THE INDONESIAN economy suffered from rapid inflation during the first half of the 1960’s, culminating in an increase of over 1,500 per cent in the Djakarta price index during the 12-month period ended June 1966. Mismanagement and inflation severely disrupted the economy and this in turn accentuated the inflationary impact of continuing monetary expansion. At the time of the political upheaval late in 1965, it was clear that unless a major effort were made to restore relative price stability, the country was faced by complete economic collapse. Accordingly, in October 1966, as soon as the new Government had consolidated its position, it launched an economic stabilization program.
Inflation is essentially an economic problem, the solution of which requires appropriate economic measures. A successful stabilization program, therefore, requires that political conditions permit the design and execution of policies that are internally consistent and coordinated. During the stabilization period, a group of high-ranking government officials, who enjoyed the unqualified support of the Indonesian Government as a whole, were responsible for formulating economic policy. In view of the difficult, and often unpopular, policy decisions that were required, this political solidarity was essential. Also important was the support in the form of economic aid and technical assistance given by the international community to Indonesia throughout the stabilization period. Substantial amounts of foreign aid were provided by a group of western countries and Japan—the Intergovernmental Group for Indonesia, with the Netherlands as chairman—who met regularly with representatives of the Indonesian Government and of the international institutions to review the progress of the stabilization program and to consider the need for additional aid. Agreements were also made between Indonesia and its creditor countries, rescheduling the debt obligations that were outstanding at the beginning of the stabilization period. Staff members of the International Monetary Fund assisted the Indonesian authorities in formulating the stabilization program, and early in 1967 the Fund assigned a resident representative to Indonesia to advise on economic policy. The Fund also served as a liaison link between the Indonesian Government and the foreign governments that were aiding the stabilization effort. Beginning in 1968, the Fund extended financial support to Indonesia under the first of successive stand-by arrangements. In the second half of 1968, the World Bank also established a resident mission in Indonesia, mainly to assist in long-term development planning.
At the outset, most observers believed that the restoration of price stability would require several years. However, the actual progress of the stabilization program belied this initial skepticism; from 639 per cent in 1966, the increase in the Djakarta consumer price index decelerated to 113 per cent and 85 per cent in 1967 and 1968, respectively, and to 10 per cent in 1969. This remarkable achievement, which has few if any parallels in recent years, reflects the determined implementation of comprehensive economic policies over a three-year period. Although specific circumstances may differ in other economies, the success of the Indonesian stabilization program may provide valuable guidance on how rapid inflation can be controlled.
THE STABILIZATION PROGRAM
The stabilization program was aimed not only at restoring relative price stability as an essential prerequisite for orderly long-term economic growth and development but also at achieving this aim quickly. The Indonesian authorities recognized that an effective program would impose hardship on the general public as economic resources were directed away from current consumption to productive uses, and they were especially concerned, therefore, that the period of hardship should be brief. This concern was reflected in the fiscal and monetary policies adopted by the Government, which sought to curtail less essential budget expenditures and to eliminate the large operational losses of many public sector enterprises, while providing bank credit for agricultural, industrial, and essential distribution activities. A major effort was made to increase current budget revenues, which had declined sharply during the early 1960’s, in order to balance the current budget and later to provide funds for financing the development budget. The emphasis on economic growth and development was also reflected in the establishment in 1966 of a National Planning Board for coordinating development activities and for preparing a long-term development plan.
On the external side, Indonesia had accumulated large foreign debts during the inflationary period, while its export earnings had declined because of economic dislocations. It was very important, therefore, for the success of the stabilization program that Indonesia was able to reschedule most of the foreign debt maturities that were due during the stabilization period and to obtain substantial amounts of new foreign aid. In addition to relieving the balance of payments pressure by providing foreign exchange resources for financing essential imports, the foreign aid program generated counterpart funds that were a major factor in the noninflationary financing of the budget deficit throughout the stabilization period.
