP Nongold reserveslimports (in weeks) GDP growth rate (8) Inflation rate (%)

1970

1971

1972

1973

1974

1975

1976

1917

1978

-3.4

-4.0

-3.0

-2.9

2.3

-3.6

-2.4

-0.1

2.7

13.6

14.8

17.2

20.7

29.1

23.1

23.6

23.9

22.0

8.1 6.5 12.3

8.7 7.0 4.4

19.1 9.4 6.4

15.3 11.3 31.0

20.2 7.6 40.6

6.4 5.0 19.1

13.7 6.9 19.8

20.9 8.9 11.0

20.4 7.7

8.1

GDP, when the rosy economic prospects induced by the oil boom caused both private and public spending to soar. The proportion of national income from current account receipts leaped from the 1970-72 average of 15 percent to an average of 24 percent during 1973-78. The fear of a balance-of-payments crisis was never further away from the authorities’ minds; there was little fear of not being able to accommodate any short-run speculative flight. The level of nongold reserves, measured as the number of weeks the nongold reserves could sustain existing import levels, was consistently higher than the 4.8 weeks of the 1967-69 period and the 12 weeks of the 1970-72 period^.^ The impressive balance-of-payments performance is largely due to the rapid development of the petroleum and LNG sectors and the fourfold oil price increase at the end of 1973. Besides the absence of a balance-of-payments reason for changing the exchange rate, the macroeconomic conditions of this period also did not warrant any additional stimulus which a devaluation would surely bring. The sustained high income growth rates of this period were without precedent in the Soekarno years. This high average income growth rate of 7.9 percent was achieved with substantial overheating of the economy-the average inflation rate was 22 percent compared with the 8 percent of 1970-72.

6.4 The November 1978 Devaluation For most observers the devaluation of the rupiah on 15 November 1978 was a surprise. While it was generally agreed that the real exchange rate had appreciated significantly since 1971 and that there would be a need in the future, when oil reserves were closer to depletion, to devalue in order to boost nonoil exports, there was little expectation of an immediate deval~ation.~ There were no signs that the balance of payments was deteriorating-the current account deficit was 2.7 percent of GDP in 1978 and 0.1 percent in 1977, compared with 2.4 percent in 1976 and 3.6 percent in 1975. There were, in fact, numerous speculations in the Indonesian press during April and May 1978 that a revaluation of the rupiah might be

100

Wing Thye Woo and Anwar Nasution

necessary given the plunge of the dollar vis-6-vis the other major currencie~.~ Many explanations have been offered for the timing of the exchange rate realignment but they all tend to be combinations, with different emphasis, of two main interpretations. In the first interpretation the November 1978 devaluation is seen as an anticipatory action to the inevitable dropoff in oil export earnings due to resource depletion.6 Arguments in support of the anticipatory devaluation interpretation are: (1) that it is better to act before a balance-of-payments crisis actually develops because this would prevent the financial chaos attendant upon a speculative outflow of domestic capital; and (2) since exports and imports react to relative price changes with substantial lags, a devaluation during a balance-of-payments crisis would have to be larger than is really necessary in order to have any immediate beneficial effects. The second interpretation 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/ dollar despite the large domestic inflations from 1974 to 1977. This meant that Indonesian producers of tradables were experiencing a profit squeezethe 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. The stagnation of the manufacturing export industries was worrying because, being of a labor-intensive nature, they were looked upon as the means to soak up the natural increases in the labor force. Indonesia was suffering from the Dutch disease. The growth of the extremely capital-intensive oil industry caused the real exchange rate to appreciate, hence decimating the labor-intensive tradables industries. Since the oil industry constituted an enclave export sector with minimal linkages to the rest of the economy, the steady movement of resources into the service (nontradables) industries was a threat to the long-run growth rate of the economy. The movement of resources out of the rural sector was hastened by another development. Protection was increasingly granted to importcompeting industries in order to offset the profit squeeze caused by the overvalued rupiah, and this protectionist policy deteriorated the rural-urban terms of trade. Politically, the distress in the rural sector was undermining the efforts of the Soeharto regime to prevent the resurgence of the PKI, and it was also raising inter-island tensions because the Outer Islands depended heavily on the export of agricultural products. Given these economic and political costs of the Dutch disease, it was therefore not surprising that the government devalued, even in the absence of a balance-of-payments crisis.7 Max Corden (1982) has aptly labelled the use of the exchange rate to protect

101

IndonesidChapter 6

the tradable sector for reasons unrelated to balance-of-payments considerations as “exchange rate protection.” The anticipatory devaluation interpretation and the Dutch disease interpretation could both be right. They do not contradict each other. It must be mentioned, however, that anticipatory devaluations are extremely rare events, not only by the past experiences of other LDCs but also by Indonesia’s own history of devaluations. Devaluations, including the Indonesian ones prior to 1978 and those of 1983 and 1986, usually occur either in the midst of a balance-of-payments problem or when one is imminent. And as shown in table 6.2, the level of foreign reserves in 1978 would have been able to sustain the existing amount of imports longer than at any time during the 1970-76 period. Further, the anticipatory devaluation explanation can be judged plausible only if it explains why the technocrats reacted quite differently in 1978 toward potential balance-of-payments problems than at any time before or after 1978. It must be admitted, however, that the alleged deleterious effects of the Dutch disease on the nonoil export sector are not obvious. Nonoil, nonLNG 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 the Dutch disease period of 1972-78 (see the first three columns in table 6.3). The 1975 dip in export earnings is due to a recession in the industrial hrfomance of Nonoll NonLNG Exports (1974 = 100)

Table 6.3

Physical Volume NA NA 73.9 83.4 96.3 100.0 99.6 111.9 121.0 118.0 160.0 144.5

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

U.S. Dollars

Foreign Purchasing Power

Domestic Purchasing Power

52.2 58.5 59.4 60.2 91.1 100.0 74.2 103.8 133.0 123.0 162.4 155.9

51.6 60.1 66.9 73.7 103.2 100.0 69.5 80.8 100.9 103.6 184.6 170.8

28.6 33.6 36.0

40.0 73.2 100.0 82.6 115.2 159.7 166.4 253.7 276.4

Memo item: Average annual growth rate of nonoil exports in 1973-78 period. Exports in US. dollars

Growth rate (70)

Indonesia

Malaysia

Thailand

South Korea

Hong Kong

Singapore

15.5

32.3

19.9

30.6

19.0

20.0

Nore: Physical volume from deflating rupiah value series by nonoil export price index. Foreign purchasing

power from deflating U.S. dollar value series by export unit value of industrial countries. Local purchasing power from deflating rupiah value series by Indonesian CPI. The CPI contains prices of imported consumption goods in its construction. NA

=

not available

102

Wing Thye Woo and Anwar Nasution

countries rather than to a fall in domestic production. The fact that the value indices of columns 1, 2, and 3 went up in 1979 and 1980 only shows that a devaluation is effective in increasing supply rather than that there was stagnation in the nonoil export sector. The production disincentive faced by the nonoil export industries is clearly seen only when one measures the amount of local purchasing power which their exports are able to command (see column 4 of table 6.3). Even though the 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. The first three measures show that total export earnings in 1976 and 1977 were at unprecedented heights, whereas the fourth measure puts the 1976 and 1977 earnings below that of 1973. In terms of foreign purchasing power (column 3), the nonoil export industries increased their revenues by 32 percent between 1973 and 1978, but their revenues were unchanged if measured in local purchasing power. Another indicator that the Indonesian tradables sector was suffering from the Dutch disease is its poor growth performance compared to Malaysia and Thailand, which exported similar products (see memo item in table 6.3). The respective annual growth rates of nonoil exports over the 1973-78 period for Indonesia, Malaysia, and Thailand were 16 percent, 32 percent, and 20 percent, respectively. The most telling comparison is with Malaysia, which had an oil boom like Indonesia and which also kept its currency fixed (almost) to the dollar. The big difference was that the average annual inflation rate for Malaysia was 7.5 percent as against Indonesia’s 21.6 percent. Table 6.4 gives the prices of the five largest agricultural exports, measured in different ways. Other than the price of coffee, the other agricultural prices move more or less in tandem. Again, because of real exchange rate appreciation, the foreign purchasing power measures (item a) of palm oil, rubber, log, and plywood prices gave a less bleak picture of the 1974-78 period than the local purchasing power measure (item b). The average fall in prices was 12 percent by the first measure, but 29 percent by the second measure. Local purchasing power is the relevant measure for assessing the degree of profit squeeze on the smallholders. To smooth out individual price deviations, as in the case of coffee prices, in table 6.4, aggregate price indices were constructed to study overall movements in the ratio of prices of tradables to prices of nontradables, PT/PN (see table 6.5). Two proxies for the ratio were obtained by (1) normalizing the output price indices of several sectors by the CPI and (2) normalizing the sectoral prices by the housing component of the CPI.8 Since housing cost is a more direct proxy for nontradables, we would expect the second ratio to move more than the first.

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IndonesidChapter 6

Table 6.4

Commodity Price Indices (1974= 100) Coffee

Palm Oil

Rubber

Logs

Plywood

56.7 74.4 65.7 74.2 91.5 100.0 106.7 208.9 337.1 228.1 249.4 221.8

28.0 42.9 43.4 36.9 47.8 100.0 94.6 71.3 102.0 106.3 118.7 105.8

68.0 57.1 43.6 41.3 83.3 100.0 75.3 102.0 110.3 131.0 170.3 194.5

47.7 52.9 53.1 49.8 83.5 100.0 82.8 112.8 110.1 112.3 197.0 236.7

55.3 67.5 53.7 63.4 124.3 100.0 79.8 96.7 105.8 124.1 171.9 179.3

124.1 99.4 71.9 62.2 103.7 100.0 67.6 91.9 91.9 96.8 109.1 109.7

87.1 92.2 87.5 74.8 103.9 100.0 74.4 101.7 91.8 83.0 126.1 133.5

100.9 117.5 88.6 95.4 154.7 100.0 71.6 87.1 88.1 91.7 110.0 101.1

(a) In U.S. dollars

1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

(b) In terms of real exports from industrial countries 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980

103.5 129.4 108.4 111.6 113.9 100.0 95.8 188.2 280.9 168.6 159.7 125.1

51.1 74.7 71.6 55.5 59.5 100.0 84.9 64.2 85.0 78.6 76.0 59.7

(c) In terms of baskets of domestic:ally consumed goods (real rupiah prices as given 1969 102.3 50.5 122.7 1970 133.0 76.7 102.1 1971 122.0 80.6 81.0 1972 136.7 67.9 76.1 1973 129.0 67.4 117.5 1974 100.0 100.0 100.0 1975 89.8 79.6 63.4 1976 146.6 50.0 71.6 1977 213.1 64.5 69.7 1978 134.4 62.6 77.2 86.4 123.9 1979 181.5 1980 137.1 65.4 120.2

by CPI) 86.2 94.7 98.5 91.7 117.7 100.0 69.7 79.2 69.6 66.2 143.3 146.2

99.7 120.6 99.7 116.9 175.2 100.0 67.1 67.8 66.9 73.1 125.0 110.8

In our opinion, the most reliable indicators of PT/PN are the normalized wholesale price indices of imports and of nonoil exports. This is because: 1. Beginning in 1974, some segments of the manufacturing sector started receiving quantitative restrictions on imports to protect domestic industries hurt by the real appreciation and to promote import substitution. Goods sheltered by quantitative restrictions are effectively nontradables from the analytical viewpoint. This is because imports cannot enter, regardless of the spread between domestic and international

104

Wing Thye Woo and Anwar Nasution

prices. With a given quota, prices of the domestically produced substitutes are insulated from international price movements and move only in response to changes in domestic demand and cost conditions.' 2. Rice is a very large portion of domestic agricultural output, and its price has been deliberately set to increase slightly more than CPI movements in order to promote the goal of self-sufficiency in rice. Prices of a number of other food crops such as corn, soybean, and sugar are also protected from external competition. This means that tree crops are the main tradable component of the agricultural sector. Part (a) of table 6.5 shows that, except for agriculture, wholesale prices normalized on the CPI show a downward trend from 1973 to 1978, indicating pressure on producers of tradables to shift to nontradables. We suspect that it is for the reasons given above that the production incentive in the manufacturing sector fell less than in the general tradables sectors. Judging from the normalized export and import indices, the incentive to produce tradable as against the general basket of consumption goods fell 22 to 27 percent between 1973 and 1978." When prices were normalized by the nontradable price variable, housing cost, all series showed a downward trend (see part b of table 6.5). Again, the differences in the decline of the series, PT/PN, reflect the fact that the food component of agriculture is essentially a nontradable because of the self-sufficiency goals, and that the manufacturing sector has been receiving increasing quota protection over the period. In this direct measure of FT/PN, the production disincentive increased by about 26 percent in the 1973-78 interval. Table 6.5

Indicators of Tradable-NontradablePrice Ratio, PT/PN (1974= 100) 1980

Wholesale F'rices

1971

1972

1973

1974

1975

1976

1977

197V

1979

(a) Relative to Jakarta CPI Imports Exports, nonpetroleum Agriculture Manufacturing

105.9 90.2 90.2 103.9

111.1 88.9

107.0 107.0 102.8 114.1

100.0 100.0 100.0 100.0

91.6 69.7 98.3 89.9

81.8 72.0 102.8 88.1

76.7 83.0 113.2 88.1

78.3 84.3 116.9 92.2

87.0 110.2 120.8 94.9

84.8 112.9 127.7 97.7

(h) Relative to housing component in Jakarta CPI Imports 75.0 82.2 91.6 Exports, nonpetroleum 63.9 65.8 91.6 Agriculture 63.9 74.0 88.0 Manufacturing 73.6 79.5 97.6

100.0 100.0 100.0 100.0

87.2 66.4 93.6 85.6

74.5 65.6 93.6 80.3

66.3 71.7 97.8 76.1

65.3 70.4 97.5 16.9

73.7 93.3 102.4 80.4

70.5 93.8 106.2 81.2

(c) Morgan Guaranty's competitiveness measure

100.0

87.3

74.8

74.2

79.6

111.3

101.1

114.1

100.0 107.4

127.1

120.3

-

Note: Part (a) and (b) are calculated from table 3 in Wan (1986), but some of our calculated numbers differ from the

calculations in his table 4. The series in this table and those in table 6.7 are not comparable because the definition of wholesale price index changed over the two periods. The competitiveness measure is from inverting the Morgan Guaranty real exchange rate. "January to October 1978

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IndonesidChapter 6

6.5 Effects of the 1978 Devaluation The 50 percent devaluation caused a much bigger jump in the normalized nonoil export prices than in the normalized import prices; on average, a 24 percentage point jump in the former versus 8 percentage points in the latter. The minor improvements in the normalized manufacturing and agricultural prices may reflect the significant use of quantitative restrictions (QRs) which have pushed these goods closer to the nontradables category. The 24 percentage point improvement in relative prices for the tradable sector may not be an exaggeration because the rise in the Morgan Guaranty measure of competitiveness was even more substantial-32 percentage points. l 2 The speed and size of the response of nonoil, nonLNG exports were extremely impres~ive.'~ The devaluation happened at the end of 1978, and the expansion of nonoil exports in 1979 was considerable according to all four of the earning measures used in table 6.3. Export volume went up by 36 percent in one year, raising dollar earnings by 52 percent. Measured in units of exports from industrial countries, the value growth from the 1978 level was 32 percent in 1979 and 27 percent in 1980. This growth in foreign purchasing power translated into domestic purchasing power increases of 78 percent in 1979 and 65 percent in 1980. The nonoil export response caused the nongold reserves of the central bank to swell from twenty weeks of imports at the end of 1978 to twenty-six weeks in the third quarter of 1979, just before the OPEC-2 October price increase further boosted official reserves. What makes this export achievement particularly notable is that 1979 was the beginning of the slide into the deep recession of 1982. The real GDP of the industrial countries grew only 3 percent in 1979 and 0.6 percent in 1980, compared to a 1976-78 average of 4.4 percent. While the big response by nonoil exports may not be surprising given the large devaluation, what may not have been expected at the outset was the speed of the response. This is because the bulk of Indonesian nonoil exports is agricultural raw materials and minerals, with manufactured exports averaging only 6.7 percent of nonoil exports in the 1972-78 period. l4 Since the supply of both of these primary commodities is typically assumed to be inelastic in the short run, either because of their long gestation periods (tree crops) or their heavy capital-intensive nature (minerals), the 36 percent expansion in the physical volume of nonoil exports in 1979 was bewildering. The quick response is proof of the Dutch disease. The mounting severity of the Dutch disease 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 as the real prices of their agricultural products sank with the maintenance of a constant nominal exchange rate in the face of big domestic price increases. Another source of the excess capacity in the agricultural raw materials sector was that, given the low real prices, producers were not fully exploiting the now matured

106

Wing Thye Woo and Anwar Nasution

trees planted in the early 1970s in the wake of the stabilization and rehabilitation of the economy. Hence, production was easily increased when PT/PN was improved by the 50 percent devaluation. The above point is very well brought out by table 6.6 which shows the value of nonoil exports before and after the November 1978 devaluation. Total nonoil exports, measured in dollars, went up by 54 percent in fiscal 1979.l5 The rates of increase for the seven biggest nonoil export items were all at the two-digit level: timber, 91 percent; rubber, 42 percent; palm oil, 16 percent; coffee, 41 percent; animals and animal products, 19 percent; and manufactured goods, 82 percent. The sizable expansion of the tree crop Table 6.6

Nonoil, NonLNG Exports of Indonesia

Product

1977178

I978179

I979180

(a) In millions of U.S.dollars Timber Rubber Palm oil Coffee Tea Tobacco Pepper Palm kernel Copra cake Tapioca Other foodstuffs Animals and animal products Tin Copper Other minerals Manufactured products Total value of nonoil exports

943.0 608.0 202.0 626.0 120.0 59.0 62.0 5.0 33.0 13.0 48.0 179.0 253.0 74.0 36.0 245.0 3,506.0

I , 130.0 774.0 221.0 508.0 98.0 58.0 66.0 2.0 34.0 28.0 65.0 214.0 324.0 64.0 49.0 361.0 3,996.0

2,166.0 I.101 .o 257.0 715.0 91.0 60.0 46.0 12.0 65.0 59.0 79.0 255.0 388.0 95.0 126.0 656.0 6,171.0

-

(b) Rate of change from preceding year ( I ) Timber Rubber Palm oil Coffee Tea Tobacco Pepper Palm kernel Copra cake Tapioca Other foodstuffs Animals and animal products Tin Copper Other minerals Manufactured products Total value of nonoil products Memo item: Manufactured exports as proportion of total nonoil exports

19.8 27.3 9.4 - 18.8 - 18.3 -1.7 6.5 -60.0 3.0 115.4 35.4 19.6 28.1 - 13.5 36.1 47.3 14.0

7.0

9.0

91.7 42.2 16.3 40.7 -7.1 3.4 -30.3 500.0 91.2 110.7 21.5

19.2 19.8 48.4 157.1 81.7 54.4

10.6

107

IndonesidChapter 6

exports-rubber, palm oil, and coffee-and tin exports testified eloquently to the presence of excess production capacity in these industries prior to 1979. The large reaction of manufactured exports was particularly gratifying to the technocrats who had advocated the devaluation because they viewed the labor-intensive manufactured industries as a crucial sector for Indonesian industrialization and the creation of employment. l 6 6.6 The March 1983 Devaluation

Management of the exchange rate after the 1978 devaluation was much more flexible; the rupiah glided gently downward against a basket of currencies to compensate for the higher inflation rate in Indonesia. The OPEC-2 shock in November 1979, however, unleashed external and internal forces which led ultimately to the 38 percent rupiah devaluation in March 1983. Specifically, the doubling of oil prices provoked the industrial countries to tighten their monetary policies to ward off the cost-push inflation, and the result was three years of negligible growth with its nadir in 1982 when the world experienced its deepest recession since the Great Depression. At the same time, the great inflow of oil revenue caused the Indonesian government to augment its investment spending as dictated by the balanced budget rule. Because of the primitive state of domestic financial markets, ruling out the use of open market operations by the central bank, the conversion of the dollar-denominated oil revenue by the government into rupiah expenditure led to an explosion of the money supply. As in the aftermath of the OPEC-1 shock, Bank Indonesia temporarily lost control of the money supply. Reserve money grew by 28 percent in 1979 and 40 percent in 1980. The result was that the expected one-time price level increase due to the November 1978 devaluation was given new momentum; the inflation rate was 18.5 percent in 1979 and 12.2 percent in 1980. The inflation rate would have been higher if stagnation in the industrial countries had not exerted a moderating effect on prices via lower import prices. The internal shock of high inflation, which appreciated the real exchange rate, and the external shock OF low OECD growth caused the balance of payments to deteriorate. The slowdown of the OECD economies shifted the demand for Indonesian exports downward, and the real exchange rate appreciation decreased the supply of nonoil exports. The import price index normalized by housing cost went from 74 to 66 in the 1979-82 period, while the Morgan Guaranty competitiveness index declined from 111 to 80; a fall of 10 and 20 percent, respectively (see table 6.7). The consequence of these internal and external shocks was that both the volume and real domestic value of nonoil exports in 1982 were half of their 1979 level. The current account deficit was a record 6 percent of GDP, with reserves falling to ten weeks of imports.

