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Country Strategy and Program Update 2002-2005: Indonesia

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I. Current Development Trends and Issues

A. Economic Growth

1. Indonesia's Archipelagic Nature Defines Development

1. As the world’s largest archipelago and without adequate transport and communications, Indonesia is economically fragmented. Transport relies on a variety of systems (public roads; relatively small railways in Java and Sumatra; inland waterways in Kalimantan, Papua, and Sumatra; and extensive shipping and air networks) that do not generally provide efficient, low-cost service. Restructuring and new investment are badly needed, and maintenance has been particularly poor in recent years. Communications vary from Internet facilities in some areas to the poorly accessed and maintained landline telephone systems in most urban areas. Inappropriate sectoral policies and legal and judicial weaknesses continue to discourage private sector investment in transport and communications.

2. The different islands have distinct cultures, economic resources, and problems and opportunities. Bali's development is based on tourism; Kalimantan's and Papua's, on forestry and mineral resources; and Aceh's and Riau's, on substantial hydrocarbon reserves. As a whole, economic development has been based on a rich resource base. Indonesia is Asia’s second-largest oil producer and the world’s largest exporter of liquefied natural gas. Extensive coal and other mineral deposits support extractive industries in many areas. Diversification beyond natural resources is essential to achieve long-term equitable and sustainable growth.

2. Pro-Poor Growth Prospects

3. Changing Economic Structure. Gross domestic product (GDP) growth exceeded 7% annually in the decades before the financial crisis, leading to fundamental changes in the structure of the economy and helping elevate Indonesia from a low- to middle-income country. By the mid-1990s, the manufacturing sector (excluding oil and gas) accounted for just under one quarter of GDP, surpassing agriculture. Service sectors, including communications, finance, and construction, grew rapidly. Yet, agriculture still employed 43% of the labor force in 1999, and agriculture and natural resources remain the base of much of manufacturing, especially for exports.

4. The Economic Crisis. The economic crisis in Asia in 1997-1998 affected Indonesia more than any other country. Like its neighbors, Indonesia saw a sharp currency depreciation, the collapse of equity and asset markets, corporate bankruptcies, bank failures, and a massive increase in public indebtedness. Now the banking system is largely nationalized as a result of recapitalization exercises and large public sector debts. Unlike in other countries, however, the crisis also led to a profound political change. Decades of authoritarian rule were replaced with fledgling democratic institutions, civil society gained license, and an intense debate ensued over the nation's political course. These changes are still very new and Indonesia is in a far-reaching transition from central control to democratic, market-oriented institutions.

5. Deep Public Sector Involvement in Economy. Precrisis growth relied upon state monopolies in many sectors, especially in energy: National Oil Mining Company (PERTAMINA) in oil and gas, Indonesian State Gas Enterprises (PGN) in gas transmission, and State Electricity Corporation (PT Persero PLN) in power. Although the importance of moving to private sector-supported growth is now well recognized, structural changes in state-owned enterprises (SOEs) and significant divestiture of state assets have been slow. Partly as a result of the crisisand the failure of private banks, the Government controls 80% of banking assets, reversing earlier policies opening the sector.

6. Rural Development. Stagnating agricultural productivity threatens the long-term potential of the large rural sector, which employs many of the poor. Agricultural growth averaged about 3.8% annually in the 1980s, but fell to 2.9% in the early 1990s, and worsened due to the crisis and bad weather. Shrinking average farm size and low level of capital available to small farmers hamper efforts to improve productivity.

7. Urban Development. The rapid increase in the urban population—roughly 5% per year—poses a considerable challenge to improving the standard of living, especially of the poor. Although provision of services such as water supply, sanitation, and solid waste disposal has increased, most urban residents lack basic services as well as adequate shelter. Serious environmental problems include uncollected garbage, water and air pollution, and traffic congestion.

3. Macroeconomic Trends

8. Modest Economic Growth. Economic recovery, which began in 2000, has remained moderate: GDP growth is expected at 3.2% in 2002, and 4.4% in 2003. Current growth has relied upon household and public sector spending. More rapid growth will depend upon robust private investment. Figure 2 shows the "log" of GDP—the slope of the line is the growth rate— and the fall-off in growth and investment since the crisis. Private spending on plant and capital equipment in 2001 ran at only 70% of the mid-1990s level. Half a decade of relatively low private and public investment has yielded only a limited capacity to sustain growth that could reduce poverty. Investment—domestic and foreign—has been discouraged by a number of factors: (i) incomplete financial reforms, (ii) increasing concerns about poor governance, and (iii) political uncertainty.¹

9. Macroeconomic Stability. Successful International Monetary Fund (IMF) program reviews in 2002 have improved economic prospects and helped ease debt burdens through Paris Club debt restructuring. The IMF program has also encouraged a tighter monetary policy that helps control inflation. Between 2001-Q1 and 2002-Q1, prices had increased 14% annually. Petroleum price and power rate hikes exacerbated supply costs, and a relatively accommodative monetary policy in 2001 validated price increases. At the end of 2001, monetary policy focused on reducing inflation, and by mid-2002, inflationary pressure appeared to have eased. The exchange rate weakened significantly in 2001 as a result of political uncertainty, slackening international markets, and worsening inflation. In 2002, however, the exchange rate rebounded, and by July, it was around Rp9,000=$1.