These specific economic measures, important as they were, represented only a part of the attack on inflation. Equally important was the basic change away from a government-directed economy toward a system in which market forces played a predominant role. This change was evidenced by permitting public utility prices and other administered prices to rise to economic levels, and by the decision to introduce an exchange system virtually free of restrictions on payments, with flexible exchange rates for most transactions. Although the public sector retained a predominant role in the economy, much greater scope was given to the private sector, and direct foreign investment was encouraged.
The government budget deficit had been the principal factor in the past inflation, reflecting a serious deterioration in tax administration and a large increase in current expenditures. Between 1960 and 1966 the ratio of budget receipts to national income is estimated to have declined from about 10 per cent to about 4 per cent, and the current account deficit in 1966 amounted to over 90 per cent of current receipts. The Government’s economic program, therefore, gave high priority to a major improvement in the fiscal field, including the early elimination of bank financing of the budget deficit. Current budget expenditures, including wages and salaries of government employees, were maintained at an austerity level throughout the stabilization period, and a concerted effort was made to increase current budget receipts through improved fiscal administration. As a result of these measures, the current budget deficit was reduced to 20 per cent of current receipts in 1967, while the over-all deficit was only about 5 per cent of total budget receipts, because of aid counterpart receipts in excess of development expenditures. In 1968 both the current budget and the over-all budget were balanced, and in 1969 there was a sizable surplus on the current budget while the over-all budget remained in balance. By the end of the stabilization period, it was estimated that domestic budget revenues had been increased to about 8 per cent of national income.
The achievement in the fiscal field reflected the determination of the authorities to limit budget expenditures to available budget resources. In a country ravaged by inflation, this policy of course involved the postponement of many urgent expenditures, especially for maintenance of public facilities and for adequate government salaries. To ease the implementation of fiscal policy in a rapidly changing economic situation, procedures for quarterly budget programing were introduced early in the stabilization period. Thereafter, quarterly expenditure programs were prepared regularly on the basis of projected receipts, and with allowance for seasonal variations in both budget expenditures and receipts. Once the quarterly program had been approved, expenditure authorizations were limited strictly to the program amount, unless budget receipts exceeded the original estimate, in which case authorizations were usually increased by an equal amount. On the other hand, if there was a shortfall in actual receipts, the expenditure program for the following quarter was adjusted accordingly.
On the receipt side, emphasis was placed on increasing customs duty collections, direct tax revenues, and proceeds from excises and sales taxes. At the customs, the average effective tariff rate on imports was increased substantially by the use of a realistic accounting rate for determining the local currency value of imports on which the duty was levied. A sales tax on imports was introduced, and close attention was paid to improving customs administration and to reducing underinvoicing of imports and other irregularities. This effort resulted in a sharp increase in proceeds from import levies, which rose by about 115 per cent in real terms between 1967 and 1969/70,1 while total imports increased by only 60 per cent, including a relatively larger share of low-duty or duty-free imports. Equally impressive increases were recorded in revenue from the domestic sales tax and general excises, owing to improved administration and increased economic activity, and in income tax collections, especially from oil companies.
The most striking increase, however, was in excise and sales taxes on petroleum products, which rose more than sixfold in real terms between 1967 and 1969/70, from 2.6 per cent of current receipts to 7.5 per cent. Before 1966 petroleum products, including kerosene for household use, had been sold at a small fraction of production cost. Soon after the introduction of the stabilization program, and at intervals thereafter, the prices of all petroleum products were raised in order to eliminate the huge implicit consumer subsidies and to generate budget revenue. These and similar adjustments in public utility prices had a very sharp impact on the cost of living and were, therefore, among the most difficult and courageous decisions taken by the authorities during the stabilization period. However, they are a clear example of the basic change in fiscal policy that was an integral part of the stabilization program.
As noted before, the counterpart of foreign commodity aid was an important source of budget receipts during the stabilization period. The Indonesian Government, however, attached great importance to financing all current expenditures from current receipts while assigning aid counterpart funds to development. This objective was not fully realized in 1967, but beginning with the 1968 budget, all counterpart proceeds were used exclusively for financing development expenditures. By 1969/70, the first year of the Government’s Five-Year Development Plan, the current budget position had improved sufficiently to generate a surplus equal to about 30 per cent of development budget outlays, excluding foreign project aid disbursements.