108 Table 6.7

Wing Thye Woo and Anwar Nasution Background to Devaluations of 1983 and 1986

(a) General economic conditions Income growth in industrial nations ( W ) Real price of oil in foreign purchasing power (1980= 100) Indonesian inflation rate ( W ) Indonesian growth rate ( Q )

1979

1980

1981

1982

1983

1984

1985

3.4

1.3

1.4

67.7 20.6 6.3

100.0 18.5 9.9

119.2 12.2 7.9

27.5 1.9 29.3

27.9 4.0 25.9

13.5

65.2 99.0 111.3 160.0 184.6 162.4

1986

-0.4

2.7

4.7

3.0

2.4

124.1 9.5 2.2

111.6 11.8 4.2

109.1 10.5 6.6

104.1 4.7 1.1

59.1 5.9 2.4

25.2 -0.7 19.6

20.8 -5.9 9.7

23.1 -7.8 11.8

24.3 -2.5 17.9

21.4 -2.1 20.5

21.4 -4.3 23.0

7.9

8.2

10.6

12.8

14.7

20.1

29.3

62.8 101.0

63.0 91.1 89.0 90.2 111.8 118.1

56.9

63.2 105.9 98.4 100.9 148.1 142.6

59.8 102.9 91.8

58.2 98.4 92.7 129.2 188.5 177.0

57.7 98.9 109.7 142.7 222.4 168.2

(b) Balance-of-payments situation Merchandise exports to GDP (%) Current account balance to GDP ( 8 ) Reserves to imports ratio (weeks) External long-term public debt service 10 exports (%I (c) Nonoil export sector (1974= 100) Import price deflated by housing cost Export price deflated by housing COSI Competitiveness B la Morgan Guaranty In physical volume In local purchasing power In foreign purchasing power

101.1 144.5 170.8 155.9

80.5 79.5 80.3 93.5 107.3

115.5

175.0 169.3

Note: IWPN proxies for 1983 are for post-March devaluation and for 1986 are pre-September devaluation. PT/PN proxies here are not comparable to those in table 6.5 because of changes in the definition of price indices. This is why the 1979 and 1980 figures in this table are different from table 6.5.

The balance-of-payments picture worsened in the first quarter of 1983. Imports continued to grow with no sign of export recovery, and capital outflow started accelerating. The category of errors and omissions, into which the official balance-of-payments account put all private portfolio capital flows, soared from -$0.6 million in 1979 to over -$2.0 billion annually during 1980-82. The weak export earning together with this avalanche of capital outflow caused total nongold reserves to fall to 5.3 weeks of imports by the end of the first quarter of 1983. The grim balance-of-payments picture at that point was definitely the reason for the 38 percent devaluation. An economic stimulus coming at the time when the economy was growing at 2.2 percent was an added incentive to devalue. Because Mexico was unable to meet its debt service in August 1982 and two other borrowers, Argentina and Brazil, were on the brink of a debt crisis, it was prudent for Indonesia to take some preventive measures, especially since the price of oil was moving downward. It seems likely that the external debt did not play more than a cautionary role in the government’s decision to devalue in 1983. Although the external public debt-service ratio rose from 8 percent in 1980 to 11 percent in 1982, it was still well below the 1981 (pre-crisis) Mexican debt-service ratio of 28 percent. l7

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IndonesidChapter 6

The March 1983 devaluation restored PT/PN back to the level set by the devaluation of November 1978. The response of the nonoil export sector was impressive, as in the previous devaluation-exports expanded 26 percent in physical volume and 58 percent in local purchasing power. The reason the 1983 nonoil export levels (in real terms) were significantly lower than the 1979 levels, even though the value of the real exchange rate was the same in both instances, is that foreign demand was much lower in 1983 than in 1979. Real GDP of industrial countries grew 2.7 percent in 1983, compared to 3.4 percent in 1979. Nevertheless, the increase in nonoil exports was enough to shrink the current account deficit to 2.5 percent of GDP in 1984. Manufacturing exports grew especially rapidly, jumping from $850 million in fiscal 1982 to $1,480 million in fiscal 1983, and then to $2,166 million in fiscal 1984 (see table 6.8). It is noteworthy that a greater variety of manufactured goods were being exported because of the favorable PT/PN. Manufactured goods in the “others” category shot up by 300 percent in real terms in just two years. This reaction of the manufacturing sector strongly indicates that export-oriented industrialization is a real possibility as long as favorable relative prices are maintained through appropriate exchange rate and trade policies. It must be emphasized that the government supported the 1983 exchange rate devaluation with conservative macroeconomic policies. Both monetary and fiscal policies were tightened. The latter was done by massive postponement of capital-intensive (hence, import-intensive) projects and by increasing tax revenue through streamlining a cumbersome tax system. The government budget deficit went from Rp 13 billion in 1982 to Rp 10 billion in 1983, and then to Rp 0.5 billion in 1984.” The conservative macroeconomic policies succeeded in keeping inflation to just a shade over 10 percent in 1983 and 1984, hence preventing a fast reversal of the real depreciation of the exchange rate. The government may also have sought to improve the trade balance directly by rapidly expanding the list of import items subject to quotas. While imposition of quotas may be due largely to the efforts of infant industries advocates and rent-seekers, the timing of the flood of quantitative Table 6.8

The Response of the Manufacturing Sector to the March 1983 Devaluation (in millions of dollars)

Plywood Textiles and clothing Electrical appliances (e.g., T.V.. semiconductor, transistor) Others (e.g., fertilizer, cement, iron and steel, floor coverings) Total manufactured exports Source: World Bank (1985, 20; 1986, 91; 1987a, 16).

1982183

1983/84

1984/85

320 I80 1 LO 240 850

580

697 519 I35 815 2,166

360 130 410 1,480

110

Wing Thye Woo and Anwar Nasution

restrictions seems to suggest a role for balance-of-payments considerations as of November 1982. The increased protectionism may help the balance of payments in the short run, but the quota form of protectionism (for reasons given in section 6.8 below) is counterproductive in the medium and long run. Quantitative restrictions could very well have contributed substantially to the need for another devaluation in September 1986.

6.7 The September 1986 Devaluation The world economy showed no signs of returning to sustained economic growth after the deep 1982 recession. There was a spurt of activity in 1984 (see table 6.7) which was normal after such a deep recession and was helped along by the large U.S. budget deficits. But U.S. budget deficits could not keep on widening indefinitely in order to provide the same stimulus. In 1985 the growth rate in the industrial countries slowed down to 3.0 percent. After the middle of 1986 it was clear that immediate growth prospects were lower than anticipated. The IMF revised its growth rate projections for industrial countries downward, from 3.0 to 2.7 percent for 1986, and from 3.2 to 3.1 percent for 1987 (IMF 1986b, 1986~).The actual 1986 growth rate turned out to be even lower than the midyear forecast; it was 2.4 percent.19 For Indonesia, the slow global economic recovery translated directly into uncharacteristically low oil and commodity prices. The average oil price in fiscal 1985 was $25 per barrel, and it fell to $13 per barrel in fiscal 1986.*’ The nonoil terms of trade also turned harshly against Indonesia with the result that even though nonoil exports increased by 10 percent in physical volume, their value decreased by 5 percent in terms of foreign purchasing power. Despite the adoption of stringent macroeconomic policies and the steady floating down of the exchange rate from 970 rupiahs/dollar in 1983:lQ to 1,131 rupiahs/dollar in 1986:2Q, the current account deficit doubled to 4.3 percent of GDP from 2.1 percent. Added to the balance-of-payments problems of 1986 was a quickening of the rise in the external public (medium- and long-term) debt-service ratio since 1984. The 1986 debt-service ratio stood at 29 percent, the same level as the Mexican debt-service ratio in 1981. The primary factors behind this drastic rise were the export collapse, which decreased the denominator, and the “uncontrollable” increased debt payments, which increased the numerator. The increased debt-service payments were termed ‘‘uncontrollable” because since less than 30 percent of Indonesia’s external debt is denominated in U.S. dollars, the drastic drop of the dollar against the other currencies accounted for more than 70 percent of the $1.1 billion increase in annual debt service over the 1984-86 period (World Bank 1987a). Given that Japan is Indonesia’ biggest creditor (36 percent of debt), as well as its biggest trade partner, the 29 percent dollar depreciation against the yen in 1986 put Indonesia in the uncomfortable position of receiving dollars for its

111

IndonesidChapter 6

chief export, oil, and paying yen for its imports and for a third of its debt service. With the worsening of the trade balance, the growing shadow of a debt crisis, and the slowing down of economic activities, the September 1986 devaluation of 45 percent against the dollar was the single most effective step Indonesia could have taken to simultaneously improve its capacity to earn foreign exchange and stimulate its economy.

6.8 Relative Prices and the 1986 Devaluation While it is clear that negative external demand shock had a role in worsening the balance of payments, we want to point out that there were also internal developments over this period which caused substantial movements in relative prices unfavorable to the tradable sector. Specifically, the widespread use of QRs in the 1980s depressed the outputhnput price ratio faced by the tradable sector and caused the supply of nonoil exports to fall. Our point is that the introduction of QRs on the imported inputs of the tradables sector transfers part of the profits previously received by the producers of tradables to the holders of the input quota. QRs on inputs and real exchange rate appreciation are alike in that they both cause a profit squeeze in the tradables sector.21 The use of QRs has a long history. (QRs take the form of either import licenses or quotas.) The first use of QRs in the Soeharto regime was in 1970, and by the end of 1971 twenty-four items were under this form of protection. The use of nontariff barriers increased significantly throughout the 1970s, partly in response to the Dutch disease squeeze on the profit margins of the import-substituting industries.22 In November 1982, when the balanceof-payments situation looked precarious, the use of QRs accelerated.23 By 1985 QRs were undoubtedly the dominant form of protection in Indonesia. The pervasiveness of QRs is very well shown in table 6.9. 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. The method of license issuance effectively conferred monopoly status on the license recipient. Quotas spanned the whole spectrum from zero to a discretionary quantity decided by a bureaucrat at the time the import application was submitted. License restrictions covered 30 percent of total import value. The range of activities protected by import licenses accounted for 32 percent of total domestic value added (excluding construction and services).24 If the petroleum sector, which requires no protection, is also excluded, then the coverage is 53 percent of total domestic value added. The types of goods under QRs is very diverse, ranging from basic inputs to consumption goods. Basic inputs under monopoly import licenses include cold-rolled steel sheets, key chemicals for making plastics, and tin plate.25It

112

Wing Thye Woo and Anwar Nasution

Table 6.9

Import Licensing in 1985 Agriculture

Number of CCCN items Total Under license Under quota Import value" Total Under license Share of value addedb In sector Under license

Minerals

1,024 122

139 2

64 127 170

40.6 21.4

Manufacturing

Total

1

4,066 1.360 23 1

5,229 1.484 296

1,451 I

8,082 2,539

8,987 2.710

42.4 .I

17.0 10.3

100.0 31.8

Source: Central Bureau of Statistics, Indonesia, and World Bank staff estimates. Nore: CCCN = Customs Cooperation Council Nomenclature.

"In millions of U.S. dollars. Based on CBS data for 1985, which vary from balance of payments estimates for 1985186 "In percentages. Based on the 1980 input-output table. Excludes construction and services. Due to differences in classification, these numbers may vary from national account estimates.

is clear that protectionism is not always extended for infant industry reasons; for example, there is no domestic producer of cold-rolled steel. In the case of plastic inputs (where there is one domestic producer), the monopoly importer imposed an administrative fee for each raw material which amounted to about 18 percent of its value, resulting in a 30 to 40 percent rise in costs to the end users.26 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 drawing conclusions from the movements of the macroecnomic proxies for PT/PN, as we did for table 6.5. This is because the introduction of quotas on inputs to the tradables sector reduces the sector's production incentive for a given PT/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 whose level is determined by, primarily, 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 tradables sector will reduce the profitability of the tradable sector without any change in the proxies for PT/PN. The fact that in table 6.7 the two proxies for PT/PN in predevaluation 1986 are at least as favorable as in postdevaluation 1979 does not imply that the production incentive (measured in terms of local purchasing power) has not worsened if we abstract from demand conditions. The economic effects of a QR can be modelled by the addition of another cost, henceforth called rent, to the production of the good. The limit of the rent is determined chiefly by the shape of the demand curve for the output

113

IndonesidChapter 6

and by the cost of ~muggling.~’The existence of this rent imposes a potential check on the ability of devaluation to restore international competitiveness. This is because the effectiveness of a devaluation in boosting production of tradables depends crucially on its ability to raise the domestic output price without a corresponding rise in the domestic cost of nontraded domestic inputs. As a first approximation, a devaluation works by increasing the real profits of the tradable sector by cutting the real wage (which is more easily achieved if austere macro policies are undertaken simultaneously). We can think of the QR-introduced rent as a payment for a nontradable input service. Since there is no competitive determination if this rent, its level is at the discretion of the monopoly import license holder. How the license holder reacts to a devaluation determines the effectiveness of the devaluation in boosting production of tradables. If the license holder keeps the rent constant, either in nominal terms or in local purchasing power, then production of tradables will increase as long as the costs of other nontraded inputs fall in terms of local purchasing power. However, if the license holder increases his rent so that the loss of other nontraded inputs is entirely transferred to him, then the production level will remain unchanged. As a practical matter, it may be reasonable to assume that the license holder is usually not able to scoop all of the “released payments,” and hence devaluation would in most cases increase the output of tradables. This means that a devaluation in the presence of QRs will have to be larger than one undertaken in their absence in order to achieve the same output response. We can say that the August 1986 real exchange rate was overvalued in the sense that the introduction of QRs caused a drop in the supply of nonoil exportables which a devaluation would be able to offset. 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 l 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 Marshallian price-quantity space as in 1979, a devaluation was clearly warranted in light of the shrunken gap between output and input prices.28 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 it may not have doubled as it did.29

114

7

Wing Thye Woo and Anwar Nasution

External Debt Management

7.1 Introduction In the preceding chapters we identified historical and political economy factors and showed how they have influenced economic policymaking in Indonesia. The distributional impact of fiscal policy (chapter 4) was the outcome of the interaction between the comparative-advantage-based economic program of the technocrats and the political concerns of President Soeharto. The pattern of allocation of subsidized credit (chapter 5) and the granting of monopoly import licenses (chapter 6) showed clearly the need to cater to both economic nationalist aspirations and the rent-seeking activities of key political allies. In this chapter, we will see how these economic policies (especially fiscal policy) have affected the accumulation of external debt and how the resulting Pertamina crisis set the tone for external debt management after mid- 1975.

