&,ㄴ,戱 -,  A WORLD BANK COUNTRY STUDY Indonesia Sustaining Development The World Bank Washington, D.C. Copyright @ 1994 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing January 1994 World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910,222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66, avenue d'I6na, 75116 Paris, France. ISSN: 0253-2123 Library of Congress Cataloging-in-Publication Data Indonesia : sustaining development. p. cm. - (A World Bank country study) ISBN 0-8213-2750-X 1. Sustainable development-Indonesia. 2. Indonesia-Economic policy. I. International Bank for Reconstruction and Development. II. Series. HC450.E5153 1994 338.9598-dc2O 93-44825 CIP INDONESIA: SUSTAINING DEVELOPMENT CONTENTS A bstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Acknowledgments .... .............................................. xi Currency Equivalents................................................ xii Executive Sununary .............................................. xiii 1 Sustaining Development ........................................ 1 A. Overview .............................................. 1 B. Progress on Development .................................... 2 C. Sustaining Development ..................................... 9 Growth with Stability ...................................... 10 Equity through Wider Participation ............................. 14 Protecting the Environment ....................... .......... 16 The Challenge of Integration ................................. 18 D. Toward an Integrated Agenda for Sustained Development ................ 20 Macroeconomic Management .................................... 20 Incentives .... ............................................ 22 Investment ............................................. 24 Institutions ............................................. 27 2 The Macroeconomic Foundation .................................. 31 A. Overview .............................................. 31 B. Response to Recent Macroeconomic Pressures ....................... 31 Macroeconomic Policy in 1992/93 .............................. 32 Macroeconomic Outcomes ................................... 37 C. Sustained Growth and Macroeconomic Consistency .................... 42 The Challenges .......................................... 42 Prospects for Growth and Structural Change ........................ 45 External Financing and Debt Management Strategy ................... 48 Consistent Macroeconomic Policies for Sustained Growth ............... 52 D. Economic Management in an Uncertain External Environment ............. 56 The Main External Sources of Uncertainty ......................... 56 Quantifying External Uncertainty ............................... 60 Policy Implications ....................................... 61 iii iv Contents 3 Incentives ... . 63 A. Overview: Making the Most of Markets ........................... 63 B. Extending and Strengthening Competition .......................... 64 Extending Trade Policy Reform ............................... 64 Removing Price Controls ....... ............................. 71 Dismantling Barriers to Entry ................................. 76 C. Developing Factor Markets ................................... 79 Advancing Financial Reforms ................................. 79 Developing Well-Functioning Land Markets ........................ 83 Spurring Technology Markets ................................. 87 D. Improving Market Infrastructure ................................ 88 Establishing Transparent Market Rules ........................... 89 Broadening Market Access ................................... 90 E. Managing the Environment .................................... 94 Overcoming Policy Failures: Win-Win Policies ..................... 94 Overcoming Market Failures: Targeted Interventions .................. 95 Combating Poverty to Improve the Environment ..................... 99 Choosing Environmental Management Tools ........................ 100 4 Investment ................................................ 101 A. Overview: More and Better Investment ............................ 101 B. Overall Investment and the Private-Public Balance ..................... 102 C. Priorities for Public Investment.................................... 107 Raising the Efficiency of Investment and the Quality of Services ........... .. 107 Directly Productive Activities .................................... 108 Infrastructure Development ... ................................. 110 Human Resource Development ................................... 116 D. Targeting Social Sector Expenditures to the Poor ...................... 123 Access of the Poor to Social Services ............................ 123 Who Benefits from Public Subsidies? ............................ 124 Pricing Policies for Better Targeting ............................. 127 E. Priorities for Environmental Investment ............................ 129 5 Institutions ................................................ 135 A. Overview: Fostering Responsive Institutions ........................ 135 B. Strengthening the Institutional Underpinnings for Private Enterprise .......... 136 Contents v The Commercial Legal System ................................ 136 Framework for Accounting and Auditing .......................... 138 C. Public Enterprise Reform ... .................................... 140 Recent Reforms and Performance .. .............................. 140 Current Issues ............................................. 142 Directions for Future Reform ................................. 144 D. Public Administration and Civil Service Reform ...................... 146 Recent Trends in Civil Service ................................ 147 Ongoing Reforms ........................................ 148 Intensifying Administrative Reform ............................. 149 E. Fiscal Decentralization ...................................... 152 Assignment of Expenditure Responsibilities ........................ 153 Increasing Local Government Revenues ........................... 155 Inter-governmental Transfers and Loan Finance ...................... 157 Framework for Planning, Budgeting and Monitoring ................... 159 Building Local Government Institutional Capacities ................... 161 F. Institutional Framework for Environmental Management ................. 162 Improving Information and Analysis ............................. 162 Developing Institutional Arrangements ........................... 163 Enhancing Local Participation ................................. 164 ANNEXES Statistical Annex ............................................. 167 TABLES IN TEXT 1.1 Key Economic Indicators ..................................... 4 1.2 Human Resource Development: Selected Countries, 1960-1990 ............ 7 2.1 Indonesia: Monetary Survey ..................................... 33 2.2 Central Government Operations, 1988/89-1993/94 ..................... ... 36 2.3 Key Macroeconomic Indicators .................................... 38 2.4 Non-Oil Merchandise Imports, 1987/88-1991/92 ...................... ... 40 2.5 Balance of Payments, 1988/89-1992/93 ............................ ... 41 2.6 Projections of Key Macroeconomic Indicators ........................ ... 46 2.7 Balance of Payments Projections, 1992/93-2000/01 ....................... 47 2.8 Projected External Financing ..................................... 49 2.9 Medium- and Long-Term Debt Indicators, 1990-2000 ................... 51 2.10 Savings-Investment Balances, 1983-2000 ........................... 55 2.11 Currency Composition of Exports and Imports ....................... 60 3.1 Coverage of Non-Tariff Barriers ................................ 65 Vi Contents 3.2 Changes in the Tariff Schedule ................................. 66 3.3 The Structure of Protection ................................... 70 3.4 Conglomerates in Indonesia, 1990 ............................... 91 4.1 Sectoral Investment Priorities for Public Investment .................... 106 4.2 Indicative Public Expenditures in Agriculture ........................ ... 109 4.3 Indicative Infrastructure Investment Program by Sector and Public/ Private Participation......................................... 111 4.4 Indicative Public Investment Program for Electric Power ................. .. 112 4.5 Indicative Public Investment Program for Telecommunications ............. .. 113 4.6 Indicative Public Investment Program for Transport .................... 114 4.7 Changing Priorities in Irrigation and Water Resource Expenditures ........... . 115 4.8 Reading Achievement Test Scores, 1992 .............................. 118 4.9 Government Budget for Education and Health ........................ 120 4.10 Education Development Goals and 1998 Expenditure Scenarios: MOEC Education Policy and Planning Project ......................... 121 4.11 Role of Private Providers and Household Expenditures in Education .......... . 122 4.12 Indicative Public Investment Program for Water and Sanitation ............. .. 131 5.1 Overview of Public Enterprise Financial Performance, 1987-91 ............. 141 5.2 Central-Local Fiscal Relations: Some International Comparisons ............ 153 FIGURES IN TEXT 1.1 Selected Indicators of Economic Performance ........................ 2 1.2 Incidence of Poverty and Income Distribution, 1970-1990 ................ 5 1.3 Trends in Regional Income Distribution ........................... 6 1.4 Access of the Poor to Social Services ............................. 6 1.5 Indicators of Infrastructure Development, 1970-1990 ................... 8 1.6 Changing Economic Structure .................................. 13 1.7 Environmental Challenges: Urban and Industrial Pollution ................ 18 2.1 Non-Oil Trade Deficit ......................................... 32 2.2 Devaluation Expectations........................................ 34 2.3 Indonesia Country Risk Premium ................................. 34 2.4 Commercial Bank Interest Rate Spread ............................ 34 2.5 Real Effective Exchange Rate ..................................... 37 2.6 Growth of Non-Oil Exports by Destination, 1989-1992 .................. ... 39 2.7 Growth on Non-Oil Exports by Product and Market, 1989-1992 ............ ... 39 2.8 Sources of Foreign Direct Investment ............................. ... 49 2.9 The Changing Composition of Indonesia's Exports ..................... ... 57 2.10 Manufactured Exports and the Nature of Potential Market Constraints ......... .. 58 2.11 The Interest Rate Structure of Public Debt, 1980 to 1991 ................. ... 59 2.12 Currency Composition of Public Debt Outstanding ..................... ... 59 2.13 Impact of Shocks on Current Account Deficit ........................ ... 60 4.1 Private and Public Investment Trends and Projections ................... 103 4.2 Education Subsidy Per Capita by Program, 1989 ...................... 125 Contents vii 4.3 Health Subsidy Per Capita by Program, 1990 ........................ 126 5.1 Financial Soundness of Public Enterprises .......................... 142 5.2 Civil Service Size ......................................... 147 5.3 Financing of Local Government Expenditures, 1990/91 .................. 155 BOXES IN TEXT 1.1 Indonesia's PROKASIH (Clean Rivers) Program ...................... 8 1.2 Adjusting Fuel Prices: An example of "Win-Win-Win" Policies ............ 19 3.1 Customs and Tariff Reform ................................... 67 3.2 Economic and Environmental Sustainability: The Forestry Example .......... 68 3.3 Examples of Domestic Trade Restrictions .......................... 72 3.4 Permits for Land Acquisition and Development ....................... 86 3.5 Pollution Control for the Brantas River Basin ........................ 99 4.1 Public Pricing Policy for Junior Secondary Schools .................... 107 4.2 AIDS in Indonesia: Trends and Options ........................... 118 5.1 Qualifying as a CPA in Thailand and Malaysia ....................... 140 5.2 Benefits of Privatization: Some International Findings .................. 145 5.3 Administrative Reform in Singapore .............................. 150 5.4 An Experiment in Decentralizing Health Services ..................... 160 5.5 Environmental Management: The Search for Creative Solutions ............ 165 5.6 Local Participation Fosters Development Effectiveness and Sustainability ........................................... 166  ABSTRACT This report reviews Indonesia's impressive record of economic development and focuses on the challenges the country faces in sustaining development in the years ahead. It discusses the task of sustaining development in three major, complementary dimensions: maintaining robust economic growth, to continue to improve living standards and generate adequate, gainful employment for the growing labor force; promoting equity, by further reducing poverty and broadening participation in development; and protecting the environment. The report outlines emerging new challenges in each of these areas. Exports have been a major engine of growth, but export growth in the future will have to contend with increasingly competitive international markets and the need to diversify into new products. Increases in efficiency and productivity will become more important as a source of growth. Improvements in economic equity will depend on success in dealing with the increasingly regional character of poverty and in promoting wider participation by small and medium-size enterprises in the growth of the modem private sector by broadening access to market opportunities. In the area of environmental protection, action will be needed both to conserve Indonesia's natural resources and to limit industrial and urban pollution. Effective integration of growth, equity and environmental protection is the crux of sustained development. The report develops an analytical framework that integrates these objectives, encompassing policies that take maximum advantage of the complementarities that exist among them as well as policies to deal effectively and efficiently with the trade-offs. The report outlines an agenda for sustained development, integrating the objectives of growth, equity, and environmental protection under four broad themes: macroeconomic management, incentives, investment, and institutions. Emphasizing that a stable macroeconomic foundation is essential to sustained growth, the report discusses macroeconomic policies to maintain financial stability, mobilize domestic resources, and ease the burden of external debt. It stresses that raising both public and private savings will be central to macroeconomic management for growth with stability. In reforming the incentive regime, the report calls for exposing enterprises to increased competition from both external and domestic sources to promote efficient and broad-based private sector development, building environmental concerns into the framework of incentives. It notes that greater integration with the regional and global economy, through removing barriers to international flows of trade, investment, and technology, should form a principal thrust of policies to raise efficiency and productivity. Maintaining the momentum of regulatory reform should command high priority. At the same time, a sustained, strong investment effort, supported by increased domestic savings, will be needed to meet Indonesia's development objectives. The report calls for focusing public investment on infrastructure and human resource development, emphasizing efficiency, quality of services, and better targeting for the poor. In the directly productive sectors, the primary role of government should be in providing a competitive environment for private investment. A central theme underlying the agenda for adapting and developing public institutions discussed in the report is the changing role of government, which calls for focusing public capacities on providing the institutional underpinnings for efficient and equitable functioning of markets and on effectively delivering public services, including environmental protection. ix  ACKNOWLEDGMENTS This report was prepared by a core team led by Zia Qureshi and including Timothy Condon, Dipak Dasgupta, and Don Hanna. Major contributions were made by Ramgopal Agarwala, Swati Ghosh, James Harrison, Oscar de Bruyn Kops, and Nicholas Prescott. Yasmine Hamid prepared the Statistical Annex and the graphics and, together with Cyrus Talati, provided research support. The report draws on background inputs prepared by Izak Atiyas, Richard Calkins, Rozany Deen, Stephen Dice, James Douglas, Chita Jarvis, Frida Johansen, Albert Kennefick, Brian Levy, Andres Liebenthal, Samuel Lieberman, John Nellis, Akihiko Nishio, Vicente Paqueo, Aftab Raza, Arun Sanghvi, Anwar Shah, Hafeez Shaikh, A. Shanmugarajah, David Wheeler, Stuart Whitehead, and Heng-Fu Zou (all Bank staff) and by Amaresh Bagchi, Brian Binder, Petr Hanel, David Hawes, Chris Jones, Sanjaya Lall, and Samuel Paul (consultants). Jessica Ardinoto, Inneke Herawati, Mary Kepferle, Datty Sembodo, Ester Tjahyadi, and Phyllis Williams were responsible for document processing. This report was completed in May 1993, and served as the main background document at the meeting of the Consultative Group for Indonesia held in Paris in June 1993. Its contents, therefore, are based on data and other information as of May 1993. xi CURRENCY EQUIVALENTS Before November 15, 1978, US$1.00 =Rp.415 Annual Average 1979-1992 1979 US$1.00 = Rp.623 1980 US$1.00 = Rp.627 1981 US$1.00 = Rp.632 1982 US$1.00 = Rp.661 1983 US$1.00 = Rp.909 a 1984 US$1.00 = Rp.1,026 1985 US$1.00 = Rp.1,111 1986 US$1.00 = Rp.1,283 b 1987 US$1.00 = Rp.1,644 1988 US$1.00 = Rp.1,686 1989 US$1.00 = Rp.1,770 1990 US$1.00 = Rp.1,843 1991 US$1.00 = Rp.1,950 1992 US$1.00 = Rp.2,030 October 25, 1993 US$1.00 = Rp.2,107 FISCAL YEAR Government April 1 to March 31 Bank Indonesia - April 1 to March 31 State Banks January 1 to December 31 a On March 30, 1983 the Rupiah was devalued from US$1.00 = Rp.703 to US$1.00 = Rp.970. b On September 12, 1986 the Rupiah was devalued from US$1.00 = Rp.1,134 to US$1.00 = Rp.1,644. xii EXECUTIVE SUMMARY i. This report discusses the challenges Indonesia faces in sustaining development. Indonesia's economic achievements over the past twenty-five years are significant: continued strong growth; resilience to major external shocks; implementation of substantial structural reforms that diversified the economy, expanding the role of the private sector and reducing reliance on oil; considerable reduction of poverty; and a notable start on improving environmental management. These achievements have brought Indonesia to a new threshold of development. Although Indonesia remains a low-income country with a per capita income of $650 and 27 million people still living in absolute poverty, it is well placed to make substantial progress that would place it firmly in the ranks of middle-income countries by the turn of the century. A strong economic foundation has been laid that the Government can now build on as it looks ahead and formulates the Sixth Five-Year Development Plan (REPELITA) and the Second Long- Term (25-year) Development Program, both of which start next year. ii. This progress can be realized, however, only if there is a clear recognition of and response to the formidable challenges of sustaining development. While past achievements have opened up new opportunities for development, they have also given rise to new challenges. The transition to a higher level of development will be associated with important structural shifts and changes in the nature of the policy agenda. The momentum of growth will need to be maintained amid a changing economic landscape, while improving equity and dealing with emerging issues of environmental management. Export growth will have to contend with increasingly competitive international markets and the need to diversify into new products. Indonesia's past success in managing structural change and rising to new challenges gives confidence that the important transitions likely in the years ahead can be managed smoothly. The key will be a continued commitment to sound economic management and action on an evolving agenda for development. iii. Many of the key challenges of sustaining development are reflected in the issues that currently occupy Indonesian policymakers. Concerns about Indonesia's high external debt explain the increased attention to domestic resource mobilization and careful management of external financing. The current high real interest rates, their effect on private investment, and strains in the financial system have raised concerns about the risks they pose to the sustainability of growth and to financial stability. Questions as to what policies would best support the next phase of industrial development in Indonesia motivate the current debate on industrial and technology policy. Concerns about the relative dominance of conglomerates in industry stem from the implications for both the efficiency and equity of private sector development. Recognition of the evolving challenges of development is also reflected in the increased emphasis on raising the quality of human resources. Moreover, growing awareness, in Indonesia and around the world, of how environmental degradation can jeopardize the sustainability of development underlies the increased interest of policymakers in improved environmental management. The report analyzes these and other issues within the broad framework of its central theme of sustaining development. Sustaining Development: The Challenges iv. The report discusses the task of sustaining development in its three major, complementary dimensions: * maintaining robust economic growth, by capturing the enhanced opportunities for xiii xiv Executive Summary development and diversification that now present themselves; * promoting equity, by further reducing poverty and broadening participation in development; and * protecting the environment, by conserving resources and limiting pollution. Growth, equity and environmental protection are all necessary ingredients of sustained development. Strong synergies exist among them. Growth generates the employment and increase in resources necessary to reduce poverty and improve environmental management. Equitable development broadens the base of growth and reduces poverty-a major source of pressures on the environment. Protection of the environment fosters efficient, long-term growth and benefits the poor, who tend to suffer most from environmental degradation. Trade-offs also exist, for example, between industrial growth and pollution control. But the answer is not to produce less, but differently. Effectively integrating the objectives of growth, equity and environmental protection is the crux of sustained development. It calls for a long-term vision of development, and policies and programs, such as those supporting efficient functioning of markets and human resource development, that take maximum advantage of the complementarities that exist among these objectives. It also calls for actions that deal effectively and efficiently with trade-offs among the objectives. v. Within this broad framework for sustained development, the future policy agenda will be shaped by some fundamental structural transformations and transitions. As outlined below, in all the three areas of growth, equity and environmental protection, a new generation of issues is emerging that will test the responsiveness of the policy and institutional framework. vi. Growth with Stability. Indonesia needs to sustain growth of 6-7% p.a. in non-oil GDP to employ the growing labor force (annual increase of about 2.3 million) at rising levels of productivity and continue to improve the general living standards. A fundamental condition for sustained, robust growth is the maintenance of a stable macroeconomic environment, a condition reinforced by Indonesia's high external debt and debt service (58% of GNP and 30% of exports, respectively, for medium- and long-term debt). But policies will also need to adapt to some fundamental qualitative shifts in the growth process as well as to continuing major structural transformations in the economy. The qualitative shifts include: * an increasingly important role for improvements in efficiency and productivity as a source of growth; and * a transition from quantity to quality in the production of goods and services. With increasing competition in international markets, raising efficiency and productivity will be the key to sustaining the dynamism of non-oil exports, which will remain a major driving force of Indonesia's growth and diversification. The sources of Indonesia's competitive edge will shift gradually from the basic cost advantages of cheap domestic labor and abundant raw materials to gains in productivity. Besides exports, efficiently supplying the large domestic market offers substantial scope for productivity improvements and growth, with large gains for Indonesian consumers. The critical need is to foster increased competition, not only by opening the economy further to competition from abroad, but also by intensifying efforts to remove barriers to competition within the domestic economy. The need to give greater attention to quality will manifest itself in several ways: shifts in the focus of public service provision increasingly toward quality improvements as quantity targets are met (e.g., in basic education); increasing private use of quality improvements and new product development to capture markets; and a Executive Summary xv shift toward environmentally benign methods of production. vii. Key structural transformations that will shape the pattern of future growth include: * a continuing shift in public-private roles; * a declining role of oil in the economy; and * major inter-sectoral and intra-sectoral shifts within the non-oil economy. With the private sector leading in expanding productive capacity, the Government's role will need to continue to shift to ensuring efficient functioning of markets and providing public services effectively and equitably. The share of oil could fall to as low as 5% of GDP over the next two decades, from about 28% in 1980 and 18% in 1990. This underscores the importance of continuing to promote non-oil sources of growth and exports. Maintaining the dynamism of non-oil manufacturing constitutes the core of this effort; the sector will need to post growth of around 10% p.a. for Indonesia to achieve its overall growth and export targets, which would double the sector's share in GDP over the next two decades (to over 33%). Within the sector, the structure of production will be expected to shift gradually in response to market forces toward more downstream processing and higher value-added activities. But, with labor supply remaining relatively abundant, labor-intensive industries will remain Indonesia's main area of comparative advantage. Agriculture will continue to lose share in GDP, but will still play a vital role as the main source of employment and producer of wage goods and raw materials. Growth in the sector will rely increasingly on non-rice activities. Sustaining the overall growth momentum while adapting to the foregoing qualitative and structural shifts in the economy, and maintaining macroeconomic stability, will be a major challenge. viii. Equity through Wider Participation. Ensuring equitable development will call for continued progress on three related