The rate of monetary expansion during the stabilization period, although still rapid, decelerated sharply. Money supply, which increased by 760 per cent in 1966, rose by about 130 per cent and 120 per cent in 1967 and 1968, respectively. Even in 1969, when relative price stability was largely restored, money supply increased by as much as 60 per cent, reflecting a return to a more normal level of real liquidity in the economy. Most of the increase in money supply reflected nongovernment bank credit, which increased by 388 per cent in 1967 and further by 306 per cent and 85 per cent in 1968 and 1969, respectively. The process of stabilization, therefore, could tolerate a high rate of monetary expansion as long as new credit was directed primarily to essential economic activities, rather than to financing current budget deficits or the losses of public utilities, and provided that the balance of payments impact of the expansion could be met by available foreign exchange resources including foreign aid. Central bank credit represented the major part of the monetary expansion, especially during the first two years of the stabilization program, as the authorities sought to eliminate the physical shortages of essential consumer and production goods, which were a major factor in the inflationary spiral. This primary credit expansion was essential to the Government’s objective of restoring price stability while expanding over-all domestic production, because the level of real liquidity in the economy had been reduced by about 60 per cent during 1960-66, and the capital resources of both business enterprises and the commercial banking system had been largely depleted by the inflation.
DJAKARTA CONSUMER PRICE INDEX
Inflation in Indonesia was due not simply to excessive monetary expansion but also to a serious breakdown of public confidence in the currency and the emergence of critical supply bottlenecks and the disruption of production. The importance of nonmonetary factors was vividly demonstrated by developments late in 1967 and early in 1968, when a rice shortage coincided with speculative demand for foreign exchange which could not be met from official reserves. As a result, the price of rice increased by about 100 per cent in one month alone, the free market foreign exchange rate depreciated by 42 per cent in three months, and the general price level rose by 82 per cent from October 1967 to February 1968. Subsequently, despite an increase of 57 per cent in money supply, the Djakarta price index rose by only 11 per cent during the six-month period after March 1968, when supplies of food and foreign exchange became more adequate. The periodic sharp adjustments in public utility prices and in the prices of oil products, although important as a part of the stabilization program, also tended to have an inflationary impact on the economy. However, after relative price stability and confidence in the currency had been restored, an increase of from 50 per cent to 150 per cent in the prices of important oil products in January 1970 had little noticeable effect on other prices.
Interest Rate Policy
Interest rate policy was largely passive during the first two years of the stabilization period, and real interest rates on bank borrowing were generally negative, except in the relatively small private banking sector. No attempt was made to generate private savings deposits while the rate of inflation remained very high. In October 1968, however, amidst increasing indications that inflation was being contained, a savings deposit scheme was introduced. Under the scheme, state commercial banks paid an interest rate of 6 per cent a month for 12-month deposits and somewhat lower rates for 3-month and 6-month deposits. Although the level of interest rates was lowered in March 1969, the central bank had to subsidize the interest cost to the commercial banks, which until May 1969 exceeded the average rate of interest earned on their loans.
The savings deposit scheme proved very successful. After a sharp speculative attack in the foreign exchange market late in 1968 had resulted in a heavy loss for the speculators, and with increasing domestic price stability, time deposits rose by 175 per cent during January-April 1969, increasing from about 11 per cent to about 25 per cent of money supply. In retrospect, these developments marked an important turning point in the stabilization effort; the foreign exchange speculation was the last of several encountered during the stabilization period, and the increase in time deposits marked the restoration of confidence in the currency and the beginning of a rapid reconstitution of the economy’s real liquid holdings.
Credit policy was unquestionably one of the critical factors in the Indonesian stabilization program. As already indicated, its basic premise was that extension of credit to existing production units for financing rehabilitation and working capital requirements would facilitate the fight against inflation through its impact on production for the domestic market and for export. Therefore, for the first two and a half years of the stabilization period, most bank credit was extended for short-term current financing rather than for medium-term investment financing. However, a limited amount of investment funds was provided through the Government’s development budget and through the disbursement of foreign project aid. With the return of relative price stability, a medium-term investment credit program was introduced in April 1969, financed primarily by the central bank and by budget funds. Although comprehensive statistics are not available, import and export data as well as other indicators strongly suggest that the stabilization period was marked by a substantial increase in economic activity.