7.2 Trial by Fire 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. The situation was grim. Indonesia had defaulted on its 1965 debt service because the swingeing current account deficits of 1961-65 had completely drained the foreign exchange reserves and turbulent domestic conditions had caused the country to be shut out from the private external credit market. Faced with debt payments (including arrears) of $530 million for 1966, which was 70 percent of GDP and 132 percent of exports, Indonesia requested a meeting with its debtors to organize her debt.' The result of the debt rescheduling meetings that year in Tokyo (September) and in Paris (December) was that the major Western countries gave Indonesia the following: 100 percent relief from principal and interest payments on credits of more than 180 days, related to contracts effective prior to July 1, 1966 [and which were due in 1966 and 19671. The new schedule of payments [was] to start January 1, 1971, after a 4-year grace period, and the rescheduled or refinanced amount [was] to be repaid over a period of eight years on an ascending scale starting at 5 percent in 1971 and reaching 20 percent in 1978 . . . The Paris meeting also reaffirmed that, in respect of the interest rate on the rescheduled payments, interest during the respective grace periods (moratorium interest) should not exceed 4 percent per annum; that

115

IndonesidChapter 7

this interest should not be payable during the grace periods, and when paid, should not be compounded. (World Bank 1968, 54-55) Given the desperate situation of Indonesia, the Western countries established the IGGI to draw up a long-term plan of official assistance and to coordinate the form of aid to maximize its effectiveness. To ensure maximum institutional flexibility, IGGI was not given formal status and, operationally, The IGGI is a series of meetings between Indonesia and its donor countries and organizations; it is not based on an international agreement, nor do its conclusions and recommendations represent such agreements. (Posthumus 1971, 7) The terms of IGGI lending were kept as soft as possible: repayment period of twenty-five years, including seven years of grace, and an interest rate of 3 percent. IGGI was also generous in the amount of official assistance it granted (in millions of dollars): 1967, 167.3; 1968, 361.2; 1969/70, 507.7; 1970/71, 609.7; 1971/72, 633.7; and 1972/73, 670.0 requested (Posthumus 1972). The mix of generous external assistance and corrective economic policies implemented by the Soeharto government imparted a new dynamism to the Indonesian economy and boosted it to a higher growth path. 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. 7.3 Debt Management in the 1970s The inflow of foreign resources to finance government spending was substantial in the early days of the Soeharto regime. They financed 20 to 28 percent of total government expenditure from 1967 to 1972/73. Since 1968, all of foreign borrowing has been officially designated in the budget under the development expenditure category. Whether Indonesia’s dependence on external funds has decreased or increased in the 1970s depends on the measure of dependence. If the focus is strictly on the actual financing of government expenditure, then the role of foreign borrowing has diminished. The ratio of foreign resources to expenditure declined secularly from 27 percent in 1969/70 to 17 percent in 1979/80 (see table 7.1). The growth of the petroleum and LNG sector since 1971 brought in tax revenues at a rate faster than the rise in government expenditure, hence reducing the role of foreign financing. On the other hand, if the issue of foreign borrowing rests on fears of an excessive debt-service burden in the future, then an appropriate measure of external financial dependence is the amount of annual government borrowing in the international markets normalized by the GDP. The movement of this

Table 7.1

Total expenditure Total revenue Foreign borrowing As percentage of expenditure As percentage of GDP Memo item GDP deflator (1980= 100)

Total expenditure Total revenue Foreign borrowing As percentage of expenditure As percentage of GDP Memo item GDP deflator (1980= loo)

Trends in Aggregate Expenditure and Revenue, FY1969 to FY1979 (in billions ofrupiahs) 69/70

70171

71172

72173

73/74

74175

75176

76/77

77/78

78179

342.7 251.6 91.1

467.8 354.7 113.1

557.0 440.0 117.0

736.3 590.6 145.7

1,164.2 967.7 196.5

1,977.9 1,753.7 224.2

2,730.3 2,241.9 488.4

3,684.3 2,906.0 778.3

4,305.7 3.534.4 771.3

5,299.3 4,266.1 1,033.2

26.6

24.2

21.0

19.8

16.9

11.3

17.9

21.1

17.9

19.5

3.4

3.5

3.2

3.2

2.9

2. I

3.9

5.0

4.1

4.3

13.9

15.4

16.3

18.5

24.6

36.2

40.7

46.6

52.7

58.4

79/80

80181

81182

82/83

83/84

84/85

85/86

86/87

87/88

8,076.0 6,696.8 1.379.2

11,716.1 10,227.0 1,489.1

13,917.6 12,212.6 1,705.0

14,355.9 12,418.3 1,937.6

18,311.0 14,432.7 3,878.3

19,380.8 15.905.5 3,475.3

22,824.6 19,252.8 3,571.8

21,421.6 17,832.5 3,589.1

23,583.2 17,236.1 6,347.1

17.1

12.7

12.3

13.5

21.2

17.9

15.6

16.8

26.9

4.0

3.0

2.9

3. I

5.3

4.0

3.7

3.5

5 .9

77.4

100.0

111.2

119.6

136.3

152.6

165.8

170.9

176.0

117

IndonesidChapter 7

measure in the face of the rapid economic growth which Indonesia experienced indicates the extent to which the government had mobilized internal resources to replace foreign credit in development financing. The ratio of foreign borrowing to GDP showed a slight increase, from 2.9 percent in 1970-74 to 4.5 percent in 1975-79. This resource inflow measured in real terms-foreign borrowing normalized on the GDP deflator indexed on 1 9 8 C w a s Rp 657 billion in 1969-70 and Rp 1,468 billion in 1977178, a doubling of the annual inflow in eight years. The continued heavy borrowing was partly the result of the government’s unwillingness to increase taxes by broadening its tax base and partly the result of the greater availability of foreign credit at favorable interest rates. By 1974 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. Three reasons were responsible for this change: 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. The eagerness of the international financial community to lend to Indonesia is best captured by the casualness with which it committed $10.5 billion in loans (as of February 1975) to the state oil company, Pertamina, most of it in the two years before 1975. These loans were extended to Pertamina without access to any detailed official financial statements of the oil company! The improvement in the creditworthiness of Indonesia can be clearly seen by comparing the years 1970 and 1980 in table 7.2. Of the $12.5 billion increase in publicly-guaranteed debt in this period, 41 percent of it came from private creditors. Concessionary lending from official creditors was no longer the only important source of external funds, and it was only natural after 1973 that official loans declined. The IGGI loans were no longer as eagerly sought after the OPEC-I oil price increase because the advice (“policy recommendations”) which was dispensed with the loans was resented in many circles as a foreign intrusion into the domestic policymaking process. Furthermore, the newfound petroleum wealth of the Indonesian economy reduced the intensity of the charitable feelings which made concessionary loans possible in the first place. The ending of private credit rationing against Indonesia was amply justified by political and economic developments. Since 1970 the Soeharto regime had been firmly in power with neither strong domestic opposition nor outstanding regional tension being a credible threat. On the economic front, the export sector showed an amazing ability to earn foreign exchange and the economy was increasingly showing signs of growing beyond 7 percent annually. Despite the sixfold increase in debt between 1970 and 1980, the

Table 7.2

External Public and Publicly-Guaranteed Debt" of Indonesia, 1970-80

Debt outstanding and undisbursed Debt outstanding and disbursed (DOD) Private creditors Total debt service (TDS) Private creditors Principal ratios ( 8 ) DODIXGSb DODIGNP TDSIXGS TDSIGNP Proportion of DOD which: Is concessionary Bears variable i-rates Is from private creditors Memo items Proportion of debt service paid to private creditors Central Bank net foreign assets

1970

1973

1974

1975

1976

2,947.2 2,443.2 282.6 82.2 42.4

6,693.6 5,248.8 1,218.9 207.5 114.8

9.060.9 6,358.2 1,739.4 291.6 168.4

1 1.741.2

7,994.0 2,990.1 523.5 388.9

14,572.5 10,001.6 4,089. I 760.6 573.6

205.5 27.1 6.9 .9

158.8 33.5 6.3 1.3

85.2 25.8 3.9 1.2

113.8 27.4 7.5 I .8

78.0 11.6

75.3 4.5 23.2

71.3 6.8 27.4

51.6 55.6

55.3 800.0

57.8 1,494.0

.o

1977

1978

1979

1980

16,134.6 4,583.1 1,261.7 985.3

19,037.3 13.149.7 4,761.1 2.062. I 1.632.9

21,199.8 13,277.8 4,767.8 2,099.6 1,535.7

24,451.9 14,971.3 5,464.9 1,758.5 1,127.6

114.0 27.7 8.7 2. I

106.7 26.4 11.5 2.9

116.3 26.6 18.2 4.2

85.5 27. I 13.5 4.3

67.4 21.6 7.9 2.5

60.8 19.4 37.4

53.4 20.7 40.9

52.2 18.7 39.3

53.2 15.0 36.2

51.5 14.5 35.9

50.2 16.8 36.5

74.3 -691.6

75.4 - 159.0

78. I 1,108.4

79.2 1,312.0

73.1 3,282.3

64.I 5,868.4

1 1,658.3

Note: Central Bank assets position calculated from Infernational Financial Srutisrics data prior to February 1987, using series I 1 and 16c. Bank Indonesia changed its valuation procedures in February 1987. The new procedures caused net asset position to improve quite substantially.

"Debt reported is end of period, in millions of U.S. dollars. bXGS

=

export of goods and services.

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debvexport ratio fell from 206 percent to 67 percent, and the debt/GNP ratio fell from 27 percent to 22 percent. The eagerness of the banks to extend credit appears to have been matched by the eagerness of the Indonesian public sector to borrow. It was quite normal for Indonesia to contract additional loan commitments even when it was unable to spend these funds quickly enough. The ratio of funds drawn to the total committed was 61 percent in 1980 compared to 83 percent in 1970. It must be mentioned at this point that there is no paradox in why in 1970-80 the debt-service/export and debt-service/GNP ratios went up as the debvexport and debVGNP ratios moved down. The rise in the former two ratios was a good sign in this case because it meant that Indonesia had regained access to the private capital market. The increase in the DSRs was inevitable for two reasons. First, Indonesia was now borrowing an increasing proportion of its loans at market interest rates rather than at concessionary IGGI rates. Only 50 percent of the outstanding long-term Indonesian debt in 1980 was concessionary compared with 78 percent in 1970. Second, private credit generally has a shorter maturity than official credit. In 1970 only 11 percent of total debt was owed to private creditors compared with 37 percent in 1980. So it is not that the Indonesian DSRs in 1980 were high, but that these ratios were unusually low in 1970. The low 1970 DSRs were the result of Indonesia being shut off from the private credit market and of IGGI having to forward emergency loans at 3 percent to help the Soeharto government weather its inherited financial crisis. The point is that the higher DSRs in 1980 were the result of an economic situation superior to that in 1970. 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, however, as Indonesia was now exposed to two new risks. The first risk is systemic in nature and threatens every country with external debts. An example of such a systemic risk is the simultaneous collapse of a debtor’s export earnings and a large increase in the real rate of interest. The second new risk is the possibility of imprudent borrowing by Indonesia. This danger was realized in February 1975 when Pertamina could not roll over a $400 million short-term loan and defaulted. The government bailed Pertamina out by guaranteeing repayment of all of its debts. The enormity of the Pertamina rescue operation is clearly indicated by the jump in the principal ratios in table 7.2. The debvexport ratio jumped from 85 percent in 1974 to 114 percent in 1975, and it returned to the 85 percent level only in 1979. By taking over Pertamina’s debts, the proportion of private credit to total credit jumped by 10 percentage points-a magnitude unprecedented and not repeated. It is clear that most of Pertamina’s debt bore variable interest rates because the percentage of variable interest rate loans almost trebled from 1974 to 1975 (see table 7.1).

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7.4 The Pertamina Debt Crisis Pertamina, on the eve of the crisis, was more than an oil company.* It was an extremely diversified conglomerate with the distinction of being the largest corporation in Asia outside of Japan. Table 7.3 gives a partial listing of the range of businesses engaged in by Pertamina. As discussed earlier, one of Soeharto’s key operating styles is to appoint a “dynamiser” to solve problems of industrial development and to grant him broad discretion in achieving the goals. General Ibnu Sutowo, who became chairman of the National Oil Committee in 1966 and president-director of Pertamina in 1968, lived up to the “dynamiser” image. Oil production rose from less than half a million barrels a day in 1966 to 1.4 million barrels a day in 1973. Furthermore, it was widely accepted that General Sutowo had driven a hard bargain with the oil companies, receiving terms which were more favorable than those received by the Saudis (Hunter 1967). His innovative “production-sharing’’ scheme avoided many of the monitoring difficulties of the “posted price” approach adopted by the Gulf states.

Table 7.3

F’ertamina Subsidiaries and Joint Ventures

Company and Status Whollv owned subsidiaries in Indonesia PT Electronika Nusantara (Elnusa)

Functions

Services for marine, land, and offshore operations

PT Palembang Rice Estate

Large-scale rice project in South Sumatra

PT Patra Jasa

Providing facilities to oil and service contractors (offices, housing, and land transport)

PT Pelita Air Service Pertamina Gulf Industrial Processing

Air services Packaging of fertilizer and other chemical products Operating non-vessel tankers

PT Pertamina Tongkang Wholly owned subsidiaries outside lndonesia Ocean Petrol Ltd. (Hong Kong)

Joinr ventures in lndonesia PT Arun Natural Gas Liquefaction Co. (Pertamina 55%; Mobil 30%; Jilco 15%) PT Badak Natural Gas Liquefaction Co. (Pertamina 5 5 6 ; Huffco 30%; Jilco 15%) PT Brown and Root Indonesia (Pertamina 20%; Brown & Root USA 80%)

PT Chicago Bridge and Iron lndonesia (Pertamina 51%; Chicago Bridge and Iron Co.. USA 49%)

Operating and managing ocean-going tankers Processing and sale of LNG produced in Aceh Processing and sale of LNG produced in East Kalimantan Manufacture of components and appurtenances for offshore constructions; concrete coating of steel pipes: design and construction of processing plants and engineering works for oil and gas; procurement and storage of materials To furnish metal plate structure, process facilities equipment, and construction services throughout Indonesia for government agencies of Indonesia and companies operating in Indonesia

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Table 7.3

(continued)

Company and Status

PT Dresser Magcobar (Pertamina 10%; Dresser Magcobar. USA 90%) FT Indonesia Chemical Co. (Pertamina 60%; PT Sempurna 10%; Teijin Ltd and Toyo Menka 30%)

PT Krakatau Steel (infrastructure; on behalf of the GOI, $6 million)

FT Kuda Laut Batam Island (Pertamina 50%; Intera-

Functions Mud for drilling To produce annually 100,000 tons of peravele and 120,000 tons of dimethyl telethalate (DMT) in South Sumatra To rehabilitate and operate the abandoned Soviet steel mill project at Cilegon Supply frozen and dry foodstuffs

gencies Hong Kong 50%)

PT Nippon Steel Construction (Nisconi) (Pertamina 10%;Nippon Steel Japan 90%)

PT Patra Vickers Batam (Pertamina 50%; Vickers Ruwolt Australia 50%) PT Permiko Engineering and Construction (Pertamina 10%;Nippon Kokan KK and Mitsubishi 90%)

FT F'ertafenikki (Pertamina 30%; Japan Gasoline 60%; Far East Trading Co. 10%) Pexa Oil Co. (Pertamina 25%; Pexa Oil Co. 75%)

I T Burna Bina Indonesia (Pertamina 51%; Bechtel

To provide support for oil and gas industry including: fabrication, assembling, and construction of steel structures; coating of gas and oil pipes; supply storage and servicing Heavy engineering facilities to service the oil, mineral processing extraction, and other manufacturing industries. Fabrication, coating, assembly, installation. and construction of pipelines and steel structures for oil and gas exploration drilling; production and distribution; supply of services including design, inspection, testing, repairing, and surveying for gas and oil; storage and lease of goods and equipment related to these Consulting engineering Oil exploration onshore South and East Kalimantan Engineering consulting

Inc. 49%)

PT Sankyu International (Pertamina 10%;Sankyu Tokyo 90%) PT Toyo Kanetsu (Pertamina 51%; Toyo Kanetsu 35%: Nissho lwai 14%) Joint ventures outside Indonesia Far East Oil Trading Co. Ltd. (Japan) (Pertamina 50%; various Japanese companies 50%) Indonesian Enterprises Ltd., USA (Pertamina 50%; vanous companies 50%) Japan-Indonesia LNG Import Co. (Jilco) (Pertamina 15% through Far East Oil Trading Co.; five Japanese companies 5 I %; Tokyo Electric and Tokyo Gas 4%; Industrial Bank of Japan 6%; Nisano Iwai 15%; other trading companies 9%) Japan Indonesian Oil Kabushiki (Pertamina 50%; Toyota Motor Sales Co., The Tokyo Electric Power Co., The Kansai Electric Power Co., The Chuba Electric Power Co.. Maruzen Oil Co.. Daikyo Oil Co., ldemitsu Kosan Co., total 50%) Perta Oil Co.. USA (Pertamina 50%; United States International Investment Corp. 50%) Tugu Insurance Co. Ltd., Hong Kong (Pertamina 40%; private investors 64%)

Fabrication, assembling, installation, and construction of pipelines and steel structures Engineering consulting

Marketing of crude oil in Japan Promotion of tourism in the USA

To supply the low sulphur crude oil produced in Indonesia to Japan, and other associated matters

Transport and marketing of Indonesian crude oil Insurance

Source: Bulletin of Indonesian Economic Studiey (July 1974)

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Sutowo’s ability to get things done, albeit many times by paying a high p r e m i ~ m resulted ,~ in him being asked by the president to take over lagging projects. The biggest of such projects was the completion of the Krakatau Steel Mill for which Pertamina had assumed responsibility in 1970 and which had been abandoned uncompleted by the Soviet Union in 1966. Partly by allowing itself to be volunteered to take over the management of more and more state projects, and partly because of Sutowo’s desire to play a pioneering role in Indonesian economic development, Pertamina developed into an autonomous development agency independent of the control of the technocrats at BAPPENAS. Pertamina improved harbors, developed residential and commercial estates, and built roads and hospitals. Although these expanded activities of Pertamina intruded upon the economic policymaking turf of the technocrats, there was not much domestic pressure which they could bring to reverse this state of affairs. There were good reasons why the president chose to maintain the status quo with Pertamina. An obvious one was that criticisms of a success story were hard to make stick, especially when Pertamina’s largess had won it many supporters in the president’s circle. An equally important reason could be that General Ibnu Sutowo had come to epitomize the kind of economic nationalism favored by a large segment of the military and the intellectuals. As explained in chapter 3, one thorny problem of Indonesian economic development has been the disproportionate economic power of the Indonesian Chinese community. General Sutowo’s much heralded success as a big-time businessman was a source of considerable ethnic pride. It was widely held in some intellectual circles that the only effective containment of Chinese economic strength was to allow the small number of capable priburni entrepreneurs to each head a gigantic state enterprise modelled after the Japanese zaibatsu. It was believed that only such gigantic enterprises could reap the economies of scale and sustain the short-term losses of an infant industry. What was really alarming to the technocrats who had gone through the trials of rescheduling Soekamo’s debts was that this new independent development agency was now borrowing heavily in the international credit market to finance its nonoil activities. In March 1972 the minister of finance chose to enter into another standby agreement with the IMF, even after the IMF had concluded that a balance-of-payments crisis was unlikely. The standby agreement set a ceiling of $14 million on medium-term external borrowing for 1972/73. Given this ceiling, a decree was issued requiring all state bodies to seek approval from the Ministry of Finance before contracting foreign borrowing. Pertamina ignored this decree, borrowing $350 million in short-and medium-term debt in 1972 without informing the Ministry of Finance. When this transgression came to the attention of the United States, the biggest aid donor, American economic aid was suspended. And in February 1973 U.S.

