3 Obstacles to Continued Reform: Indonesia’s Experience

Laura Wallace
Published Date:
May 1997
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Dahlan M. Sutalaksana

When indonesia embarked on a more rational attempt to develop its economy at the end of the 1960s, it designed a series of economic reforms to support the implementation of its string of Five Year Plans. I would like to briefly review these reforms and the motivations behind them, and then see what lessons we can draw from Indonesia’s experience in overcoming obstacles to continued reform.

Economic Reforms in the 1970s

The first major reform was the liberalization of the foreign exchange system in 1971, replacing the previously controlled regime. The objective was to restore the balance of payments to a sustainable position, as it had severely deteriorated since the early 1960s because of the previous government’s inappropriate policies. Given that Indonesia is a long stretch of islands, with a heavy dependence on international trade, a liberal foreign exchange system was considered to be a precondition for building a strong international base for the economy.

Nevertheless, this policy was not without difficulties. Following the collapse of the Bretton Woods system in the early 1970s, which gave rise to more active—and, at times, volatile—international capital movements, there was a need for a more flexible domestic monetary policy to minimize the impact of this volatility on the economy. One of the necessary conditions for a successful liberal foreign exchange policy is to avoid excessive domestic inflation, while keeping interest rates at competitive levels. In principle, the rule is to create a stable economic environment by sticking to a balanced budget policy, sterilizing capital inflows, and attuning bank credit expansion to the required level of money demand.

Soon after Indonesia began implementing its first Five Year Plan, it became clear that oil would serve as the major determinant of economic growth. Indeed, the record shows that during 1973–83, the economy was extremely dependent upon oil exports. Oil exports were the main source of foreign exchange reserves. Government revenues from oil averaged 52 percent of total government revenues annually and 64 percent of total domestic revenues.

The oil windfall led to a large increase in liquidity and brought renewed inflationary pressures. Thus, in an effort to avoid the negative effects of the oil boom on economic stabilization—and economic development in general—the government adopted a monetary policy based on the use of direct controls. In April 1974, the government imposed credit ceilings on individual banks, along with interest rate ceilings on state bank loans and deposits, as a means of checking excessive domestic money growth. At the same time, Bank Indonesia furnished the banks with liquidity, so they could make large amounts of credits available at lower lending rates. A certain amount of credit was also directly allocated to priority sectors in conjunction with government programs.

Direct monetary control succeeded in controlling inflation and stimulating economic progress. But the end of the oil boom, followed by a world recession in the early 1980s, hit Indonesia hard. Economic growth, which had reached a high of 9.9 percent in 1980, slipped to 7.6 percent in 1982 and then to 2.3 percent in 1983. The balance of payments deficit widened from US$395 million in 1981 to $1,391 million in 1982, after having posted continuous surpluses since 1970. It was clear that although Indonesia had achieved some of its economic goals, it remained highly susceptible to world recessions and sharp economic fluctuations.

Economic Reforms in the 1980s and 1990s

The government responded in the early 1980s by instituting a set of economic reforms—known in Indonesia as “deregulation and debureaucratization”—that included a major restructuring of the financial sector.

In January 1982, the government introduced a new policy to promote nonfuel exports, which included lowering the interest rates applied to export credits, reducing export credit requirements, and increasing the number of export facilities. On March 30, 1983, the government devalued the rupiah by 28 percent1 in an effort to boost the competitiveness of traded goods. At the same time, it reconfirmed that it would adhere to a managed floating exchange rate system, free of foreign exchange controls. It also reduced certain subsidies on food and a few other commodities, and rescheduled some large development projects to place less stress on the balance of payments.

Following these actions, the government embarked on a drastic reform of the financial sector, which was hindering the mobilization of funds and doing little to raise the efficiency and professional management of bank operations. Moreover, with the sharp drop in revenues from oil exports, it was expected that the government would confront heavy constraints in pursuing economic development. Clearly, the private sector would have to take on a much greater role in the economic development process—and that meant helping the financial institutions find a way to mobilize more funds for this group. The promotion of small- and medium-scale entrepreneurs2 was also encouraged to reduce the productivity discrepancies among different scales of economic actors.

