Compared to other countries in the region, economic performance has been disappointingly modest in Indonesia since the Asian liquidity crisis. Overly tight fiscal policy courtesy of the IMF has prevented any recovery of domestic investment, containing gross domestic product growth. Without increased public sector expenditure, Indonesia's one-dimensional economic growth will slow in 2005, triggering capital flight and rupiah depreciation.
Regional Laggard
Between 1999 and 2003, annual average GDP growth in Indonesia was 3.4%. Over the same period the annual average rate of GDP growth was 4% in the Philippines, 4.7% in Thailand and 4.8% in Malaysia.
Indonesia's economic growth during the past several years has been almost exclusively driven by the expansion of private consumption expenditure. The impact of net exports on growth has fallen to almost nothing, while continuously contracting private investment has been a drag on the economy.
Decentralization has increased government transfers to Indonesia's regions but central government expenditure has been spiraling downward since 2001 as IMF-directed fiscal austerity has pushed the budget deficit lower. Tight fiscal policy has helped lower inflation and interest rates while stabilizing the rupiah. Perversely, IMF policies in Indonesia have also strongly undermined the recovery of private investment, making economic growth increasingly one-dimensional.
Corporate Sector Weakness
Within the region, Indonesia's banks and private enterprises were the hardest hit by the Asian liquidity crisis. At their peak, non-performing loans (NPLs) were equivalent to 64% of total credit outstanding in Indonesia. The ratio of NPLs to total credit in the Philippines, Malaysia and Thailand never exceeded 20%.
Though the operation of Indonesia's bank restructuring organization, IBRA, ended early this year, much of the corporate sector's debt remains in default. Notoriously weak legal and judicial systems have prevented resolution of this defaulted debt and will keep its resolution in limbo for the foreseeable future. The continuing overhang of defaulted debt has almost eliminated the flow of domestic credit to private enterprises, making the decline of interest rates of little consequence to investment.
The contraction of investment in Indonesia has been stunning. Prior to the crisis, investment accounted for 30% of GDP. Last year, investment accounted for only 16% of GDP. Without investment, Indonesia's export manufacturing sector has become increasingly uncompetitive. More worrying, contracting investment has led to plummeting oil production.
Ill Effects of Contracting Investment
Between 2001 and 2003, Indonesia's non-oil exports shrank at an annual average rate of almost 2%. This year, non-oil exports are expected to shrink by 3%. The lack of investment in export manufacturing has been a gift to Indonesia's export competitors, which are gaining market share at Indonesia's expense.
Weakness in the export manufacturing industry has led to widespread job losses and rapidly rising unemployment and underemployment. It has also encouraged the further shift of employment from the formal to informal sector of the economy, where wages are substantially lower. With unemployment rising and incomes declining, the primary fuel for growing private consumption expenditure has been rapid growth of credit to individuals.
Though bank lending to private enterprises has seized, bank lending to individuals has expanded rapidly. The growth of real credit to individuals has been around 25% annually since 2000. High margins have encouraged banks to lend to individuals while falling interest rates and credit availability have encouraged individuals to borrow money from banks.
With employment conditions and incomes expected to continue weakening in 2005, it is safe to assume that the debt servicing capability of individuals will deteriorate, especially since interest rates have averaged about 19% for consumer credit over the past three years. Rising interest rates and slowing economic growth could trigger another banking crisis.
Remarkably, almost nobody expects interest rates to rise or economic growth to slow in Indonesia - not consumers borrowing money to buy new cars and motorcycles, or banks lending money to these consumers. Not even foreign investors who are pouring money into Indonesia's equity market, pushing it to consecutive record highs.
Fiscal Mismanagement
Fiscal mismanagement by the IMF over the past several years has laid the groundwork for an economic slowdown next year. The high probability of continued fiscal mismanagement by the Yudhoyono government amplifies the risk of economic slowdown, sudden foreign capital flight and rupiah depreciation.
Like manufactured exports, oil exports have also suffered from contracting investment. Deteriorating security and legal conditions have limited new investment by foreign operators. Tight fiscal policy has prevented new investment by the state-owned oil company Pertamina. As a result, oil production has slid from about 1.5 million barrels per day in 1998 to 966,000 barrels per day in September. The decline in production has made Indonesia a net oil importer this year.
High Oil Prices and the Balance of Payments
Continued high oil prices have very significant negative implications for Indonesia's balance of payments. After several years of large surpluses, Indonesia's current account is expected to decline toward balance this year. Next year, export contraction, led by further weakness of manufactured exports, and strong import growth, led by oil imports, will push the current account toward a deficit of about $7 billion.
The only funds available to finance the current account deficit will be foreign exchange reserves. Net foreign direct investment and lending flows into Indonesia are expected to continue their contraction, which has been almost unabated since 1998. Foreign portfolio investment, which has provided the only source of foreign capital inflow in the past several years, could easily reverse.
Indonesia could see its foreign exchange reserves decline by $10 billion to $12 billion in 2005, weakening the rupiah and pressing interest rates up. Interest rates could also be pushed higher by the tight fiscal policy of the Yudhoyono government.
Yudhoyono's Fiscal Policy
Though Indonesia exited its final IMF programme last year, the Fund appears to still have considerable influence over fiscal policy. The IMF has repeatedly tried to persuade Indonesia to reduce fuel price subsidies since the late 1990s. This year these subsidies will cost the government over $6 billion, or 3% of GDP, increasing pressure for their reduction. All indications suggest that the Yudhoyono government will begin to dismantle the fuel price subsidies next year.
Apart from the obvious upward push to inflation, the reduction of fuel price subsidies will probably provoke widespread social unrest. Fuel price hikes in 1998 sparked the social unrest that eventually ousted the Suharto regime. In early 2001, the Megawati government's attempt to raise fuel prices was met with similar unrest, forcing the government to reverse the price increase.
For a country such as Indonesia where private investment is very weak, fiscal policy must be used to spur investment, creating the conditions for sustainable economic growth. Unfortunately the IMF, in pursuing fiscal austerity for the sake of foreign investors, has undermined economic growth in Indonesia, laying the foundation for an economic downturn, declining foreign exchange reserves and capital flight.
Jephraim P. Gundzik is President of Condor Advisers, Inc. Condor Advisers provides emerging markets investment risk analysis to individuals and institutions globally. Condor Advisers' research foresaw the Asian liquidity crisis in 1997. Please visit www.condoradvisers.com for further information.