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Vice President Spiro Agnew raised the issue of Pertamina’s borrowing with President Soeharto. The president’s reaction was very much in line with his belief that a talented problem-solver like Sutowo ought to be given free rein. Soeharto “delivered a vigorous defense of Ibnu Sutowo, saying he had personally charged him with important national projects and trusted the oil chief to find his own finance” (McDonald 1980, 155). Nevertheless, when U.S. aid resumed, Pertamina stopped borrowing in the medium-term market and started financing its long-term projects with short-term loans. It was this borrowing in the short-term market which precipitated the Pertamina crisis. Short rates rose dramatically after the OPEC-1 price increase because central banks in the industrialized countries began tightening their monetary policies to dampen aggregate demand to offset the price pressures from the supply side. At the end of 1974, the discount rate was 7.8 percent in the United States and 9 percent in Japan, compared with their respective 1972 discount rates of 4.5 percent and 4.3 percent. It was also at this time that the international banking community was shocked into greater cautiousness by the failures of the Franklin National Bank in the United States and the Herstatt Bank in Germany due to foreign exchange speculation. The result was that the banks took a harder look at Pertamina’s borrowing. They were alarmed that they had extended so much credit (it turned out to be $10.5 billion) to Pertamina without any one of them having seen a full statement of Pertamina’s finances. While it was true that the future of the oil industry looked very promising in 1975, bankers were troubled because significant proportion of the borrowing was for nonoil projects, the debt was not guaranteed by the Indonesian government, and Pertamina was showing increasing signs of mismanagement. In the face of these reservations, the banks refused to automatically roll over existing debts unless they were given more information about Pertamina’s financial position. The upshot was that Pertamina defaulted on 20 February 1975 when it could not meet a $400 million payment to the Republic National Bank of Dallas. The Indonesian government announced that it would assume responsibility for Pertamina’s debt, of which $1.5 billion was in short-term loans. The rescue operation obligated the Indonesian government to undertake its first major borrowing in the external credit market since it had been readmitted into the private credit market. The Pertamina crisis was solved by a combination of repayment, rolling over part of the existing debt into longer term instruments, and cancellation of contracts. Even with access to the international financial market, Indonesian resources were still stretched thin. The net foreign reserve position of Bank Indonesia fell from $1.5 billion at the end of 1974 to a deficit of $0.7 billion at the end of 1975. An indication of the magnitude of money involved in the rescue operation can be obtained from table 7.4 in which the long-term publicly-guaranteed debt is divided between the government sector and the public enterprise

Table 7.4

Distribution of External Sovereign Debt’ by Sectors, FYI973 to FYI986 73/74

Government sector Net drawings Adjustment Outstanding debt

75/76

76/77

77/78

571.0

1,918.0

1,657.0

1,345.0

3,979.0 4,550.0

6,468.0

8,125.0

9,470.0

562.0

74/75

Public enterprises Net drawings Adjustments Outstanding debt

1,665.5 2,220.7

Unattributable drawings or adjustments during 1973-77

-118.3

Total public sector Net drawings Adjustment plus unattributed sums Outstanding debt Memo item Governmentborrowingforbudget Government borrowing from balance of payments Ratio of public enterprise to total public sectordebt (%)

352.6

555.2

-3.6

914.6

1,126.2 -3.6 5,526.2 6,767.1 - 118.3

-109.3

78/79

1,425.0 1.263.0 571.0 -975.0 11,466.0 11,754.0

-327.1

-10.0

2,162.1

1,835.0

.O 1,825.0

128.0

726.1

81/82

1,381.0 -62.0 13,073.0

2,271.0 -787.0 14,557.0

49.0 18.0 1,802.0

683.0 -5.0 2,480.0

82/83

83/84

3,226.0 3,883.0 5.0 -471.0 17,788.0 21,103.0 1,017.0 -122.0 3,375.0

84/85

85/86

86/87

4,710.0 1,678.0 3,134.0 -2,038.0 4,487.0 3,603.0 21,179.0 27,344.0 34,081.0 -408.0 77.0 3,175.0

1,430.0 2,954.0 4,243.0 3,960.0 1,017.9 1,415.0 1,190.0 1,808.7 1,707.7 -117.0 -417.0 -83.5 128.0 726.1 571.0 -992.0 -44.0 -792.0 8,495.9 10,415.1 12,031.1 13,291.0 13,489.0 14,875.0 17,037.0 21,163.0 24,609.0

4,302.0 -1,961.0 24,354.0

-83.5

-73.0 - 17.0 1,735.0

SOB1

77.0 54.0 3,506.0

2,111.4

50.7

79/80

-325.0 41.0 2,891.0

-383.0 18.0 2,526.0

1,353.0 2,751.0 4,528.0 3,621.0 30,235.0 36,607.0

491.3

559.0

1,184.6

1,888.7

1,863.6

2,105.1

2,204.1

2,382.5

2,685.0

2,877.9

3,947.9

3,314.0

3,189.3

2,544.4

643.0

660.0

1,995.0

1,823.0

2,106.0

2,208.0

2,690.0

2,684.0

3,521.0

5,011.0

5,793.0

3,519.0

3,432.0

5,296.0

30.1

32.8

24.9

20.8

15.3

13.7

12.9

12.1

14.6

15.9

14.2

13.0

9.6

6.9

Note: Figures for 1978/79 onward are from an IMF document. For the earlier years, net drawing of public sector is from the World Bank’s World Debt Tables and net drawing of government sector is from the balance of payments. The difference between the two numbers is attributed to net drawing by public enterprises. The difference between the cumulated Rows and the stocks in the World Debt Tables is reported in the “Unattributable drawings” item. ”Debt reported is end of period, in U.S. dollars.

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IndonesidChapter 7

sector. The debt flow of 1975/76 was extraordinary compared with the preceding two years-the $1.9 billion increase in the long-term debt of the government sector was more than three times that in 1973/74 and 1974/75. Four reasons have been advanced for this large increase. The first two reasons are the conversion of part of the $1.5 billion short-term obligations into long-term debt and the amortization of Pertamina’s long-term debt. The third reason is that by 1975 the government had been convinced by the 1973 oil price increase that the future income stream of the economy had been markedly increased. It decided, therefore, to embark on an expanded program of development spending to be financed by external borrowing. The fourth reason is that development expenditure in 1975 overshot its targeted level by $313 million, requiring the government to undertake additional borrowing. Since detailed data on the Pertamina rescue operation have not been released, any estimates of how much of the $2.0 billion worth of public borrowing, as shown in the balance-of-payments account, is Pertaminarelated is necessarily speculative. It could be argued that the Pertamina affair accounted for only 40 percent of the borrowing because $1.2 billion was required to finance the budget. On the other hand, one has to take into account that Pertamina had collected $8 19 million in oil taxes on behalf of the Ministry of Finance, which it had kept for its own use. If this oil revenue had been forwarded to the government, only $365.6 million would have been needed for budgetary reasons. This meant that more than 80 percent of the large external borrowing in 1975/76 was caused by the mismanagement of ~ e r t a m i n a . ~ For the next several years, Pertamina continued to be a drain on the budget and obliged the government to undertake additional external borrowing. In 1976/77 the government budget showed a debt-service transfer of $75 million to Pertamina; in 1977/78 the debt-service transfer was $208 million; and in 1979/80 the government extended a subsidy of $77 million to Pertamina.

7.5

Economic and Political Effects of the Pertamina Crisis

Since the 4.9 percent real GDP growth rate in 1975 was the lowest in the thirteen-year period from 1968 to 1981, one may be tempted to attribute the drop in aggregate demand to the across-the-board cancellation of Pertamina’s numerous investments. We do not think so, however. Instead, we believe that the large plunge of the 1975 real GDP growth rate from the rates of 9 percent in 1972, 11 percent in 1973, and 8 percent in 1974, was largely the result of the 1975 global recession induced by high oil prices. Decomposition of the sources of growth in 1975 revealed that it was external, not internal, factors which were responsible for the low growth rate: real domestic absorption increased by 17 percent, while real exports fell by 18 percent and real imports rose 8 percent.

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Wing Thye Woo and Anwar Nasution

The level of real government expenditure did grow more slowly in 1976/77 and 1977/78 because the technocrats deemed it prudent to lower the growth of external debt and, hence, diverted domestic revenue to keep Pertamina afloat. If one is looking for a silver lining in the Pertamina crisis, it could be argued that the fiscal conservatism of this period was a desirable outcome because inflation has been above 18 percent since 1973 and economic growth has picked up again.5 The Pertamina debacle was a major setback to the military advisors who favored the nationalist zaibatsu approach to economic management. The technocrats at the BAPPENAS and Ministry of Finance were once again unchallenged in the sphere of economic policymaking. The technocrats were asked to oversee the reorganization of the Pertamina empire and were granted real control over all external borrowing (short- and long-term) by state enterprises. There is no doubt that the technocrats immediately used this new authority not only to sharply curtail foreign borrowing by the state enterprises but also to reduce their outstanding debt. At the time of the Pertamina crisis, not counting short-term debt, the long-term publicly-guaranteed external debt of state enterprises stood at $2.2 billion, which was 33 percent of the total outstanding public debt. By the end of March 1979, the debt of the state enterprises was reduced to $1.7 billion, which was only 13 percent of the total. The days of Pertamina-style borrowing by public enterprises were clearly over. It could be cogently argued that the Pertamina crisis was a blessing in disguise. By reminding the Indonesian government of the importance of being prudent in external borrowing, it could be the reason why Indonesia did not experience a debt crisis in 1982. The timing of the Pertamina crisis could not have been better. The real price of oil was at an all-time high, so the international credit markets were willing to roll over the now-guaranteed debts; and the real interest rate was low, so the debt burden was not increased disproportionately. If Pertamina had not been prevented from further borrowing in the medium-term credit market and had, therefore, over-reached itself in the short-term credit market, it could have accumulated by 1982 a foreign debt at least as big as the $20 billion debt of PEMEX, the Mexican state oil company. After all, in February 1975 Pertamina already had $10.5 billion in loans (including undisbursed), and the 1979 OPEC-2 price increase would have further expanded its ability to borrow. The failure of an unchecked Pertamina in 1982 would have had cataclysmic effects on the economy. Not only would the record high real interest rates of 1982 have made the debt service painful, but the lower oil prices would have forced the implementation of more draconian austerity policies. By denying all state-owned enterprises direct access to the external credit market after the Pertamina embarrassment, Indonesia did not have as large a debt as it otherwise would

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have had when it entered 1982. With the benefit of hindsight, the Pertamina debacle could certainly be viewed as a vaccination against excessive borrowing. It is important to note that the Pertamina crisis did not reduce the role of the army in the management of state and private enterprises. The doctrine of dwijiingsi remained intact. For example, even though the technocrats were asked to reorganize Pertamina, it was an army man, General Piet Haryono, not a civilian administrator, who was appointed to replace General Ibnu Sutowo. And it was another army man who succeeded General Haryono in 1981. The point is that it is vital for the army to control key sectors of the economy, partly because of the political need to channel resources to retain the support of the military and partly because of the president’s belief that a ‘‘dynamiser” should have discretionary funds available for off-budget development projects. The legacy of the Pertamina crisis is that these extrabudgetary allocations are now unlikely to lead to an external debt crisis.

7.6 External Debt in the 1980s The Pertamina crisis also resulted in major changes in the way in which the external debt is managed. As a commitment to prudent debt management, the government now eschews short-term loans in its borrowing. Furthermore, all external borrowing by the government, government agencies, and state-owned enterprises must be approved, negotiated, and administered by the Ministry of Finance and Bank Indonesia. By law, private Indonesian enterprises are required to report all their external borrowing and to hand over the administration of these debts to Bank Indonesia. In practice, the government has control only over official borrowing. This state of affairs is due in small part to underreporting by the private sector and in large part to the Indonesian government’s pledge of maintaining an open capital account. There is close collaboration between the Ministry of Finance and Bank Indonesia in managing the external debt.6 In addition to monthly and detailed quarterly reports on changes in the external debt, Bank Indonesia also submits a weekly report of its external-debt-related activities to the Ministry of Finance. Before any payment of principal and interest can be made, Bank Indonesia must request approval from the Ministry of Finance which would then recalculate the debt service using its own records. The slow computerization of external debt information unduly increased the difficulties of debt management in the early 1980s when Latin American countries were slipping into debt crises. Manual handling and careful recalculations meant that as late as 1984, “late payments [were] frequent, resulting in late payment penalties and even defaults” (Haryono 1985, 229). The manual handling of the debt records meant that it was almost impossible to generate debt-service scenarios under different refinancing schemes to

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change the maturity structure and under different assumptions about foreign interest rate and exchange rate developments. 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 in early 1982 and the subsequent collapse of commodity prices have produced a situation which is more ominous. In 1985 public long-term debt-service ratio went above 20 percent for the first time, rising from a ‘‘comfortable’’ 15 percent in 1984 (see table 7.5). The significant rise in the DSR occurred despite a 38 percent devaluation of the rupiah in March 1983, and the large-scale postponement of public investment projects in fiscal 1983 which saved $10 billion in foreign exchange (World Bank 1987b, 24-25). External debt management in the 1980s has also been made more difficult by capital flight. The (net) errors and omissions item (which contains all private portfolio flows) in the balance-of-payments accounts shows a cumulative deficit of $6.3 billion for 1980-85 compared to one of $1.4 billion for 1969-79. Without the loss of reserves from the 1980-85 capital flight, the DSR in 1985 may have been 15 percent instead of 20 percent. Two events occurred in 1986 which worsened the debt situation dramatically. The price of oil dropped precipitously from $28 per barrel in January to $10 in August (World Bank 1987b, 24-25). 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. (If external credits for the expansion of LNG production are included, the ratio stood at 32 percent.) 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 31 percent in September 1986, and, in October 1986 and January 1987, the input costs to the export sector were lowered with the abolition of a substantial number of import restrictions. Nominal state expenditure for fiscal 1986 was cut 6 percent from the previous year (see table 4.3). In fact, real government expenditure has been steadily reduced 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-a value-added tax was 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.

Table 7.5

External Debt' of Indonesia, 1980-86

(a) External public and publicly-guaranteed long-term debt Debt outstanding and undisbursed Debt outstanding and disbursed (DOD) Private creditors Total debt service (TDS) Private creditors Principal ratios(%) DOD/XGSb WDIGNP TDSi XGS TDSIGNP Proportion of DOD which: Is concessionary Bears variable i-rates Is from private creditors Proportion of public debt service paid to private creditors (b) External private nonguaranteed long-term debt Debt outstanding and disbursed Total debt service

1980

1981

1982

1983

1984

1985

1986

24,451.9 14,911.3 5,464.9 1.758.5 1,127.6

27.21 1 .0 15,870.3 5,812.5 2.047.2 1,336.4

32,216.0 18,515.0 7,403.4 2,246.6 1,374.3

35.492.0 21.689.5 9.649.6 2.550.8 1,526.8

36.922.8 22.861.9 10,048.6 3,251.0 2.069.9

41.872.6 26,624.6 11.667.9 4,015.1 2,631.7

48,712.0 32,119.0 14.556.0 4.401.0 2,549.0

67.4 21.6 7.9 2.5

63.7 19.2 8.2 2.5

87. I 21.2 10.6 2.6

108.8 28.0 12.8 3.4

103.2 26.5 14.7 3.8

133.0 33.4 20.1 5.0

212.8 48.2 29.3 6.6

50.2 16.8 36.5 64.1

48.5 17.8 36.6 65.3

42.7 20.0 40.0 61.2

37.3 22.7 44.5 59.9

34.9 23.1 43.9 63.6

35.1 21.7 43.6 65.5

NA NA 45.3 57.9

3,142.0

3,579.0 1.173.0

3,200.0 1,260.0

3.400.0 1 , I 16.0

3,800.0 960.0

3,810.0 1,036.0

3,800.0 800.0

1,051.0

(c) External short-term debt

2,775.0

3,274.0

4.787.0

4,639.0

5,384.0

5.280.0

5.000.0

Total external debt

20,888.3

22,123.3

26,502.0

29,128.5

32,045.9

35.714.6

40.919.0

22,208.0

24,926.3

21,262.1

19,932.6

22,163.8

20,014.5

15,094.0

Memo XGS

Source: The World Bank's Wor/d Debt Tables and Country Reports. Figures do not include LNG expansion credits.

"Debt reported is end of period, in millions of US. dollars. bXGS = export of goods and services.

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Wing Thye Woo and Anwar Nasution

Conclusions and Prospects

8.1 Introduction In this chapter, we attempt to explain why Indonesia did not experience a debt crisis in 1982-84. We do so by comparing the Indonesian debt situation with that of Mexico and Brazil, two countries which have debt-servicing difficulties. In section 8.2 we examine the most common explanation for external crises which puts the blame on excessive budget deficits that force the government to borrow from abroad. Section 8.3 identifies the factors which have prevented an Indonesian debt crisis in 1982-84, and section 8.4 estimates the relative importance of each factor by using Mexico as the reference. In section 8.5 we discuss the prospects of Indonesia avoiding a future debt crisis and the role for policy in ensuring such an outcome.

8.2 A Comparative View of Fiscal Imbalances When a debt crisis occurs because the government is unable to service the external debts that it has guaranteed, it is a truism to claim that government budget deficits, i.e., fiscal imbalances, are the root of all external sovereign debt crises. By definition, an external public debt can be incurred only when a government borrows from abroad to finance part (or all) of its expenditure. In order for fiscal imbalances to have more than a tautological role in precipitating an external debt crisis, it is necessary to have a criterion which would enable one to assess whether the amount of foreign borrowing being undertaken is excessive in an ex ante sense. The statistic usually cited in support of this fiscal imbalance view is the ratio of official long-term debt to GNP, DGNP.' The official long-term debt is taken to represent the cumulated amount of fiscal deficits financed by external borrowing, and the normalization by GNP is to indicate the extent to which the country has been made to live beyond its income by the budget deficits. The fiscal imbalance explanation of external debt crises points out that DGNP rose very rapidly for those countries which experienced a debt c r i s k 2 From a value of 9.1 percent in 1970, Mexico's DGNP increased 18.7 percent in 1981, the eve of the debt crisis. In the same time period, DGNP went up from 8.7 to 19.5 percent for Argentina, from 8.2 to 17 percent for Brazil, from 8.1 to 20 percent for the Philippines, and from 6.6 to 17.2 percent for Venezuela (see top half of table 8.1). It is true that these governments increased their budget deficits significantly during this period, but it is not true that they have been cumulatively more profligate than the countries in the bottom half of table 8. I , which did not fall into debt crises.

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IndonesidChapter 8 Public and Publicly-Guaranteed Debt as Fkrcentage of GNP, DGNP, 1970-85

Table 8.1 1970

1975

1978

1980

1981

1982

1983

1984

1985

19.5 17.0 18.7 20.0 17.2

29.1 18.7 33.3* 22.7 18.3

42.6' 30.3' 50.1 31.0' 19.8

36.6 34.7 43.4 36.0 36.7*

58.7 35.5 43.4 41.7 34.3

17.7 28.3 23.1 14.6

20.5 29.7 31.4 17.2

28.0 29.8 37.5 17.9

26.5 30.3 38.6 18.6

33.4 35.0 47.8 26.4

Countries with serious debt problems in 1982-85 Argentina Brazil Mexico Philippines Venezuela

8.7 8.2 9.1 8.1 6.6

8.2 11.6 13.2 8.8 4.6

16.0 14.8 25.3 17.8 17.4

19.2 16.6 18.8 18.7 18.4

Countries with no serious debt problems in 1982-85 Indonesia Korea Malaysia Thailand

25.2 21.2 9.7 5.0

25.5 27.8 14.2 4.2

26.6 22.5 16.9 8.0

20.0 26.9 16.3 12.5

Note; Figures for 1978 are from 1985-86 edition of the World Bank's World Debr Table, and the rest are from the 1986-87 edition. *Year in which debt crisis began.

In fact, Korea and Malaysia had the highest DGNPs in 1981. There are just not enough differences in the 1981 DGNPs of Mexico, Brazil, and Indonesia to explain why Indonesia alone avoided a debt crisis in the following two years. The huge jumps in the DGNPs of Argentina, Brazil, Mexico, the Philippines, and Venezuela occurred only after they were unable to service their debts, forcing them to devalue their currencies. It must be mentioned that DGNP is a flawed indicator of public profligacy. First, the stock of long-term official debt can understate as well as overstate the amount of borrowing for budgetary reasons. This is because the government can borrow short-term to finance budget deficits and long-term to finance foreign market interventions. Second, DGNP is a measure of profligacy only in the sense of living beyond income and not in the sense of being unable to service the acquired external debt. An indicator of the latter would normalize the external debt by the level of exports, the foreign exchange earning capacity of the country. To us, the most interesting fact from table 8.1 is how much the DGNP of each country soared in the year in which its debt crisis happened. Since the big DGNP movement was the result of a devaluation, this suggests that the pre-crisis DGNPs may have been understated and hence provided misleading impressions to policymakers and bankers. This implies that inappropriate exchange rate management may have been a very important factor in precipitating a country's debt-servicing problem. The currency overvaluation not only understated the amount by which the country had lived beyond its means but, perhaps more importantly, debilitated the export sector, the foreign exchange generator for the economy.