One of the major financial sector reforms was the October 1988 Deregulation Policy Package (PAKTO 1988), aimed at improving the functioning of the money and capital markets. Bank reserve requirements were lowered from 15 percent to 2 percent. The government switched to an indirect monetary policy, intensifying the use of Bank Indonesia Certificates and other money market securities in open market operations. Tax treatment in the money and capital markets was streamlined to equalize the competitiveness between the two markets—as well as to balance the availability of short- and long-term funds by allowing market forces to prevail. The development of venture capital, leasing, factoring, and insurance was also encouraged as a source of long-term funds.

All in all, the measures were intended to intensify competition in the financial markets, encourage new channels for financial intermediation, and reduce the cost of intermediation. It was also hoped that the higher savings would support export activities, which were expected to take off, in part thanks to several new international trade measures.

  • In 1985, the government took the unprecedented step of “virtually abolishing” the Indonesian custom services—temporarily turning over customs responsibilities to the Geneva-based Societé Generale de Surveillance. Importers were freed from red tape, enabling them to reduce import costs and save time.

  • In May 1986, a duty drawback facility was set up. Exporters could import their inputs duty free and directly, regardless of licensing restrictions that applied. The administration of the facility has been regarded as efficient, and the facility has substantially reduced the cost of exports, in turn boosting competitiveness.

  • More recently, deregulation steps are aimed at strengthening Indonesia’s ability to confront the globalization process. Indonesia is systematically abolishing nontariff barriers and gradually reducing custom duties to conform with requirements of the World Trade Organization.3

These reforms are naturally being taken in tandem with measures in the real sector, such as reducing restrictions on foreign direct investments, in an effort to enhance Indonesia’s competitiveness in the century ahead.

Obstacles to Reform

What conclusions about economic reform can we draw from Indonesia’s experience? It is obvious that the basic objective of economic reform is to gradually reduce market failures and to enable the economic system to become efficient, thereby maximizing national welfare. Thus, economic reform is a continuous process of adjusting economic conditions to create a macroeconomic climate—under a set of constraints relevant to the country4—that will be instrumental for the microeconomic decisions and activities that lead to an efficient economic system.

For Indonesia, which falls under the classification of a small and open country, the strategy is a very straightforward one: to promote an efficient economy sufficiently conditioned to a competitive international market. Naturally, in the process, Indonesia needs to confront a number of obstacles, covering political, cultural, geographical, demographic, and ethnic considerations.

In gearing up the Indonesian economy to reach efficiency, reform has focused on three key components: getting the prices right, making the market mechanism work, and reducing “bureaucratic costs.” Let us examine these, one by one.

Getting the Prices Right

The goal of adjusting prices is to nudge especially the key prices in an economy to a level where they reflect the real value of commodities and resources exchanged.

In the past, Indonesia had subsidized key commodities, including petroleum products and basic foods such as rice, wheat, and sugar. But by reducing and to some extent eliminating the subsidies in recent years, price determination of these commodities is now left to the market. This has encouraged producers, including farmers, to produce more food staples—to some extent bringing Indonesia to the point of self-sufficiency in rice. This is a position that Indonesia had never even dreamed of, given its history over the past century of always importing rice from its South Asian neighbors.

Needless to say, eliminating subsidies is not an easy job for policymakers since it is a highly politically charged issue. Producers will welcome such a move, but consumers, who have enjoyed lower prices, will not. Thus, policymakers will need to be courageous, carefully weighing questions of political stability. For example, Indonesia’s recent decision to increase the domestic fuel price is a very sensitive one—-one that will not enhance the government’s popularity. Nevertheless, continually subsidizing this commodity would have placed a lasting and growing burden on the budget, in turn draining resources needed for other programs.