10. Fiscal Policy. Major fiscal challenges exist on the revenue and expenditure sides. Lower growth and stagnating tax efforts have weakened revenue mobilization, and room to maneuver has narrowed markedly (Table 1). Nontax revenues and financing are projected to fall off as the remaining assets accumulated during the crisis find few ready buyers and as the Government reduces forestry operations. Much of current expenditure is for interest payments (almost twice mid-1990s levels), subsidies, personnel expenditures, and transfers to local governments as a result of decentralization. Debt servicing largely reflects crisis-related expenditures. Debt-servicing indicators are shrinking as a result of inflation, modest growth, lower interest rates, and limited recourse to new borrowing. However, the absolute size of the external and domestic public sector debts are unlikely to materially decrease in this decade. Under even reasonably optimistic assumptions about tax collections, interest rates, and required subsidy payments, discretionary funds will be limited during the next few years.

B. Poverty

1. Income Poverty Assessment

11. The incidence of poverty (Figure 3) soared from 14.7% in early 1997 to a peak of 23.5% in early 1999, demonstrating the vulnerability of the poor to inflationary shocks, especially to food price increases. As the crisis ebbed, real incomes rose with the fall in inflation and rebound of production. Although data for 2001 and 2002 are provisional, the incidence of poverty, with respect to level and distribution, has returned to the mid-1990s pattern.

2. Human and Social Development

12. Indonesia’s long period of strong growth was accompanied by improved access to basic services. Enrollment in primary schools increased from 75% to near universal participation. Malnutrition and infant mortality declined. With declining fertility rates, the annual population growth fell from 2.3% in the 1970s to 1.5% at present. However, problems remained with respect to quality and access to services, especially by the poor. These problems became acute in the wake of the crisis and triggered an unprecedented effort to ensure basic services for the most needy. Social safety-net operations kept children, especially girls, in school, and local health service posts operating, but the fall in family incomes and severe fiscal constraints aggravated the health and nutrition status of the poor (para. 42).

13. Improving the quality of and access to services for the poor will require improved targeting, increased efficiency, and higher levels of funding. Spending in education and health are low compared to that of neighboring countries (Figure 4). This may be difficult to change given not only the fiscal constraints but also decentralization, which has devolved responsibility for basic service provision to regional governments, whose governance structures, public finances, and administrative capacities are weak. The central Government will have to move away from being a service provider to a facilitator of such provision by local governments. Considerable institutional change is needed with respect to policy, capacity building, financial support, and the establishment and enforcement of minimum service standards.

C. Political Environment

14. Institutional Development. Democratization has seen the emergence of Parliament as an active political agent. In July 2001, it impeached then-President Abdurachman Wahid and elected former Vice President Megawati Soekarnoputri as President. The relatively peaceful transition boosted currency and financial markets while also illustrating the costs of the previous political instability and uncertainty. In 2002, Parliament concluded far-reaching constitutional amendments to encourage democracy by reducing the formal role of the military in politics and defining more clearly the separation of the executive and legislative branches of government.

15. Decentralization. On 1 January 2001, the Government initiated a profound transfer of power, revenue funds, and responsibilities (for education, health, regional roads, environmental management, and several other areas of public service) from the central authorities to regional governments. Although the transition began relatively smoothly, lack of supervision and standard setting may lead to deteriorating public services and jeopardize private sector development. Local governments are failing to protect natural resources and are imposing taxes that impede growth and investment. Sufficient funds are not allocated to poor regions.

16. Internal Security. In too many areas, peace and security remain uncertain. In late 2001, the Government reported that 1.3 million persons were internally displaced due to conflict, representing a tremendous human cost and barrier to development, with the poor worst affected. The clear link between underdevelopment and political and social instability underscores the need to address the roots of civil unrest and provide livelihood and infrastructure in strife-torn regions. Besides West Timor, areas of severe sectarian or political conflict include Aceh, Central and West Kalimantan, the Moluccas, Papua, and Central Sulawesi.