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Explaining the Absence of a 1982-84 Debt Crisis

As we pointed out in chapter 1, a debt crisis does not occur only when the government does not have the reserves to service the loans it has guaranteed. A debt crisis also occurs when the government does not have the reserves to enable private domestic residents to convert their service payments on nonguaranteed debts from domestic to foreign currency. When a private borrower cannot come up with the service payments in domestic currency for his private nonguaranteed external debt, we do not consider it a national debt crisis because the government did not cause the default except in the broadest sense of not creating more favorable macroeconomic conditions, if it were able to do so. For the case of a debt crisis caused by a shortage of foreign reserves to allow conversion of private debt-service payments, 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, and the 1980-8 1 financial squeeze precipitated the PEMEX crisis of Mexico. Since the reserve position of the country is crucial for avoiding debt crises, it is not appropriate to assess the country’s ability to pay by looking at the total external debt service with respect to its income. A more appropriate indicator is the debt-service ratio-the 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. This point is well illustrated by parts (a) and (b) in table 8.2. Even though the 1980-82 debt-serviceiGNP ratios for Brazil and Indonesia are quite close, Brazil had an average total DSR of over 100 percent compared to the Indonesian average of 30 percent. And Brazil experienced a debt crisis after 1982 and Indonesia did not. One reason why the Mexican and Brazilian DSRs are so much larger than that of Indonesia is because Indonesia is a much more export-oriented economy. The average 1980-82 export/GNP ratio was 27 percent for Indonesia, but only 14 percent for Mexico and 9.5 percent for Brazil (see memo item in the table). Even if we ignore short-term debt by assuming (unrealistically) that it could always be rolled over, we see in part (c) of table 8.2 that the long-term DSRs for Mexico and Brazil were still very high compared to Indonesia. The 1980-82 average was 40 percent for Mexico, 62 percent for Brazil, and 14 percent for Indonesia. Items (b) and (c) in table 8.2 together explain why Mexico defaulted before Brazil even though their total DSRs were almost the same in 1981,

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Table 8.2

Debt Characteristics of Mexico, Brazil, and Indonesia, 1978-86 (in percentages) ~~

1978

1980

1981

1982

1983

1984

1985

1986

(a) All short- and long-term debt service as ratio of GNP Mexico 12.0 14.1 15.5 Brazil 7.5 11.0 11.6 Indonesia 9.3 7.5 7.3

24.8 12.8 9.2

17.4 13.0 10.7

13.9 11.0 11.1

11.8 10.2 13.0

NA NA

(b) All short- and long-term debt service as ratio of exports Mexico 105.8 103.6 117.1 Brazil 106.5 114.5 113.6 Indonesia 40.8 25.1 26.1

138.9 146.0 39.0

80.8 104.5 41.7

69.0 72. I 43.3

66.5 72.6 51.6

(c) Public and private long-term debt service as ratio of exports Mexico 62.4 38.0 35.0 Brazil 57.6 56.4 56.8 Indonesia 25.0 12.7 12.9

44.6 71.7 16.5

45.4 46.2 18.4

49.2 34.1 19.0

48.2 34.9 25.2

(d) Proportion of debt which is short term Mexico 14.0 Brazil 13.2 Indonesia 9.9

30.5 19.3 18.1

11.1 14.9 15.6

6.8 11.6 16.8

5.8 10.8 14.8

12.2

(e) Proportion of publicly-guaranteed long-term debt which has variable rate Mexico 59.5 71.5 75.4 76.7 82.7 Brazil 56.8 61.0 67.1 69.3 70.1 Indonesia 15.0 16.2 17.8 20.0 22.8

83.6 73.1 23.7

so. 1 71.5 21.7

NA NA NA NA NA

28.3 19.3 13.3

32.1 19.2 14.4

15.3

NA NA 67.6

NA NA 34.5

NA NA

(f) Effective interest rate for all long-term debt, calculated by (debt service/debt) Mexico Brazil Indonesia

23.4 18.0 17.5

22.8 23.3 15.5

20.1 23.7 16.6

20.8 23.0 16.1

15.9 13.9 14.6

18.0 11.7 15.8

16.1 11.2 16.6

11.3 7.1 22.8

13.7 9.6 29.7

13.2 10.2 27.9

17.9 8.7 23.6

21.5 12.4 25.8

20.1 15.3 25.7

17.8 14.0 25. I

22.6

9.3

13.4

16.1

13.7

10.2

11.8

9. I

7.0

14.5

Memo item Export/GNP ratio Mexico Brazil Indonesia One-year LIBOR for dollar deposits NA

=

NA NA

not available

117 percent versus 114 percent. This is because 70 percent of Mexican total debt service in 1981 consisted of rolling over short-term loans, as against Brazil’s 50 percent, and this was the period when the one-year London interbank offer rate for dollar deposits (LIBOR) reached and remained at historic highs. LIBOR was over 10 percent from 1979 to 1984, with a peak of 16 percent in 1981 (see item d and the memo item in the table). When it was clear in 1980 that short rates would remain high, long rates rose too. Since almost 70 percent of Brazilian publicly-guaranteed debt was on variable rates, the effective interest rate on Brazilian long-term debt rose from 18 percent in 1978 to over 23 percent during the 1980-83 period (see items c and f in table 8.2). The additional interest payments, together with the collapse of its exports due to the deep global recession in 1982, brought about the Brazilian debt crisis in 1983.

Wing Thye Woo and Anwar Nasution

134

Many authors have cited capital flight as a major cause for the external debt crisis in some of the Latin American c ~ u n t r i e s .Part ~ 1 of table 8.3 reports two sets of capital flight estimates. These estimates ought to be treated with caution; different studies have come up with significantly different figure^.^ Sometimes the sign is not even certain; for example, estimates for capital flight from Brazil ranged from -$0.2 billion to $3.9 billion. The point we want to make here is that imprudent maturity structure management may have contributed more to the Mexican debt-servicing difficulties than capital flight per se. To see this, we allow capital flight to have maximum impact on the actual DSR by assuming that Mexico financed the capital flight entirely by short-term debt. Part 2 of table 8.3 shows that Mexico’s DSR in 1982 would have dropped from the actual 138 percent to 64 percent if financing had been done with long-term loans instead. Without capital flight, the DSR would have been 45 percent. In short, the major reason why Mexico’s DSR was so high was because the way in which the government financed the capital flight added 74 percentage points. Capital flight per se added only 19 percentage points. Our conclusion of imprudence in the management of maturity structure can be shown in another way. To see that much of the Mexican short-term debt was from borrowing by the government rather than from commercial credits to finance imports, we make use of the fact that the Indonesian Table 8.3

The Role of Capital Flight in Precipitating Debt Crises

Part I : Cumulated capital flight amount up to 1982 (in billions of dollars) Khan-Haque Estimate

Morgan Guaranty Estimate

29.4 - .2 NA

36.0 3.0 6.0

Mexico Brazil Indonesia

Part 2: Constructing total debt service/export ratios in 1982 Actual Ratio

Mexico Brazil Indonesia

138.9 146.0 39.0

Counterfactual Ratios If capital flight had been financed by longterm instead of shortterm loans 64.2 143.2 20.1

No capital Right 44.6 133.2 16.5

Note: Counterfactual ratios were calculated by assuming that capital flight had maximum impact on the actual debt-service ratios. This means that capital Rights were assumed to have been financed entirely by short-term borrowing. The maximum amount of capital flight was the actual short-term debt of the country. For Mexico and Indonesia, capital flights were assumed to equal actual short-term debts in 1982; and for Brazil the Morgan Guaranty estimate was used. NA

=

data not available

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IndonesidChapter 8

government, since the Pertamina crisis, has avoided short-term external borrowing as much as possible. Assuming that the Indonesian ratio of short-term debt to imports reflects normal trade financing, we can attribute 77 percent of Mexican short-term debt in 1981 and 1982 to government borrowing. The 1981 and 1982 figures for Brazil are 68 percent and 57 percent, respectively. There is a tradeoff in external debt management between generally lower interest payments and predictability of debt-service payments. Short-term liabilities pay lower interest rates most of the time, but it is risky to rely on a strategy which rolls over large amounts of short-term debt every period. An unforeseen credit crunch would force the country to increase borrowing in order to cover its interest payments. If the credit squeeze persisted for more than three years and was accompanied by a prolonged fall in the country’s exports, this extra borrowing would be difficult to sustain because the situation smacks increasingly of a Ponzi game. Capital flight can be an important mechanism in bringing about a debt crisis, but we cannot view capital flight as an exogenous shock in the Latin American debt crises. Enders and Mattione (1984) and Dornbusch (1987) have emphasized that the large capital flight in Mexico and Argentina was the result of highly overvalued exchange rates. Even with overvalued exchange rates, our discussion based on table 8.3 concludes that capital flight would not have hurt Mexico’s debt-service capacity if it had been financed by long-term, rather than short-term, external borrowing. Pulling all of the observations about tables 8.2 and 8.3 together, we attribute the absence of an Indonesian debt crisis in 1982-84 to three factors: 1. A high proportion of Indonesia’s external debt was borrowed at fixed concessionary rates from IGGI. This ZGGZ efSect explains why the effective interest rate on Indonesian long-run debt averaged 16 percent against the 20 percent paid by Mexico and Brazil (part f of table 8.2). 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 paid by Indonesia as much as it did for that paid by Mexico and Brazil. The high degree of export orientation in Indonesia prevented its 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. Indonesia’s political concern to keep the agricultural sector vibrant no doubt helped to maintain the observed export orientation. The shock of the 1975 Pertamina crisis caused official borrowing in Indonesia to take place very cautiously with regard to exposure in the

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Wing Thye Woo and Anwar Nasution

short-term credit market. The resulting Indonesian prudence is the major reason the maturity structure of Indonesian debt was so drastically different from that of Mexico. We could also refer to the this factor as the Pertamina legacy.

8.4 The Relative Contribution of Each Factor To get a sense of the relative contribution of concessional IGGI loans, prudence in debt management, and export orientation in explaining the absence of an Indonesian debt crisis, we decompose the average 1980-82 DSR. This is done by comparing the Indonesian debt situation with that of Mexico. We chose Mexico over Brazil because the former is an oil-exporting country like Indonesia. On the eve of the debt crisis, oil was the chief foreign exchange earner and the biggest source of government revenue in both Indonesia and Mexico. We calculate what the DSRs would have been if Indonesia: (i) paid the same effective interest rates as Mexico; (ii) had managed its debt such that its maturity structure was the same as Mexico’s; and (iii) had the same export/GNP ratio as Mexico. In the construction of these counterfactual DSRs, we assume that the total debt of Indonesia remained unchanged in these alternative scenarios. Item (i) in part A of table 8.4 reports the DSRs normalized by the actual export level after the IGGI effect and the prudence factor were removed. Item (ii) normalizes the different debt services by the level of exports that would have come about if Indonesia had the same export/GNP ratio as Mexico. The last entry in item (ii) reports that if the Indonesian debt and economy assumed all three Mexican features, the resultant DSRs in 1980-82 would be two to three times larger than the actual, making a debt crisis highly probable. On average, Indonesia’s DSR would be 54 percentage points higher if it had all three Mexican features. Part B of table 8.4 reports the range of values assumed by each factor in six decompositions of their effect, along with the average contribution of each factor. We use average contribution in our discussion because theory gives us no guidance as to which decomposition is most natural. The results show that the export orientation of Indonesia is the most decisive factor in why Indonesia’s total DSR is so low compared with Mexico’s. Export orientation explains 3 1 of the 54 percentage point difference, accounting for 57 percent of the gap. The prudence factor was of moderate importance, contributing 18 percentage points and thus accounting for almost one-third of the gap. Concessional interest rates and the currency composition of debt played only a minor role in reducing the DSR, explaining less than 6 percentage points. Our finding that the IGGI effect contributed so little toward the reduction of the 1980-82 debt-serviceiexport ratio is surprising because many of the

137

IndonesidChapter 8 ~

Table 8.4

Relative Importance of IGGI, Maturity Structure, and Export Orientation Part A: Construction of counterfactual ratios for decomposition 1980 1981 1982

-

-

(i) Total debt-service normalized by actual exports Actual maturity structure 26.1 At actual interest rates 25.1 28.8 At Mexican interest rates 31.1 Mexican maturity structure 39.5 At actual interest rat37.1 41.7 At Mexican interest rates 42.0 (ii) Total debt-service normalized by counterfactual exports Actual maturity structure 54.9 At actual interest rates 54.6 60.8 At Mexican interest rates 67.6 Mexican maturity structure 83.3 At actual interest rates 80.5 87.9 At Mexican interest rates 91.3

-

Avg (80-82)

39.0 43.7

30.1 34.6

52.0 56.1

42.9 46.6

51.5 57.7

53.7 62.0

68.7 74.0

77.5 84.4

Part B: Relative importance as determined by average of the six possible decompositions Hypothetical 1980-82 average ratio when Indonesia has all three Mexican features is 84.4 percent Actual 1980-82 average ratio is 30.1 percent.

IGGI concessional loans Maturity structure due to Pertamina legacy and absence of capital flight Export orientation

Average Value

Percent of Gap Between Actual and Counterfactual Ratios Accounted For

Range of Values Assumed in the Six Decompositions

5.8

11%

3.7-8.4

17.7 30.8

32 57

12.0-23.8 23.6-37.8

informed observers we talked to cited foreign concessionary loans as the primary reason for the absence of an Indonesian debt crisis. Our point is that while the $1 billion saved annually in reduced debt service during 1980-82 is a large sum of money,5 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 which promotes exchange rate protection and by the memory of the economy-wide negative effects of exchange rate overvaluation. The fact that neither the budget deficits nor the money growth rates went out of their historical range for extended periods also helped to make exchange rate management easier.

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Prospects

Since over 30 percent of Indonesia’s public debt is denominated in yen, debt-service payments have jumped in the face of the 68 percent appreciation of the yen against the dollar in the 1985:lQ to 1987:lQ period. Debt management has become more difficult since 1984. Agricultural commodity prices and oil prices have continued to decline, often very rapidly. The price of oil plunged from $28/barrel to $lO/barrel between January and August 1986. The fall in export earnings from $21 billion in 1982 to $15 billion in 1986 has caused the total debt-servicelexport ratio to soar to 68 percent. The situation is ominous. While our analysis would place the greatest of emphasis upon an aggressive competitive real exchange 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 immediately if a debt crisis is to be avoided in the medium run. The supplementary policies which we recommend can be divided into two groups: (1) those which affect the debt service directly, and (2) those which affect export earnings. The policy measures which would ameliorate the debt service burden directly, through the reduction of foreign borrowing, are: 1. Cut budget deficits by controlling spending and increasing taxes. The fiscal policy posture must be kept consistent with that of the exchange rate. The tax reforms since January 1984 have raised domestic revenue considerably, but their implementation has not been wholly satisfactory. While the number of registered taxpayers has increased from 550,000 before the tax reform to 995,000 at the end of 1985, only 50 percent of the companies and 70 percent of registered taxpayers actually filed tax returns in 1985 (World Bank 1986, 13). The elimination of this slack in tax collection should not cost too much given that the offenders are already known. The task now is to fully enforce existing tax laws. 2. Maintain an anti-inflationary stance in monetary policy. This would help to keep trade account deficits down by reducing absorption relative to income. Interest rates should be kept internationally competitive to discourage capital flows. Both of these outcomes would make exchange rate management easier. 3. Amend the “balanced” budget rule to allow internal financing of government deficits. This rule was introduced to prevent the reoccurrence of the kind of inflation in 1961-65 that resulted from the monetization of the budget deficits. It may seem imprudent to remove this institutionalized practice but the fact is that the inflation of the final Soekarno years was the result of the breakdown of the political system which made austerity policies impossible. And if political conditions were to really degenerate, no government would deem itself bound to this practice

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IndonesidChapter 8

anyway. Furthermore, at present, while this rule prevents monetization of budgetary expenditure, it does not prevent the monetization of nonbudgetary expenditure, e.g., central bank credits to BULOG. Since bold austerity policies during bad times have never been avoided by the Soeharto regime, it makes little sense not to amend the balanced budget practice in order to reduce reliance on external funds. In addition, the development of a domestic market in government securities would make open market operations by the central bank possible. The existence of this monetary tool would enhance monetary control, and thus macroeconomic stabilization efforts, tremendously. 4. Accelerate the development of the domestic financial system. Besides further deregulation of the financial sector, financial deepening could be boosted by the privatization of many of the state-owned enterprises. The balance-of-payments position would be improved if the government were to allow foreigners to purchase shares in the former state enterprises. A developed financial market would lower intermediation costs, allow better monetary control, and, possibly, encourage savings. 5. Liberalize the controls on foreign investments in the manufacturing and agricultural sector, especially in industries that produce primarily for the export markets. This step will increase capital formation without the need of incurring external debt and will also increase foreign exchange earnings. In short, state and private enterprises should issue equities instead of bonds to foreign investors when financing their capital expenditure. It is important that protection not be used as a means of inducing foreign investments because, in all likelihood, the resulting enterprise would be inefficient and cause a net loss of foreign exchange for Indonesia. Our proposal for liberalizing foreign investment laws may be a hard one to accept given the prevailing economic nationalism in Indonesia, but it should be seriously considered if the debt situation takes another turn for the worse. The second group of supplementary external debt management policies are those which focus on the denominator of the DSR. Our analyses suggest that the viability and expansion of the Indonesian export sector depends crucially on : 1. The elimination of the wide array of monopoly import licenses. The present efforts to replace import licenses with tariffs is an improvement but it is still a second-best solution. It is important that tariffs not take the place of the import licenses removed from the imported basic inputs. The growth of manufactured exports, spurred by access to cheaper inputs, will not only increase foreign exchange earnings but will also diversify the export bundle, hence reducing the sensitivity of the DSR to the prices of a few key commodity exports. Furthermore, any Indonesian manufactured export industry that is internationally competitive will be one which uses Indonesia’s abundant semiskilled labor force intensively in its

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Wing Thye Woo and Anwar Nasution

production process. The favorable employment effects alone should be justification enough to eliminate these monopoly import licenses. 2. The expansion of the tree crop sector. Indonesia has cheaper labor than Malaysia, and with additional investments in transportation, Indonesia could potentially outcompete Malaysia in the production of rubber and palm oil. In addition to earning more foreign exchange, the strategy of accelerating the growth of agricultural export industries will also promote a more equitable rural-urban, as well as inter-island, growth pattern and ease population pressure on the urban areas.

