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Jakarta Post

A deteriorating economy amid distorted policies

The economy is deteriorating as the government incompetently responds to three current negative external shocks

Anwar Nasution (The Jakarta Post)
Jakarta
Thu, August 20, 2015

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A deteriorating economy amid distorted policies

T

he economy is deteriorating as the government incompetently responds to three current negative external shocks. If the rate of growth continues to decline at the present rate, Indonesia will be trapped at the lower middle-income level.

The first shock is due to the end of the boom in primary commodities in 2011 that reduced both demand and prices of export commodities.

Second, there is a growing likelihood of an interest rate rise in the US that could reverse short-term capital inflows. Since foreign portfolio investors have absorbed a large portion of government bonds and Bank Indonesia SBI certificates, the US monetary tightening will raise the interest cost of foreign borrowings.

The instability of international currencies will affect both trade and capital flows. The third external shock is due to the long drought that has seriously decreased agriculture production. As a result, Indonesia needs to import food this year and the next.

Indonesia is complaining about the recent 2 percent devaluation of China'€™s yuan against the US dollar that has negatively affected Indonesian exports. However, Indonesia'€™s own currency devaluation could conversely affect Chinese exports negatively. The exchange rate dropped to Rp 13,756 per US dollar on the day the new Cabinet lined up to take the oath on Aug. 12, down from Rp 13,510 (Aug. 3) and Rp 13,328 (July 15).

Jokowi has not properly responded to these economic difficulties and continuously adopts the distorted policies inherited from his predecessor, president Susilo Bambang Yudoyono (SBY). These distorted policies include the structure of government expenditure, trade and investment policies. Jokowi has frequently made overseas trips to woo foreign investors.

But he has not made a decision on how to restructure the real sector of the economy including on how to improve the licensing system, the level of investment and the business climate. There are also no exchange rate policies that provide a financial incentive for the promotion of exports or reduce interest rates to lower costs. At present, the lending rate in Indonesia is the highest among the ASEAN 5 countries. The labor market is distorted as the government has kept raising the minimum wage and provided generous unemployment benefits in a labor surplus economy.

Since he came to power 10 months ago, Jokowi has been solely focused on fiscal expenditure but has done practically nothing on other components of aggregate demand, such as domestic demand, investment and exports. He has improved logistics by shortening dwelling time at Indonesia'€™s ports. On fiscal policy, he slashed subsidies on gasoline and electricity and promised to use the savings for the development of infrastructure including energy infrastructure.

Unfortunately, his unaffordable healthcare program will soon cause a fiscal blowout. Meanwhile, after 70 years of independence, the tax ratio remains very low at 12 to 13 percent of gross domestic product. In both the Jokowi and SBY administrations, there has been no policy on how to increase the productivity of state-owned enterprises. There have been no programs to make use of labor surpluses, mainly on Java, and to eradicate corruption, collusion and nepotism.

 In the beginning of his 32-year-long administration, Soeharto'€™s economic ministers consisted of a group of highly trained economists of high integrity who were graduates of the School of Economics at the University of Indonesia. Most of them continued their studies to obtain a PhD at the University of California.

In contrast, the Jokowi'€™s Cabinet consists of mainly second-rate politicians who are low on both integrity and intellectual capability with very few exceptions. Most of them were not trained in the field of economics, but hold honorary doctorates or even professorships in economics from questionable universities.

They learned economics as businessmen in highly protected markets, or were suppliers to the public sector or dealers of foreign-made cars and other imported products. None of them has overseen the penetration of international markets through exports.

The low integrity of people in the executive, legislative and judicial branches of the government has been indicated by the cases of mismanagement and corruption handled by the Corruption Eradication Commission.

The chief justice of the Constitutional Court, many Cabinet ministers, provincial governors and deputy governors including a high-ranking official of Bank Indonesia served prison terms because of wrongdoing, including bribery, corruption and cooking balance sheets.

The Cabinet reshuffle announced on Aug. 12 hardly attracted better personalities and failed to improve the public'€™s trust in the government. Like in the previous Cabinet, President Jokowi failed to nominate a good macroeconomist to the government and central bank, one with solid training and a good reputation who understands the difficult international environment.

Bank Indonesia recently issued a regulation that mandated the use of rupiah for domestic transactions. This regulation is a kind of soft capital control to reduce the demand for foreign exchange. This policy, however, will probably not work because, traditionally, people do not trust the rupiah as a store of value.

This is because of the long history of social and economic instability, a bad legal system that was unable to protect individual property rights and enforce contracts, nationalization, inflation, economic and banking crises and expulsion of the people of Dutch and Chinese origin from Indonesia.

As mentioned earlier, the lack of trust in the rupiah has also been due to a lack of integrity and technical capability within the leadership of the central bank.

Because of these reasons, wealthy people park their money in socially and economically stable environments that possess excellent legal systems, such as Singapore, which is located right in the middle of the Indonesian archipelago.

To benefit from high interest rate differentials, the Indonesian corporate sector borrows heavily short-term capital denominated in foreign exchange from financial institutions located in nearby Singapore.

The exact size of the corporate sector'€™s external debt is unknown as many of them do not report it to Bank Indonesia or the Financial Services Authority (OJK). Nearly 40 percent of the liquidity in the domestic bond, SBI and capital markets in Jakarta comes from fragile short-term capital inflows.

The foreign debt is mainly used by the corporate sector to finance its investment in real estate and high-rise buildings, hotels and shopping malls. Some of the foreign borrowings have been invested in traded sector of the economy, such as industrial manufacturing, oil palm plantations and mining that produce goods for export and then earn foreign exchange.

The combination of the continuous decline in the demand for commodities, the rise in international interest rates and devaluation of the rupiah makes it difficult for corporations with large external borrowings to service their external debt. It has also increased non-performing loans of domestic banks.

Unlike in 1997 and 2008, exports and tourism are hardly affected by the rupiah'€™s devaluation because of international recessions that have reduced the demand for Indonesia'€™s exports and for travel to this country.
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But Jokowi has not made a decision on how to restructure the real sector ...
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The writer is a professor of economics at the University of Indonesia and a former senior deputy governor of Bank Indonesia. He obtained his PhD degree in monetary economics from the Fletcher School of Law and Diplomacy, Cambridge, US.

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