fronts: * continuing to reduce and, in the long run, largely eliminate poverty; * ensuring widespread regional participation in development; and * promoting broad-based private sector growth. Indonesia's progress in reducing poverty, sustained during the adjustment to major external shocks in the 1980s, has been impressive. In 1970, 60% of the people were absolutely poor, compared with 15% in 1990. As poverty declines, further reductions may become increasingly difficult. A progressively larger proportion of the remaining poor are likely to be those who are harder to reach through a general growth of incomes and services, such as people living in resource poor and remote areas. A reflection of this is the uneven geographical pattern of poverty in Indonesia; the incidence of poverty remains high in the Eastern Islands and parts of Java. The centerpiece of the strategy to reduce poverty will remain the promotion of a broad-based pattern of growth that expands opportunities for the productive use of labor, the poor's most abundant asset, and the widespread provision of education and health services that enhance the poor's capacity to grasp those opportunities. However, the role of interventions specifically targeted at the disadvantaged groups and backward areas will increase in importance as the poor become a smaller part of the general population. Also, non-agricultural (and within agriculture, non-rice) activities will need to make a greater contribution to poverty reduction than in the past. Given continuation of appropriate policies, Indonesia can realistically set itself the objective of reducing poverty xvi Executive Summary (as currently defined) to below 10% by 2000 and largely eliminating poverty, except for a small hard core of particularly disadvantaged people, by the end of the Second Long-Term Development Program. ix. The promotion of a broad-based pattern of growth, which uses the diverse regional potentials for development, would also help reduce regional income disparities. A source of increasing concern in recent years has been the relatively high concentration of ownership, and market power, in the modern business sector in the hands of large business groups, or conglomerates. The dominance of such business groups raises issues of both equity (equal access to market opportunities) and efficiency (removal of barriers to competition). Effectively and efficiently dealing with this issue will be an important test of policies to foster broad participation in private sector development. x. Protecting the Environment. Sustainable growth will depend on efficient use and conservation of Indonesia's natural resources, including preventing pollution from destroying those resources. Essential to sustained growth, environmental protection is closely linked to the qualitative and structural shifts in the economy outlined above. Through such shifts, the structure and sources of growth need to change, to use resources, especially non-renewable resources, less intensively and to generate less pollution. An increasingly flexible, resilient and efficient private sector is essential for such shifts to occur with minimum dampening of growth. Policies that reduce the pressure of population growth make an important contribution to environmentally sustainable growth by generating demographic shifts that permit a given standard of living to be achieved with less use of resources and less pollution. xi. Sustainable use of natural resources is particularly important to Indonesia's development prospects given the major role these resources play in the economy: direct extraction and primary processing account for about 40% of GDP; and the primary sectors still generate about 60% of export earnings and 50% of employment. Sustained growth requires carefully managing the environment as a source of these resources. Key issues concern: * increasing scarcity and deteriorating quality of water supply, especially in Java (in dense urban areas, groundwater extraction rates have already exceeded natural replenishment, leading to salt water intrusion; in Jakarta, water pumped from the ground each year is estimated to be almost three times the sustainable level); and * deforestation, land degradation and loss of biodiversity, mainly in the outer islands (harvests from tropical forests are running about 50% higher than the estimated sustainable cut). xii. In addition to utilizing the resource base, growth will lead to increased urbanization and industrialization. As noted earlier, the share of manufacturing in GDP could double over the next two decades. The urban population has been growing at 5% p.a.; from only 15% of total population in 1970, it has already reached 30%. By the end of the Second Long-Term Development Program, half of the population may reside in urban areas. Cities in Java will need to cope with 1.5 million new residents each year. Some of this growth will come from reclassifying densely populated rural areas as urban, but it will still lead to increasingly complicated problems of urban environmental management. Rising pollution and congestion intensify the need to ensure sustainable use of the capacity of the environment as a sink for urban and industrial wastes. Major issues include: * in industry, control of air and water pollution and hazardous waste disposal (industrial pollution in urban areas could increase 10-fold over the next 25 years; it is already serious in many areas on the north coast of Java); and Executive Summary xvii in cities, better sanitation and solid waste disposal, and lower air pollution-especially from vehicle emissions-and congestion (in a recent survey in Jakarta, a large proportion of shallow wells, the dominant form of residential water supply, was found to be contaminated with human waste, while tap and hydrant water samples revealed lower but still substantial rates of contamination; also in Jakarta, particulates, lead and other airborne pollutants have already reached levels that harm health). The Agenda xiii. Capturing Indonesia's enhanced prospects for growth in an equitable and sustainable manner will require action across a wide-ranging policy agenda. It will call for maintenance of a stable macroeconomic foundation; improvements in the incentives regime for enterprise; substantial investment in human and physical capital; and institutional reform and development. This suggests an agenda for sustained development, integrating the objectives of growth, equity and environmental protection, that is linked by four broad themes: macroeconomic management; incentives; investment; and institutions. xiv. Macroeconomic Management. Macroeconomic stability is a fundamental condition for sustained growth. By providing a stable setting conducive to a continuous increase in incomes and to efficient decision-making (through a clearer transmission of market signals), it also underpins efforts to reduce poverty and protect the environment. Prudent macroeconomic management has been an important hallmark of Government policies. The measures taken by the Government since 1990 to cool down an overheated economy are bearing fruit, while maintaining robust non-oil GDP growth (7.5% in 1992). The current account deficit is estimated to have declined from 3.8% of GNP in 1991/92 to 2.4% in 1992/93, helped by an exceptionally strong growth in non-oil exports (30% in dollar terms). Inflation fell from about 10% in 1991 to 5% (end-year basis) in 1992. Restrained macroeconomic policies contributed to this outcome. The resurgence of inflation in the first quarter of 1993, however, demonstrates the never- ending need for cautious macroeconomic management. xv. The main challenge in maintaining macroeconomic stability is navigating the narrow path between sufficiently rapid growth and excessive demand pressures and external shocks that would raise the current account deficit and inflation. Indonesia's room for maneuver is tightly constrained by its relatively heavy external debt, which necessitates that the current account deficit be reduced to, and then maintained at, sustainable levels. This calls for keeping the current account deficit on a downward course, to reduce it to about 2% of GNP, and carefully managing the external debt. Sustaining robust non-oil export growth will be central to achieving the current account targets. To sustain non-oil GDP growth of 6-7% p.a., the overall investment rate will need to rise, from about 23% in 1992 to about 25.5% toward the end of the decade. Reconciling the higher investment rate with a lower current account deficit will require an increase in the national savings rate, from about 20% in 1992 to 23.5% toward the end of the decade. This underscores the need to intensify domestic resource mobilization. xvi. Keeping the economy on a sustainable growth path will call for a balanced, coordinated use of fscal, monetary and exchange rate policies. The burden of reducing excess domestic demand since 1990 has been borne primarily by monetary policy. Aflrmerflscal stance would produce a better policy balance, helping to lower the current high real interest rates and allowing higher private investment without rekindling demand pressures. A fiscal stance consistent with both a sustainable external balance and continued robust growth in private investment, while adequately providing for complementary public investments, will be a key element in macroeconomic management for growth with stability. xvii. Reconciling the roles of fiscal policy in supporting stabilization and promoting growth calls xviii Executive Summary for increasing public savings and allocating them to priority investments, while generating a fiscal balance consistent with the overall macroeconomic policy framework. This, in turn, calls for: mobilizing more public revenues, emphasizing efficiency-enhancing improvements in cost recovery and better tax administration; restraining growth in government administrative spending; guiding public investment allocations by a sound set of priorities and raising the efficiency with which investments are implemented; and improving public enterprise financial performance. Incorporating all government expenditures in the budget would subject them to the discipline of the budgetary process and enhance transparency and efficiency in the use of public resources. It would also lead to more effective implementation of fiscal policy since non-budget operations were a major cause of the increase in the overall fiscal deficit in 1992/93. Private savings need to rise too. Sustaining growth, maintaining financial stability, fostering financial deepening, and promoting profitable, widespread investment opportunities through continued improvements in the incentives regime, as outlined below, should contribute to higher private savings, by households and firms. Demographic shifts resulting in a lower dependency ratio may also help boost savings rates. xviii. Incentives. Both the toughening international business climate and Indonesia's outward- oriented development strategy place a premium on policies that provide incentives to raise efficiency and productivity. Through its structural reform program, Indonesia has taken major strides in improving the incentives regime; but much still has to be done to lower the high costs that remain in many sectors of the economy. There is concern among investors, both domestic and foreign, that regulatory reforms have slowed. Restoring strong momentum to these reforms is a high priority. Reforms need to focus on making markets work better, by strengthening both external and domestic sources of competition. The reform agenda comprises three broad elements: Competition in the product markets needs to be boosted by a reinvigorated drive to remove remaining regulatory barriers. Despite substantial trade policy reform, many activities, in both industry and agriculture, remain protected from external competition, contributing to a high-cost economy. Indonesia's production coverage of non-tariff barriers (about 30% in both manufacturing and agriculture) and effective rates of protection (over 50% in manufacturing) are high relative to those in most of its East Asian neighbors. Priorities in trade reform include: eliminating virtually all non-tariff barriers; reducing tariffs so that few lie above 20% (currently nearly 4,000 tariff items, or about 45% of the total, have tariffs and surcharges above 20%; of these, about 1,450 items, 16% of the total, have tariffs and surcharges of 40% or more); and reducing export restrictions, especially on forestry products (in conjunction with raising forestry fees and royalties). Deregulation should be applied with equal vigor to domestic trade, by dismantling trading monopolies (e.g., for many,agricultural products) and removing barriers to inter-regional trade. Ensuring correct price signals also calls for reforming domestic pricing policies, including appropriate pricing of public goods (utilities) and freeing the prices of private goods (e.g., sugar, fertilizer and cement); the recent major reform of fuel pricing provides an excellent example to follow. Investment regulations, for both domestic and foreign investment, have been substantially eased, but there remain areas for further reform to increase the number of competitors in markets and attract larger inflows of foreign direct investment, including: shortening the negative investment list; relaxing minimum local content and export requirements; further easing the requirements for dilution of foreign ownership; streamlining a continuing array of regulations at the local level; increasing the scope for competitive private entry in the provision of public services; and improving the actual implementation of reform measures (e.g., in customs). Executive Summary xix * Factor markets need to become more flexible and efficient, to help translate incentive reforms into a robust supply response. For the financial system, which has grown rapidly in response to extensive deregulation, the priority tasks are to consolidate past growth, continue to strengthen prudential regulation and supervision, and safeguard the stability of the system, which is currently under strain. Increased confidence in the system and improved efficiency of banks will contribute to lowering the high real interest rates. Related issues are developing viable ways to reduce the concentration of credit and improve credit availability to smaller businesses, and developing the market for equity (to reduce relatively high debt-equity ratios). The land market remains underdeveloped, with the cost and complexity of transactions acting as a deterrent to business, especially foreign investment. A market-based system of land allocation needs to be introduced by: sharply reducing and simplifying land regulations; improving and expediting land titling and registration; and instituting competitive auctioning for the allocation of State land. An efficient market for technology will be increasingly important for maintaining the competitive edge of Indonesian industries and developing new products. International experience shows that the acquisition and assimilation of technology are best achieved by maintaining an open regime for trade, investment and technology licensing and a strong emphasis on education and training, supplemented by a technological support infrastructure-R&D facilities, standard setting and quality control-that is well-focused and responsive to private needs. In contrast, policies centered on a "technological leapfrogging" strategy, involving the development of targeted high-technology industries supported by direct public investment or subsidies and high levels of protection, have proven costly and ineffective in most countries. Also, such policies are inconsistent with Indonesia's strategy of broad-based growth and generation of enough jobs to employ the growing labor force. The labor market is relatively free of distortions in Indonesia; the main tasks are to increase the supply of better educated and more skilled workers, and to avoid actions that undermine the flexibility of the market, such as barriers to the use of expatriate skilled workers. * The policy and regulatory infrastructure for markets needs to be improved to support better market outcomes. First is the need to develop up-to-date, clear and enforceable commercial, credit and contract laws, standards for accounting, auditing and financial disclosure, and transparent procedures for Government interactions with the private sector. Such "rules of the game" support efficient and equitable functioning of markets. Policies that "level the playing field"-dismantling of trade and investment barriers and other sources of monopoly advantage, prudential regulation of bank lending to interlocking business interests, and commercial legal reform-are the best way to prevent excessive concentration of market power and ensure that conglomerates face effective competitive pressures. It is particularly important that relations between the Government and the private sector be disciplined by transparent, competitive procedures to avoid real or apparent conflict of interest and discourage rent seeking. Regulatory reforms and supportive market infrastructure that promote competition and equalize access to market opportunities will also be a more effective means of promoting the development of small and medium-sized enterprises than direct government interventions. Second is the need to improve the framework of incentives to protect the environment. Allowing markets to work efficiently helps exploit the synergies between good economics and good ecology; examples are eliminating subsidies on natural resources-maintaining economic pricing of fuel, raising water and power charges, and correcting policies that result in underpricing of forest resources-and clarifying land rights. Even where markets fail because of externalities, market-based measures (e.g., pollution taxes and tradeable permits) are likely to be more xx Executive Summary effective and cost-efficient. However, regulatory measures are also needed, such as emission or ambient standards and land-use planning; their design needs to reflect institutional capacities for implementation and enforcement. xix. Investment. A sustained, vigorous investment effort will be required to meet Indonesia's development objectives. There are four broad priorities in the investment agenda: * While the investment rate, both private and public, will need to rise, equally important will be raising the efficiency and quality of investment. Without efficiency improvements, resources will be insufficient to meet requirements. Higher productivity of private investment will depend critically on the provision of a more outward-oriented and competitive incentives regime, as outlined above. Higher efficiency of public investment will depend on continued progress in several areas: market-based public pricing policies; effective operation and maintenance of existing investments; exposure to private competition, where feasible; systematic evaluation of project proposals; and enhancement of project planning, implementation and management capacities of investment agencies. * The composition of investment should emphasize complementarity in private and public investment, with the latter focused on infrastructure and human resource development. Private enterprise should focus on investment in directly productive activities, but can also be tapped to contribute more to improving the availability and quality of public services, in both infrastructure and social sectors. The framework for private participation in public service provision needs to be carefully structured to generate competitive pressures and protect the public interest. Around 85% of total public investment over the REPELITA VI period could be allocated to infrastructure and human resource development, slightly higher than in REPELITA v, but much higher than the 70% allocation during REPELITA IV. In infrastructure, in view of the pressure of rapidly rising demand on existing capacity, the expansion of power supply is a high priority. In human resource development, basic education and health will remain the major focus of public spending, with a growing emphasis on quality enhancement. The emphasis at higher levels of education and in vocational training will also need to be on raising quality and improving relevance. * The effectiveness and efficiency of expenditures on poverty alleviation can be enhanced through better targeting of public subsidies for social services. The poor's access to education and health has improved substantially, but much could be done to make the poor benefit more effectively from public expenditures on these services. Targeting these expenditures better for the poor calls for: identifying more accurately the location of the poor; shifting expenditures more toward programs of largest benefit to the poor, such as primary education and public health centers; increasing the use of public programs by the poor where it is low, such as in junior secondary education; and reducing service charges for the poor, and financing these reductions from improved cost recovery from the better-off. * Expenditures on environmental protection will need to be raised. For public investment, the priorities will be water supply, sanitation and solid waste disposal services; improved quality of urban transport; and forest protection. Expenditures on human resource development (education, health, family planning) and poverty alleviation programs will indirectly, but importantly, benefit the environment. The private sector will need to spend more on urban and industrial pollution abatement. The incremental costs of public and Executive Summary xxi private environment-related investments are sizable, but modest in comparison with their economic and social returns. There are two important points to remember. First, improved pricing and cost recovery will be essential to pay for much of the needed public investment. Second, prevention is cheaper than cure; improved environmental evaluation of projects and adoption of cleaner technologies for new investments can save expenditures later on fighting environmental degradation. xx. Institutions. Institutional capacities will have a major bearing on the effectiveness of the incentive reforms and investments outlined above. Over the longer haul, the responsiveness of the institutional framework to strategic and structural shifts in the economy will be a major determinant of the sustainability of development. The transitions that the Indonesian economy is undergoing-the dismantling of regulatory controls, the increasing role and capacities of the private sector, and the shift toward more decentralized decision making-and the new challenges of development that are emerging, most notably that of environmental protection, have profound implications for institutional roles and capacities. The agenda encompasses both market and public institutions. It comprises three main thrusts: strengthening the institutional underpinnings of markets to support efficient and broad-based private sector development; adapting and developing public institutions, focusing their capacities on efficient and equitable provision of public services; and developing the institutional framework for environmental management. xxi. Two critically important, and related, institutional underpinnings of markets are a well- functioning legal system, to provide a predictable and fair environment for business, and a sound accounting and auditing system, to instill financial discipline. The need for clear, modem commercial laws and accounting and auditing standards was noted above, but these laws and standards would be of relatively little practical value without adequate means for their implementation and enforcement. The main needs are: strengthening the court system and arbitration mechanisms; upgrading the training of lawyers, accountants and auditors and developing their professional associations and standards; and widely disseminating legal information. xxii. The evolving role of government implies the need for major adaptations and improvements in public sector management: * Public enterprise reform needs to be accelerated, proceeding on two tracks: further commercialization of enterprises providing public goods and services that need to remain in the public domain; and a gradual divestiture of enterprises providing private goods and services. Improving the performance of enterprises remaining public needs to emphasize greater exposure to competition, autonomy in a framework of enhanced accountability, and financial discipline. Divestiture should employ transparent, competitive mechanisms that protect the public interest and allow broad private participation. * Reassessing and realigning government administrative structures and the size, deployment, skill-mix and incentives of the civil service to perform the changing functions of government are an essential complement to economic reforms. These reforms imply the elimination of many routine government administrative, control and licensing functions, and an increasing focus on policy analysis, promotion, monitoring and coordinating functions. One important implication is to move toward a leaner but more professional and technically skilled civil service, with better compensation linked to higher productivity. * A key dimension of public sector reform to provide public services more efficiently is the xxii Executive Summary decentralization of responsibilities for local services to local governments. Mobilizing more local revenues, to reduce the present heavy dependence of local governments on central transfers, and building local institutional capacities will be essential for successful decentralization. xxiii. Closing the existing large gap between environmental policy and implementation calls for strengthening the institutional capacities for environmental management. Progress will be needed on three main fronts: improving the systems for environmental information and analysis to inform priority- setting and policy design; strengthening the institutions responsible for environmental management, including clarifying their roles and improving coordination; and enhancing local participation in policymaking, monitoring and enforcement. xxiv. Priorities in the Agenda. The foregoing discussion suggests the following priorities in the agenda for sustained development: * Macroeconomic Management: continue prudent macroeconomic policies to maintain financial stability, mobilize domestic resources and ease the burden of external debt. Raising both public and private savings will be central to macroeconomic management for growth with stability. * Incentives: strengthen both external and domestic sources of competition to support efficient and broad-based private sector development, building environmental concerns into the framework of incentives. Greater integration with the regional and global economy, through removing barriers to international flows of trade, investment and technology, should form a principal thrust of policies to raise efficiency and productivity. * Investment: focus public investment on infrastructure and human resource development, emphasizing efficiency and quality of services and better targeting for the poor. In the other sectors, the primary role of Government should be in providing a competitive environment for private investment. * Institutions: adapt and develop