Condition critical: Economic reforms cannot wait

Monday, March 12, 2007 Vincent Lingga, The Jakarta Post, Jakarta

Reform is never easy when it requires changes to an entrenched economic system. That is why broad-based reforms often require a crisis or perception of crisis, or at least a sense of chronic deterioration. It was economic crisis that brought down Soeharto in May 1998 and ushered in the reform era.

And we are once again mired in a critical condition now, despite the macroeconomic stability the government often boasts of.

With unemployment and underemployment estimated at some 40 million and the number people living on less than US$2/day exceeding 100 million, our situation is clearly critical.
But both the government and the House of Representatives have yet to demonstrate a sense of crisis in accelerating the reform measures sorely needed to reinvigorate investment, generate jobs and lift people out of poverty.

We had expected good sense to prevail in the end, but the Susilo Bambang Yudhoyono administration, currently in the middle of its term, has yet to demonstrate a feeling of urgency toward policy reforms in priority areas.

The experiences of other countries that have been successful in pushing through broad reforms shows that the timing of reform depends on political leadership - the leadership to make it clear that there is a crisis.

The government moved decisively in October, 2005 to reform the energy sector by slashing fuel subsidies through a 125 percent increase in fuel prices after the rupiah had come under fierce attacks by speculators.

This move immediately gained rewards from the market in the form of confidence in the rupiah and has substantially increased the government's fiscal capacity.

But it is rather mind-boggling to notice how apparently ignorant the government and politicians at the House have been for not being able to identify the crisis conditions that should have forced them to accelerate reforms.

Look how deliberations of the taxation, labor, investment and mining bills, already several years behind schedule, have been protracted, stuck on issues that are not very important to stimulating economic efficiency. Likewise, reform in public administration, including local governments and state companies , has been quite slow.

The challenges lie on two fronts. While the pace of reform legislation has been much slower than expected, the implementation of reform measures is even more disappointing. The cascading impact of this delay is a disappointingly slow recovery in public and private investments.

The government was commended for the comprehensive reform packages in infrastructure and investment it launched in the first quarter of last year. However, their implementation has dragged.

The crash program to construct 10,000 megawatts in additional power generation capacity seems to have crashed amid bickering about tender procedures and allegations of corruption.

The negative impact of the slow pace of reform is already being felt in the quality of growth as the number of jobs created by one unit of economic growth is now much smaller than before 2000.

The steady rise in unit labor costs in excess of productivity and rigid labor regulations have prompted new investors to economize on labor by avoiding labor-intensive businesses.
Banks, whose function is supposed to center on lending, prefer plowing their funds into debt instruments that have nothing to do with financing real economic activities.

Inefficiency and rampant corruption within the public sector, notably in tax, customs and business licensing, remain the most serious obstacles to new investment and the main source of business risk.

We often fail to realize that besides legal uncertainty, which makes it extremely difficult to do a reasonable risk calculation, corruption is also a source of unpredictability because any deal could be undone by someone bribing someone in the government.

President Yudhoyono received a strong political mandate in 2004 from disillusioned people who want things to change, but he seems unable to show the leadership necessary to translate this broad dissatisfaction into concrete action and move things in the direction the people want.

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Idle funds threaten macroeconomic stability

Wednesday, March 07, 2007 Vincent Lingga, The Jakarta Post, Jakarta

The banks will publish their audited financial statements for 2006 within the next few weeks. The statements will mostly show bigger profits, but that doesn't mean the banks' managements should be commended for jobs well done.

The credit should instead go to Bank Indonesia, the nation's central bank, which had "been forced" to contribute more to banks' earnings.

Bank Indonesia Governor Burhanuddin Abdullah should indeed feel frustrated, since the new package of regulations he issued early last year to encourage bank lending has turned out to be ineffective. He should now work harder to soak up excess liquidity by issuing more Bank Indonesia Certificates (SBIs) and paying quite dearly for this instrument.

Even though many businesses are starved of finances, most major banks still prefer investing their excess funds in debt market instruments, notably risk-free SBIs and government bonds, instead of pumping them into the real economy.

It is unusual for a central bank governor to be so straightforward in airing a pessimistic outlook. But that was what Burhanuddin did last week. Apparently fed up with the slowness of the government's implementation of its reform policies, he sounded the alarm bell, warning of a weaker economy if banks remain inordinately risk-averse in their lending operations.

It is indeed a frustrating job for the central bank governor because, the more banks invest in SBIs, the higher the cost of Bank Indonesia's monetary market operations. He estimated the interest costs of SBIs this year alone at Rp 25 trillion.

While major banks pay only between seven to eight percent interest on time deposits, SBIs pay 9.25 percent. No wonder banks prefer investing their funds in SBIs. They can get more than 1.25 percentage points in interest revenue without doing anything. But investing in SBIs contributes nothing to economic growth.

As of last month, outstanding SBIs totaled almost Rp 240 trillion (US$25.8 billion). Burhanuddin estimated this amount could increase to over Rp 300 trillion by later this year if bank lending did not expand significantly.

The central bank governor certainly realized he could not jawbone commercial banks to expand their lending if business risks remain high and the overall investment climate remains highly adverse. Even the reduction of the central bank's benchmark short-term interest rate to 9 percent Tuesday will not be effective in prompting more lending.

It would be a suicide for banks to aggressively lend to businesses with unusually high risks, especially now the central bank is imposing higher standards of capital and overall credit risk management.

There is no a panacea to stimulate credit expansion. Bank lending cannot be accelerated by decree. The most effective way to stimulate bank lending is to improve the overall investment climate. Without significant improvements in the business climate the risk of bank credits turning sour will remain high.

Excess liquidity at banks is inflicting another cost on the economy. The huge sum of funds invested in SBIs and government bonds impose risks on macroeconomic stability. This is because idle money can immediately be used as ammunition for speculative attacks on the rupiah in the foreign exchange market.

Even more worrisome is the fact that, due to the unfavorable business climate, most foreign investment entering the country now consists of short-term portfolio capital. This hot money, currently estimated at nearly Rp 590 trillion, including Rp 505 trillion in stock holdings, Rp 55.5 trillion in government bonds and nearly Rp 25 trillion in SBIs, is another source of ammunition for speculative trading on the foreign exchange and stock markets.

The 3.5 percent decline in the Jakarta stock market composite index Monday had nothing to do with Indonesian economic fundamentals. The fall was due to changes in foreign investor sentiment caused by a perceived increase in the downside risk of the U.S. economy and a possible rise in Japan's interest rate.

This development is just more evidence that Indonesia's financial market and rupiah have become highly vulnerable to speculative attacks. This has been due to the steady increase in the amount of excess liquidity at the banks and in foreign portfolio capital inflows.

It should be needless to remind the government that the most effective way to push this excess liquidity into the real economy -- where it can finance the construction of factories and infrastructure -- is to reduce the country's high business risk by passing more reforms.

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