A final cautionary word on external debt management from the political perspective is pertinent. The Pertamina crisis has led to close supervision by the Ministry of Finance of external borrowing by all state enterprises, making it unlikely that a debt crisis would ever again emerge from the external adventurism of an economic fiefdom. The danger now may be the absorption of private external debts in order to save large domestic firms when they get into financial problems, as in the Indocement case. As we described in chapter 3, in July 1985 Indocement, the biggest cement company in Indonesia, began to experience cash flow problems because the recession-induced collapse of the construction industry led to a cement glut. The response of the Indonesian government was to inject U.S. $325 million in cash to acquire a 35 percent share of the company, and to form a consortium of four state banks to “convert into a rupiah liability a U.S. $120 million syndicated loan that Indocement took out in 1981.’16 If a few more such rescues are allowed, then the habit may well be impossible to break without the government having to put to the test an important source of its political power-the cohesiveness of the bureaucratic and military elite. Given the widespread participation in large private business ventures by government officials and their family members, the selective use of financial rescue will threaten the political unity of the group. If such political pressure were able to completely eradicate the already blurred line between public and large private enterprises, then the vulnerability of Indonesia to a debt crisis would be greatly increased. External debt management would become impossible because no one would know what the size of the sovereign debt really was, and the size of this debt could increase very quickly given the openness of the private capital account.

Notes Acknowledgments We received a lot of help in the writing of this monograph. We are beholden to the many government officials, policy analysts, diplomatic observers, bankers, journal-

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IndonesidNotes

ists, and academic researchers who graciously agreed to discuss the current debt situation with us. In order to keep this note brief, we have not cited each by name. Our apologies, as well as our thanks, to our unnamed benefactors. We are very grateful to the late Professor Dr. Jusuf Panglaykim Pangestu for arranging visiting privileges for Wing T. Woo at the Center for Strategic and International Studies, and to Mr. Abdulgani for doing the same at Bank Duta. Bruce Glassburner helped us greatly by giving generous access to his collection of materials on Indonesia. We also want to thank Willem Bake, Suhadi Mangkusuwondo, Masaaki Horiguchi, Richard Mattione, Stephen Mink, Gordon Nelson, Robert Rucker, Syahrir Sabirin, Pande Silalahi, Djisman Simandjuntak, Sutopo, Ast, Peter Timmer, Ralph Beak, Richard Porter, David Dapice, and Khalid Wajid for data and references which permitted us to do a more complete analysis. John Roemer, Thomas Mayer, Kevin Hoover, Tun-Jen Cheng, William Liddle, Anne Booth, John Legge, Edward Buffie, Dani Rodrik, Donald Snodgrass, Mark Sundberg, Heinz Arndt, Eric Ramstetter, and Seiji Naya read portions of an earlier draft and gave us extremely helpful comments. Evie Anwar, Ratna Astiti, Sirajudin Ahmad, Alian, Wendy Eudey, Petrina Ho, Carl Galopin, Elmer Bartley, and Jonathan Kendall provided extremely effective research support which enabled us to meet the NBER deadlines. The warm hospitality extended to Wing T. Woo during his stay in Jakarta by Donald and Oralia Foster-Gross, Mari Elka Pangestu, Sjahrir, Richard Monteverde, Ibrahim Hasan, Mr. and Mrs. Van Rennes, Mr. and Mrs. Rucker, and Ayuna Nasution made his research experience a very enjoyable one. We are deeply indebted to Max Corden, David Dapice, Peter McCawley, Sarath Rajapatirana, and Jeffrey Sachs for the many perceptive comments and advice we received while writing this monograph. Wing Thye Woo is responsible for writing chapters 1, 3, 4, 6, 7, and 8. These chapters are partially based on three earlier papers: “The Dead Hand of History in Indonesian Economic Policymaking” and “The External Debt Situation in Indonesia: Performance and Prospects” (no, 43 and no. 48, respectively, in the Applied Macroeconomics Working Paper Series issued by the University of California, Davis); and “The Economic Policy-Making Equation in Indonesia” (Pacific Rim Studies Program Working Paper no. 6, University of California, Davis). Anwar Nasution is responsible for writing chapters 2 and 5. These chapters draw on some materials from “Instruments of Monetary Policy in Indonesia after the 1983 Banking Deregulation” (a paper prepared for the Conference on Financial Research in Indonesia, August 1986) and from Financial Institutions and Policies in Indonesia, Institute of Southeast Asian Studies, Singapore, 1983.

Chapter 1 1. The “balanced” budget rule ceased to be a binding constraint on expenditure after the 1973 OPEC-1 price increase. The Indonesian government (perhaps until very recently) was pretty much able to get whatever amount of credit it wanted. This budget rule does not prevent the financing of nonbudgetary expenditure by money creation, e.g., central bank credits to state agencies. 2. The term “Dutch disease” originated with the observation that the 1973-78 growth of the Dutch natural gas industry was accompanied by a steady decline in the traditional export sector.

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3. In the case where a private borrower could not come up with the service payments in domestic currency for his private nonguaranteed external debt, we do not consider it a national debt crisis because the government did not cause the default except in the broadest sense of not creating more favorable macroeconomic conditions, if it were able to do so. 4. This is calculated assuming that Indonesia would pay the same effective interest rate as Mexico.

Chapter 3 1. Sachs (1985) argues that it is political considerations which explain why Latin American countries, but not the East Asian countries, pursued exchange rate and trade policies which rendered their economies vulnerable to an external debt crisis. 2. Other viewpoints on the political economy aspects of Indonesian policymaking are: Jackson (1978a, 1978b), Palmer (1978), Mortimer (1974), Glassburner (1978), and Liddle (1987). 3. This characterization-of state-society relations is developed in Wing Thye WOO (1988). His article also reviews and tests the competing models of the Indonesian state. 4. Since 1961 there has been a secular decline in the real money stock. See table 11.8 in Amdt (1971). 5. We postpone discussion of the reorganization of the external debt to chapter 7. 6. This figure is not strictly accurate because multiple official exchange rates for different types of transactions still existed at this time. Data is from Arndt (1966). 7. This was calculated by deflating the dollar earnings of nonoil exports by the dollar export unit value of the industrial countries. The absence of a reliable representative exchange rate for 1965 makes the calculation in local purchasing power impossible. 8. The annual real GDP growth rate of the industrialized countries averaged 5.5 percent in the three years prior to 1965 and averaged 4.9 percent in the 1965-68 period. 9. This coup is commonly referred to as the GESTAPU coup, with GESTAPU standing for Gerakan September Tiga Puloh-the September 30 Movement. 10. For example, he maintains a working farm for recreational purposes. 11. The great care which Soeharto takes to preserve his country-boy image is seen by the POP affair. POP, a popular culture magazine, claimed in 1974 that Soeharto was actually a descendent of the Yogjakarta royal family. Instead of ignoring this gossip which would only add to the legitimacy of his rule among the superstitious and conservative peasants, Soeharto publicly rebuked the close confidant who owned the magazine. 12. See Timmer (1975) for an excellent discussion of the political economy of Indonesia’s rice policy. 13. Dwifungsi is a transliteration of “dual function” and refers to the army’s dual role in defense and economic development. Harold Crouch (1978) cites official statements in 1969 and 1970 that the armed forces budget covered only 30 to 50 percent of expenses. 14. Access to these funds may be the reason the defense budget has not jumped dramatically in the face of continued military operations in East Timor.

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15. Another important reason for the use of quotas over tariffs is that tariffs would violate the GA’IT agreement. 16. See The Asian Wall Street Journal Weekfy, 1 December 1986. 17. INSIGHT, 9 February 1987, p. 33. 18. Bank Indonesia, embarrassed by the size of the rescue operations, delayed the release of information about its financial status for over a year. 19. Soekarno, Soeharto’s predecessor, had resorted to the inflation tax to pay for government operations. 20. Glassburner (1976) cited this as an instance of managerial incompetence, so he may disagree with our interpretation here. 21. Siregar (n.d., 5) noted that “it was generally believed that while the Dutch colonial rule had a stifling effect on autochthonous Indonesian entrepreneurs, it had fostered the entrepreneurial activity of the Dutch and other foreigners, particularly the Chinese.” 22. In the preface to their book, Panglaykim and Palmer (1969) advanced the proposition that state corporations could be used to provide a counterweight to Chinese domination of the private trade sector. (Zaibatsus were large holding companies that dominated the Japanese economy until the end of World War 11.) 23. Liddle (1987) labels the two groups economists and engineers, respectively. 24. An account of IGGI’s role in the 1966-70 period is given in Posthumus (1971). 25. Because of their influential foreign constituency, their lack of ideological aversion toward foreign investment, and the fact that several of them received doctorates from the University of California, the technocrats were called the “Berkeley Mafia” by their detractors. 26. Two earlier attempts to check Pertamina’s influence had failed. When the minister of mining attempted to assert his control over Pertamina in 1969, Soeharto transferred the company out of the minister’s jurisdiction. In 1971 Soeharto ignored the recommendation by a presidential commission on corruption that Pertamina be placed under the supervision of the Ministry of Finance. 27. The term “technician” is used because of the increasingly prominent role of Minister of Technology Habibie, who is an outstanding aerospace engineer. 28. This belief is evident in the following editorial in a magazine identified with the military advisors to the president: One [path of economic development] leads via the BAPPENAS technocrats to a free-flight and laissez fake pattern of development in the Western and American fashion. Another [path] takes the form of cooperation with Japan on the basis of one’s own strength without loans from the IGGI, the IMF and the World Bank with Pertarnina as guarantee. (Ekpres, 18 January 1974, quoted in Fur Eastern Economic Review, 4 February 1974)

Chapter 4 1. The Indonesian government made this change beginning with 1984185 but did not revise the figures of earlier years, so our revision merely makes the official categories consistent across time. 2. Real import tax revenue, measured in 1980 prices, fell by Rp 62 billion in the 1969-83 period.

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3. The rise in oil tax revenues in 1983/84 is illusory because the 1983 devaluation increases the rupiah value of this revenue, which is paid in U.S. dollars. 4. Nonmining RGDP is used instead of RGDP because while the presence of oil and LNG industries increases a region’s production tremendously, their impact on the region’s income is small. This is because almost the entire revenue is taken by the central government and, being extremely capital-intensive industries, their local wage bills are small. 5 . Jakarta is excluded here because its high figure “reflects the substantial level of spending on the apparatus of the Central Government rather than on the development of Jakarta” (World Bank 1984, 133).

Chapter 5 1. More detailed descriptions of the Indonesian financial markets from 1970 to 1979 are found in Nasution (1983) and Suwidjana (1984). 2. A fuller discussion of the new monetary instruments is in Nasution (1986). 3. This liquidity squeeze has been immortalized in the Indonesian press as the Sumarlin shock treatment, Gebrakan Sumarlin.

Chapter 6 1. See Corden and Mackie (1962) and Kanesa-Thasan (1966) for analyses of the Indonesian exchange rate system prior to the Soeharto years. 2. Glassburner (1970) and Pitt (1971) describe the pricing of foreign exchange during the transition to the unified exchange rate. 3. The low figure of 6.4 weeks for 1975 shown in table 6.2 was not because of a sharp drop in exports or a big increase in imports; it was because of the transitional financing of Pertamina’s debts while negotiations were underway to convert the company’s short-term debts to long-term debts. 4. On the eve of the devaluation, Arndt (1978, 10) wrote:

The overall picture for Indonesia’s balance of payments in the current fiscal year is thus still reasonably reassuring. On a longer view, it is difficult to resist the traditional balance of payments pessimism of economists everywhere, official and unofficial alike.

5. See stories in Warta Berita, April 6; Sinar Harapan, April 13; and Merdeka, May 5 and May 24. 6. An exponent of this view is Kincaid (1984, 88), who wrote that the 1978 “exchange rate adjustment” was prompted by “the balance of payments constraint.” 7. Notable supporters of the Dutch disease interpretation of the 1978 devaluation are Malcolm Gillis, Dwight Perkins, Michael Roemer, and Donald Snodgrass (1987, 539) who wrote: [In 19781 the country had ample foreign exchange reserves to defend the vale of the rupiah, and the business community viewed devaluation as unthinkable. Nevertheless, the Indonesian rupiah was devalued by 50 percent in November 1978, not to protect a precarious foreign exchange reserve situation but primarily to encourage labor-intensive manufactured and agricultural exports.

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8. These normalizations were suggested by Peter Warr (1986). 9. This statement is true as long as international prices do not rise above the domestic prices of the quota-protected goods. Tariff-protected goods are still considered tradables because their domestic prices are higher than international prices only by the amount of the tariff and they move in tandem with international prices. 10. The OPEC-1 price increase occurred in October 1973. 1I . Pangestu (1986) constructed several price indices for tradables and nontradables by decomposing the gross domestic product, the CPI, and the WPI. Her results are qualitatively the same as those reported in table 6.5. 12. The Morgan Guaranty measure of competitiveness is the inverse of the real exchange rate reported in World Financial Markets published by Morgan Guaranty. The unit of measurement of competitiveness here is rupiahs per basket of foreign currencies. 13. Kincaid (1984) and Pangestu (1986) provide formal econometric explorations of the devaluation. 14. We have. as Gillis (1984) did in his table 4, identified the “miscellaneous” category in the World Bank list of nonoil exports as manufactured goods. 15. These disaggregated nonoil export data are available only in fiscal year intervals. Fiscal year 1979 goes from April 1979 to March 1980 and is henceforth represented by 1979/80. 16. McCawley (1980) discusses the need for other economic policy changes in order for the beneficial structural effects of the devaluation to be viable. 17. Debt here refers to medium- and long-term external public debt. 18. International Financial Statistics, June 1987. 19. International Financial Statistics, June 1987. The IMF, at the beginning of 1987, further lowered its prediction of the 1987 growth rate to 2.3 percent (IMF 1987). 20. Even after taking into account the fall in import prices, the real price of oil measured in terms of foreign purchasing power fell a whopping 40 percent in one year. 21. In this section, we confine our attention to the consequences of quotas on the supply of exportables within a static setting. For an excellent discussion of the impact of protection on growth, see Corden (1972). 22. Pitt (1971) and World Bank (1981) are two comprehensive studies of effective rates of protection in 1970 and 1975, respectively. 23. As pointed out in section 6.4, goods with QR protection are effectively sheltered from international price trends and are hence regarded as nontradables from an analytical viewpoint. 24. This is not the total level of protection as this figure does not take into account activities protected by quotas and tariffs. 25. See Wall Street Journal, 24 November 1986 for a longer list of vital inputs with a small number of approved traders. 26. Figures are from The Asian Wall Street Journal Weekly, 1 December 1986. 27. This assumes that the rent-seeker is rational enough not to demand too high a price and obliterate the industry. 28. We are abstracting from natural growth considerations here to make this point within a static context. 29. Current account expressed as a percentage of GDP.

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Chapter 7 1. The conversion to rupiah was done using the average BE Market rate of October to December, 99.5 rupiahs/dollar. The average curb market rate was 130 rupiahsldollar. Data are from the World Bank (1968), Basic Data section and pp. 39, 50, and 54. 2. Lipsky (1978), Glassburner (1976), and McCawley (1978) are excellent sources about and analyses of the Pertamina crisis. 3. According to Glassburner (1976), the power installation at the Krakatau Steel Mill cost three times more than the same installation in Taiwan. 4. These figures are only guesses because the same item from three official sources-balance of payments, the government debt record, and the government budget-sometimes shows gaping discrepancies. See also the note in table 7.4 on how the 1973/74 through 1977/78 data were constructed. 5. The rate of change in the CPI was 31 percent in 1973, 41 percent in 1974, and 19 percent in 1975; and real GDP growth was 7 percent in 1976, 9 percent in 1977 and 8 percent in 1978. 6. This paragraph draws upon the article by Haryono (1985). Chapter 8 1. A textbook exposition of this fiscal cause of external debt crisis is Rivera-Batiz and Rivera-Batiz (1985). 2. For example, see table 17.5 of Rivera-Batiz and Rivera-Batiz (1985, 557). 3. For example, Dombusch (1987), Lever and Huhne (1986), and Cline (1984). 4. Cuddington (1986), Dooley (1986), Khan and Haque (1987), and Morgan Guaranty (1986). 5. This is calculated assuming that Indonesia would pay the same effective interest rate as Mexico. 6. Quote is from the Far Eastern Economic Review, 25 July 1985. The Asian Wall Street Journal Weekly, 12 May 1986, put the cash injection at U.S. $360 million.

References Amdt, H. W. 1966. Survey of current developments. Bulletin of Indonesian Economic Studies October. -. 1971. Banking in hyperinflation and stabilization. In The economy of Indonesia: Selected readings, ed. by B. Glassburner. Ithaca, N.Y.: Cornell University Press. -. 1978. Survey of recent developments. Bulletin of Indonesian Economic Studies November. -. 1979. Monetary policy instruments in Indonesia. Bulletin of Indonesian Economic Studies November. Bank Indonesia. Annual Report, various issues. Jakarta.

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Indonesian Financial Statistics, various issues. Jakarta. Report of the Governor, various issues covering financial years 1950/51 through 1960/65. Jakarta. -. Yearly Report, various issues. Jakarta. Biro Perancang Negara. 1960. Report on the execution of the five-year development plan, 195640: Covering the years 1956, 1957, and 1958. Jakarta, August. Biro Pusat Statistik. Statistical Pocketbook of Indonesia, various issues. -. Statistical Yearbook of Indonesia, various issues. Booth, Anne, and Peter McCawley, ed. 1981a. The Indonesian economy during the Soeharto era. Oxford: Oxford University Press. . 1981b. Fiscal policy. In Booth and McCawley (1981a). Cline, William. 1984. International debt: Systemic risk and policy response. Washington, D.C.: Institute for International Economics. Corden, Max. 1972. Protection and growth. In International economics and development: Essays in honor of Raul Prebisch, ed. Luis Marco. New York: Academic Press. . 1982. Exchange rate protection. In The international monetary system under flexible exchange rates, ed. Richard Cooper, Peter Kenen, George de Macedo, and Jacques van Ypersele. Cambridge, Mass.: Ballinger. Corden, Max, and J. A. C. Mackie. 1962. The development of the Indonesian exchange rate system. Malayan Economic Review April. Crouch, Harold. 1978. The army and politics in Indonesia. Ithaca, N.Y.: Cornell University Press. Cuddington, John. 1986. Capital flight: Estimates, issues and explanations. Princeton Studies in International Finance 58 (December). Dake, Antonie. 1973. In the spirit of the Red Banteng: Indonesian communists between Moscow and Peking, 1959-1965. The Netherlands: Mouton. Dapice, David 0. 1980. An overview of the Indonesian economy. In The Indonesian economy, ed. Gustav F . Papanek. New York: Praeger. Dooley, Michael. 1986. Capital flight: A response to differences in financial risks. Mimeo, July. Dornbusch, Rudiger. 1987. The world debt problem: Anatomy and solutions. Study paper for the Twentieth Century Fund, New York. Enders, Thomas, and Richard Mattione. 1984. Latin America: The crisis of debt and growth. Washington, D.C.: Brookings Institution. Gablis, V. 1977. Financial intermediation and economic growth in LDC: A theoretical approach. Journal of Development Studies January. Geertz, Hildred. 1963. Indonesia culture and community. In Indonesia, ed. Ruth McVey. New Haven, CT: Yale University Press. Gillis, Malcolm. 1984. Episodes in Indonesian economic growth. In World economic growth, ed. Arnold Harberger Institute of Contemporary Studies. Gillis, Malcolm, Dwight Perkins, Michael Roemer, and Donald Snodgrass, 1987. Economics of development. 2d.ed. New York: W. W. Norton. Glassburner, Bruce. 1970. Pricing of foreign exchange in Indonesia, 1966- 1967. Economic Development and Cultural Change January. -, ed. 1971. The economy of Indonesia: Selected readings. Ithaca, N.Y.: Cornell University Press.