public institutions in line with the evolving role of government, focusing public capacities on providing the institutional underpinnings for efficient functioning of markets and on effectively and equitably delivering public services, including environmental protection. External Financing Implications xxv. The projected pace of growth, poverty reduction and reform will call for substantial external resources, even with the expected rise in domestic savings. Given Indonesia's still low per capita income, substantial poverty and heavy debt-service burden, much of the external financing needs to be on concessional terms and in forms that effectively meet the financing requirements of the economy. In 1993/94, total gross external financing is projected to be about $10.5 billion, substantially lower than in the past three years. This reflects the major progress achieved since 1990 in reducing unsustainably high current account deficits and associated large increases in foreign borrowing, especially private borrowing. The projected financing plan for 1993/94 is based on the following important assumptions. First, the current account deficit will be contained to $2.9 billion, about the same as in 1992/93, despite an expected decline in the world oil price; this implies an improvement in the non-oil current account balance of $0.5 billion and a decline in the total current account deficit from 2.4% of GNP in 1992/93 to 2.2% in 1993/94. Second, amortization payments will rise sharply from $7.4 billion in 1992/93 to Executive Summary xxiii $8.4 billion. Third, part of the large financial inflows attracted by high domestic interest rates in 1992/93 will flow out as interest rates gradually decline toward international levels. Fourth, official reserves will be maintained at levels equivalent to 4-4.5 months of imports, levels that are prudent given Indonesia's open capital account and vulnerability to external shocks. xxvi. Private borrowing is expected to decline to more sustainable levels in 1993/94, but would rise again thereafter. Private capital, including foreign direct investment, would provide about half of Indonesia's total external financing needs in the 1990s, compared to negligible amounts in the 1980s. The increasing role of private capital in external financing calls for continued careful attention to debt management and policies that ensure efficient use of resources, especially given Indonesia's already large stock of debt. First, the incentives framework needs to ensure that these external resources flow into efficient uses and generate rapid, high returns, especially in export-oriented activities. In this regard, large, capital-intensive projects, and projects with high follow-up costs, need particularly careful scrutiny as such projects can add rapidly to Indonesia's debt, while crowding out potentially more profitable investments by small and medium-sized enterprises. Second, the availability of private financing at the projected levels cannot be taken for granted and will depend heavily on perceptions of Indonesia's creditworthiness. Third, the shift in the composition of Indonesia's debt toward private capital implies that Indonesia will have to cope with a rising average borrowing cost and a shortening maturity profile of debt. xxvii. Given the size of Indonesia's existing debt and the hardening of average terms, direct investment needs to be a larger share of capital inflows. Such inflows reduce the need for borrowing, and the risks associated with higher levels of debt, and also provide new technologies and export market access. Foreign direct investment has risen significantly in response to the regulatory reforms of recent years, but larger flows can be promoted by policies that enhance Indonesia's attractiveness as a home for foreign investment. xxviii. Within the overall financing plan, concessional assistance will play a strategically important role, even though such assistance will decline significantly in net terms and in relation to the size of the economy throughout the decade. An adequate flow of concessional assistance is an essential part of Indonesia's transition to a more diversified financing pattern. First, such assistance will continue to provide financial support to projects and programs in such key areas as infrastructure and human resource development. Second, it will enable Indonesia to continue to pursue with confidence its program of structural reforms to enhance productivity and competitiveness, while it seeks to improve further its macroeconomic balances. Third, as amortization payments rise, it will be important to ensure that the net flow of concessional external resources does not fall too rapidly. Fourth, an adequate degree of concessionality will support prudent external debt management by keeping the rising average borrowing costs noted above within limits that are manageable, given Indonesia's high indebtedness. Working together, these factors will help improve Indonesia's access to international financial markets, and attractiveness to foreign direct investment, and thus increase the probability that the projected private and commercial flows will be available as needed. xxix. This financing scenario projects that current levels of concessional financing are maintained. With an appropriate mix of project and sector assistance, and further efforts to improve project implementation, CGI commitments at about the same level as last year ($4.9 billion) would generate the projected concessional flows. As discussed at last year's CGI meeting, infrastructure and human resource development remain priority areas for this assistance.  1 SUSTAINING DEVELOPMENT A. Overview 1.01 "The achievement of sustained and equitable development remains the greatest challenge facing the human race." So begins the last World Development Report.' This also provides an apt opening for this Report which focuses on the challenges Indonesia faces in sustaining development in the years ahead. Indonesia's recent development record is impressive: continued rapid growth; resilience to major external shocks; management of substantial structural change; considerable reduction of poverty; and a notable start on improving environmental management. Past achievements have laid a good foundation for further progress, to move the country up the income ladder. Indonesia is still a low income country, though fast closing the gap with the middle income group; large numbers remain poor; and there are major issues emerging in environmental preservation. Sustaining development, the central theme of this Report, has three major, complementary dimensions: maintaining robust growth, capturing the enhanced opportunities for economic expansion and diversification that now present themselves; promoting equity in development, in further reducing poverty and broadening participation in the process of economic growth; and protecting the environment. Effectively integrating these objectives is the essence of sustained development. 1.02 In sustaining development, Indonesia will face continuing major structural shifts in the economy and an evolving array of challenges associated with the transition to a higher level of development and an increasingly competitive world. These range from the shifting roles of government and economic sectors to the rising imperatives of improving efficiency and productivity (and hence fostering greater competition) in the production of goods and services. The focus of investment will need to shift increasingly from quantity to quality. The issues of environmental management will in general require greater attention. Institutional development and reform, encompassing both market and public institutions, will have an increasingly important role in the policy agenda. Indonesia's effective management of structural change in the past inspires confidence that the transitions that lie ahead can be managed successfully. But the challenges of sustaining success are formidable, and should not be underestimated. The key will be a continued firm commitment to sound economic management and responsiveness to an evolving agenda of reforms. 1.03 This chapter sets out the thematic and structural framework of the Report, and provides an overview of its main conclusions. Starting with a review of Indonesia's progress on development in Section B, it discusses, in Section C, the main challenges of sustaining development. The discussion highlights the evolving nature of the challenges. It also brings out the links between the three dimensions of sustained development: growth, equity and environmental preservation. Meeting these challenges will require action across a broad policy agenda. This agenda is discussed in Section D, organized under four themes: macroeconomic management; incentives; investment; and institutions. Each of these themes in turn forms the subject of a subsequent chapter, where the various elements of the agenda are analyzed and developed more fully. World Development Report 1992: Development and the Environment, World Bank, Oxford University Press, May 1992, p. 1. 2 Chapter 1 1.04 The themes of macroeconomic management, incentives, investment and institutions provide a useful, cross-cutting framework for integrating the agenda for growth, equity and the environment. Thus, for example, the chapter on incentives (Chapter 3) addresses reforms needed in the incentives regime not only to promote productivity and efficiency-and hence economic growth-but also to foster equity through wider access to opportunities and to improve environmental outcomes; the complex of issues discussed ranges across sectors, public/private as well as economic sectors. A similar, integrated approach is taken in the chapters on investment (Chapter 4), which includes social spending, and on institutions (Chapter 5). Also, the chapter on macroeconomic management (Chapter 2) goes beyond the usual macroeconomic issues to analyze the implications of the medium- to long-term economic outlook for poverty and the environment. This way, the three dimensions of the challenge of sustained development are discussed in each chapter, bringing out their complementarities as well as noting the trade-offs. B. Progress on Development 1.05 Indonesia can be justifiably proud of its development record. Twenty five years ago, it was one of the poorest countries in the world, with a per capita income of only $50. Since then, it has made great strides, achieving an average GDP growth of almost 7% p.a., a growth performance that ranks among the ten fastest in the world and on par with that of the dynamic East Asian economies (Figure 1.1). Rising at a rate of about 4.5% p.a. over this period, Indonesia's per capita income reached $650 in 1992, implying a substantial improvement in living standards. Indonesia is still classified as a low income country, but, provided the momentum of development is sustained, it is now within striking distance of joining the ranks of middle income countries. Figure 1.1: Selected Indicators of Economic Perormance GDP Growth (% p.a.) Export Growth (% p.a.) 03 6 2 4 2 1 1967-73 1974-80 1981-85 1986-91 1968-73 1974-80 1981-85 1986-91 0 Indonesia E East Asia E Adl DC's Indonesia [ East Asia 2AM DC% *Dollars termns; non-oll for Irndonesla Inflation (% p.a.) Debt Service Ratio 60 202- 1967-73 1974-80 1981-85 1986-91 1967-73 197440 198145 1986-91 0 indonesia ES East Asia 10l D' Indonesia E3 East Asia E2 Highly IndlelDtad D Sustaining Development 3 1.06 Growth, Financial Stability and Structural Reform. Consistent emphasis on maintaining economic stability, marked by the willingness to take hard decisions in times of both boom and bust, provided a solid foundation for sustained, robust growth. Prudence was exercised during the years of the oil boom in the 1970s, spreading the use of the oil windfalls over time and across sectors in a manner that avoided the erosion of the non-oil sectors that plagued most other oil-exporting countries. The development strategy emphasized channeling oil revenues into raising agricultural output and developing physical and social infrastructure. The emphasis on agriculture supported broad-based growth of rural incomes. The development of infrastructure strengthened the foundations for future growth. The economy grew at nearly 8% p.a. during the 1970s. A quick, tough response in the mid-1970s avoided a potentially serious debt problem. Subsequent cautious macroeconomic policies, including a conservative external borrowing strategy, maintained financial balances, although inflation rose moderately in response to the increased spending based on oil revenues. At the turn of the decade, the external current account was in surplus and the debt-service ratio was below 13%, about one-quarter of Mexico's level. 1.07 Indonesia faced a series of severe external shocks in the mid-1980s, including the collapse of oil prices, the rise in international interest rates and the depreciation of the US dollar. These developments sharply reduced exports and fiscal revenues, opening up sizable external and domestic financial imbalances, and raised external debt service (these shocks together are estimated to have entailed an average loss of income for Indonesia of 7-8% of GDP p.a. during 1983-88). The Government responded promptly and effectively by embarking on a two-pronged adjustment program: restoring macroeconomic stability through fiscal and monetary restraint, supported by improvement of external competitiveness through a responsive exchange rate policy; and establishing a more diversified and efficient productive base through structural reforms that reduced the dependence on oil. The strategy to develop the non-oil economy had two main thrusts: promotion of the private sector; and encouragement of a more outward-oriented economic structure. The structural reforms were developed within a comprehensive, medium-term framework that fostered credibility through consistent implementation. While wide-ranging in scope, the reforms were particularly far-reaching in the areas of trade, investment, taxation and finance. 1.08 This strategy was successful in stabilizing the economy, maintaining growth and transforming the structure of production (Table 1.1). Sound macroeconomic management substantially reduced the current account and fiscal deficits, and contained inflation to below 10% p.a. Prudence in external borrowing allowed Indonesia to service its debt without requiring any rescheduling, at a time when many other oil-exporting countries encountered serious debt difficulties. Despite its large debt, Indonesia retained access to voluntary market finance throughout the adjustment period, in contrast to the general experience of the heavily-indebted developing countries. 1.09 Supported by prompt macroeconomic stabilization measures and structural reforms that spurred competition and enlarged opportunities for growth, especially of non-oil exports, the economy rebounded quickly from the effects of the shocks. Economic growth averaged close to 7% during 1988-91, having dipped to around 4% in the mid-1980s in the wake of the severe external shocks. The major force driving economic recovery was the private sector, as private investment responded vigorously to the policies of deregulation. The private sector contributed over 70% of the total GDP growth during 1983-91. Besides the increasing role of the private sector, evidence of successful structural diversification abounds. Non-oil exports and non-oil budget revenues increased from about one-quarter of total exports and budget revenues in the early 1980s to about two-thirds by the end of the decade, while the share of non-oil manufacturing in total GDP almost doubled (Table 1.1). Non-oil export growth averaged about 18% over the past five years, with a still faster growth of 26% p.a. in exports of manufactures, an achievement that compares favorably with the region's best performers. 4 Chapter 1 Table 1.1: Key Economic Indicators a 1975-83 1983-87 1988-89 1990 1991 1992 (est.) Average real growth rates (% p.a.) GDP 6.5 5.0 6.6 7.1 6.6 5.8 Non-oil 7.0 5.7 7.8 6.9 6.3 7.5 Non-oil exports 10.5 12.2 17.8 2.8 24.3 26.6 Fixed investment 10.7 -3.7 11.9 14.6 6.0 5.0 Private 9.1 0.9 10.7 16.2 3.0 3.7 Macroeconomic balances (%) b Current account/GNP -7.8 -2.5 -1.9 -3.4 -3.8 -2.4 Overall public sector balance/GDP -4.8 -2.7 -2.1 0.3 -1.1 -1.4 MLT debt service/exports 16.8 34.8 35.8 29.7 31.6 30.0 Structure of the economy (%) b Non-oil exports/total exports 23.0 51.9 61.1 55.0 64.0 70.5 Non-oil revenues/total revenues 35.6 56.5 58.9 57.0 62.3 66.0 Non-oil manufacturing/GDP 9.9 12.8 13.9 14.9 15.4 16.0 Private fixed investment/ total fixed investmeni 52.1 60.6 58.7 59.1 57.7 57.0 a Balance of payments data are for fiscal years (starting April 1). b For last year of multi-year periods. Source: Central Bureau of Statistics and World Bank staff estimates. 1.10 Following the successful adjustment to the external shocks of the 1980s, the Government has faced the challenge of managing dynamic, private-sector led growth in an increasingly deregulated economy. In 1990/91, a strong surge in private investment, responding to the incentive and regulatory reform, combined with an easing of monetary policy, led to the emergence of excess demand pressures. These were reflected in a widening of the current account deficit, an associated sharp increase in external borrowing, and higher inflation. The Government responded by tightening monetary and fiscal policies and restraining public and publicly-related external borrowing, which helped dampen the demand pressures. It moved to strengthen the framework for prudential regulation of the financial sector, which showed signs of stress following rapid growth spurred by extensive sector deregulation. At the same time, the Government continued to build on earlier reforms in trade policy and investment and industrial regulations. These more recent macroeconomic developments and structural reforms are reviewed in greater detail in Chapters 2 and 3, respectively. 1.11 Poverty and Income Distribution. Perhaps the most powerful indicator of the success of Indonesia's development strategy and adjustment to the shocks of the 1980s is the degree of poverty reduction. Indonesia started the 1970s with around 70 million people, or 60% of the population, in absolute poverty. By 1990, the number of the poor had dropped to about 27 million, or 15% of the population (Figure 1.2). Even during the difficult adjustment period in the 1980s, poverty reduction was sustained. The 1990 World Development Report found that, over the last two decades, Indonesia achieved the highest annual average reduction in the incidence of poverty among all the countries studied. Sustaining Development 5 Indonesia's success in reducing poverty is attributable to several elements of its development strategy: substantial investment in economic and social infrastructure that supported sustained, broad-based growth; strong emphasis on improving productivity in agriculture, the source of livelihood to a majority of the population and the overwhelming bulk of the rural poor; structural reforms that induced a shift from inward-oriented, capital-intensive activities toward export-oriented, labor-intensive activities; and cushioning of the impact of adjustment in the 1980s on expenditure programs beneficial to the poor, notably social services. FIgure 1.2: Incidence of Poverty and Income Distribution, 1970-1990 Poverty Income Distrbution 140 10 % Hedct hIdlK (oft pop.) 82l 8D.0 8- 66.0 -106 Numbif of;1 6- 70.0 70 28.6 - 03 3 so.oosea 284 15 .16 . 23 2 . 3 2 - 17.8] 1970 1980 1990 1970 1980 1990 1q70 1980 99D C]Stm ~orse2% OGN od 1.12 Evidence on the distribution of income, personal and regional, is more limited than on poverty, but the available indicators point to a gradual reduction of disparities. The share of personal expenditures by the poorest 20% of the population improved from 6.9% in 1970 to 8.9% in 1990; the latter compares with 5.5 % in the Philippines, and 4.5 % in Malaysia and Sri Lanka. Indonesia's relatively low and declining level of inequality is also indicated by the trend in the Gini Coefficient (estimated from the distribution of personal expenditures), which fell from 0.35 in 1970 (0.38 in 1978) to 0.32 in 1990 (Figure 1.2). There is evidence also of a gradual narrowing of regional income disparities, though the disparities remain large (Figure 1.3). Against these favorable trends, a source of concern has been the emergence of a relatively high concentration of ownership, and market power, in the modem business sector in the hands of large business groups, or conglomerates, and its implications for bath the efficiency and equity of private sector growth. The operations of the top 200 such groups were estimated in 1990 at the equivalent of around one-third of GDP (excluding the smallholder and the oil extraction sectors), of which about a third was accounted for by the top 5 groups. 6 Chapter 1 Figure 1.3: Trends in Regional Income Distribution Provincial GDP Shares (Constant Indices of Regional Per Capita Income* 1983 prices) Share In Total GDP 0.9 ~~~~~~250- K-- nt n 0.1 0.8 20 0.7 0.6 1150- u ar 0.5 0.4 198 1 00 -01 8 88 78 9 0.3 04 02 ~501 Others 0.1 0 01 1 1 1 . I I I I I 0 0.2 0.4 0.6 0.8 1 78 79 80 81 82 83 84 85 86 87 88 89 90 Share in Popullai* National per capita income = 100 Figure 1.4: Access of the Poor to Social Services Changes in Enrollment Rates Changes in Utilisation of Health Services Among the Poorest 40%, 1978-1987 Among the Poorest 40%,1978-1987 (% of age group enrolled) of reporing ill in last week who were treate) 81 Male 67 67 52 5161 51 48 41 35 33 3 26 277 26~l Ir Sd.2 rta6 111 Prmary r Tertiary 19781987 19781987 1978987 19781987 90 Urban Java -Rural Java Lk urW Rural OtalrMuids 78 F Heth Center 0 Other Mode ProFaders 62 37 24 0 2 Primary Secnn*ay Terfiary A to1978 m1os7 Sustaining Development 7 1.13 Human Resource Development, Infrastructure and Environment. Human resource development has received strong emphasis in the Government's development strategy, both as a means of raising living standards and increasing the capacities for growth. The successes are evident from the social indicators shown in Table 1.2. Infant survival, life expectancy, literacy, school enrollments and access to health services have all improved substantially. Cross-country comparisons of social services show Indonesia catching up fast with its East Asian neighbors, despite having a much lower income level and starting from a much lower base. Attention to women's role in development and poverty reduction is reflected in female school enrollments rising faster than average, so that 48% of all primary school students and 45 % of secondary school students are female. The development of social services has been accompanied by an improvement in the access of the poor to these services (Figure 1.4). Improved access of the poor to basic education and health services has been an important factor in the reduction of poverty. Table 1.2: Human Resource Development - Selected Countries, 1960-1990 Life expectancy Infant Adult Primary Secondary Population at birth mortality illiteracy enrollment enrollment per (years) rate a rate b ratio c ratio d physician 1960 1990 1960 1990 1960 1990 1960 1989 1960 1989 1960 1984 Indonesia 41 62 159 61 61 23 71 118 6 47 46,780 9,410 East Asia & Pacific Philippines 53 64 134 41 28 10 95 111 26 73 n.a. 6,570 Malaysia 54 70 105 16 42 22 96 96 19 59 7,020 1,930 Thailand 52 66 149 27 32 7 83 86 13 28 7,950 6,290 South Korea 54 71 120 17 29 4 94 108 27 86 3,540 1,160 South Asia India 43 59 165 92 72 52 61 98 20 43 4,850 2,520 Sri Lanka 62 71 71 19 25 12 95 107 27 74 4,490 5,520 All Developing Countries 46 63 233 69 n.a. 40 n.a. 105 n.a. 43 n.a. 4,980 a Number of infants per thousand live births, in a given year, who die before reaching one year of age. b Proportion of the population over the age of fifteen who cannot, with understanding, read and write a short, simple statement on their everyday life. Base period illiteracy rate is for 1960 except for: Indonesia and India (1961); Malaysia (1970); and Sri Lanka (1963). C Gross enrollment of all ages at the primary level as a percentage of primary-school-age children. d Computed in the same manner as the primary enrollment ratio. Source: World Development Report, various issues; The State of The World's Children, 1989. 8 Chapter 1 1.14 The development of physical infrastructure has been a second major plank, Figure 1.5 : Indicators of Infrastructure Development, 1970-1990 alongside human resource development, of the PLN's Instaled Capacity (GM Telephone Lines (000) Government's strategy to promote strong, 10.0 1,200 broad-based growth. Infrastructure 8.0 1,000- development has consistently received high soo - priority in successive five-year development 6co- plans (REPELITAs), averaging over 40% of all 4.0 400, development expenditure. This is reflected in 2.0 200[ M a substantial expansion of services in all 0.0 1 major infrastructure sectors over the past two decades. For example, the installed capacity Paved Roads (000 km) Land Under TeIal iigMion (mil. h) of the state electricity company (PLN) 12c 3.0 increased 18-fold; the number of telephone 10 2.s lines rose seven-fold; and the length of paved 0 2.0 roads increased nearly six-fold (Figure 1.5). 