Making the Market Mechanism Work

The goal in this area is to create an atmosphere that is conducive for the market to set prices without any intervention by the authorities. This will keep the process of developing efficient prices on the right track, in turn improving resource allocation.

Of course, this is easy to say but difficult to execute. Although everybody knows that the remedy for ailing economies is to let the market take care of itself, opposition will come from virtually all directions. First, it will come from those who are benefiting from special privileges of procuring certain commodities both for consumption and as inputs in manufacturing. Second, it will come from consumers, such as city dwellers who are used to lower prices for consumer goods, especially food staples. Clearly, the government will not be able to satisfy everybody, as there will be conflicting interests.

Indonesia’s experience suggests that as long as the government holds firm, market participants will adjust to the new conditions, although of course not immediately. The government’s strategy should be to eradicate obstacles gradually, in a sympathetic but systematic way—if necessary through indirect measures that will bring the market mechanism into play. Moreover, once the financial market becomes more competitive, it will help bring the whole economy, including the real sector, to a market-based system with minimal intervention. Efficient price determination through a market mechanism is a sine qua non for enhancing the global competitiveness of Indonesian products. Competition also forces producers to place more weight on an efficient manufacturing strategy, which in turn will reduce costs and ultimately boost productivity and profits. In addition, producers will be able to find a favorable niche and survive in the global market.

For Indonesia, two other special considerations have surfaced. First, the world’s largest island country has had to contend with unbalanced regional conditions. For example, Eastern Indonesia has been left behind in certain areas of development—even sometimes in agriculture—owing to unbalanced demographic spreads (i.e., lower population). Second, some ethnic groups are still demanding government intervention in certain sectors of the economy, such as land ownership. Thus, the government needs to carefully and wisely address this issue, because if mishandled it could create a crisis that would quickly spiral out of control.

Reducing Bureaucratic Costs

This third component of reform is rather difficult to execute, but the problem is without question a source of high economic cost. It involves a nonmarket allocation of “rent” going to the institutions, as well as to the bureaucrats themselves. Thus, reform must embrace institutional reform, including interinstitutional relations, and organizational reform within the bureaucratic system, including the supervision aspect.

Policymakers sometimes ignore the importance of reforming bureaucracies, especially due to the fact that it takes years to succeed. But unless institutional reforms are made, bureaucracy will hinder the process of making market mechanisms work—possibly negating the fruit of the reform itself.

Needless to say, one of the strategies is to establish an environment of discipline. This includes budget discipline, banking and monetary discipline, and bureaucratic discipline (e.g., relations among the various governmental agencies). Of course, it also helps if the affected bureaucratic elements understand the necessity of the reform. Indonesia’s experience with reforming the customs service is a good example, underscoring that even an extreme reform can be executed smoothly with relatively little conflict, providing that everybody understands and accepts the objective.

Concluding Remarks

In sum, the Indonesian experience tells us that it is very hard to differentiate economic reforms from policy adjustment. One may say economic reform is an activist policy, while policy adjustment is reactionary, when, in fact, economic reform also involves a series of adjustments. However, it is true that the rationale behind the economic reforms may include a long-term impact, whereas the rationale behind policy adjustment may be focused on short-term considerations. Moreover, the series of adjustments to the long-term vision of reform will be necessary to remove the obstacles that policymakers encounter.

This brought the rupiah to Rp 970 per U.S. dollar, following a 1978 devaluation of 34 percent; later, in 1986, the rupiah was devalued by another 31 percent.

Also includes the nonformal sector and petty traders.

Indonesia is actively preparing itself to conform with conditions of its membership in the World Trade Organization and goals of regional economic agreements (e.g., the expected completion of the Asian Free Trade Arrangement in 2003, and the goal of free trade for developing economy members of the Asia Pacific Economic Cooperation Forum in 2020).

Indonesia adopts a working definition known as the development trilogy: stability, growth, and equity, which essentially combines objectives and targets in interchangeable order.

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