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. 1976. In the wake of General Ibnu: Crisis in the Indonesian oil industry. Asian Survey December. . 1978. Political economy and the Soeharto regime. Bulletin of Indonesian Economic Studies November. Gray, Clive. 1979. Civil service compensation in Indonesia. Bulletin of Indonesian Economic Studies March. Haryono, Subaliono. 1985. Indonesia. In External debt management, ed. Hassanali Mehran. Washington, D.C.: International Monetary Fund. Hunter, Alex. 1967. Indonesian oil: A new generation of explorers. Bulktin of Indonesian Economic Studies October. International Financial Statistics. various issues. International Monetary Fund. International Monetary Fund. 1986a. Indonesia Country Report. -. 1986b. World Economic Outlook April. -. 1986c. World Economic Outlook October. -. 1987. World Economic Outlook, April. Jackson, Karl. 1978a. The prospects for bureaucratic polity in Indonesia. In Jackson and Pye (1978). . 1978b. Bureaucratic polity: A theoretical framework for the analysis of power and communications in Indonesia. In Jackson and Pye (1978). Jackson, Karl, and Lucian Pye, ed. 1978. Political power and communications in Indonesia. Berkeley, Calif.: University of California Press. Kanesa-Thasan, S. 1966. Multiple exchange rates: The Indonesian experience. International Monetary Fund Staff Papers, July. Khan, Mohsin, and Nadeem Haque. 1987. Capital flight from developing countries. Finance and Development 24, no. 1 (March) 2-5. Kincaid, G . Russell 1984. A test of the efficacy of exchange rate adjustments in Indonesia. International Monetary Fund Staff Papers, March. Lever, Harold, and Christopher Huhne. 1986. Debt and danger: The worldfinancial crisis. Boston, Mass.: Atlantic Monthly Press. Liddle, William. 1987. Indonesia in 1986: Contending with scarcity. Asian Survey February. Lipsky, Seth. 1978. The billion dollar bubble. In The billion dollar bubble, ed. Seth Lipsky. Hong Kong: Dow Jones. McCawley, Peter. 1978. Some consequences of the Pertamina crisis in Indonesia. Journal of Southeast Asian Studies March. -. 1980. The devaluation and structural change in Indonesia. Southeast Asian Afsairs 1980. Singapore: Institute of Southeast Asian Studies. McDonald, Hamish. 1980. Suharto’s Indonesia. London: Fontana. McKinnon, Ronald. 1973. Money and capital in economic development. Washington, D.C.: Brookings Institution. McVey, Ruth, ed. 1963. Indonesia. New Haven, CT: Yale University Press. Morgan Guaranty. 1986. LDC capital flight. World Financial Markets March. Mortimer, Rex, ed. 1974. Showcase state: The illusion of Indonesia’s “accelerated modernization”. London: Angus and Robertson. Nasution, Anwar. 1983. Financial institutions and policies in Indonesia. Singapore: Institute of Southeast Asian Studies. -. 1986. Instruments of monetary policy in Indonesia after the 1983 banking deregulation. Paper presented to the Conference on Financial Research in Indonesia. August. Jakarta, Indonesia.

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Newmann, John. 1974. Inflation in Indonesia: A case study of causes, stabilization policies and implementation (1966- 1970). Ph.D. diss., Tufts University. Palmer, Ingrid. 1978. The Indonesian economy since 1965: A case study of political economy. London: Frank Cass. Pangestu, Mari Elka. 1986. The effects of an oil boom on a small oil exporting country: The case of Indonesia. Ph.D. diss. University of California, Davis, September. Panglaykim, Jusuf, and Ingrid Palmer. 1969. State trading corporations. Rotterdam. Papanek, Gustav, F., ed. 1980. The Indonesian economy. New York: Praeger. Penny, D. H., and Dahlan Thalib. 1967. Survey of current developments. Bulletin of Indonesian Economic Studies February. Pitt, Mark. 1971. Alternative trade strategies and employment in Indonesia. In Trade and employment in developing countries, volume I , ed. Anne Krueger, Hal Lary, Terry Monson, and Narongchai Akransee. Chicago: University of Chicago Press. Posthumus, G. A. 1971. The Inter-Governmental Group on Indonesia. Rotterdam: Rotterdam University Press. . 1972. The Inter-Governmental Group on Indonesia. Bulletin of Indonesian Economic Studies July. Rivera-Batiz, Francisco, and Luis Rivera-Batiz. 1985. International finance and open economy macroeconomics. New York: Macmillan. Sachs, Jeffrey. 1985. External debt and macroeconomic performance in Latin America and East Asia. Brookings Papers on Economic Activity 2. Siregar, Arifin. n.d. Indonesian entrepreneurs. Mimeo. Sundhaussen, Ulf. 1978. The military: Structure, procedure and effects on Indonesian society. In Political power and communications in Indonesia, ed. K. Jackson and L. Pye. Berkeley, Calif.: University of California Press. Suwidjana, Njoman. 1984. Jakarta dollar market: A case offinancial development in ASEAN. Occasional paper no. 76. Singapore: Institute of Southeast Asian Studies. Timmer. Peter. 1975. The political economy of rice in Asia: Indonesia. Food Research Institute Studies 14(3). Warr, Peter. 1986. Indonesia’s other Dutch disease: Economic effects of the petroleum boom. Working Papers in Trade and Development no. 86/2. Research School of Pacific Studies, Australian National University, April. Woo, Wing Thye. 1988. The economic policy-making equation in Indonesia. Pacific Rim Studies Program Working Paper no. 6. University of California, Davis. World Bank. 1968. World Bank country report on Indonesia. . 1975. World Bank country report on Indonesia. -. 198I . Indonesia: Selected issues of industrial development and trade strategy, annex 2: The foreign trade regime. -. 1984. World Bank country report on Indonesia. . 1985. World Bank country report on Indonesia. -. 1986. World Bank country report on Indonesia. -. 1987a. World Bank country report on Indonesia. . 1987b. World development report 1987.

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I1

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

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1

Introduction

In 198 1 South Korea was the world’s fourth largest debtor country and in the midst of an economic crisis. It had accumulated $17.6 billion of debt within three years, raising its debt stock to $32.4 billion and its debt/GDP ratio to 49 percent. Output had declined by 4.8 percent in 1980, compared to average growth rates in excess of 9 percent during 1970-79. Inflation had doubled from 14.4 percent in 1978 to 28.7 percent in 1980.’ Korea’s adjustment to the 1979-82 debt crisis has been remarkable. Some of the key elements in the adjustment are shown in table 1 . I . By 1986 it had substantially reduced the debt burden. Inflation had fallen to just 3 percent, while the government budget deficit had been cut in half. Exports grew by 26.6 percent, fueling a 12.5 percent increase in output and a current account surplus (4.9 percent of GNP). At the same time, real wages, per capita income, and consumption all increased, and the country maintained historically high levels of fixed capital formation. In stark contrast, the World Bank’s World Development Report (1986, 54) describes the plight of seventeen of the middle-income debtor countries as follows: The bulk of the adjustment has been undertaken through lower demand, which has meant, in practice, reducing imports and investment. The volume of imports for the heavily indebted middle income countries in 1985 was 32 percent below its 1981 level. The ratio of investment to GDP fell from 25 percent in 1981 to 18 percent in 1985. GDP has stagnated since 1980, and per capita incomes have declined substantially. The The views expressed in this study represent those of the authors and not necessarily those of their respective institutions. The authors would like to thank Vittorio Corbo, Anne Krueger, and an anonymous reviewer for comments and suggestions, and Joo-yup Ahn, long-ha Yoon, Jee-won Park. and Ana Revenga for research assistance. Susan Collins gratefully acknowledges financial support from an Olin Fellowship.

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Table 1.1

Korea’s Economic Reeoverv

A: Average Growth Rates

1970-79

1980-82

1983-85

1986

9.5 14.9

2.3 18.8

B: External Indicators (selected years)

1978

1980

1982

1985

1986

Debt (billions U.S. $) DebVGNP Current accounVGNP

14.8 28.5 - 3.0

27.2 45.0 -9.6

37.1 53.5 -4.5

46.8 56.3 - 1.8

44.5 46.8 4.9

GNP growth Consumer prices

8.5 2.7

12.5 2.3

reduction in demand has pushed the collective trade balance of these countries into a large surplus, which has brought their current account into rough balance. Yet the main indicators of debt at the end of 1985 were close to their previous peaks. Despite their adjustment efforts, these countries seem to be as far as they ever were from reconciling growth and creditworthiness. Thus, it is not surprising that Korea’s experience has been labeled “a case of successful adjustment” (Aghevli and Marquez-Ruarte 1985) raising a number of important and provocative questions. What were the secrets of Korea’s performance? How important were economic structure, policy choices, social and political factors, and external developments? Are there lessons to be learned which could help other debtor countries to achieve a more favorable balance between growth and external adjustment? This study analyzes Korea’s macroeconomic performance, policy, and prospects so as to provide answers to these questions. Particular emphasis is given to the role of external debt in contributing to the crises as well as to the recoveries. Korea’s position in the limelight is not new. The remarkable transformation from a war-devastated economic “basket case” heavily dependent on foreign aid in the 1950s to a newly industrialized “economic miracle” with impressive growth rates during the 1970s has been well documented.2 Clearly, this historical development is linked to Korea’s ability to adjust to the recent crisis so rapidly. We pay close attention to the implications of Korea’s structural development in putting together the pieces to explain the 1980s performance. Korea has also received international attention due to labor unrest and to opposition to the slow progress toward a democratic political process. While an in-depth analysis of the interactions between politics and economic performance is beyond the scope of this study, we recognize that political and social factors are integral forces in the process of economic development. Thus we have attempted to integrate some of these factors into our discussion in places where we found them to be especially relevant. For example, the sociopolitical environment seems to have had an influence over

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wage determination, over the extent to which announced economic plans have been viewed as credible, and over the enforceability of economic policy. The purpose of this chapter is to provide an overview of the key elements of Korea’s experience so as to set the stage for the remaining chapters. It is composed of two sections. The first section briefly reviews Korea’s macroeconomic performance, identifying the central issues to be analyzed. The second section outlines the rest of the chapters in the study.

1.1 Overview of Macroeconomic Experience Korea’s macroeconomic history can be divided roughly into five periods. The early period, from 1945 to 1953, was one of continued disruption. First came the division into North and South Korea at the 38th parallel after World War 11. The South was left with rich agricultural lands and light manufacturing industries, but almost no heavy industry or power facilities. Attempts to begin economic recovery were interrupted by the devastation of the Korean War which is estimated to have killed over one million people and destroyed over one-third of South Korea’s physical capital. Another development during this period, with lasting implications for Korean development, was a major land reform. During 1947-49, farmland previously owned by Japanese landlords was either redistributed or sold, dramatically decreasing the concentration of land ownership. This is perhaps the most important factor in explaining the relatively egalitarian distribution of income in Korea. The second period (1953-60) was one of slow recovery financed by massive foreign aid, primarily from the United States. Foreign aid inflows averaged nearly U.S. $300 million per annum during 1955-59, reaching 16 percent of GNP in 1957. Inflation rates jumped to 60 percent immediately following the war, while output growth remained moderate. Under the complex system of trade restrictions erected by the Syngman Rhee dictatorship, exports grew by only 1.3 percent per year. In contrast, the third period, from 1960-73, saw a dramatic economic turnaround fueled by rapid rates of export growth. Exports grew by 40-50 percent per year during 1960-73, while output grew by more than 10 percent during 1965-73. The economic transition coincided with a change in political regime and economic policy. Syngman Rhee was forced to resign in 1960 after a student uprising. The new government, led by Chang Myon, collapsed in May 1961 following a military coup led by General Park Chung Hee, who remained president of Korea until a second coup in 1979. Under General Park, Korea switched from an import-substitution strategy to an active export-promotion strategy. The first of a series of five-year plans, initiated in 1962, identified investment and economic growth as the

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number one priorities. Other hallmarks of the strategy were extensive government intervention in domestic and international capital markets, the development of close links between government and industry, import liberalization, and the more active use of exchange rates to maintain competitiveness. Foreign aid inflows fell dramatically during the period. During 1960-64, they averaged $210 million per year, over ten times the average annual accumulation of external debt. This inflow dropped to $1 10 million per year during 1965-69, just one-third of the average annual debt accumulation, and to only $28 million per year during 1970-74, or 0.03 percent of the debt accumulation. Foreign aid to Korea had essentially ended by 1975. Gross fixed investment was raised from 15 percent of GNP in 1965 to 26 percent in 1969. To finance the investment, declining foreign aid flows were replaced by increased reliance on external borrowing and by increased domestic saving. Firms (especially exporters) were given strong incentives to borrow abroad. A system of loan guarantees substantially reduced the risks. Furthermore, the real cost of borrowing abroad (in won) turned negative. External debt jumped to 27 percent of GNP by 1969. Difficulties emerged during 1970-72. As growth slowed, domestic savings dropped, increasing the current account deficit and reducing Korea’s debt service ability. A devaluation to stimulate exports exacerbated repayment difficulties for externally indebted firms. The government bailed them out and continued to pursue its investment strategy. Further depreciation was combined with some monetary and fiscal restraint. Taking advantage of strong world demand, exports grew by 90 percent in 1973. Output growth rose to a record 16 percent, stimulating a spurt in domestic saving and pulling Korea out of the first period of debt difficulties. The fourth period (1973-78) included a second period of rapid debt accumulation, economic difficulty, and recovery. It also coincided with a major shift in economic strategy-a renewed industrialization, coupled with increased government intervention. The “Big Push” was a massive investment program in heavy and chemical industries initiated in 1973 both because policymakers feared that Korea’s comparative advantage was shifting away from light industry and because they wished to strengthen Korea’s defense capabilities. The program coincided with a resurgence in inflation, a slowdown in export growth, a rise in the incremental capital output ratio, and a deterioration in the distribution of income. Import restrictions and credit rationing increased, and the exchange rate was fixed (1975-79) and allowed to appreciate. Although widely viewed as a policy mistake, some of the investments (e.g., autos) have begun to pay off. Economic growth slowed during 1974-75 in the aftermath of the oil and commodity price rise. Again, there was a drop in domestic savings, increasing the borrowing necessary to finance the investment program.

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Korea elected to “borrow its way” through the crisis so as to fulfill planned investment and to relax monetary and fiscal policies. As world demand recovered during 1976-78, high growth rates resumed, raising domestic savings and improving the debt position. In 1979 Korea underwent another shift in economic strategy. Motivated by concern over rising inflation rates and economic distortions from the Big Push, the new stabilization plan included monetary and fiscal restraint plus the gradual reduction of price controls, import restrictions, and financial market interventions. However, 1979-82 were years of crisis for Korea. The 1979 assassination of President Park together with a disastrous agricultural harvest and the second oil shock all contributed to a severe economic and political crisis in 1980. The military assumed effective control of the country in May 1980 under General Chun Doo Hwan. Chun formally assumed power in September, promulgated a new constitution in November, and became president in March 1981 when his Democratic Justice Party (DJP) won a majority of seats in the new National Assembly. Chun was succeeded by Roh Tae Woo after the DJP won the December 1987 presidential election. The poor performance in 1979-82 is documented in table 1.1. Output stagnated, actually declining ( - 4.8 percent) during 1980. As domestic savings plunged, the current account deficit mushroomed, financed by massive external borrowing. Korea accumulated over $22 billion of debt during 1979-82, raising its debt stock to 53.5 percent of GNP. Unlike the earlier episodes, the 1979-82 period was an economic crisis, comparable to the crises experienced in many other large debtor countries after the second oil price rise. During 1980-81 the exchange rate was devalued, while the position of monetary and fiscal policies alternated. Korea continued to borrow heavily to maintain investment. By 1982 growth was still low by Korean standards (5-6 percent) and exports stagnated, but inflation and the current account deficits had fallen significantly. The government initiated a more expansionary policy to stimulate growth. As world demand recovered and the terms of trade improved during 1983-84, Korea again underwent a remarkable economic recovery. Growth rates spurted. Savings rose reducing the current account deficit. Authorities responded to the 1985 slowdown in export growth as world demand stagnated with a 6 percent real depreciation and a further 15 percent real depreciation in 1986. By 1986 the economy was booming, inflationary difficulties had been resolved, and there was a substantial trade surplus. In contrast to many of the other large Third World debtor countries currently negotiating rescheduling arrangements with their creditors, Korea not only met all debt service obligations, but began to repay the principal, reducing its debt stock by nearly 5 percent.

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1.2 Overview of the Chapters Four questions emerge from our summary: 1. What caused Korea’s debt crises? 2. How was Korea able to achieve rapid, successful recoveries? 3. What role has external borrowing played in Korean development? 4. What are the lessons for other debtor countries?

Answering these questions involves examining and synthesizing a number of interrelated factors. We focus on the individual factors in the body of our study, bringing them together to address the four questions above in the final chapter. The study is composed of three parts. The first part, chapters 2-5, provides a detailed discussion of Korea’s macroeconomic experience and the role of external debt. The historical background given in chapter 2 is a review of the experience prior to 1962 which set the stage for the impressive economic developments during the 1960s. Chapter 3 gives an overview of external debt, presenting a variety of debt statistics. It highlights the fact that external debt has gone primarily to finance current account deficits and not capital flight. The point is important because it focuses attention on the domestic counterpart to current account imbalance-an excess of domestic investment over savings. It also discusses the process of borrowing in Korea. Chapter 4 examines the three periods of rapid debt accumulation in detail. It reviews the economic and political developments during each cycle of debt accumulation, difficulty, and recovery, discussing the roles of policy and external shocks. Chapter 5 provides a further analysis of the current account deficits which triggered the heavy external borrowing during 1974-77 and 1979-82. Using both accounting decompositions and simulations from a macroeconomic model for Korea, it examines the importance of external shocks in the current account deteriorations. The chronological analysis in part 1 identifies a number of key factors in the experience to be examined individually in the second part of the study (chap. 6- 12). After a brief introduction in chapter 6, we examine economic growth in chapter 7. Chapter 8 analyzes saving behavior and the role of investment and Korea’s five-year plans. Exchange rate, trade, and industrial policy are studied in chapter 9, while in chapter 10 we discuss the important linkages between wages, productivity, and international competitiveness. Chapter 1 I examines monetary and fiscal policy, and income distribution is discussed in chapter 12. Finally, we provide a synthesis of these pieces in part 3 (chap. 13) and discuss the lessons from Korea’s experience.