60- 1.5 The expansion and improvement of 40 1.0 infrastructure facilitated the strong private 20 0.s supply response to the investment o 1970 190 1970 1990 opportunities opened up by Government deregulation policies. Box 1.1: Indonesia's PROKASIH (Clean Rivers) Program The PROKASIH Program in Indonesia was initiated in 1989 in response to growing pollution loads, especially from rapidly expanding industries, in critical watersheds. It was designed to overcome the fragmentation of previous efforts to control pollution. At its inception, the Program included the eight most industrialized provinces: East Java, Central Java, West Java, DKI Jakarta, North Sumatra, South Sumatra, Lampung and East Kalimantan. In 1990, Riau, Aceh and West Kalimantan also joined. The initial focus was on the worst industrial polluters in the 24 most affected rivers, with a stated goal of reducing their pollution loads by 50% within two years. Technical and administrative coordination of the Program is provided by central agencies, but the implementation is carried out by provincial authorities, with central support as needed. The mass media is encouraged to report on the environmental damage caused by pollution and on significant clean-up efforts. NGOs are encouraged to help community groups participate in environmental activities. The Program involves five key steps: (a) establishing the local PROKASIH Teams; (b) identifying specific firms in highly polluting industries; (c) getting these firms to sign voluntary "Letters of Commitment" to cut pollution loads in half within an agreed time frame; (d) monitoring subsequent results; and (e) applying increasing pressure on those not making a good-faith effort to comply with their commitment. While it is still a relatively new program, there have been some notable successes. PROKASIH Teams are now in place in the 11 provinces, and voluntary agreements have been signed by some 2,000 firms. Pollution loads have been reduced in several provinces, particularly in those with the strongest technical capacity to pursue the objectives of the Program. There are still major shortcomings in the Government's capacity to monitor actual industrial effluents, and in the private sector's capacity to design and operate pollution abatement systems. The political commitment to enforce environmental standards, however, has been greatly enhanced by the favorable publicity surrounding the PROKASIH Program, which in turn has increased the credibility of the national and provincial authorities in their enforcement efforts with individual firms. Sustaining Development 9 1.15 Indonesia has taken important steps to improve environmental management. This reflects growing awareness, in Indonesia and around the world, of the serious risks environmental degradation poses to sustainable development. Among developing countries, Indonesia has played a leading role in articulating a sustainable development strategy and putting in place essential elements of a regulatory and institutional framework to support that strategy. These initiatives include: establishment of an environmental protection agency (BAPEDAL); environmental impact analysis (EIA) requirements for development projects; and new legislation on spatial planning. Specific sectoral or cross-sectoral environmental initiatives include: the preparation of a Tropical Forestry Action Plan, setting out the agenda for sustainable management of forest resources; the preparation of a National Biodiversity Action Plan, aimed at preserving Indonesia's rich array of plant, animal and marine life; the start of a Clean Rivers Program, PROKASIH, which targets reducing industrial pollution in 24 most polluted rivers across Indonesia (Box 1.1); and a review of the institutional arrangements for water resource management. In the years ahead, Indonesia faces major challenges of environmental sustainability. The implementation of the above initiatives is constrained by institutional weaknesses and limited financial resources, but a good foundation has been laid for future efforts in responding to these challenges. C. Sustaining Development 1.16 Indonesia's development achievements over the past twenty-five years, including the demonstrated resilience to major external shocks, are impressive. The past successes enable the Government to build on a strong economic foundation as it looks ahead and formulates the next (Sixth) Five-Year Development Plan (REPELITA) and the Second Long-Term (25-year) Development Program (both of which start next year). At the same time, there needs to be a clear recognition of the formidable challenges of sustaining development that lie ahead. While past achievements have opened up new opportunities for development, they have also given rise to new challenges. Future challenges stem both from the fact that, despite past progress, Indonesia remains a low income country, with a sizable segment of its population still living in absolute poverty, and from significant changes in the nature of the policy agenda associated with the economy's transition to a higher level of development. The task of sustaining development is three-fold: * maintaining a robust pace of economic growth to improve living standards and provide gainful employment to the rapidly expanding labor force; * promoting equity by reducing poverty and broadening participation in development; and * protecting the environment by conserving resources and limiting pollution. Sharing the common aim of improving human welfare, growth, equity and environmental protection are all essential to sustained development. Strong synergies exist among these objectives.2 Growth supplies the increase in resources necessary to reduce poverty and improve environmental management. Equitable development broadens the base of growth and alleviates a major source of pressures on the environment-poverty. Protection of the environment fosters efficient, long-term growth and contributes to equity as the poor tend to be the most vulnerable to the consequences of environmental degradation. Trade-offs also exist. An example is industrial growth and the control of pollution. However, 2 "Promoting growth, alleviating poverty, and protecting the environment are mutually supportive objectives...", Environment, Growth, and Development, World Bank, Development Committee Pamphlet 14, 1987, p. 5. 10 Chapter 1 appropriate, well-targeted policies can mitigate these trade-offs. Concerns about the costs of environmental protection, such as pollution control, in terms of foregone income growth are often short- sighted and based on an incomplete consideration of the benefits of better environmental management (or of the costs of environmental inaction). The 1992 World Development Report aptly termed the distinction between development and the environment a false dichotomy.' Similarly, there exists no inherent dichotomy between growth and equity, as borne out by increasing international evidence of a positive correlation between strong and equitable growth-the East Asian, and Indonesia's own, record of robust growth combined with impressive reductions in poverty is a case in point." The central challenge in sustainable development is to take maximum advantage of the complementarities that exist between growth, equity and environmental protection and to minimize the costs of addressing the trade-offs. 1.17 In Indonesia, the harmonization of growth, equity and stability, often referred to as the "Trilogy of Development", has been a fundamental principle guiding development policy for the past 25 years. In a major statement on economic policy (1992 Independence Day Speech), President Soeharto underlined the Government's continuing emphasis on the consistency of these goals, but, looking ahead to the next Long-Term Development Program, also noted the increasingly important need to improve environmental management.' The fundamental objectives of Government development policy thus support the goal of sustainable development in its broadest sense, and provide a guiding framework for consistent policy formulation to meet the challenges of sustained economic progress. 1.18 Within this broad framework for sustaining development, the future policy agenda will be shaped by some fundamental structural transformations and transitions underway in the economy. These shifts associated with the evolution of the economy imply important changes in the nature of ongoing challenges as well as the emergence of new challenges. As elaborated below, in all the three areas of growth, equity, and environmental protection, a new generation of issues is emerging. Success in sustaining development will depend on both pressing ahead with the unfinished agenda in the existing areas of policy reform and adapting and developing policies and capacities to cope with the new issues. Growth with Stability 1.19 Sustained robust growth is central to achieving Indonesia's development objectives. To employ the labor force, which is increasing by 2.3 million people annually, at rising levels of productivity, improve living standards and continue to reduce poverty, non-oil GDP will need to grow at 6-7% p.a. At this growth rate, Indonesia's per capita income would exceed $1,000 by the year 2000, placing it in the category of middle income countries, and rise to more than $2,000 by the end of the Second Long-Term Development Program. Sustaining this rate of growth, while maintaining macroeconomic stability and adapting t, major structural transformations and transitions the economy will undergo, will be a major challenge. 3 World Development Report 1992, op. cit., p. 25. 4 More Evidence on Income Distribution and Growth, George R. G. Clarke, Policy Research Working Paper No. 1064, World Bank, January 1993. "Another challenge that we have to take into account from now on is the scarcity and limitation of natural resources, (and) the impact of industrialization on the quality of our environment. We are determined that our industrialization is a sustainable one." State Address by President Soeharto on the 47th Independence Day, August 17, 1992, Sustaining Development 11 1.20 A stable macroeconomic foundation is a necessary condition for sustained economic growth.' In maintaining a stable macroeconomic environment, the main challenge stems from Indonesia's large external debt; total MLT debt amounted to 58% of GNP and 176% of exports at end-1992. The MLT debt-service ratio in 1992 was 30%. In absolute terms, Indonesia's external debt is now one of the largest in the developing world. Cautious external borrowing policies, backed by strong growth in non-oil exports, have allowed Indonesia to maintain an unblemished debt service record, unlike most countries in similar circumstances. Nonetheless, the debt burden is heavy, and it limits Indonesia's policy flexibility and raises its vulnerability to external shocks. A central goal of macroeconomic management will be to reduce this burden gradually to levels that are more sustainable in the medium to long term. This goal has two important implications: reducing the current account deficit; and maintaining a prudent approach to external financing. Sustaining robust non-oil export growth will be the key to reducing the external deficit. To achieve and sustain a non-oil GDP growth of 6-7% p.a., the investment rate will need to rise, from about 23% of GDP in 1992 to about 25.5% by the end of the decade. Reconciling the higher investment rate with the need to reduce the current account deficit will require an increase in the national savings rate, from about 20% of GDP in 1992 to about 23.5% toward the end of the decade. This underscores the need to intensify domestic resource mobilization. Even with a declining current account deficit, Indonesia will need substantial external financing in coming years. One challenge will be to manage a smooth transition to an increased role of private capital in external financing, and to diversify the sources and types of financing. A related challenge will be to promote greater foreign direct investment, with its twin advantages of reducing the need for debt-creating flows, and providing new technologies and market access. 1.21 Policies for growth will need to adapt to the evolving nature of the growth process as the economy moves toward higher levels of development. Success in sustaining the momentum of growth will depend greatly on how effectively Indonesia manages some important dimensions of this evolution. These will include both some fundamental qualitative shifts in the growth process and major structural transformations in the economy. The former comprise: * an increasingly important role of improvements in efficiency and productivity as a source of growth; and * a transition from quantity to quality in the production of goods and services. 1.22 In an increasingly tougher international business climate, marked by globalization and keener competition, raising efficiency and productivity would be the key to sustaining the dynamism of non-oil exports, which will remain the primum mobile of Indonesia's economic growth and diversification. The sources of Indonesia's competitive edge will need to shift gradually from the basic cost advantages arising from the availability of cheap unskilled and semi-skilled labor and relatively abundant raw materials to gains in productivity. Besides exports, efficiency and productivity improvements hold the key to the role the domestic market will play in future growth. Indonesia has a large domestic market. Supplying this market more efficiently offers substantial scope for productivity gains and future growth, with large benefits for Indonesian consumers. The critical need is to foster increased competition, not only by opening the economy further to competition from abroad, but also by intensifying efforts to remove barriers to competition within the domestic economy. More broadly, raising efficiency and productivity will be essential to realizing Indonesia's growth objectives within the limits of available resources. 6 Strong cross-country evidence showing macroeconomic stability is positively associated with long-run economic growth is provided in Macroeconomic Factors in Growth, Stanley Fischer, paper presented to World Bank Conference on "How Do National Policies Affect Long-Run Growth", Washington D.C., February 1993. 12 Chapter 1 International-including East Asian-experience provides strong evidence of a positive correlation between economic growth and productivity increases and between the latter and the reduction of market distortions (more openness and domestic competition).' President Soeharto underlined the Government's clear recognition of these fundamental challenges by making efficiency and productivity a central theme of his 1992 Independence Day Speech.' 1.23 A transition from quantity to quality in the production of goods and services is closely related to raising efficiency and productivity. It has several important dimensions. In the public sector, it implies a shift of focus from expanding services to improving their quality. In the key area of human resource development, for example, past efforts have been instrumental in putting a school and a health clinic in almost every village; the priority now, as recognized by the Government, is to improve the quality of the education and health services, a critical element in the effort to raise the productivity of labor and support technological progress. In physical infrastructure as well, the quality and reliability of services, increasingly important to the competitiveness of domestic production as it grows in sophistication, will need stronger emphasis. The reorientation of the focus of public investment from quantity to quality will need to be supported by improved operation and maintenance of investments. In the private sector, improving the quality of goods, and developing new products, will become increasingly important sources of market growth. Another dimension of quality requiring increased attention, and relevant to both the public and private sectors, is the shift toward environmentally cleaner methods of production. 1.24 Accompanying these fundamental qualitative shifts in the growth process will be the challenge of managing continuing major transformations in the structure of the economy, in the form of changing roles of sectors, and of activities within sectors. Key structural changes will include: * a continuing shift in public-private sector roles; * a declining role of oil in the economy; and * major inter-sectoral and intra-sectoral shifts within the non-oil economy. 1.25 The Government's role will need to continue to shift from direct management and control of productive activities, including the production of many private goods and services, toward the facilitation of sound private sector development. This translates into an increasing Government focus on: maintaining a stable macroeconomy; facilitating efficient functioning of markets; and providing public goods, notably infrastructure and human resource development services, efficiently and equitably. In addition to being the dominant provider of private goods and services, the private sector will be expected to play an increased role in the provision of public services that can be provided within a competitive framework. This reorientation of the Government's role entails a major agenda of policy reform and institutional restructuring. 7 World Development Report 1991: The Challenge of Development, World Bank, Oxford University Press, June 1991, pp. 45-46 and 98-100. On the lessons of East Asian experience with productivity growth, see Government Policies and Productivity Growth: Is East Asia an Exception, Vinod Thomas and Yan Wang, mimeo., World Bank, 1992. * "We must [use] heightened national efficiency and productivity as the primary basis of our economic growth, for today and in the future. ...A resilient economy is one that consists of resilient industries, namely those which rely on high productivity and efficiency..." President Soeharto, op. cit. Sustaining Development 13 1.26 The continuing decline in the Fgure 1.6: ChangIng EonomIc Struoture role of oil is reflected in the prospect that (GDP shares, at 1983 constant prices) Indonesia would likely become a net oil importer within this decade and the sector's 60 share in GDP would drop to about 6% by the 50 year 2010, compared to 18% in 1990 and 28% in 1980 (Figure 1.6). By the end of the 40 Second Long-Term Development Program, 30-28 oil may play only a minor role in the 20 1820 Indonesian economy. These prospects 10 underscore the case for continuing to strengthen the non-oil sources of growth, 1980 1990 2000 2010 exports and fiscal revenues. For example, EOi I LNG 0Agriculture El Manufactu non-oil exports would likely need to generate about 85% of total export earnings in 2000. Including construction and inrastructure services. 1.27 Growth in non-oil exports, as well as the momentum of overall growth in the economy, will depend heavily on the continued dynamism of non-oil manufacturing. Maintaining a non-oil manufacturing growth rate of around 10 % p.(a. would be important, and appears feasible provided efforts to improve the environment for efficient private sector development are sustained. At this rate, the share of non-oil manufacturing in GDP could rise from around 16 % currently to 23 % by 2000. The sector's share would be expected to rise further to around 33% by 2010 (Figure 1.6). The critical role of the sector in export growth is indicated by the expected increase in the share of manufactures in total exports, to about 65 % by 2000 from 45 % recently. Given the fiercely competitive export markets for manufactures, this again underscores the importance of promoting efficiency and productivity in industrial growth. The likely increase in the share of non-oil manufacturing in total employment will be slower (from about 10 % currently to 13 % by 2000), but would still make an important contribution to absorbing new entrants into the labor force and raisir.e, the average labor productivity in the economy. 1.28 In contrast, the share of agriculture in GDP would be expected to continue to decline, from about 20 % in 1990 to 15 % by 2000 and further to 11 % by 20 10. Nonetheless, the sector will continue to play a vital role in the economy, as the main source of employment (still providing about 50% of the jobs in 2000 and 40% in 2010) as well as the producer of critical wage goods, industrial raw materials and commodity exports. Also, given supportive policies, agricultural growth, while slowing, could still average 3% p.a. during 1990-2010, exceeding population growth and thereby continuing to contribute to raising living standards and reducing poverty. In services, a moderate increase in the sector's share in GDP and employment is likely (Figure 1.6). Spurred by deregulation, financial services have grown rapidly in recent years. In coming years, infrastructure-related services and tourism are the likely major sources of growth. Sustaining robust industrial growth and dismantling regulatory barriers would be key to the prospects for expansion and productivity gains in services, and would allow the sector as a whole to grow by around 7% p. a. 1.29 Intra-sectoral shifts will be an equally important dimension of the likely development transitions. In manufacturing, the share of basic processing activities is expected to decline gradually while that of more downstream processing and higher value-added activities is expected to increase. A relative decline in the contribution of resource-intensive industries would reflect both the normal evolution of industrialization and moves toward a more sustainable use of natural resources. Labor-intensive industries will remain Indonesia's main area of comparative advantage, as the domestic supply of labor will remain plentiful even though labor force growth is likely to decelerate somewhat later in the decade 14 Chapter 1 as the effects of slower population growth are felt on working-age groups. An outward-oriented strategy is essential to ensure these industries are efficient and generate adequate employment. In agriculture, the share of rice is expected to decline, and those of such other activities as non-rice food crops, livestock and fisheries are expected to increase. Successfully achieving this diversification in agriculture, through policies that allow the sector to respond flexibility to evolving needs, will be important to sustained growth in the sector and to continued progress on poverty alleviation and regional development. 1.30 These inter- and intra-sectoral structural shifts are fundamentally similar to those experienced by both the developed countries and the rapidly industrializing economies of East Asia at corresponding stages of their economic evolution. International experience shows they are achievable, but it also shows they are not automatic; the difference between success and failure has been the sustained implementation of a strategy conducive to development, such as the one that has brought Indonesia to its present threshold of opportunity. Equity through Wider Participation 1.31 The promotion of an equitable pattern of economic growth has been a major goal of the Government.9 In pursuing this goal in the years ahead, the Government will face three main, related challenges: * continuing to reduce and, in the long run, largely eliminate poverty; * ensuring widespread regional participation in development; and * promoting broad-based private sector growth. 1.32 Progress in reducing poverty over the past two decades has been impressive, but major challenges remain. About 27 million people, 15% of the population, remain below the poverty line, with many millions more of "near poor" with incomes just above that level. In addition to the large number of the remaining poor, the nature of the challenge to reduce poverty is likely to change. As poverty declines, further reductions in poverty tend to become increasingly difficult as a progressively larger proportion of the remaining poor are likely to be those who are harder to reach through a general growth of incomes and services, such as people in resource poor or remote areas. A reflection of this is the uneven geographical pattern of the incidence of poverty in Indonesia; it remains high in the Eastern Islands and parts of Java. The incidence of poverty ranged from 45.6% in East Nusa Tenggara to 1.3% in DKI Jakarta in 1990. Within Java, the incidence of poverty is lower than in most of the Eastern Islands, but there remain large pockets of poverty, with the result that, in absolute terms, the majority of the poor still live in Java. The centerpiece of the strategy to reduce poverty will remain the promotion of a pattern of growth that expands opportunities for the productive use of the poor's most abundant asset-labor-and the widespread provision of basic social services-education and health-that enhance the poor's capacity to grasp those opportunities. However, finding ways to target these interventions to reach the disadvantaged groups and backward areas will be increasingly important. Accordingly, accurate identification of where the poor are located, and proper design of the targeted interventions (such as subsidized basic education and health for the poor), will have an increasingly important bearing on the efficiency and effectiveness of poverty alleviation programs. 9 "From the very onset we realized that equitable distribution without growth will only mean sharing poverty. Growth without equitable distribution means sharing injustice." President Soeharto, 1991/92 Budget Speech. Sustaining Development 15 1.33 Provided Indonesia can sustain the pace and pattern of growth of output and employment discussed in the previous section, and complement it with specific policies and programs effectively targeted at the needs and location of the poor, it can look forward to continued robust progress in reducing poverty. It can realistically set itself the targets of reducing poverty (as currently defined) below 10% by the year 2000 and largely eliminating poverty, except for a small hard core of the poor with particular disadvantages, by the end of the Second Long-Term Development Program. 1.34 Related to the reduction of regional disparities in the incidence of poverty is the broader objective of promoting more balanced regional development. Regional income disparities have shown a tendency to narrow, but they remain large. The development potential and options vary considerably across the regions, reflecting wide regional differences in resource endowments and the level of past development. More research is needed to identify what specific development options hold the most promise in different lower income regions, in the Eastern Islands as well as in Java. However, in broad, strategic terms, three important elements of the challenge to bolster the development of these regions can be distinguished: * In areas where the resource base provides good potential for agricultural development, the provision of agricultural services tailored to the specific regional needs would be important. The strategy of rice-led agricultural development, which has played a major role in reducing poverty and raising incomes in Java, is less relevant off-Java where the resource base for such development is lacking (and also in similar parts within Java, such as the uplands in Central and East Java and the coastal areas in North Java). However, good opportunities for non-rice agricultural development-in non-rice food crops, tree crops, fisheries, livestock and forestry-exist in some of these areas. The development of agricultural support services, e.g., extension, hitherto focused primarily on rice, needs to be oriented more toward such opportunities in these areas. In exploiting these opportunities, there is a need to devise approaches that do not deplete the fragile resource base and that promote linkages with the local economies rather than result in enclaves. * In areas where the natural resource base precludes significant agricultural growth, the emphasis needs to be on exploring and developing viable non-agricultural activities, such as light manufacturing, marketing and other services. To the extent such activities could be developed in rural areas, it would help reduce the incentive to migrate and add to urban congestion. Where potential for viable non-agricultural rural activities exists, adequate provision of rural infrastructure, such as transport and power, and access to credit acquire particular importance. The development of both non-rice agricultural activities and rural non-agricultural activities should not be inhibited by regulatory restrictions on cropping patterns and land use. * In areas of very limited productive potential, the primary emphasis needs to be on improving the population's access to quality human resource development services. In addition to raising the local people's present welfare, this would enhance their capacity to find alternative income-earning opportunities, including through migration to other areas of greater productive potential. 1.35 Both poverty reduction and the broader objective of narrowing regional income disparities would benefit from fuller participation of women in development, for which women's access to adequate education, health and family planning services is critically important. These objectives would also benefit from wider participation of local institutions and communities, including project beneficiaries, in the 16 Chapter 1 planning and implementation of development. Building more constructive partnerships with local representatives would help tailor development programs and projects better to local needs, opportunities and constraints. 