The Indonesian case, therefore, clearly contradicts the popular belief that stabilization needs to entail economic stagnation or recession. Provided that available resources are allocated primarily on the basis of economic criteria, stabilization can indeed proceed simultaneously with economic growth.
Balance of Payments Policy
The policies adopted by the Indonesian Government in the external sector were the third major component of the stabilization program. During the first half of the 1960’s the foreign exchange system itself had become an important distorting factor in the economy as the authorities sought to cope with continued pressure on the balance of payments by introducing a vastly complicated system of exchange allocation and multiple exchange rates—which, in the absence of effective measures to deal with the underlying monetary causes of the imbalance, was quite ineffective. By 1966 export production was declining, partly because of heavy taxes on export proceeds; there were critical shortages of imported raw materials and spare parts in most sectors of the economy; and additional foreign assistance was increasingly difficult to obtain. Moreover, new foreign investment had practically ceased following the nationalization of most foreign-owned enterprises in 1964 and 1965. Since, in addition, repayments of past debts were falling due, Indonesia faced external insolvency.
One of the first tasks of the new Indonesian Government was accordingly to negotiate debt relief agreements with its creditors. The first such agreement was reached in 1966 with the major western creditors and Japan; subsequently, there were annual agreements on the rescheduling of debt maturities falling due each year. Separate agreements were negotiated with Indonesia’s East European creditors. As a result of these agreements the otherwise heavy burden of debt repayment was lifted from the balance of payments during the stabilization period.
In addition, substantial amounts of new foreign aid were provided by a-number of western creditor countries and Japan, which joined in a consultative group under the chairmanship of the Dutch Government to consider Indonesia’s annual aid requirements. Throughout the stabilization period a large part of the aid was used to finance imports of essential consumer goods and raw materials, but an increasing share was earmarked for financing development projects. The local currency counterpart of the nonproject aid was also the chief means of financing Indonesia’s development budget. The importance of nonproject aid for the balance of payments is reflected in import statistics: excluding project imports and imports for the oil sector, total imports increased by 25 per cent in 1967 and further by 11 per cent in both 1968 and 1969, while the share financed by aid increased from 23 per cent in 1966 to 34 per cent in 1968. In 1969 the ratio declined to 30 per cent.
Indonesia’s own foreign exchange earnings also increased substantially during the stabilization period from $714 million in 1966 to $975 million in 1969; during the three years 1967-69 oil exports rose by 67 per cent, to $358 million, and other exports by 24 per cent, to $617 million. Export promotion was an important aspect of the new Government’s policy, as shown by the decrease in official exchange taxes on exports from as much as 50 per cent at the end of 1966 to less than 15 per cent at the end of 1969.
In determining their long-term strategy for economic growth, the Indonesian authorities recognized that early development of the country’s substantial and varied natural resources would require a large inflow of foreign capital and technical skills. In line with their basic policy of developing an open economy, they decided to encourage private foreign capital investment and to return foreign properties that had been taken over by the State to their former owners. A special foreign investment board was established to negotiate agreements with individual foreign investors, and work was started on a complete revision of Indonesian company and taxation laws to adapt them to prevailing international standards. In addition to approved projects in the oil sector in which there is great interest by foreign investors, foreign investment proposals involving potential capital outlay of over $1.0 billion had been approved by the end of 1969. The largest part, $463 million, represents investment in the mining industry, and an additional $353 million investment in the forestry sector.
Foreign exchange transactions during the stabilization period were conducted mainly in two markets, called the BE (Bonus Export) market and the DP (Complementary Foreign Exchange) market, each of which had a flexible rate. The BE market was by far the more important of the two and included the major part of exports and imports, government transactions, approved foreign investments, and certain invisibles. Exporters of nonoil commodities were permitted to sell a certain part of their export proceeds in the DP market, where the exchange rate tended to be about 15 per cent more depreciated than the BE rate. In addition, the DP market covered less essential imports, miscellaneous capital flows, and nontrade invisibles.