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Historical Background: Economic Development Prior to 1962

Korea, once known as the "Hermit Kingdom," has been among the fastest growing economies, attracting the attention of both developing and developed countries. The outward-looking strategy, adopted since the establishment of the first five-year development plan in 1962, has led the economy to record impressive growth rates. The economic performance has been cited as the most successful export-led growth among the developing countries. From 1962 to 1984, the Korean economy grew at an average annual rate of 8.4 percent. Within that time, Korea was transformed from a largely agricultural, subsistence economy to a newly industrialized one, despite initially low levels of domestic savings and a lack of natural resources. This chapter briefly describes the sociocultural development, the political history, and the economic factors that brought about the rapid growth in the 1960s.' We divide the period prior to the initiation of the first five-yew economic plan into three subperiods: (1) the colonial period, ending in 1945; (2) the post-liberation and Korean War period from 1945 to 1953; and (3) the construction period after the war from 1954 to 1962. The phases of economic development cannot be completely matched with these subperiods. For example, severe economic dislocations prior to the end of the Korean War could be regarded as starting conditions for later development. Even the later reconstruction process could be viewed as a continuation of the economic rehabilitation program prior to the war, which aimed to overcome the barriers to self-sustaining economic growth with foreign aid. However, political and social changes have a significant impact on the economy, so it is useful to divide the period according to political chronology. Unfortunately, most data in the early period are scattered, and even those available seem to be inconsistent. However, all efforts have been made to gather available information.

2.1 The Colonial Period, 1910-45 Traditionally, China was a suzerain to Korea and, not surprisingly, Korea's trade was dominated by China. But as Japan began to modernize after the Meiji Restoration, it became more powerful and began to exert more influence over Korea. In 1876 Korea could not resist the military pressures from Japan to open trade and signed a trade treaty in Kang-Wha. Other countries such as the United States, Great Britain, China, Germany,

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Russia, Italy, and France followed, coming to Korea and signing similar treaties on trade and commerce. Korea became a battleground for many foreign powers during the late nineteenth century, but Japan’s decisive victories in the Sino-Japanese War (1884-85) and Russo-Japanese War (1904-5) enabled Japan to ward off other foreign powers. Japan’s dominance over Korea intensified and eventually, in 1910, Japan officially annexed Korea. During the colonial period, 1910-45, the colonial government introduced many new social and economic institutions and built agricultural and social infrastructure. Also, a large number of Koreans gained experience in factories and received education at modem schools. As a result, Korea was able to post high rates of growth in both agricultural and industrial sectors by the standards of that time. In addition, colonial forces improved the industrial structure by increasing the share of manufacturing and mining sectors from a mere 4.1 percent in 1910-20 to 26.4 percent in 1938-40. But this structural change had been catalyzed by Japan’s desire to utilize Korea as its logistical base. In a real sense, the period can be labelled as the industrialization of Korea for Japan. The Korean economy was distorted into becoming an adjunct to Japan, controlled by the totalitarian rule of the colonial government. The pattern of trade was typified by the export of primary goods such as rice and mineral ores to Japan and the import of finished manufactured goods from Japan. Also, the industrialization process in colonial times prevented indigenous development of an entrepreneurial class and hindered the emergence of technical and skilled manpower among the Koreans. The ownership of physical capital was also heavily concentrated among the Japanese.

2.2 Post-Liberation Development and the Korean War, 1945-53 Japan’s direct influence over Korea ended with the Second World War. The liberation on 15 August 1945 divided Korea into two regions, and the U.S. Army Military Government in Korea (USAMGIK) was established to control the political and social turmoil and support the transition of South Korea (henceforth, Korea) into an independent republic. However, severe dislocations were associated both with the departure of the Japanese and with the partition of the peninsula. The resources of the two regions were almost completely complementary, with most of the mineral ores and hydraulic power resources concentrated in the North, and the agricultural resources predominant in the South. The South was deprived of its traditional sources of intermediate and capital goods. USAMGIK implemented measures to revitalize the economy which suffered from a drastic decline in domestic production, severe food shortages, rapid population increase owing to an influx of refugees,

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primarily from North Korea, and rampant inflation. Some of the measures, particularly redistribution of Japanese-owned land and modern education programs, laid the foundation for further economic development. USAMGIK also initiated the first foreign trade regulations to eliminate smuggling and attempted to control inflation by rationing essential goods and directly suppressing their prices. These economic rehabilitation programs were implemented with massive foreign aid as discussed below. According to the preset political schedule, the first Republic of Korea was established on 15 August 1948, replacing USAMGIK. Its immediate tasks were to reorganize the governmental administration and reduce social unrest and economic instability following the governmental change. For the most part it adopted USAMGIK’s economic policies, in particular by continuing the land reform, managing the grain supply, and organizing trade and foreign exchange policies. There were times, however, when the U.S. and Korean governments had conflicting opinions about the appropriate forms of foreign assistance, exchange rate management, and monetary and fiscal stance. The abrupt outbreak of the Korean War in 1950 halted the rehabilitation of the economy. The war destroyed production facilities and took the lives of many hundreds of thousands of military and civilian people. The three-year war ended in a stalemate in 1953, with the same hostile forces facing each other. The armistice signed between the Soviet and UN forces left Korea in total devastation and extreme poverty, bringing it back to the starting point of economic reconstruction. We turn next to documenting economic growth, inflation, the role of foreign aid, and the major institutional reforms during this period. 2.2.1

Economic Stagnation

Production fell far below the pre-World War I1 level as both the liberation and sudden partition disconnected the economic links between North and South Korea as well as between Korea and Japan. Average rice production for 1945-64 was 9.3 percent below that for 1940-44. In 1948 manufacturing output was about 15 percent of the 1939 level. As shown in table 2.1, the economy started to recover slowly during 1947-49 as a result of increases in industrial production and tungsten exports until production fell sharply in the first two years of the Korean War. As the war gradually stalemated during 1952-53, production recovered to well above the prewar level. Still, net commodity product for 1953 was 27 percent less than that for 1940 in the southern region, as shown in table 2.2. Table 2.3 also shows that the volume of commercial and governmentfinanced trade flows during the 1946-53 period was almost trivial by preliberation standards. Adjusted for the sharp rise in the wholesale price index, the annual trade volume prior to 1953 never exceeded 7 percent of the 1940 level.

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Table 2.1

Average index

Production Indexes, 1946-53 1946

1947

1948

1949

1950

1951

1952

1953

100

115.1

148.8

208.8

131.8

106.2

183.6

239.6

Source: K. S. Kim and Roemer (1979, 29).

Table 2.2

Net Commodity Product, 1940 and 1953 (in billions of constant 1953 won)

Agriculture Forestry Fishery Mining Manufacturing Total commodity product (net)

26.44 2.62 3.38 0.84 4.44 37.72

Percentage Change

1953

I940 (70.2) (6.9) (9.0) (2.2) (11.7) (100.0)

21.20 1.16 0.43 0.53 4.28 27.60

(76.8) (4.2) (1.6) (1.9)

(15.5) (100.0)

- 19.8

-55.7 -87.3 -36.9 -2.7 -26.8

~~~~~~

Source Kim and Roemer (1979, 35)

Table 2.3

Merchandise Exports and Imports for South Korea, 194@-53 (in millions of won) Current Prices

I940 1946 1947 I948 1949 1950 1951 1952 1953

1947 Constant Prices

Exports”

Imports”

Seoul WPI (1947= 100)

0.48 0.05 1.11 7.20 11.27 32.57b 45.91 194.96 398.72

0.77 0.16 2.09 8.86 14.74 5.2Ib 121.83 704.42 2,237.01

55.0 100.0 162.9 222.8 348.0‘ 2,194.Id 4,570.8 5,951.0

0.4

Exports

Imports

118.75 0.09 1.11 4.42 5.06 9.36b 2.09 4.27 6.70

192.50 0.29 2.09 5.44 6.62 1 SOb

5.55 15.41 37.59

Source: BOK, Economic Review 4 (1949):51, and BOK, Annual Economic Review, 1955. See also Kim and Roemer (1979, 31). Nore: Trade volumes for 1940 represent one-half of all Korean exports and imports. The trade data for 1946-53 include only private and government trade, and thus exclude financed imports, transactions with North Korea, and smuggling. ‘Exports and imports were originally valued in won (yen in 1940) on the basis of f.0.b. export or c.i.f. import prices until March 1951 and thereafter on the basis of domestic market prices (tariffs, domestic taxes, and trade margins were subtracted from domestic prices to estimate the price of imports). bImports and exports made through Inchon and Seoul customs offices during March-June 1950 were not included because of missing data due to the war. ‘Average index for June 1950. dAverage index for April-December in F’usan

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2.2.2 Foreign Aid and Foreign Exchange Regimes Dislocation, poverty, and extreme shortages of many commodities made the survival of South Korea as an independent political entity after the liberation infeasible without massive foreign aid. The United States provided most of the foreign aid mainly in the form of food, clothing, medicines, fuel, and fertilizers to meet emergency needs and to raise rice production toward self-sufficiency. A small amount was spent on reconstruction works. Table 2.4 lists the foreign aid agencies and their contributions. The Government Appropriations for Relief in Occupied Areas (GARIOA) aid program started early in the USAMGIK period, and it provided nearly half of the total aid during 1945-53. The GARIOA program was followed by the Economic Cooperation Administration (ECA) program, which emphasized capital development and restrictive economic policies. Although there were often donor-recipient conflicts over the primary role for foreign aid, pressing demands from the U.S. for economic (especially price) stabilization led to a significant reduction in the money supply before the outbreak of the Korean War. The war reshuffled the entire recovery program, with more emphasis on relief than development. The Civil Relief in Korea (CRIK) program, mainly financed by the U.S., provided almost all assistance during 1952-53, followed by the United Nations Korean Reconstruction Agency (UNKRA) which was multinationally based. These programs financed nearly 70 percent of total imports during 1951-53 as commercial export earnings for imports were almost negligible. Since the export performance was so poor, imports were constrained with trade regulations. Indeed, USAMGIK had initiated strong foreign trade regulations that restricted exports and imports only to licensed traders. Exports were linked to imports by a barter trading system, and imports faced a 10 percent across-the-board tariff. Also, quantitative restrictions were pervasive, and the overvalued exchange system was maintained. Economic Assistance to Korea, 194553 (in millions of U.S. dollars)

Table 2.4

GARIOA ~~~~

~

1945 1946 I947 1948 1949 1950 1951 I952 I953

Total

4.9 49.9 175.4 179.6 92.7

502.5

ECA

CRIK

~~

23.8 49.3 32.0 3.8 0.2 109.1

Source: BOK, Economic Statistics Yearbook. various years.

9.4 74.4 155.2 158.8 397.8

Total

UNKRA ~~

~~

4.9 49.9 175.4 179.6 116.5 58.7

0. I 2.0 29.6 31.7

106.5

161.0 188.4 1,040.9

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The overvaluation of Korean currency had been the focus of conflicts between the U . S . and Korea. Currency overvaluation discouraged exports and, as exports could not match import demand, excess demand for foreign exchange produced a black market in which rates were substantially higher than the official ones. Because foreign exchange earnings from sales to U . S . and UN forces were substantial, the Korean government intended to overvalue its currency to gain more foreign exchange for a given amount of won. The same intent was apparent in the giving of a large won “advance” to the UN Command, the repayment of which in U.S. dollars would occur in due time. Thus, the Korean government was more concerned with obtaining foreign exchange through won sales to the U.S. and the UN than with promoting exports, because of the belief that devaluation would be ineffective in improving the balance. It was thought that the barter system, with some export incentives, tariffs, and strict quantity restriction on imports could effectively reduce the trade deficit. These trade and payment regimes prevailed for the rest of the 1950s without major changes. 2.2.3

War-related Inflation

Very high inflation rates first appeared as strict price controls were removed after the liberation. The price index jumped twenty-five-fold between July and August of 1945, although the issue of notes stayed moderate during the period. Rapid inflation continued in 1946 with a 366 percent increase in prices. However, inflation rates declined steadily during 1947-49, as economic stabilization measures were implemented. Monetary expansion during the Korean War gave a second momentum for hyperinflation. Prices shot up drastically after the outbreak of the war and surged again in the next year with an expansion in government military expenditure. In 1951 the annual inflation rate reached 530 percent. However, as table 2.5 shows, inflation had been reduced to 30 percent by 1953. During 1945-53 inflation rates were high compared with those during the colonial period, reflecting the expansionary effects of banks’ lending to the government for economic recovery and war financing. Also important was the role of aid goods and foreign monies such as U.S. dollars and U.S. military payment certificates (MPCs) that were circulated in the unorganized financial markets in exchange for goods. The hyperinflationary process invoked a flight from money into goods, which in turn brought about a flow of commodities and foreign monies through the unorganized financial markets. While a detailed analysis of this early inflationary episode is beyond the scope of this chapter, it does seem that the provision of massive aid immediately after the war helped to arrest the hyperinflationary bias. 2.2.4

Educational Expansion and Land Reform

Two institutional changes, educational expansion and land reform, seem to have been critical for the subsequent success of export-led development. Both changes were motivated by egalitarianism.

KoreafChapter 2

165

lsble 2.5

Money Supply and Inllation, 194653 Bank of Chosun Notes Issued (in million won”)

Seoul WPI (1947= 100)

Inflation over Previous Period (9%)

3.14 4.70 4.98 8.50 8.76

0.60 0.69 17.0b 1 1.2b ll.gb

15 2,364 - 34 5

December 1944 July 1945 August 15, 1945 September 8, 1945 December 3 I, 1945

1946 I947 1948 1949 1950 1951 1952 1953

Money Supply Index (1947= 100)

Seoul WPI (I947= 100)

Annual Inflation (%)

49.I 100.0 166.2 264.7 458.3 1.588.4 3.148.2 6,762.6

55.0 100.0 162.9 222.8 348.0‘ 2.194.Id 4.570.8 5,951.0

366 82 63 37 56 530 108 30

Source: BOK, Annual Economic Review. 1947. 1955, and Bloomfield and Jenson (1951).

‘The amount of bank notes issued in old won denomination is converted into the presently used won denomination. bMonthly average. ‘Average index for June 1950. dAverage index for April-December in F’usan.

The high aspirations for educational attainment typical of Koreans stems from their cultural traditions. The Japanese had established facilities for primary education, however, these were used to “Japanize” the Koreans. All instruction was in Japanese prior to 1945. Furthermore, the opportunities for higher education were extremely limited. The liberation opened the way to the higher education that was a prerequisite for social advancement. An extensive public education system (with instruction in Korean) was initiated during the USAMGIK period. The initial focus on elementary levels was followed by a rapid expansion of the school population in higher education. Another social program that modernized Korea on a egalitarian basis was land reform. The measure was first implemented by USAMGIK in 1947 by distributing farmland previously owned by the Japanese to the tenants. The new Korean government continued the process in 1949, so that most of the land had either been redistributed or sold privately by landlords who had anticipated the redistribution. As a result, the number of farmers owning all the land they farmed increased dramatically, and the number of tenants fell from 48.9 percent of the total in 1945 to just 5-7 percent by 1952. The reform effectively reduced the concentration of land ownership, and it led to further-reaching social consequences: it ushered in the decline of the

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landlord class which had formed the backbone of the traditional society for centuries. In sum, the two institutional changes put Korea in a far better position to achieve growth with relative equity than many other developing countries. Equity and income distribution are discussed further in chapter 12.

2.3 The Postwar Reconstruction Period, 1954-62 When the Korean War ended with the armistice in 1953, all efforts were made to reconstruct the infrastructure and industrial facilities of Korea. The government endeavored to curb inflationary pressures, viewing inflation as a stumbling block to the effective implementation of monetary, fiscal, and trade policies. However, continuing hostility between North and South Korea necessitated big military spending that otherwise would have been used for reconstruction and stabilization. Thus, reconstruction, stabilization, and strong defense were the main tasks of the government after the war. No doubt the government was also concerned about economic growth, but it remained of secondary importance. 2.3.1 Slow Economic Growth with Import Substitution With the aid of the reconstruction and stabilization programs of the aid agencies, the economy grew at 4.1 percent during the period from 1953-55 to 1960-62, and the industrial sector grew over 10 percent per year (table 2.6), with its share of GNP increasing from 13.6 to 18 percent. Table 2.6

Economic Growth, 1953-62 (in percentages) Industry

Year

Primary

Total

1954 1955 1956 1957 1958 1959 1960 1961 1962

6.7 2.7 -5.8 9.4 6. I -0.9 -0.5 11.8 -5.0

20.0 17.1 13.3 11.8 8.1 11.3 6.7 4.6 14.0

2.0

10.8

45.2 39.9

13.6 18.2

Average 1953-55 to 1960-62 Share of GNP 1953-55 1960-62

(Manufacturing)

Services 2.5 5.7 4.0 5.8 3.5 7.5 2.8

GNP

(Commodity Export) 36.0)

( - 20.3)

8.9

5.5 5.4 0.4 1.7 5.2 3.9 1.9 4.8 3. I

(13.2)

4.3

4. I

(7.6)

(10.5) (13.8)

40.0 41.0

100.0 100.0

- 1.1

Source: BOK, National Income in Korea, 1975. Nofe: Percentages based on constant I970 market prices

(-

( - 27.9)

(42.1)

(1.5) (11.3) (54.1) (22.7) (30.0)

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Industry grew at a much faster rate than agriculture because industry began from such a low base after the devastation of the war. Still, the major source of industrial growth in the 1950s was the government’s policy of import substitution. A study by Frank, Kim, and Westphal (1975) showed that the direct contribution of import substitution to the growth of the manufacturing sector was far greater than that of export expansion and that the shares of exports and imports in GDP were appreciably below Chenery’s estimates of the structural “norm” of countries at similar stages of development and capital flows (Chenery, Robinson, and Syrquin 1986). 2.3.2 Aid, Trade, and Payments Foreign aid and the trade and payments regimes were highly interdependent. As the value of commodity imports in current U.S. dollars was more than eleven times the value of exports on average from 1953 to 1962, foreign aid financed commodity imports. The major sources of foreign exchange were aid and the local currency expenditures of the UN forces. When aid imports were sold in the domestic market, the sales receipts were deposited in “counterpart funds.” The Korean government could then use those funds only for purposes mutually agreed upon with the American government. Therefore, the impact of aid on Korean economic policies, either through the commodity imports or the counterpart funds, was tremendous because the inflow of commodity imports was crucial to economic reconstruction and price stabilization and because the government deficit was largely financed by counterpart funds. In this situation conflicts were bound to arise between the aid donor and recipient about the objectives of aid flows. The frictions centered on whether the primary objective was aid to finance economic reconstruction or to attain self-sufficiency. Table 2.7 quantifies the significance of foreign assistance. Unfortunately, the foreign aid figures do not coincide according to sources and coverage of foreign aid. In addition to data problems, the overvaluation of the won leads to an underestimation of aid and imports as a fraction of GNP. Aid, however, seems to constitute over 70 percent of imports during 1953-60. The trade and payments regime continued t