1.36 A third challenge is to promote wider participation in the growth of the modern private sector. Besides equity, broad participation, by large and small firms, is conducive to the efficiency, diversity and robustness of private sector development. The key to addressing the concerns arising from the dominance of large business groups in industry lies in pressing ahead with Government regulatory reforms to expose businesses to greater domestic and external competition, and dismantle the sources of monopoly protection and rent seeking that remain. To establish a level playing field so that businesses face the same kinds of competitive pressures and opportunities, underpinning market forces with a stronger and transparent commercial legal framework and prudential regulation of the financial sector are equally important. Protecting the Environment 1.37 Sustainable growth will depend on efficient use and conservation of Indonesia's natural resources, including preventing pollution from destroying those resources. Essential to sustained growth, environmental protection is closely linked to the qualitative and structural shifts in the economy discussed above. Through such shifts, the structure and sources of growth need to change, to use resources, especially non-renewable resources, less intensively and to generate less pollution. An increasingly flexible, resilient and efficient private sector is essential for such shifts to occur with minimum loss to the pace of growth. Policies that reduce the pressure of population growth will also mean that a given standard of living can be achieved with the use of fewer resources and less pollution. The effects of population pressures on people's lives and on the environment will become increasingly stark on marginal lands, on the edges of forests and in urban slums. 1.38 Sustainable use of natural resources is particularly important to Indonesia's development prospects given the major role these resources play in the economy: direct extraction and primary processing account for about 40% of GDP; and the primary sectors generate about 60% of export earnings and 50% of employment. Sustained growth requires carefully managing the environment as a source of these resources. Key issues concern: * increasing scarcity and deteriorating quality of water supply, especially in Java; and * deforestation, land degradation and loss of biodiversity, mainly in the outer islands. 1.39 In addition to utilizing the resource base, future growth will lead to increased urbanization and industrialization. As noted earlier, the share of manufacturing in GDP could double over the next two decades, rising to 33% by 2010. Urban population has been growing at 5% p.a. From only 15% of total population in 1970, the urban population has already reached 30% and, by the end of the Second Long- Term Development Program, half of the population may reside in urban areas. Cities on Java will need to cope with 1.5 million new residents each year. Some of this growth will come from reclassifying densely populated rural areas as urban, but it will still lead to increasingly complicated problems of urban environmental management. Rising pollution and congestion intensify the need to ensure sustainable use of the capacity of the environment as a sink for urban and industrial wastes. Major issues include: * in industry: control of air and water pollution and hazardous waste disposal, particularly on the north coast of Java; and * in cities: better sanitation and solid waste disposal, and lower air pollution and congestion. Sustaining Development 17 1.40 Water, Forests, Land and Biodiversity. Increasing and often conflicting demands on water resources on Java from agriculture, industry and sanitation have limited the availability of water and degraded its quality. The major demand is for irrigation, where supply and demand need to be brought into a more efficient balance by developing viable pricing schemes. In dense urban areas, high rates of ground water extraction have already exceeded natural replenishment, leading to salt water intrusion. In Jakarta, for example, water pumped from the ground each year is estimated to be almost three times the sustainable level. With this imbalance, salt water intrusion is advancing 0.5-1 kilometer per year. As with irrigation water, environmentally sound urban water use will require improved pricing. 1.41 Sustainable cuts from Indonesia's tropical forest are estimated at 22 mcm per year, but harvests are currently running at over 33 mcm per year. Logging, in combination with conversion for agricultural use and forest fires, claims 1.1 million ha. of forest each year, roughly 1 % of Indonesia's forests. Forests are a major source of exports and livelihood and are important to the quality of the environment. While steps are being taken, developing and implementing an effective policy and institutional framework for sustainable management of forests will be a key challenge. Sustainable forest management is also central to the prevention of land degradation and loss of Indonesia's rich biodiversity. 1.42 Urban and Industrial Pollution. In the urban environment, the Government is struggling with the burden of household and industrial wastes, both major sources of pollution, and both sources that will expand substantially as growth (especially industrial growth) continues apace (Figure 1.7). Lack of adequate sewerage treatment leads to contaminated rivers and ground water. In a recent survey in Jakarta, a large proportion of shallow wells, the dominant form of residential water supply, was found to be contaminated with human waste; tap water and hydrant samples revealed lower but still substantial rates of contamination. About 75% of the biological oxygen demand (BOD) in Jakarta's rivers comes from household waste, with another 15% coming from industry. Industrial BOD loads have increased one and a half times since 1980, and are projected to do so again before 2000, and increase 10-fold by 2020. In addition, industrial growth is raising concentrations of toxic chemicals and heavy metals in water. Increased urban households and firms are also generating growing amounts of solid waste, 5-6% more each year. Collection and disposal are inadequate, with as much as 40% of solid waste dumped illegally, often into rivers and canals. The largest cities are also suffering from increasing problems of air pollution. Vehicle emissions are the largest single factor in urban air pollution, and are also likely to be the fastest growing source (Figure 1.7). Already in Jakarta, particulates, lead and other airborne pollutants have reached levels that harm health. Air pollution from industrial sources is becoming an increasingly serious problem in many areas of the country. Even with a decline in the pollution-intensity of industrial output, total industrial air pollution loads will increase considerably: an estimated 13-fold increase in sulphur dioxide by 2020, a 15-fold increase in suspended particulates and a 19-fold increase in the emissions of bio-accumulative metals. 1.43 Air and water pollution from household and industrial sources imposes significant costs on the economy and human welfare. Air pollution in Jakarta alone costs between $200-$500 million per year in reduced human health. The costs of fatal diarrhea contracted from polluted water are $100-300 million per year, leave alone the costs from less serious diarrhea or other diseases. Water pollution also imposes significant costs in terms of destruction of aquatic ecosystems. As urban pollution and congestion rise, they act as an increasingly important deterrent to economic activity, as the experience of several cities (e.g., Bangkok) demonstrates. Containment of such environmental degradation is thus important both on grounds of health and sustainability of economic growth in urban and industrial centers. 18 Chapter 1 Figure 1.7: Environmental Challenges: Urban and Industrial Pollution Pollution from Urban Sources: DKJ Jakarta 6 1nd.x Humaen and Sold Waste 20 Vehicle Emissions: Particulates 4-- - uman Wa1te - --S -li-Wst 3 lo ----- -- .. .-.. .-. . 2. . . . . . . 5 -- - - - - - - - - - - -- - - - - - - 1%70 19'80 19,90 20'00 2010 1'§70 19,80 1990 2000 2010 -Human Waste - - Solid Waste Pollution from Industry : Indonesia Totals Waff and Ar 200 1nKk All Media: Tadc Pollulais 60 -- - - - - ---- - --- - - - - - - - 15 0 -- - - - - - - - -- - - - - - - - - - - - - - - -- - - 4 - - -- - --1 0 0 --- - - - - - - - - - - - - - - - - - - - - - - 20~~~s ------ ---- 170 1980 1990 2000 2010 0 1970 1980 1990 2000 2010 Water :BOD --Air: Particulates A od Source: Stalf estimates. r I oi - Metals The Challenge of Integration 1.44 Effectively integrating the growth, equity and environmental objectives discussed above is the crux of the challenge of achieving sustained development. The main elements of the policy agenda to meet this challenge are discussed in the next section. Successful integration of growth, equity and environmental protection requires that three key principles guide this effort. These are: * adopting and maintaining a long-termn focus; * taking maximum advantage of the complementarities that exist between growth, equity and environmental protection; and * dealing effectively and efficiently with the trade-offs. 1.45 A long-term vision is central to the issues of sustainability of development. It facilitates a clearer recognition of the consequences-costs and benefits-of policies down the road. It helps bring out the complementarity of objectives that might appear to be in conflict in the short run (e.g., growth and equity), and shows the unsustainability of policies that might not be evident with a shorter horizon (e.g., distortions encouraging wasteful resource use). There is considerable scope for policies that simultaneously promote income growth, improve equity and protect the envirornent. Examples of such Sustaining Development 19 policies are: appropriate pricing of resources; clarifying property rights and resource ownership, and strengthening the legal framework supporting the functioning of markets; and improving access to, and the quality of, human resource development services (Box 1.2). The discussion above emphasized efficiency and quality as major underpinnings of future growth; these are also necessary for sustainable improvements in equity and better environmental management. In general, policies that allow markets to work efficiently also make them more equitable and environmentally friendlier. Box 1.2: Adjusting Fuel Prices: An Example of "Win-Win-Win" Policies In a landmark decision announced by President Soeharto in his 1993/94 Budget Speech, the Government substantially raised domestic fuel prices with the aim of eliminating budgetary subsidies for all fuel products, except for a reduced and temporary kerosene subsidy. The President asserted the important principle that "we have to treat energy as an ordinary commodity with the going price at the international market". Retail prices for diesel, fuel oil and aviation fuels were raised to their world market levels, while the implicit tax on gasoline was raised to 66% to cross-subsidize the remaining 33% subsidy on kerosene. The overall price adjustment averaged 24%. The estimated fiscal impact of these price increases is large: revenues from domestic sales will increase by about Rp.3 trillion (1.1% of GDP) in 1993/94, switching an estimated budgetary fuel subsidy of about Rp. 1 trillion (at the assumed world oil price of $18/bbl.) to a surplus of about Rp.2 trillion. This adjustment provides a powerful example of policies that simultaneously contribute to growth, equity and environmental protection. Growth. Adjusting fuel prices by eliminating subsidies will improve the efficiency of use of fuel products and encourage substitution by economically cheaper fuels. It will ease macroeconomic constraints on higher economic growth. Higher prices will help to slow the rapid growth in domestic consumption, maintain Indonesia's exportable oil surplus longer, and reduce pressures on the current account balance. At the same time, eliminating fuel subsidies will improve the fiscal balance, mobilizing additional public savings needed to finance public investments in infrastructure and human resources to support sustained private sector growth. Equity. Eliminating fuel subsidies will support better targeting of public expenditures to help the poor. Just eliminating the large automotive diesel subsidy, which did not benefit the poor directly, will save about Rp.1.3 trillion in 1993/94. Reallocating these resources to strongly pro-poor programs, such as primary education, health centers and health subcenters, could dramatically raise their quality and coverage. Recurrent public expenditure on these programs amounted to only Rp.1,800 billion, Rp.190 billion and Rp.55 billion, respectively, in 1990/91. Going one step further to eliminate the remaining kerosene subsidy, only 8% of which benefits the poorest 20% of the population, would release additional resources, about Rp.0.7 trillion, that could be reallocated to better targeted programs. Moreover, the adverse welfare impact on the poor of raising the price of kerosene could be largely offset by deregulating trade in sugar, which the poorest 20% of the population spend more on than on kerosene (3.3% compared to 2.5% of consumption expenditure). Import controls raise the domestic sugar price by about 40% above the world market price; eliminating import controls could reduce the price by about 30%. Environment. The environment would benefit from more efficient use of petroleum products, a non-renewable resource, as well as substitution by less polluting alternatives, such as natural gas (in industry and transport), central station power generation (instead of diesel-based captive power generation) and LPG (in household and industrial uses). 20 Chapter 1 1.46 While such "win-win-win" policies are extremely important, and must be exploited fully, they alone are not enough to harmonize growth with equity and the environment. Specific policies are also needed to deal with the trade-offs or negative links that exist between economic activity and the environment, such as industrial production and pollution, and to address aspects of equity that growth alone might not, such as attacking hard-to-reach pockets of poverty. Appropriate choice, design and targeting of policies, working as much as possible with the grain of the market rather than against it, are important both to dealing with these problems effectively and to keeping the costs of these interventions to a minimum. D. Toward an Integrated Agenda for Sustained Development 1.47 As reviewed in the preceding sections, Indonesia's rapid economic progress over the past two decades has laid the foundations for substantial further advances in development, including the prospect of the country reaching middle income status within this decade. With the new opportunities opened up by past progress, however, have come new challenges, including continuing structural shifts in the economy and a new generation of issues in the efficiency, equity and sustainability of development. Maintaining the momentum of progress will depend on how effectively these challenges are met. Of fundamental importance is the need for the economy to be flexible and adaptable, able to respond to change. 1.48 The agenda for sustaining development is wide ranging. The 1991 World Development Report" highlighted four key elements of the development agenda: a stable macroeconomic foundation; a competitive climate for enterprise; investment in human and physical infrastructure; and institutional development. Drawing on these themes, the discussion of Indonesia's agenda for sustained development in this Report is organized under four broad headings: macroeconomic management; incentives; investment; and institutions. These themes provide a useful, overarching framework for integrating the agenda for growth, equity and environmental protection. The main elements of this agenda outlined below are developed more fully in the chapters that follow. Macroeconomic Management 1.49 Macroeconomic stability is an essential foundation for sustained growth. Realizing Indonesia's growth objectives will require higher investment but, given the need to reduce the external debt burden, also higher savings to finance it. Macroeconomic stability fosters a climate conducive to both investment and savings. It promotes competitiveness, by providing a solid foundation for pressing ahead with structural reforms that raise productivity and by holding down inflation, thus helping to maintain the critically important non-oil export growth. At the same time, by providing a setting conducive to a sustained growth of incomes and to efficient decision-making (through a clearer transmission of market signals), it underpins efforts to reduce poverty and protect the environment. The macroeconomic policy agenda has three broad, related elements: following balanced, coordinated fiscal, monetary and exchange rate policies to manage aggregate demand, mobilize domestic resources and support external competitiveness; 10 World Development Report 1991, op. cit., pp. 6-11. Sustaining Development 21 * maintaining a prudent approach to external financing and improving external risk and debt management; and * improving the capacity to monitor economic trends and developing the indirect policy instruments needed for macroeconomic management in an increasingly deregulated, private- sector-led economy. 1.50 The stabilization measures taken by the Government to cool down an overheated economy are bearing results, as reflected in a declining current account deficit and inflation in 1992/93. The principal task for macroeconomic management is to keep the current account deficit on a downward path to achieve a more sustainable level of around 2% of GNP in the medium term (from an estimated 2.4% in 1992/93), while supporting economic growth at a rate that continues to generate sufficient employment for the growing labor force at rising levels of productivity. Charting this narrow course between adequate growth and maintenance of financial stability will call for a balanced, coordinated use of fiscal, monetary and exchange rate policies. The burden of restraining domestic demand has been borne primarily by monetary policy. A firmer fiscal stance would produce a better policy balance, helping to lower the current high real interest rates and allowing higher private investment without risking a rekindling of domestic demand pressures. A fiscal stance consistent with both a sustainable external balance and continued robust growth in private investment, while adequately providing for complementary public investments, is the key to macroeconomic management for growth with stability. 1.51 Reconciling the roles of fiscal policy in supporting stabilization and promoting growth requires increasing public savings and allocating them to priority investments, while generating a fiscal balance consistent with the overall macroeconomic policy framework. This, in turn, calls for: mobilizing more public revenues, emphasizing efficiency-enhancing improvements in cost recovery and better tax administration; restraining growth in government current spending, by reducing subsidies, such as on fertilizer, and containing personnel spending; guiding public investment allocations by a sound set of priorities; and improving the financial performance of public enterprises. Private savings need to rise too. Sustaining strong economic growth, maintaining a stable financial environment, fostering financial deepening, and promoting profitable, widespread investment opportunities through continued improvements in the incentives regime, as outlined in the next section, should contribute to higher private savings, by household and firms. A lower dependency ratio resulting from demographic shifts should also help boost savings. 1.52 The high level of external indebtedness underscores the need for a cautious approach to external borrowing. Both to guide the overall level of borrowing, to ensure it stays within sustainable limits, and to help diversify the sources and types of borrowing to obtain the best possible terms as the role of private capital in Indonesia's external financing increases, call for further developing the institutional framework for managing external debt and formulating policies and advice on access to international financial markets. Greater attention will also need to be given to the use of financial instruments in managing external risks. The most important external risk insurance mechanism, however, remains the continued diversification of Indonesia's exports. Much potential exists for attracting larger flows of foreign direct investment; tapping it would depend on maintaining a stable macroeconomic environment and further improving the investment climate. 1.53 With the progressive dismantling of direct economic controls, such as interest and credit restrictions, and investment and import barriers, macroeconomic management needs to rely increasingly on indirect mechanisms. Also, deregulation has caused changes in relationships among economic variables, e.g., among monetary aggregates as a result of financial sector reforms, and the role of private 22 Chapter 1 capital flows has increased. These developments have two important implications for the conduct of macroeconomic policy. First, continuous and improved economic monitoring will be necessary, to enable macroeconomic management to respond promptly to changing conditions. The recent overheating of the economy illustrates how quickly demand pressures can develop. The timeliness, reliability and analysis of economic data will need to improve to support vigilant, responsive macroeconomic management. Second, the indirect mechanisms for influencing economic behavior will need to be developed further. Examples include: deepening and broadening the market for monetary instruments for more effective open market operations; and using improved mechanisms for review of public enterprise investment programs, and prudential measures promoting financial discipline in banks and firms, to influence their external borrowing in place of directly administered borrowing ceilings. Incentives 1.54 Bolstering incentives to raise efficiency and productivity will be fundamental to sustaining the dynamism of the economy and maintaining the momentum of the private sector. Indonesia's outward- oriented development strategy and the increasingly tougher international business climate place a premium on policies that enhance competition. Through its structural reform program, Indonesia has taken major strides in improving the incentives regime, but this effort needs to be sustained and extended to respond to emerging new challenges. The focus of this effort is markets, and its central thrust is to increase competition, both from abroad and within the domestic economy. The future agenda comprises three broad elements: * removing regulatory barriers to stronger competition in the product markets; * developing more flexible, efficient factor markets; and * supporting better market outcomes, by improving market infrastructure (transparent "rules of the game" contributing to a level playing field for large and small firms) and strengthening incentives for environmentally sound growth. 1.55 Further reductions in trade barriers will be a key source of increased competition and productivity. Despite substantial trade policy reform, many activities, in both industry and agriculture, remain shielded from external competition by non-tariff barriers (NTBs) and high tariff walls, contributing to a high-cost economy and biasing incentives against exports. While declining, Indonesia's production coverage of NTBs (about 30% in both manufacturing and agriculture) and effective rates of protection (an effective rate of protection of 52% in manufacturing) remain appreciably higher than those in its East Asian neighbors. Activities with particularly high protection include food crops, food processing, paper products and engineering industries. Priorities in trade reform include: accelerating the elimination of NTBs; reducing tariffs so that few lie above 20% and simplifying the tariff structure; and reducing export restrictions, especially on forestry products (coupled with an increase in forestry fees) to support more efficient and sustainable use of forest resources. Deregulation should be applied with equal vigor to domestic trade, by dismantling trading monopolies (such as the clove and citrus trading monopolies and several BULOG-State Logistics Agency-monopolies) and removing barriers to inter-regional trade. Ensuring correct price signals in the economy also calls for reforming domestic pricing policies, including appropriate pricing of public goods (utilities) and freeing the prices of private goods (e.g., sugar, fertilizer and cement) in conjunction with removal of barriers to trade and entry to ensure a competitive environment. While moving utility tariffs toward efficiency levels, their equity goals, where relevant, could be safeguarded through improved targeting. Sustaining Development 23 1.56 Besides "getting prices right", increasing the number of competitors by removing barriers to entry is important to enabling markets to spur efficiency. Restrictions on both domestic and foreign investment have been substantially eased, but there remain areas for further reform, including: shortening the negative investment list; relaxing local content, export and divestment conditions; easing approval requirements for capacity expansion; streamlining a continuing array of regulations at the local level; and improving the actual implementation of reform measures (e.g., in customs). Continuing trade policy reform complemented by investment deregulation would allow Indonesia to benefit more fully from export-oriented foreign direct investment, as well as promote more efficient and broad-based domestic investment. There is scope also for exposing the provision of public goods and services, dominated by public monopolies, to greater competition. 1.57 Flexible factor markets help translate incentives reform into an efficient supply response. Spurred by extensive deregulation in recent years, the banking system has expanded rapidly and become more competitive. The major tasks ahead are to consolidate past growth, strengthen the framework for prudential regulation and supervision, and safeguard the stability of the system which has recently come under strain as the loan portfolio quality has weakened. Increased confidence in the banking system will contribute to lowering the high real interest rates. Related issues are developing viable ways of reducing the concentration of credit and improving credit availability to smaller businesses, and deepening and diversifying the financial and capital markets, including developing the market for equity (there is relatively high leveraging). In the market for land, the cost and complexity of transactions are a major deterrent to business activity, especially foreign direct investment; the underpricing of State land causes inefficient allocation and feeds rent-seeking; and the lack of clear property rights undermines equity and concern for the environment. A market-based system of land allocation needs to be introduced by: sharply reducing and simplifying land regulations; using auctions for allocating State land; and improving and expediting land titling and registration. 