In the foreign exchange field the abolition of the old system of payment restrictions and direct allocation of exchange was a major element in the stabilization program, as was the establishment of a system of flexible exchange rates. These changes, which were introduced at the beginning of the stabilization period in October 1966, ensured that the foreign exchange resources of the economy would be allocated on the basis of market demand and supply and at a price set by the market itself, rather than through arbitrary administrative decisions. The authorities recognized, of course, that the foreign exchange rate is an important factor in any inflationary spiral, and that depreciation of the rate would have a multiplier impact on the general domestic price level. However, in their exchange rate policy, as in their decision not to restrict capital movements through the secondary exchange market, the authorities chose not to address themselves to the symptoms of inflation and external imbalance but to attack the underlying causes. Apart from the greatly improved allocation of foreign exchange resources under the new system, complemented, of course, by the Government’s credit and fiscal policies, the freedom of transactions itself was an important psychological factor in the restoration of confidence and reflected the Government’s own confidence in the ultimate success of its stabilization effort.
The Indonesian Government moved consistently between 1966 and 1969 toward a unified foreign exchange system. Unification, however, was not considered desirable until confidence in the domestic currency had been restored, because of the possibility of permitting speculative outflow of funds at a more depreciated rate through the DP market without having to adjust the principal exchange rate itself. The two exchange rates fluctuated freely during the first half of the stabilization period. However, by May 1968 the disequilibrium in the domestic economy had been substantially reduced and the prospects for an early restoration of relative price stability appeared favorable. Therefore, a new policy was introduced for exchange rate management in the BE market, whereby short-term fluctuations in the rate were eliminated. The authorities continued, nevertheless, to permit the BE rate to move according to basic market conditions. At the end of October 1968, a similar policy was adopted with respect to the DP market, and after March 1969 the two rates were kept stable, with the DP rate 15 per cent below the BE rate. This stability prepared the ground for the unification of the exchange rates in April 1970.
The introduction of a major exchange reform on April 17, 1970 may be regarded as marking the end of the stabilization period. Under the reform, the BE and the DP markets were unified at the DP rate of Rp 378 = US$1. With the exception of program aid funds for commodity imports and related services, which continue to be sold at the previous BE rate of Rp 326, all trade, capital, and invisible transactions are effected without restrictions at the unified rate of Rp 378. This reform culminated the efforts of the Indonesian Government throughout the stabilization period to improve the efficiency of the foreign exchange system and to rely on monetary, fiscal, and trade policies to attain their balance of payments objectives.
Considering the severity of the inflationary problem, the success of the Indonesian stabilization program was a remarkable achievement. Although circumstances will differ in other countries faced with rapid inflation, the basic approach of the Indonesian program represents a promising model of anti-inflationary policies. The principal factor in the Indonesian case was the clear recognition from the outset that a stabilization program could not succeed if it did not attack directly the underlying causes of excessive monetary expansion, i.e., the budget deficit and other public sector deficits. The second important factor was the implementation of a selective credit program, which directed new bank credit to economic activities that were essential for the elimination of supply bottlenecks and for the reactivation of existing production facilities, rather than for financing new investment. A third major component was the dismantling of the previous, complex foreign exchange system and the maintenance throughout the stabilization period of a liberal trade and payments system in which the exchange rates were permitted to move according to underlying demand and supply conditions.
The stabilization program did not proceed without encountering temporary difficulties and setbacks, some of which had not been foreseen at the beginning of the period. In meeting each of these, however, the Indonesian authorities consistently sought to apply corrective measures that were consistent with the basic strategy of the stabilization program, rather than to deviate even temporarily from that strategy. This consistency was an important factor in restoring public confidence in the Government’s economic policies and, therefore, was essential for the success of the stabilization program.
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From April 1, 1969, the Indonesian fiscal year was changed to cover the period April/March instead of the calendar year.