D. Governance and Institutional Capacity

17. The 2001 Country Operational Strategy (COS) of the Asian Development Bank (ADB) noted that the weakest link in the past development strategy was governance (p.14). Good governance is crucial to Indonesia’s commitment to democracy and market-oriented economic institutions. International experience shows that strengthening governance—encouraging government that is accountable, transparent, and participatory—requires time, strong commitment, and persistence. Important steps have been taken through the recent passage of a series of constitutional amendments tackling broad issues, but also through specific actions such as the passage of the Anti-Money-Laundering Law and preparation to establish an Anticorruption Commission. These steps must be backed by forceful implementation as emphasized repeatedly by the international community through the Consultative Group for Indonesia (CGI).

18. Systemic corruption is perhaps the most difficult problem to solve. It reduces the effectiveness of investment, is a regressive tax falling mainly on the poor, undermines international cooperation, and diminishes trust in public institutions. Reducing corruption demands specific steps:

1. Ensure adequate funding of public institutions. Off-budget accounts, low salaries, and underfunding invite corruption.
2. Improve the quality and transparency of audits and fiduciary control functions.
3. Implement appropriate legislation and enforce legal protection. Weaknesses in the legal and judicial system may be the most damaging defects in the state structure.
4. Reform the civil service. Reorienting public agencies to service demands changes in internal incentive and administrative structures.
5. Encourage civil-society groups and the media to be vigilant. Non-government organizations (NGOs) are important to reducing the scope for corruption.

E. Gender Issues

19. Indonesia ranks behind its neighbors in the gender development index of the United Nations Development Programme (UNDP).² Access to secondary and tertiary education is highly unequal. Embedded perceptions of gender roles hinder health education and are reflected in high maternal mortality and abortion rates, and in poor nutrition. Women face unequal treatment in the labor market, where they sometimes can obtain only low-skill, low-paying jobs. Women have also lagged in participating in high levels of economic and political decision making. Decentralization has complicated gender issues, requiring that national gender policies be adjusted to the local context.

20. These issues need to be addressed systematically by mainstreaming gender equity concerns in all applicable policies, programs, and projects. Decentralization particularly demands building the capacity of local government institutions and encouraging greater sensitivity to gender issues by public officials. This can be accomplished in part by strengthening community-based approaches to gender equity, including awareness of relevant laws and regulations, and facilitating the participation of women in local government.

F. Private Sector

21. Deregulation, reform, and a shift to market-based resource allocation were important elements of precrisis economic performance. Reforms such as privatization of SOEs enhanced the private sector’s role. However, the pace of reforms slackened even as growth continued. Critically needed changes in the financial sector, legal and judicial system, and corporate governance were not pursued. The crisis reinforced the conclusion that if the private sector is not strengthened, it will have insufficient capacity for growth and continue to be vulnerable to shocks. The crisis also burdened the corporate and financial sectors with unserviceable foreign currency debts, rendering firms and banks insolvent. A series of reforms is needed to solve, for example, overly concentrated industries and a lack of bankruptcy mechanisms.

22. Keys to reinvigorating the private sector lie in the small- and medium-sized enterprises (SME) and SOE sectors. Inappropriate regulation, lack of market-oriented business support systems, deficient infrastructure, and lack of market-based credit impede SME growth—growth that could provide substantial economic opportunities to the poor and to women. The investment law under preparation could encourage an equal "playing field" for enterprises, including SMEs, and needs to be supported by better governance in the legal and judicial system and in local administration. The extensive set of SOEs also limits dynamic economic growth. SOEs, with access to subsidized Government financing, are inefficient, drain public finances, and encourage corruption. Direct budget subsidies, largely flowing to SOEs, represent roughly 3% of GDP. Privatization of SOEs under regulatory structures is essential to provide a basis for new investment, improved competitiveness, and long-term growth.³

H. Regional Cooperation

25. Regional cooperation can increase growth prospects by (i) enhancing participation in the global economy, (ii) encouraging cross-border trade and traffic, and (iii) solving transborder problems such as cross-border pollution. With respect to the first, low foreign direct investment (FDI) and continued capital outflow are signs of policy deficiencies. Indonesia’s membership in ASEAN is important to maintain a generally open economy and encourage the use of international regulatory standards. With respect to cross-border traffic, Kalimantan and Sulawesi could benefit from expanded economic activity within the Brunei-Indonesia-Malaysia-Philippines— East ASEAN Growth Area (BIMP-EAGA). Modest economic cooperation could significantly benefit the people of Timor, on both sides of the border. Finally, regional cooperation can help identify win-win solutions to cross-border environmental problems, including policing polluters and those overexploiting natural resources, reducing forest fires, and regulating fishing.

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