1.58 The labor market in Indonesia is relatively flexible and free of distortions, and has facilitated the expansion of labor-absorbing, export-oriented activities in which the country has comparative advantage. The main requirement, discussed in the next section, is to raise skill levels through improved education and training. Skill development is closely related to the development of the technology market. An efficient market for technology will be an increasingly important condition for sustaining the competitiveness of Indonesia's industries and for developing new sources of growth. International experience shows that the development, acquisition and assimilation of technology are best achieved by maintaining an open trade and investment regime, accompanied by emphasis on education and training. In addition to investing in education and training, the Government can contribute to technological advancement by undertaking sound research and development (R&D) activities, which are well-focused and responsive to private sector needs, and by strengthening and coordinating the technological support infrastructure (e.g., standard setting and quality control). 1.59 Clear, enforceable commercial, credit and contract laws, and standards for accounting, auditing and financial disclosure constitute important infrastructure for markets to function efficiently and equitably. The existing gaps in these laws and standards raise the risks and costs of doing business, reduce confidence of foreign and domestic investors, undermine financial discipline, and place smaller enterprises at a disadvantage. Equally important, transparent rules and procedures can limit rent seeking. Providing adequate legal underpinnings for markets is a key function of government. Over the past year or so, the Government has initiated some important efforts in that direction. Priorities include: adopting new company laws, including clear rules on mergers, acquisition and bankruptcy; establishing proper legal requirements for accounting and auditing of company financial records and disclosure of information; instituting modern credit and security laws, incorporating current practices and expanding 24 Chapter 1 the range of permitted securities and thereby broadening the credit possibilities for smaller businesses; and improving credit and security registration and information systems. Together with the dismantling of trade and other sources of monopoly advantage and prudential regulation of bank lending to interlocking business interests, commercial legal reform is important to leveling the playing field for businesses and addressing concerns arising from the concentration of economic power in the hands of a relatively few business groups. 1.60 The framework of incentives to protect the environment also needs systematic improvements. The first priority is for policies that exploit the synergies between good economics and good ecology. Allowing markets to work efficiently is central to these policies. Important examples are eliminating subsidies on natural resources-maintaining economic pricing of fuel, raising water and power charges, correcting policies that result in underpricing of forest resources-and supporting market development, e.g., land titling. Poverty alleviation, education, and dissemination of information on the environment complement the working of the market. Where markets fail because of externalities, policy interventions to change private behavior are necessary. Even here, measures that work through the market-pollution taxes/charges and tradeable permits-are likely to be more effective and cost-efficient. However, regulatory measures, such as effluent/emission and ambient standards for water and air and land-use planning, are also needed. Their design needs to reflect institutional capacities for implementation. As in commerce, clear legal ground rules-laws and sanctions-are important for compliance and enforcement. Investment 1.61 Achieving Indonesia's development objectives will require sustaining a robust investment effort, including increases in both private and public investment. Key elements of the investment agenda are:" * raising the efficiency and quality of investment, both private and public; * fostering complementarity in private and public investment, focusing the latter on infrastructure and human resource development; * better targeting expenditures on poverty alleviation; and * adequately reflecting emerging environmental concerns in investment policies and programs. 1.62 While the investment rate will need to rise (para. 1.20), an equally important challenge will be to raise the efficiency and quality of investment. The latter is essential both to improve the competitiveness of the economy and to ensure that prospective investment requirements could be met within available resources. Enhancing the productivity of private investment will require further reforms of the incentives regime, to provide a more outward-oriented and competitive market environment, as discussed above. International experience shows that economic rates of return on investment projects are " In addition to capital investment, the discussion here encompasses issues relating to recurrent expenditure that is developmental in nature, such as recurrent expenditure on human resource development and expenditure on operation and maintenance of existing investments. Sustaining Development 25 higher in markets that are less distorted." By promoting higher profitability and guiding resources to more viable activities, market reforms support not only more efficient but also higher and more sustainable private investment. Raising the efficiency of public investment will require continued progress on several fronts: basing public pricing policies on economic costs (important to both the efficiency of investment and cost recovery); providing adequately for effective operation and maintenance of existing investments; where feasible, exposing public investment to competition from the private sector; promoting systematic evaluation of project proposals; and implementing institutional reforms to enhance project planning and management capacities of investment agencies, bolster incentives for improved public enterprise performance, and decentralize responsibilities that are more efficiently performed at the local level. 1.63 The private sector will need to provide the bulk of investment in directly productive activities. Consistent with this, the public sector would be expected progressively to reduce its role in these activities, through limiting fresh investment and through divestiture. The private sector is expected to play an increased role also in the provision of public services. Its role in providing social services is already substantial, but there are possibilities for increased participation in both existing and new areas, e.g., vocational, including employer-based, training, and health insurance. The public sector will remain the dominant provider of physical infrastructure, but increased private participation could contribute to raising efficiency, by introducing competition, and to alleviating pressures on public institutional and financial capacities. Infrastructure services are often near natural monopolies and the policy and institutional framework for private participation will need to be carefully designed to generate competitive pressures and protect the public interest. The scope for private participation is largest for those services that can be provided in a competitive market setting, such as transport and power generation. Given a sound, supportive framework, the private sector's share in total investment in physical infrastructure could rise to about one-third in REPELITA VI, from around 15% in REPELITA IV. 1.64 While the share of the private sector in total investment is likely to continue to increase, public investment will remain important. Complementing private investment, the priorities for public investment are infrastructure and human resource development, areas well-suited for public investment because of their public good nature and important positive externalities. Increasing national and international evidence supports the complementarity of public infrastructure investment with private investment and overall growth." Infrastructure provision is an important element of government role in providing an enabling environment for private enterprise; public infrastructure shortages force private firms to resort to higher cost alternatives, for example, captive power generation, and can deter growth, especially of small businesses. Supporting human resource development is an equally, if not an even more, important role of government. Recent years have seen a spate of studies bringing out the 12 World Development Report 1991, op. cit., pp. 82-84. 13 Among recent studies, see, for example, Infrastructure Sector Policy Review, World Bank, Urban Development Division, December 1992 (Working Draft), and Fiscal Policy and Economic Growth: An Empirical Investigation, William Easterly and Sergio Rebelo, paper presented at World Bank Conference on "How Do National Policies Affect Long-Run Growth", Washington D.C., February 1993. 26 Chapter 1 importance of human resource development to increasing productivity and growth and alleviating poverty, and providing evidence of very high rates of return on investing in people.'4 1.65 Already accorded priority by the Government, the further shift in public resource allocation toward infrastructure and human resource development in recent years is in order, and needs to be maintained, raising the share of these sectors in total public investment from around 70% in REPELITA IV to around 85% in REPELITA VI. Physical infrastructure (power, transport, telecommunications, and water and sanitation) will likely claim more than one-half of total public investment during REPELITA Vi. With existing facilities coming under strong pressure from rapid economic growth, expanding infrastructure capacity, and improving the quality and reliability of services, are important to maintaining the dynamism of the private sector. Power sector investment will command an especially high priority. In human resource development (education, health, nutrition and family planning), which will likely claim close to one-third of total public investment during REPELITA VI, expenditure priorities will be shaped by an increasing shift in emphasis from service expansion to improving service quality and by the changing needs associated with the demographic transition (e.g., change in age structure). Basic education and health will remain the major focus of public expenditure, but incremental resources will need to be directed primarily to quality enhancing measures, such as better teaching materials and teacher training, and adequate and better quality health staff and medical supplies. The emphasis at higher levels of education, and in vocational training, will also need to be on raising quality. Effectively responding to the country's evolving, and differentiated, human resource development needs will require improvements in service design and means of delivery, as well as varying the public-private mix for different services. 1.66 Improving the poor's access to quality education and health services will be central to further poverty reduction. These services address directly some of the worst consequences of being poor, but they also attack some of the most important causes of poverty. While the poor's access has increased, much remains to be done to make the poor benefit more effectively from public expenditures on these services. Public subsidy on education and health per capita accruing to the richest quintile of the population was recently estimated to be more than twice as large as that accruing to the poorest." Better targeting public education and health expenditures on the poor calls for: more accurately identifying where the poor are located; shifting expenditures more toward pro-poor programs, such as primary education and public health centers/subcenters; increasing utilization by the poor of public programs where it is low, such as in junior secondary education, while inducing the better-off to shift to privately provided services, such as in hospital care; and reducing service charges for the poor, and financing these reductions from improved cost recovery from the better-off. 14 See, for example, World Development Report 1991, op. cit., Chapter 3, and International Comparisons of Educational Attainment, Robert Barro and Jong-wha Lee, paper presented at the World Bank February 1993 Conference, op. cit. The latter underscores the role of education of women, and a passage from it is worth quoting: "Our results about female human capital accord in some respects with the viewpoints of [L. H.] Summers [Investing in All the People: Educating Women in Developing Countries, presented at 1992 World Bank Annual Meetings]. He goes quite far, however, and even argues "...the education of girls may well be the highest return investment available in the developing world." It is unclear how to reconcile this conclusion with the findings of [J. B.] de Long and [L. H.] Summers [How Robust is the Growth-Machinery Nexus, paper presented at the World Bank February 1993 Conference, op.cit.] ... that investment in machinery is the key element in economic growth. Perhaps the true key is to have educated women working with machines." 15 Indonesia: Public Expenditures, Prices and the Poor, Draft, World Bank, 1993. Sustaining Development 27 1.67 Effective human resource development, including family planning, and poverty alleviation programs will contribute to better environmental outcomes. However, expenditures on more directly environment-related programs will also need to rise. For public investment, the priorities will be: improved urban water supply, sanitation and solid waste disposal services; improved quality of public urban transport (to reduce congestion and emissions from private vehicles); and protection of forests. Improved cost recovery from public services, e.g., from water and sanitation charges, and increasing public rent capture in forestry can pay for much of the incremental public investment that is needed. The costs of investments in urban and industrial pollution abatement will be borne primarily by the private sector, following the "polluter-pays" principle. The incremental costs of environment-related public and private investments are sizable, but amount to a relatively small proportion of total investment, and are modest in comparison with the benefits of these investments in terms of improved efficiency, growth and human welfare. Prevention is cheaper than cure; carefully evaluating the environmental implications of public projects, though the EIA process, and adopting cleaner technologies for new private investments will avoid larger expenditures later to tackle environmental degradation. Institutions 1.68 Stronger institutions will make the policy reforms and investments outlined above more effective. Similar policies have been found to produce different results across countries, and a major part of the explanation lies in the variation in respective institutional capabilities." The foregoing discussion highlighted major strategic and structural shifts underway in the economy, such as the dismantling of regulatory controls, the increasing role and capacities of the private sector, and the shift toward more decentralized decision-making and greater local participation. Together with the evolving challenges in maintaining robust, equitable growth, new challenges are emerging, notably in environmental management. An important determinant of the sustainability of development would be the responsiveness of the country's institutional framework to these changes and challenges. Adapting to, and managing, this process of change entails profound implications for institutional roles and capacities. 1.69 The institutional development agenda encompasses both market and public institutions. It comprises three fundamental thrusts: * strengthening the institutional underpinnings of markets to support efficient and broad- based private sector development; * adapting and developing public institutions, focusing their capacities on efficient and equitable provision of public services; and * developing the institutional framework for improved environmental management. Specific issues of institutional reform and capacity building, supporting a strategy of a stronger orientation toward the market and a more focused, efficient public sector, are many and relatively complex. The main areas and directions of reform are outlined below. 1.70 A competitive incentives regime works best when reinforced by an institutional framework that provides the rules and information needed for efficient markets. Two critically important, and related, institutional underpinnings of markets are a well-functioning legal system, to provide a 16 Restructuring Economies in Distress, Vinod Thomas, Ajay Chhibber, Mansoor Dailami and Jaime de Melo, New York, Oxford University Press, 1991. 28 Chapter 1 predictable and fair environment for business, and a sound accounting and auditing system, to support financial discipline. The need for clear, modem commercial laws and accounting and auditing standards was noted earlier (para. 1.59), but these laws and standards would be of relatively little practical value without adequate means for their implementation and enforcement. Key requirements are: strengthening the court system, including the establishment of specialized commercial courts and the development of arbitration mechanisms; upgrading the training of legal officials, accountants and auditors, and supporting the development of their professional bodies; and widely and systematically disseminating information on laws. Other important tasks in strengthening the institutional underpinnings for private enterprise include: developing the capacities of regulatory institutions in financial (including capital) and land markets; ensuring efficient customs operations; and making key support services for small enterprise development-in industry and agriculture-more efficient and responsive to changing needs. 1.71 Focusing public capacities on the provision of a policy and institutional framework for sound private enterprise, and on efficient and effective service delivery will require major adaptations and improvements in public sector management: * Public enterprise reform needs to be accelerated, proceeding on the twin tracks of: further improving the performance of enterprises producing public goods and services that need to remain in the public domain; and gradual divestiture of enterprises engaged in the production of private goods and services. Policies to improve the performance of enterprises remaining public need to focus on exposing them to greater competition and increasing their operational and financial autonomy within a framework of improved accountability and financial discipline. Transparent mechanisms need to be employed to ensure that divestiture occurs efficiently, protects the public interest and allows broad private participation. * Past and prospective deregulation implies the elimination of many routine government administrative, control and licensing functions, and an increasing focus on policy analysis, promotion, monitoring and coordinating functions. Reassessing and realigning government administrative structures and the size, deployment, skill-mix and incentives of the civil service to perform the changing functions of government are an essential complement to these economic reforms. One major implication is the need to move toward a leaner but more professional and technically skilled civil service, with better compensation linked to higher productivity. * An important dimension of the reform of government administrative structure is decentralization. Appropriately devolving responsibilities to lower-level governments can contribute to more efficient and equitable delivery of public services by tapping local initiative, better matching expenditures with local needs, allowing more effective targeting of poverty alleviation programs, and fostering accountability. It also helps reduce the burden on central capacities. These considerations are especially relevant in a large and diverse country such as Indonesia, and become increasingly important as the economy expands. Mobilizing more local revenues, thereby reducing the current heavy local dependence on central transfers, and building local institutional capacities will be essential for successful decentralization. 1.72 Developing the institutional framework and capacities is a crucial part of the agenda to improve environmental management. While a policy and regulatory framework has been taking shape, there remains a large gap between policy and implementation because of institutional weaknesses. Sustaining Development 29 Enhancing institutional capacities for environmental management will require progress on three fronts. First, the roles of the various agencies involved in environmental management need to be clearly defined and arrangements for inter-agency coordination improved. Important dimensions of this effort include the effective decentralization of relevant responsibilities to the regional level, and improved coordination among central agencies and with their regional counterparts on programs that cut across sectors and regional boundaries, e.g., water resource management. Second, the supply of staff skilled in environmental analysis and management, especially limited at the regional level, will need to be increased. Where appropriate, as in monitoring and inspection, contracting out of services to the private sector can relieve the skills constraint in government agencies. Third, efforts need to continue to involve local communities, project beneficiaries and NGOs more closely. Generally beneficial to the effectiveness of development activities, a more participatory approach is particularly valuable in environmental-and complementary poverty alleviation-programs, many of which require solutions closely tailored to local problems and conditions.  The Macroeconomic Foundation 31 2 THE MACROECONOMIC FOUNDATION A. Overview 2.1 Indonesia's development over the past 25 years has been based on achieving a trilogy of objectives: growth, stability and equity. This trilogy is very close to the themes of this report. In particular, this chapter discusses macroeconomic policies for sustainable growth. Sustainable growth in Indonesia should be rapid enough to absorb new entrants to the labor force at a rising average standard of living. Sustainable growth should also result in widespread sharing of the benefits of growth, including continued progress in reducing poverty. Sustainable growth should protect the environment so that future generations also benefit from Indonesia's rich endowment of natural resources. Finally, sustainable growth should be financeable; it must be consistent with the constraints Indonesia faces in using foreign savings to finance investment. 2.2 This report discusses policies to secure a sustainable growth path; this chapter focuses on the macroeconomic implications of this path, including measures to realize it. A key feature of the sustainable growth path is the need to raise domestic resources-public and private savings-in order to finance investment needed for growth, while containing the current account deficit. An important dimension of this is a macroeconomic policy mix that uses a larger fiscal adjustment to raise public savings. A firmer fiscal stance would help improve private confidence in macroeconomic policy, contributing to reducing domestic interest rates and keeping them closely aligned with off-shore rates, and free resources needed to finance higher private investment upon which continued rapid GDP growth will depend. This chapter identifies measures for raising public savings and prudent macroeconomic policies that will provide an environment conducive to raising private savings. 2.3 Indonesia has adjusted substantially since the 1989-90 period of overheated domestic demand. The policies that supported this adjustment and its main features are discussed in the next section. Having reduced macroeconomic imbalances, Indonesia is well placed to continue on a sustainable growth path with low inflation and manageable external borrowing requirements. Section C identifies the medium-term challenges for the sustainable growth path, and presents a growth scenario that meets these challenges. Section C concludes with an analysis of the macroeconomic policies needed to support the growth scenario. Indonesia remains vulnerable to external shocks, particularly in view of its high external debt, and needs to manage growth carefully to keep inflation and the current account deficit in check. The last section analyzes the sources of uncertainty-fluctuations in commodity prices, interest rates and exchange rates-as well as the uncertainties emerging trade blocs pose for Indonesia. B. Response to Recent Macroeconomic Pressures 2.4 Background. In 1990, a surge in domestic demand combined with an accommodating monetary policy caused accelerating inflation, a widening current account deficit and a decline in international reserves. Efforts to restrain demand started in 1990 and intensified in February 1991 when deposits of state enterprises equivalent to 25% of base money were converted into claims on Bank Indonesia (BI), the central bank. Later that year, limits were imposed on external borrowing by state enterprises, supplemented by guidelines for private external borrowing. Bank Indonesia also raised interest rates on its certificates (SBIs), the primary instrument for influencing monetary and credit conditions, by four percentage points. Deposit and lending rates followed suit. Restrained growth in money supply and higher interest rates started to stem the reserve outflow after mid-1990, and in the last 32 Chapter 2 three quarters of 1991/92 net foreign assets recovered by nearly $3 billion. The policies reduced domestic demand, especially fixed investment, thus restraining import growth and accommodating rapid growth of non-oil exports. Strong net export demand sustained robust 6.6% GDP growth. It was evident by March 1992 that the stabilization measures were working. 2.5 Considerable further adjustment was achieved in 1992/93. The most prominent gain Figur 1 - Trad Defci was the fall in the non-oil trade balance (Figure 2.1). The ambitious target for non-oil US$ Billions export growth-24% growth in value-was exceeded despite slower than projected growth in the world economy. The dramatic reduction in the non-oil trade deficit was the main reason for the strong current account performance; the 4 current account deficit fell from 3.8% of GNP in 1991/92 to 2.4%. The strength of the current 2- account was matched in the capital account by large inflows of foreign capital, which permitted 0 ... a further build-up of international reserves. J A J 0 J A J 0 J A J 0 J A J 0 J 89 ( 9n 1 91 92 P3 Inflation slowed to 5 % in 1992 (end-year basis) Cumnulative trade data for the previous 12 months. and deposit interest rates declined markedly. A Source: Centra Bureau of Statiscs. significant step toward a more supportive fiscal stance was taken in January 1993 with the elimination of subsidies for most fuel products. However, the sizable adjustments in fuel and some other administered prices contributed to a jump in the consumer price index in the first quarter of 1993. Macroeconomic Policy in 1992/93 2.6 The objective of monetary policy in 1992/93 was to support improvement in the external balance by keeping domestic demand pressures in check while achieving further progress in reducing inflation. Although the growth of domestic demand was slowing, the Government recognized that any relaxation of policies would be premature, particularly in view of the already large external debt. Slow domestic demand growth was expected to continue to improve the non-oil trade account, but a projected $2abbl. decline in oil prices and higher interest payments on external debt were expected to prevent this from leading to a reduction in the current account deficit. A small increase in international reserves was anticipated. 2.7 The stronger than anticipated external adjustment made it difficult to keep the growth of monetary and credit aggregates on target. Oil prices and non-oil export growth turned out to be higher than expected, reducing the projected current account deficit by $1.4 billion. The stronger current account bolstered confidence in the stability of the rupiah, which made domestic interest rates attractive and led to short-term capital inflows. Net foreign assets increased by nearly Rp. 10 trillion (Table 2. 1) compared with the projected increase of less than Rp.0.5 trillion. However, much of the inflow was sterilized by commercial bank purchases of sms, contributing to sre sales of over Rp. 13 trillion. Because of the sterilization of most of the capital inflow, broad money growth of 22% was only a little higher than initially projected. However, private sector credit growth of 9% was well below initial projections. Subtracting estimated interest capitalization of impaired loans, private sector credit growth was only about 5.5%. The Macroeconomic Foundation 33 Table 2.1: Indonesia: Monetary Survey (Rp. trillion) Annual Growth Rates (%) 1990 1991 1992 1993 1990 1991 1992 1993 March March March March March March March March Net Foreign Assets 17.9 20.2 23.6 33.3 -4.0 12.7 17.2 41.1 Net Domestic Credit 71.4 96.3 115.1 128.3 70.9 34.9 19.5 11.5 Public Sector 0.9 -5.4 -6.3 -6.3 -0.8 -61.3 -19.0 -0.1 Public Enterprises 8.8 7.3 8.8 8.6 14.4 -17.1 20.7 -2.6 Private sector 70.4 101.7 121.3 132.6 68.2 44.4 19.4 9.2 Other items, net -24.9 -35.4 -37.9 -41.8 -53.4 -41.9 -7.0 -10.3 Broad Money 64.4 81.1 100.8 123.2 45.7 26.0 24.2 22.2 Memo item: Average velocity 2.7 2.5 2.3 2.1 Source: Bank Indonesia. 2.8 Bank Indonesia faced a difficult job of lowering the interest rate on SBIs in an effort to encourage commercial banks to extend loans to the private sector rather than invest in SBIs while avoiding a premature relaxation that could rekindle domestic demand pressures. The rate on one-month sBIs was reduced from 18% in March 1992 to 16% in June 1992 and 12.5% in March 1993. However, for a variety of reasons, commercial banks continued to use the proceeds of sales of foreign exchange to BI to purchase SBIs. One reason was weak domestic demand, which reduced credit demand from enterprises dependent on domestic sales. Portfolio problems in the commercial banks also were a factor. Efforts of banks to meet tighter prudential norms established by BI (para. 2.11) made purchase of SBI's, a risk- free asset, an attractive option. Regulatory restrictions-the requirement that banks lend 20% of their portfolio to small borrowers and that joint venture banks lend 50% of their portfolio to exporters-may also have inhibited the supply of credit (Chapter 3). In addition to encouraging commercial banks to lend to the private sector, lower SBI rates were desireable to ease the strain on BI's cash flow. The sterilization of capital inflows by commercial bank purchases of SBIs cost BI an estimated $0.9 billion in 1992/93 from the interest differential between foreign assets and SBIs. Quasi-fiscal operations (para. 2.15) added to the strain. A more supportive fiscal stance could have made it easier for BI to lower SBI interest rates by reducing the danger that domestic demand would become overheated as rates fell. 2.9 The experience of 1992/93 highlights the limited scope for policy measures to affect directly domestic deposit interest rates. High nominal rupiah deposit interest rates reflect expectations of devaluation and a country risk premium. A measure of expected exchange rate depreciation is given by the nominal interest rate differential between financial assets that are identical in all respects except for the currency of denomination (Figure 2.2). A sharp increase in expectations of devaluation can be seen during 1990 leading to a peak in early 1991. Since then, adherence to sound macroeconomic policies has reduced expectations of depreciation. The scope for further reductions in expectations of depreciation and interest rates seems high, however, especially in view of the strength of the balance of payments and 34 Chapter 2 the fact that over the past five years the actual annual depreciation of the rupiah against the u.s. Figure 2.2: Devaluation Expectations dollar has averaged less than 5 %. A larger fiscal Interest rate difierental between one-month rupiah~ and US$ lime deposits adjustment can reduce expectations of exchange at_state-owned_commercial_banks rate depreciation by raising confidence in 20- exchange rate and price stability. By following 15 i consistent macroeconomic policies that keep the domestic economy from overheating, market 9 interest rates will decline further. ml. i 2.10 The country risk premium can be measured by the spread between interest rates on 0 u.s. dollar deposits in Indonesian commercial 86 88 im89 90 91 9 banks and on U.S. dollar deposits in offshore Source: Data providad by Bank Indonesia and World Bank staH Calculations. banks (Figure 2.3). This measure of Indonesian country risk rose in 1987-88, was very low in 1989-90, and increased steadily from 1991 through 1992. The increase in 1992 coincides with the emergence of problems in the financial Figure 2.3: Indonesia Country Risk Premium sector. It will take time for perceptions of (On-shore/Otl-shore US$ Deposit Interest Differential) riskiness to fall and the role of policy in bringing this about is to keep money and credit growth 2.5 within prudent limits consistent with robust growth with low, stable inflation. An important role for the Government in reducing country risk 1 5 is in creating a stable climate for investors, 1.0 including an efficient, sound financial system. Chapter 3 discusses specific measures for 0.5 improving the investment climate and ensuring the 0.0 -, soundness of the financial system. 2.11 The decline in rupiah deposit rates Source: Data proided by Bank Indonesia and World Bank staff calcutions. was not matched by falling lending rates, leading to widening commercial bank nominal spreads (Figure 2.4). The downward stickiness of lending rates reflected several factors. The most obvious Figure 2. Commercial Bank Interest Rate Spread was the need for banks to strengthen their Working Capil Credits - 3-mnth ime Depsi Inteest Ditlerential portfolios to meet new prudential guidelines. 8 Also, changes to the regulatory system affecting the income statements and balance sheets of 6 commercial banks made the extension of new loans more costly. In March 1991, BI tightened loan loss provisioning standards and mandated that commercial banks raise their capital-asset ratios to 5% by March 1992, 7% by March 1993 2 and 8% by December 1993. For banks where the 1 capital adequacy requirement was binding, an 33/ / 11/91 1/92 3/92 6/92 7/92 9/9211/92 increase in assets with a positive risk weighting, such as commercial loans, required additions to Source: Data provded by Bank Indonesia and Wodd Bank staft calculations. bank capital. Up to the point that the bank's The Macroeconomic Foundation 35 blended cost of funds reached the sRI rate, the banks could defray the cost of increased time deposits by investing in sBls, which have a zero risk weighting.' 2.12 The higher spreads will help banks improve their income and balance sheets. Over time this will lead to a closer alignment of deposit and lending rates. Further, competitive pressures will emerge to narrow the spread. Substitutes for commercial bank loans are becoming more attractive: 11 domestic bonds worth Rp. 875 billion ($425 million) were issued on the Jakarta Stock Exchange in 1992, use of promissory notes is increasing and a commercial paper market is developing. Healthy banks-those that meet the capital-asset ratio requirement-will also begin to be more aggressive and take market share. In this way, commercial bank lending rates will gradually fall and margins narrow. Relaxing the 20% requirement (para. 2.8), as discussed in Chapter 3, would hasten this process. In addition, the 50% requirement (para. 2.8) could also be reviewed to assess its impact on domestic credit availability. Measures to deal with the strains in the financial system are discussed in Chapter 3. Steady growth in the economy will help ease the financial strains in the banking system. A well-balanced policy mix, including a stronger fiscal effort, would promote sustainable growth by helping to bring about a more rapid decline in interest rates. 2.13 An improved macroeconomic policy balance including the attainment of a fiscal surplus was an important objective of fiscal policy in 1992/93. By reducing the public sector's absorption of resources, more credit could be made available to the private sector without creating pressures on the external balance target. An increase equivalent to about 1 % of GDP in the overall fiscal balance of the Central Government compared with the previous year outcome was targeted (Table 2.2). The authorities projected a 24% increase in non-oil tax revenues to be brought about mainly by higher revenues from the income and the value added taxes. 2.14 Lower than projected revenue from non-oil taxes, mainly a shortfall in indirect tax receipts, and higher current and development (both budget and off-budget) outlays more than offset higher oil/LNG revenues and lower interest payments on external debt and resulted in a slippage in the budget balance of Rp.3.4 trillion compared with the target (Table 2.2). About Rp. 1 trillion of the recorded fiscal deficit in 1993/94 reflected outlays on oil subsidy arrears and state bank recapitalization, outlays that did not add directly to domestic demand. However, even allowing for these factors, the fiscal outcome was not consistent with a balanced stance of macroeconomic policies conducive to an easing of interest rates and a pick up in private investment while safeguarding the external position. The 1993/94 budget implies an improvement equivalent to about 1.5% of GDP over the 1992/93 fiscal balance. Continued strong growth in revenues from the income tax is the main reason for the 23% increase projected in non-oil tax revenues. Total expenditures are projected to increase by about 8%, with a somewhat faster increase in current expenditures because of an average 15% adjustment in civil service salaries announced in January. The fiscal adjustment targeted for 1993/94 would improve the macroeconomic policy mix and make a significant contribution toward a consistent, sustainable fiscal stance, which would help achieve sustainable growth targets, as discussed below (paras. 2.60-62). A major step toward achieving the targeted adjustment was taken in January with the elimination of the budgetary subsidy on fuel. 2.15 Quasi-fiscal operations of BI added to the strain on its cash flow. A 35% increase in liquidity credits to BULOG for procurement and storage of the bumper rice crop was offset by a reduction in other liquidity credits. However, during the year the Clove Marketing Board announced that it would be unable to repay maturing liquidity credits of about Rp.750 billion, which had been extended the The blended cost of funds to banks was 11.5% as of January 1993 (based on a 24%/76% demand/time deposit mix at interest rates of 6%/13%), when the interest rate on sBis was around 13%. 36 Chapter 2 previous year. BI rolled over the overdue principal. Apart from highlighting the well-known problems with the operations of the Clove Marketing Board, the incident underscores the importance of phasing out credits at below market interest rates, including below market rediscounting of liquidity credits and export bills. Credit is seldom the most appropriate way of providing subsidies. In the exceptional case a credit subsidy is called for, the need for transparency argues for showing the subsidy explicitly in the government budget. Table 2.2: Central Government Operations, 1988/89-1993/94 a (Rp. trillion at current prices) Actual 1992/93 1993194 1988/89 1989/90 1990/91 1991/92 Budget Prov. Est. Budget Revenue and grants 23.9 30.0 41.1 42.1 47.1 45.6 53.3 Oil and LNG taxes 9.9 11.8 17.6 15.5 13.9 15.3 15.1 Non-oil taxes 11.9 15.4 20.8 23.4 28.9 27.4 33.8 Non-tax revenues 1.6 2.2 2.4 2.7 3.7 2.3 3.8 Grants 0.5 0.6 0.4 0.4 0.6 0.6 0.5 Current expenditures 16.8 19.8 23.8 25.6 26.8 27.8 30.5 External interest 4.3 4.5 4.9 5.2 5.8 5.1 6.1 Subsidies 1.0 1.5 3.4 1.6 0.2 1.1 0.2 Other 11.5 13.8 15.5 18.8 20.8 21.6 24.2 Government savings 7.1 10.2 17.3 16.5 20.3 17.8 22.8 Capital expenditures 10.6 11.6 13.6 18.0 19.5 20.4 21.5 Budget balance -3.5 -1.4 3.8 -1.5 0.8 -2.6 1.3 Financed by: External loans (net) 5.0 2.6 1.3 2.4 -0.8 0.8 -1.3 Asset drawdown -1.5 -1.2 -5.1 -0.9 0.0 1.8 0.0 Memo items (% of GDP): Non-oil taxes (% of non-oil GDP) 10.0 11.2 12.4 12.3 13.3 12.7 14.0 Government savings 4.8 5.9 8.5 7.0 7.7 6.8 7.9 Budget balance -2.4 -0.8 1.9 -0.6 0.3 -1.0 0.5 Total expenditure 18.6 18.3 18.2 18.6 17.7 18.4 18.1 Primary balance b 0.6 1.9 4.3 1.6 2.5 0.9 2.5 a This table presents Central Government fiscal accounts in the standard format used by the IMF's Government Financial Statistics, which differs from the format used in the Government of Indonesia's Budget. Tables in Section 5 of the Statistical Annex present the fiscal accounts in the Government's format. b Budget balance net of external interest payments. Source: Ministry of Finance and World Bank staff estimates. The Macroeconomic Foundation 37 2.16 The value of the exchange rate is determined by BI under a system of managed float. BI seeks to maintain the Figure 5: Real Effective Exchange Rate* rupiah's competitiveness against a basket of (Jan 1988 = 100) currencies, mainly by depreciating the rupiah 110 to compensate for the differential between Indonesian and u.s. inflation and adjusting for 105 fluctuations in the u.s. dollar cross-exchange rate with other currencies. The 100 competitiveness of the rupiah as measured by the real effective exchange rate was 95 maintained in 1992 (Figure 2.5). It showed signs of appreciating in early 1993 due to the 90J __MMJ__NJM__JSN__MM___NJ___JJ__ large increases in the consumer price index 88J 1J89S1M90J1J91 M92 resulting from the increase in domestic fuel A decline is a depreciation. and other administered prices, which widened Source: IMF the inflation differential between Indonesia and its trading partners. Since the first( quarter jump in the consumer price index reflects one-time adjustments and not an acceleration of underlying inflation, it is not likely to lead to a loss of competitiveness. A policy of slowing the rate of depreciation of the exchange rate can be instrumental in slowing inflation, both by keeping tradable goods price inflation low and, by providing a more stable nominal anchor for domestic prices, dampening inflationary expectations. However, to maintain competitiveness, this policy needs to be accompanied by appropriate restraint in financial policies to lower the rate of inflation and by continuing structural reforms to raise productivity and eliminate the sources of high costs in the economy. Macroeconomic Outcomes 2.17 Despite the considerable challenges to policymnakers described above, the economy's performance in 1992/93 was impressive. Non-oil GDP growth accelerated, led again by a remarkable performance of non-oil exports. There was a significant reduction in the current account deficit and the underlying inflation rate was brought under control. In short, the process of correcting the macroeconomic imbalances that emerged in 1990 was consolidated. 2.18 Total GDP and non-oil GDP grew by 5.8 % and 7.5 %, respectively, somewhat higher than initially projected (Table 2.3). Favorable weather accounts for part of the faster than expected growth in non-oil GDP. Rice production rebounded from the drought-depressed 1991 production level of 44.7 million tons, reaching 47.3 million tons in 1992 and providing a major boost to overall growth in agriculture. Construction growth exceeded projections, in part reflecting the strength of public fixed investment. Growth in manufacturing remained strong in 1992 because of rapid growth of labor-intensive non-oil manufacturing exports, especially clothing and textiles, footwear, electronics and furniture. There was a 3.8% reduction in oil/LNG value added, reflecting lower opEc quotas in 1992 following the Gulf-war-related increases. 2.19 As in 1991, non-oUl exports were the fastest growing component of demand (Table 2.3). In view of the slowdown in major world economies and rising protectionism, the performance of non-oil exports is remarkable. Developing Asia has emerged as an important destination and now absorbs nearly 40 % of Indonesia's non-oil exports, though some of this may be re-exported to other regions. Some 43 % of the increase in non-oil exports over 1989-92 went to Developing Asia (Figure 2.6), followed by the European Community and North America. Japan absorbed 17% of Indonesia's non-oil exports in 1992, 38 Chapter 2 but only 4% of the 1989-92 growth in non-oil exports was to Japan. Textiles (including garments), Indonesia's, largest non-oil export, accounted for over 40% of the growth of non-oil exports during 1989-92 (Figure 2.7). Developing Asia is the most important destination of garment exports, followed by the European Community and North America. The second largest increase was in "other industry". Table 2.3: Key Macroeconomic Indicators a Actual Estimated 1988-89 1990 1991 1992 Average real growth rates (% p.a.) GDP 6.6 7.1 6.6 5.8 Non-oil GDP 7.8 6.9 6.3 7.5 Agriculture 4.1 2.0 1.3 3.6 Manufacturing 12.2 13.0 10.6 9.7 Mining 4.8 14.6 18.1 24.0 Construction 10.6 13.5 10.9 11.9 Other Services 8.2 7.4 6.0 7.2 GNY 7.0 8.4 5.4 5.5 Non-oil exports 17.8 2.8 24.3 26.6 Non-oil imports 12.7 26.0 9.6 7.7 Fixed investment 11.9 14.6 6.0 5.0 Public 13.8 11.9 11.2 7.0 Private 10.7 16.2 3.0 3.7 Macroeconomic balances (%) Current account/GNP -1.9 -3.4 -3.8 -2.4 Non-interest current account/GNP 2.3 0.4 0.3 1.4 Overall public sector balance/GDP -2.1 0.3 -1.1 -1.4 MLT debt service/exports 35.8 29.7 31.6 30.0 MLT debt/exports 212.2 187.6 196.5 176.4 MLT debt/GNP 60.1 57.8 59.0 57.9 Structure of the economy (%) Non-oil manufacturing/GDP 13.9 14.9 15.4 16.0 Non-oil exports/non-oil imports 88.8 71.2 77.5 90.2 Public savings/GDP 6.4 9.5 8.5 8.3 National savings/GDP 20.9 20.9 20.3 20.1 Fixed investment/GDP 20.6 22.5 22.7 22.5 Private fixed investment/ total fixed investment 58.7 59.1 57.7 56.9 Consumption/GDP 74.2 74.2 75.0 75.0 Consumption/GNY 75.1 75.0 75.6 76.0 Prices Oil prices (us$/bbl) 17.9 22.6 18.3 17.4 Non-oil terms of trade (1983/84= 100) 95.9 95.3 91.5 90.6 Domestic inflation (% p.a.) b 6.7 7.9 9.4 7.5 a Balance of payments data are for fiscal years (starting April 1). Other indicators are for calendar years. b As measured by the average consumer price index, with an adjustment for rice prices during 1987-89. Source: Bank Indonesia, Central Bureau of Statistics and World Bank staff estimates. The Macroeconomic Foundation 39 This is a large and diverse group of products including footwear, ceramics, plastics and furniture. Footwear exports have been particularly dynamic. They surpassed the $1 billion mark in 1992 to become Indonesia's EA third largest manufactured export following 22% textiles (including garments) and plywood. Indonesia's share of world footwear exports is still negligible and footwear exports are not Japan subject to quotas, so prospects for continued rapid 4% 4% growth appear bright as long as Indonesia's competitiveness is maintained. 2.20 Following several years of rapid Developing Asia growth, fixed investment growth was moderate in 43% 1992 for a second year in a row (Table 2.3). The wm Geta Bum~u ot Stabdac. slowdown in private fixed investment during the past two years reflects the cooling off of domestic demand in response to contractionary policies. Public fixed investment growth exceeded that of the private sector. Weaker than projected private demand is consistent with the observed slow growth of credit to the private sector. Overall consumption increased by 6. 0% with real private consumption growing by 5. 0%, due mainly to higher rural incomes from the bumper rice crop. Farm household consumption grew by 7 % in 1992. Figure 2.7: Growth of Non-Oil Exports by Product and Market, 1989-1992 us$ bilions Min4% Others% k Mining T0 Om Bletrim! rnachPtRanld papa prod. 2% ONoMh mmidca EDEC JqmpEO De4*V Adia 19Obnes Swrce: Central Bureau of Srotistfcs. 40 Chapter 2 2.21 The dampening of domestic demand was also reflected in a second consecutive year of slow growth of non-oil imports (Table 2.4). Capital goods imports, which account for roughly one-third of the total, fell by 2.3% due to the slowdown in investment demand. Imports realized for Indonesian Investment Coordinating Board (BKPM2 approved investments grew by an estimated 114% in 1990 but only 13% in 1991 and fell by 16% in 1992. The largest absolute increases were in parts and accessories and intermediate goods, reflecting in part the inputs needed for rapid export expansion. The fastest growth was recorded by consumer good imports, which are a small fraction of total non-oil imports. Food imports, which account for much of this increase, were unusually high as a consequence of the need to replenish rice stocks following the drawdown in 1991/92 when drought reduced the rice harvest. Passenger car imports declined for a second consecutive year. Reports throughout the year that a deregulation package for the automotive sector was to be introduced may have prompted consumers to delay their car purchase plans in the hopes that deregulation would result in lower imported automobile prices. Table 2.4: Non-Oil Merchandise Imports, 1987/88-1991/92 a Value at current prices Growth in current prices (US$ billion) (Percent p.a.) Actual 1989/90- 1990/91- 1991192- 1987/88 1989/90 1990/91 1991/92 1992/93 1990/91 1991/92 1992/93 Capital goods 2.5 4.0 6.6 7.8 7.6 64.5 14.3 -2.3 Parts & accessories 2.2 2.6 3.8 4.2 5.1 48.7 14.2 21.5 Intermediate goods 6.4 8.9 10.1 11.1 13.0 14.1 9.4 16.6 Passenger vehicles 0.2 0.2 0.4 0.2 0.2 53.7 -45.2 0.0 Consumer goods 0.4 0.5 0.6 0.7 1.2 24.1 44.7 58.1 Other b 0.1 0.1 0.1 0.1 0.1 -51.7 97.7 -26.5 TOTAL 11.8 16.3 21.6 24.2 27.2 32.5 12.0 12.5 a Disaggregation based on BPS import statistics, applied to BI estimated non-oil imports. b Goods not elsewhere specified. Source: Central Bureau of Statistics, Bank Indonesia and World Bank Staff estimates. 2.22 Inflation decelerated steadily during 1992. Annual average consumer price inflation was 7.5%, but only 5% measured on an end-year basis. One reason was the slower rate of depreciation of the rupiah, which kept tradable goods price inflation low. Another was the large rice harvest, which put downward pressure on the consumer price index by holding rice prices virtually unchanged. Delayed adjustments in administered prices also kept the increase in the index low. Tighter demand management policies that kept the growth of monetary aggregates broadly in line with the target rates also contributed by dampening inflation expectations as reflected in the narrowing dollar-rupiah interest rate differential (Figure 2.2). The consumer price index jumped sharply in January-March 1993 as a result of substantial fuel price adjustments in January 1993, adjustments in electricity and transport tariffs, and seasonal pressure arising from the Idul Fitri and Chinese New Year holidays in March. These one-time pressures abated sharply in April 1993. Despite the large jump in the CPI in the first quarter of 1993, adherence to the 17% broad money growth target with projected 6.3% real GDP growth and continued reductions in rupiah deposit rates would make 1993 end-year inflation of about 8% attainable. 2 BKPM licenses investment projects that benefit from duty exemptions for capital goods and initial inputs. The Macroeconomic Foundation 41 2.23 Balance of payments developments were dominated by the rapid growth of non-oil exports, slow growth in non-oil imports, the higher than anticipated oil price and the strength of capital inflows. The first two of these produced a $2.5 billion fall in the non-oil current account deficit (Table 2.5). The higher oil price raised the oil/LNG current account surplus by $1.2 billion over the initial projection, though it declined by $1.1 billion from 1991/92. Higher interest payments on short-term debt offset part of the overall improvement. Nevertheless, the current account deficit of $2.9 billion, or 2.4% of GNP, was $1.4 billion lower than anticipated. The stronger current account performance was matched by a stronger capital account performance, leading to a $6.1 billion increase in net foreign assets. The increase in net foreign assets was split between official reserves, which increased to $11.8 billion, equivalent to a prudent four months of imports, and reserves of the banking system. Table 2.5: Balance of Payments, 1988/89-1992/93 (US$ billion) Actual Estimated 1988/89 1989/90 1990/91 1991/92 1992/93 Merchandise exports (fob) 19.8 23.6 28.0 29.4 34.9 Oil & LNG 7.6 9.3 12.6 10.6 10.3 Non-oil 12.2 14.3 15.4 18.8 24.6 Merchandise imports (cif) -16.2 -19.4 -25.7 -27.8 -31.0 Oil & LNG -2.6 -3.1 -4.1 -3.6 -3.8 Non-oil -13.6 -16.3 -21.6 -24.2 -27.2 Trade balance 3.6 4.2 2.3 1.5 3.9 Non-factor services (net) -1.2 -1.2 -0.6 -0.6 -0.4 Interest payments (MLT) -3.2 -3.4 -3.4 -3.8 -3.9 Other factor services and transfers (net) -0.9 -1.2 -1.9 -1.5 -2.5 Current account balance -1.8 -1.5 -3.6 -4.3 -2.9 Oil/LNG current account 3.1 4.0 6.1 4.7 3.6 Non-oil current account -4.8 -5.5 -9.6 -9.0 -6.5 Public MLT loans (net) 3.1 1.4 0.5 1.8 2.1 Disbursements 7.4 6.1 5.1 6.6 6.8 Principal repayments a -4.3 -4.9 -4.6 -4.7 -4.8 Other capital (net) -1.6 0.2 6.3 3.9 6.9 Use of net foreign assets 0.3 0.1 -3.2 -1.4 -6.1 Use of official reserves 0.6 -0.4 -3.9 -0.9 -1.3 Use of comm. bank reserves -0.3 0.5 0.7 -0.5 -4.8 Memo items: Net official reserves (US$ bln.) b 5.3 5.7 9.6 10.5 11.8 - Months of importsc (3.3) (2.6) (4.1) (4.1) (4.1) Current account/GNP (%) -2.2 -1.7 -3.4 -3.8 -2.4 Non-interest CA/GNP (%) 2.2 2.4 0.4 0.3 1.4 MLT debt servicelexports (%) d 36.8 34.7 29.7 31.6 30.0 a Includes prepayments of $341 million in 1988/89 and $300 million in 1989/90. b Net official reserves are defined as gross official reserves minus outstanding liabilities to the IMF and other short-term liabilities. c Net official reserves in months of next year's expected merchandise imports (oil/LNG and non-oil). d Debt service on public and private debt, excluding prepayments; denominator is gross exports of goods and services. Source: Bank Indonesia and World Bank staff estimates. 42 Chapter 2 2.24 The composition of the capital account flows in 1992/93 reflected high domestic interest rates as well as confidence in Indonesia's economic prospects and management. Net foreign direct investment rose to $1.7 billion, three times the level of four years ago. The sustainable growth path discussed below projects continued growth of foreign direct investment. Short-term borrowing, estimated at $3.1 billion, reflected growth in trade finance and the scope for profiting from the wide differential between off-shore and on-shore interest rates. Medium- and long-term external borrowing by the private sector increased, though at a slower pace than in the previous two years. Gross disbursements of official assistance remained at the previous year level of $3.8 billion. Slower growth of debt and the increase in international reserves held the increase in net debt to $3.1 billion, a substantial slowdown from the increases of the previous two years ($9.8 billion and $8.4 billion in 1990/91 and 1991/92, respectively). C. Sustained Growth and Macroeconomic Consistency 2.25 Significant adjustment in 1992/93 sets the stage for continued robust and sustainable growth. Sustainable growth over the medium term has four dimensions: it needs to be rapid enough to absorb new entrants to the labor force at a rising average standard of living; it should also allow a wider sharing of the benefits of growth, in particular continued progress in alleviating poverty; it should protect the environment; and it should be financeable, consistent with the constraints Indonesia faces in using foreign savings to finance investment. These challenges are quantified below and their implications for the economy analyzed. This is followed by a discussion of the macroeconomic policies needed to support this growth path, and meet the challenges it represents. 2.26 The economy should develop along a growth path rapid enough to meet the challenges without provoking demand pressures that lead to overheating. Such growth will require higher investment. The high level of external debt limits maneuverability by claiming a large share of Indonesia's cash flow from exports. It also raises Indonesia's vulnerability to external shocks. A reduction in the debt burden is in order to increase flexibility and reduce vulnerability. However, reducing external borrowing means reducing the current account deficit-foreign savings-in relation to GDP, while rapid GDP growth requires higher total savings to finance the higher investment needs. Therefore, the essential requirement for achieving sustainable growth is to generate higher national savings, both public and private. The Challenges 2.27 Labor Absorption. Indonesia's growth path during the 1990s will continue to be marked by a substantial shift of labor from agricultural to non-agricultural employment. The share of employment in agriculture fell from 65% in the early 1970s to about 50% in the early 1990s. Although agriculture's employment share has fallen, the absolute number of farm workers has increased, with no decline in productivity. However, the shift of labor into non-oil manufacturing has been accomplished at higher levels of productivity. Growth of labor productivity in non-oil manufacturing of over 6% per year since the early 1980s has driven overall non-oil labor productivity growth to over 3% per year. 2.28 Indonesia's rapid GDP growth during the past decade has thus substantially raised the average productivity of Indonesian workers. This has been accomplished by drawing workers from agriculture into more productive jobs outside agriculture. Sustainable growth requires smooth continuation of this process, avoiding a rise in unemployment. Continued expansion of labor-intensive, non-agricultural employment is needed to absorb the stream of workers leaving agriculture as well as new entrants to the labor force. Continued expansion of productive employment in agriculture is needed too, so that the stream of workers to non-agricultural activities does not become a flood. Moreover, agricultural production and productivity must rise to provide food and raw materials for the rest of the economy. The Macroeconomic Foundation 43 2.29 Indonesia's past record suggests an elasticity of non-oil employment with respect to non-oil GDP of about 0.4. Although Indonesia's population growth rate is not high, the effects of more rapid population growth in the past will be felt through the 1990s. Indonesia needs to sustain non-oil GDP growth on the order of 6-7% p.a. to absorb new entrants into the labor force at rising levels of productivity. Agriculture is projected to maintain trend growth of 3% per year in the medium to long term. This implies that non-oil, non-agricultural GDP needs to grow by 7.5-8% annually. This compares with average annual growth of 8.6% during 1986-92. 2.30 With a labor force now at 81 million and projected to grow by 2.3 million each year for the rest of the 1990s, one percentage point slower non-oil GDP growth than,noted above would mean 320,000 fewer jobs created annually. Since the mid-1980s, when deregulation and other structural reform measures started, employment growth has averaged 2.5% annually. Continuation of these reforms will help sustain rapid employment growth. The extension of deregulation to still heavily protected activities will encourage the balanced growth needed to generate adequate employment. The expansion of labor- intensive non-oil manufacturing activities calls for improved availability of the direct input-a well- educated labor force--and indirect inputs-physical and institutional infrastructure required for business. Chapter 4 discusses the roles of the Government and the private sector in increasing the quantity and improving the quality of human and physical infrastructure. 2.31 Poverty Alleviation. In view of the dramatic progress in poverty alleviation in the past two decades and the Government's commitment to extend this progress, a sustainable growth path for Indonesia would also seek to maintain the positive link between economic growth and poverty alleviation. Poverty declined from 40% of the population in 1976 to 15% in 1990, when real GDP rose nearly 2.5 times, implying a unitary elasticity of the reduction of poverty incidence with respect to GDP growth. Data for 1987-90 suggest an elasticity of the reduction of poverty incidence with respect to non-oil GDP of 0.6. Assuming non-oil GDP grows at around 7% each year, as discussed above, maintenance of the pace of poverty alleviation attained during 1987-90 would mean the share of the population living in poverty could decline from 15% in 1990 to around 10% by 2000. This would be a remarkable achievement by any standard. 2.32 The best means to alleviate poverty is job creation. So, the implications for Government policy are fundamentally the same as for employment generation: policies that support labor-intensive manufacturing growth, combined with continued robust growth of agriculture and human and physical infrastructure development. The majority of the poor remain in rural areas, and sustaining a high rate of growth of agriculture will be essential. Extending deregulation to agriculture, as discussed in Chapter 3, will raise productivity and reduce costs and thus improve the efficiency and employment-generating capacity of the sector. In addition, mechanisms to target Government anti-poverty programs more effectively would be needed. The priorities for poverty alleviation are discussed further in Chapter 4. 2.33 Environmentally Responsible Growth. With a per capita income of $650 and 27 million people still below the poverty line, raising the overall standard of living remains the highest priority. This will require rapid economic growth that is environmentally responsible. Synergies between economic growth, poverty alleviation and the environment will need to be exploited (see Chapter 1). However, there will also be tradeoffs. It will be impossible, for example, to preserve all the existing stock of natural resources. Nor will it be possible to push economic growth up irrespective of the effects on environmental resources. Recognizing this, Indonesia has adopted a policy of sustainable growth that allows for natural resources to be converted into other forms of capital as an essential part of development. There are two important dimensions of this approach. First, some natural resources must be protected to preserve critical ecosystems (e.g., upland forest cover for watershed protection, groundwater aquifers that provide safe drinking water). Second, where natural resources are converted 44 Chapter 2 into other forms of capital-exploiting mineral resources, cutting down tropical forests-sound environmental (and economic) management requires that those resources be utilized efficiently. 2.34 Environmentally sustainable growth in Indonesia faces two basic challenges. First, natural resources play an important role in Indonesia's economic growth, and will continue to do so; sustainable exploitation of these resources, therefore, is intimately linked to the sustainability of long-term growth. The share of primary commodities (minerals, output in the agricultural, forestry, and fisheries sectors) in GDP has declined from about 60% in 1970 to 40% today, and could decline further to below 20% by 2010. However, in absolute terms, the value added of primary commodities has more than doubled over the past two decades, and is likely to increase by a further 50% by 2010, even though its growth rate will slow. Increased use of natural resources will also result from growth in the basic processing of primary commodities. Value added from these activities increased nearly eight-fold between 1970 and 1990, and is likely to continue to increase rapidly over the next two decades, rising another six-fold. 2.35 The second main challenge stems from the control of pollution from future industrial and urban growth. Indonesia's medium- to long-term growth path relies heavily on the growth of industry for the creation of higher-productivity jobs and non-oil exports. The nature and magnitude of future pollution loads from industry will depend on the scale of output and the intensity of various pollutants per unit of output. The damage/costs resulting from increasing pollution loads will depend on the location of specific industries and the size and concentration of the exposed population. Total industrial output has increased eight-fold since 1970, and is likely to expand another 13-fold by 2020. There has been a gradual shift in sectoral composition, with processing industries growing more slowly than assembly-type industries. Since the former are by far more pollution-intensive (especially for water pollutants, but also for many of the traditional air pollutants), there has been a noticeable deline in the pollution intensity of industrial output since 1970. Projections to the year 2020 indicate that this trend will continue. Nonetheless, with rapid growth of industrial output, pollution loads are still projected to increase 10-fold. 2.36 Growing congestion and pollution, especially in the main urban and industrial centers, will increase the difficulty of attracting foreign investment. The increasing social and economic costs of uncontrolled pollution will force a trade-off with economic growth. With urban population expected to more than double over the next 25 years, and with the increase in total industrial pollution, the pressure to slow the expansion of industry-in those areas most critical for future growth-will increase. Increasing community resistance is exemplified by the experience of other industrialized and industrializing countries in the region (Japan, Korea and Taiwan). Meeting the challenge posed by increasing industrial pollution will require an incentive framework that encourages industry to adopt clean technology and requires it to bear the economic costs of pollution. Incentives for dealing with pollution are discussed in Chapter 3. In addition, investments in pollution abatement will be required to achieve environmentally sustainable growth. Chapter 4 discusses the investment implications of controlling industrial pollution. 2.37 Efforts to reduce poverty further will contribute to environmentally responsible growth. The poor have few alternatives. Little access to capital, few skills and insecure tenure force the rural poor to farm marginal lands that quickly degrade. Efforts to lift people out of poverty will give them the option and incentive to use the environment responsibly, benefiting themselves and others. Continued implementation of effective voluntary programs to reduce the birth rate, combined with rising incomes and increased access to education and health services, will help reduce population growth and enable a given standard of living to be achieved with less growth, less use of non-renewable and other resources and less pollution. In the medium term, it will also reduce growth in the labor force, easing the challenge of generating adequate employment growth. The Macroeconomic Foundation 45 2.38 The External Constraint. Even with its admirable growth record, Indonesia remains a low-income country; but one with abundant resources. It possesses a large, hard-working labor force and a rich endowment of natural resources. These endowments make it natural that investment opportunities to develop Indonesia's potential exceed the current saving capacity of the national economy. As in the past, Indonesia can rely on effective use of foreign resources to bridge the gap between the saving capacity of the national economy and the investments needed to develop its potential. 2.39 However, in 1990/91-1991/92, Indonesia's reliance on foreign resources was unsustainably high and led to a large build-up of external debt. According to World Bank estimates, total external debt reached $79.4 billion by end-1991; $27.7 billion was owed by the private sector and $14.5 billion of this was short-term. Servicing this debt absorbs over 30% of Indonesia's export earnings, which increases Indonesia's vulnerability to external shocks, such as an unexpected drop in oil prices or slowdown in major export markets. Experience indicates that developing countries that use foreign capital effectively to achieve satisfactory growth of incomes and exports can sustain current account deficits of about 2% of GDP over long periods without excessive build-up of foreign liabilities or erosion of creditworthiness. Reflecting this, the current account deficit is projected to decline steadily from 2.4% of GNP in 1992/93 to the 2% level in 1995/96 and remain at that level in the medium term. Current account deficits in this range will provide adequate external resources for growth and result in improved creditworthiness, provided there is a commensurate increase in national savings and improvement in investment efficiency. Increasing national savings is the only way to reconcile the greater need for resources required to develop Indonesia's potential and sustain rapid GDP growth with the goal of reducing the current account deficit (in relation to GNP) to a sustainable level. This requires both higher public and private savings. Prospects for Growth and Structural Change 2.40 Medium-term projections consistent with Indonesia's main challenges, as outlined above, are summarized in Table 2.6. Growth of domestic demand is projected to accelerate slightly in 1993/94, with a compositional shift toward investment. Fixed investment growth could rise to 7%, consistent with declining interest rates, with consumption growth at 5.2%. The higher level of fixed investment demand would generate a higher level of imports. Non-oil export growth is projected to remain robust at around 10%. Overall GDP growth of 6.3% is projected, with non-oil GDP growing by 6.7%. On the supply side, non-oil manufacturing is projected to continue to grow rapidly in response to continued strong export demand and recovering domestic demand. Agricultural growth is projected at 3% p.a. Favorable rains provide grounds for optimism that the projection for agricultural growth in 1993 will be realized. Oil/LNG production is projected to grow by 1.1%; expansion of LNG production accounts for all the increase. 2.41 Over the medium term, non-oil GDP grows by about 7% each year (7.8% excluding agriculture), sufficient to provide needed jobs. Consistent with projected strong non-oil export demand, non-oil manufacturing remains the main engine of growth in the economy on the supply side. Projected annual agricultural growth of 3% is nearly one percentage point lower than during the 1970s and up to the mid-1980s, when large public investments in irrigation and supportive infrastructure and provision of subsidized inputs spurred rapid growth. However, the projected growth rate is in line with average growth since the mid-1980s. One measure of the structural change Indonesia will undergo during the 1990s is the decline in agriculture's share in GDP from 20% in the early 1990s to 15% in 2000. Overall GDP is projected to grow by an average of about 6% during the rest of the decade. Declining oil production is likely to be offset by rising LNG production so that combined oil/LNG sector value added remains almost unchanged in real terms over the medium term. However, the share of the oil/LNG sector would decline from nearly 20% of GDP in the late 1980s to 12% by 2000, another indicator of the continuing structural transformation of the economy. 46 Chapter 2 Table 2.6: Projections of Key Macroeconomic Indicators a Estimated Projected 1992 1993 1994-95 1995-2000 Average real growth rates (% p.a.) GDP 5.8 6.3 5.7 6.0 Non-oil GDP 7.5 6.7 6.9 7.0 Agriculture 3.6 3.0 3.0 3.0 Manufacturing 9.7 10.0 10.2 10.5 Mining 24.0 20.0 10.0 10.0 Construction 11.9 9.0 8.0 8.0 Other services 7.2 6.2 6.8 6.6 GNY 5.5 5.9 6.6 6.7 Non-oil exports 26.6 10.4 9.3 8.6 Non-oil imports 7.7 8.6 9.2 8.6 Fixed investment 5.0 7.0 7.2 7.6 Public 7.0 6.0 6.0 6.9 Private 3.7 7.6 7.9 8.0 Macroeconomic balances b Current account/GNP -2.4 -2.2 -2.0 -2.0 Non-interest current account/GNP 1.4 1.5 1.5 0.9 Overall public sector balance/GDP -1.4 -0.6 0.4 0.2 MLT debt service/exports 30.0 29.7 25.5 17.6 MLT debt/exports 176.4 163.5 137.3 92.4 MLT debt/GNP 57.9 54.6 47.2 35.1 Structure of the economy b Non-oil manufacturing/GDP 16.0 16.6 18.0 22.2 Non-oil exports/non-oil imports 90.2 92.6 94.6 97.0 Public savings/GDP 8.3 9.2 10.2 10.4 National savings/GDP 20.1 20.8 22.1 23.5 Fixed investment/GDP 22.5 22.8 23.2 24.4 Private fixed investment/ Total fixed investment 56.9 57.0 57.6 58.1 Consumption/GDP 75.0 74.6 73.9 73.4 Consumption/GNY 76.0 75.7 74.8 74.1 Prices Oil prices (Us$/bbl) b 17.4 16.7 17.8 24.6 Non-oil terms of trade (1983/84= 100) b 90.6 91.5 93.4 95.6 a Balance of payments data are for fiscal years (starting April 1). Other indicators are for calendar years. b For last year of multi-year periods. Source: Central Bureau of Statistics and World Bank staff estimates. 2.42 The developments in the oil sector highlight the crucial role of non-oil exports in reducing the current account deficit to a sustainable level, and maintaining it at that level. Oil prices are projected to decline by $0.7/bbl in 1993/94. With production projected to remain constant and domestic consumption increasing, a $0.5 billion narrowing of the oil current account surplus is projected (Table 2.7). Holding the overall current account deficit at the 1992/93 level thus requires a compensating The Macroeconomic Foundation 47 improvement in the non-oil current account. The oil surplus is projected to continue to decline, so that progress in narrowing the overall current account deficit toward 2% of GDP by 1995 will require additional improvement in the non-oil trade balance. The main uncertainties in the balance of payments, discussed in section D, arise from fluctuations in world oil prices and in import growth in Indonesia's main trading partners. In the event either of these is lower than projected, measures to raise the competitiveness of non-oil exports would be needed to sustain progress in reaching the desired current account deficit. Table 2.7: Balance of Payments Projections, 1992/93-2000/01 (US$ billion) Estimated Projected 1992/93 1993/94 1995/96 2000/01 Merchandise exports (fob) 34.9 38.4 45.9 79.0 Oil & LNG 10.3 10.0 9.6 12.0 Non-oil 24.6 28.4 36.3 67.0 Merchandise import (cif) -31.0 -34.9 -42.4 -76.3 Oil & LNG -3.8 -4.2 -4.1 -7.2 Non-oil -27.2 -30.7 -38.4 -69.1 Trade balance 3.9 3.5 3.5 2.7 Non-factor services (net) -0.4 -0.3 -0.2 0.2 Interest payments (MLT) -3.9 -4.0 -4.2 -4.9 Other factor services and transfers (net) -2.5 -2.1 -2.1 -2.9 Current account balance -2.9 -2.9 -3.0 -4.9 Oil/LNG current account 3.6 3.1 2.7 1.0 Non-oil current account -6.5 -6.0 -5.8 -5.8 Public MLT loans (net) 2.1 2.0 1.6 2.0 Disbursements 6.8 7.0 6.8 8.9 Principal repayments -4.8 -5.0 -5.2 -6.8 Other capital (net) 6.9 0.1 3.3 5.8 Use of net foreign assets -6.1 0.8 -1.9 -2.9 Memo items: Net official reserves a 11.8 12.6 16.3 29.2 - Months of imports b 4.1 4.0 4.1 4.1 Current account/GNP (%) -2.4 -2.2 -2.0 -2.0 Non-interest CA/GNP (%) 1.4 1.5 1.5 0.9 MLT debt servicelexports (%) 30.0 29.7 25.5 17.6 a Net official reserves are defined as gross official reserves minus outstanding liabilities to the IMF and other short-term liabilities. b Net official reserves in months of next year's expected total merchandise imports. Source: Bank Indonesia and World Bank staff estimates. 2.43 Indonesia should be able to realize the rapid non-oil export growth projected for sustainable growth. Much of Indonesia's recent success in expanding non-oil exports is attributable to growth of 48 Chapter 2 textile (including clothing) exports. Textile exports surpassed plywood exports in value in 1990/91 to become Indonesia's largest manufactured export. Although Indonesia's textile exports have a significant 3% share of world exports in a sector where non-tariff barriers are important, there is reason for optimism about textile export prospects since Indonesia recently reached an agreement with the U.S. for a 35% larger textile quota. Textile investment projects requiring imports worth $10.6 billion have been approved by BKPM since 1986, and the realization rate for approved textile investments has been 45%, which is one of the highest rates of any sector. Greater capacity and the expansion of the U.S. quota should support the 12% annual growth of textile exports projected over the medium term. 2.44 In addition to continued growth of textiles, rapid growth of non-oil exports will increasingly depend on Indonesia's ability to expand exports of "other manufactures". Growth in this large, diverse group of products has been rapid since the late 1980s, yet Indonesia's share of world exports of these products remains small. The scope for further expansion is thus substantial. In footwear, the largest and one of the most rapidly growing other manufactures, Indonesia's share of world exports is less than 1 %. Competitiveness rather than external market constraints will determine Indonesia's ability to expand this group of exports. The importance of competitiveness highlights the role of regulatory reform that exposes domestic sources of high costs to competitive pressures. With continued progress on that front and improving competitiveness, Indonesia should be able to sustain the 9-10% real growth of non-oil exports projected over the medium term. External Financing and Debt Management Strategy 2.45 External Financing. Projections of Indonesia's external financing, based on the scenario outlined above, are presented in Table 2.8. Total gross external financing in 1993/94 is projected to be about $10.5 billion, substantially lower than in the past three years. This is due to the major progress achieved since 1990 in reducing unsustainable current account deficits and associated large increases in foreign borrowing, especially private non-guaranteed borrowing. The pattern of financing in 1992/93 included a large build-up of net foreign assets, including capital inflows attracted by high rupiah interest rates. As interest rates gradually decline toward international levels, it is probable that some of that capital will flow out, and this is reflected in the 1993/94 projection. At the same time, official reserves would be maintained equivalent to 4-4.5 months of imports, levels that are prudent given Indonesia's open capital account and vulnerability to external shocks, as discussed in Section D. The other major change in financing requirements is the growth in debt repayments from $7.4 billion in 1992/93 to $8.4 billion in 1993/94. Beyond 1993/94, Indonesia's external financing needs will continue to grow, reflecting growing debt repayment obligations, the need to maintain reserve levels in relation to growing imports, and a gradual, sustainable rise in the current account deficit (in absolute terms). 2.46 The financing plan implicit in the sources of financing projected in Table 2.8 recognizes the strategic role of continued official assistance, but also foresees a growing reliance on other sources of finance. Following reductions to more sustainable levels in 1993/94, private capital inflows (including foreign direct investment, private medium- and long-term borrowing and trade-related flows) will become an increasingly important part of overall financing. Within public borrowing, loans from commercial sources will become more important as gross flows of official assistance are projected to remain roughly constant as total external borrowing rises. The Macroeconomic Foundation 49 Table 2.8: Projected External Financing (Period average for multi-year periods, us$ billion) Actual Estimated Projected 1986/87- 1990/91- 1992/93 1994/95 1996/97 1989/90 1991/92 1993194 1995/96 2002001 External Financing 6.6 12.4 16.4 10.5 13.6 16.2 Current account deficit 2.4 3.9 2.9 2.9 2.9 4.1 (of which, MLT interest payments) (2.9) (3.6) (3.9) (4.0) (4.3) (4.6) Principal repayments 4.7 6.3 7.4 8.4 8.9 10.0 Increase in net foreign assets -0.5 2.2 6.1 -0.8 1.9 2.1 Sources 6.6 12.4 16.4 10.5 13.8 16.2 Direct foreign investment (net) 0.5 1.5 1.7 1.8 1.9 2.1 Private MLT loans 1.1 4.9 3.6 2.7 3.8 4.7 Other capital (net) -1.1 0.5 4.3 -1.0 1.3 1.8 Public MLT loans 6.1 5.5 6.8 7.0 6.8 7.5 of which: Official assistance a (3.5) (3.8) (3.8) (3.8) (4.0) (4.0) Other (2.6) (1.7) (3.0) (3.2) (2.8) (3.5) a Excludes grants, which are included in transfers in the current account. Source: Bank Indonesia and World Bank staff estimates. 2.47 Net inflows of foreign direct Figure 2.8: Sources of Foreign Direct Investment investment (FDI) rose from $0.2 billion in ( 1992 A Istmnt of US$10.3 bIllon) 1985/86, before the opening of the economy through deregulation, to $1.7 billion in 1992/93. Ka HK In addition to increasing Indonesia's access to new ideas and technology, FDI provides resources for investment without creating debt. The sources of private investment have been quite diversified (see Figure 2.8). Gradual increases from the recently-achieved high foreign investment level are projected. Higher levels of FDI are possible, 42% together with higher import levels and rates of EC growth, but even maintaining the current level will depend on progress in several areas: reform S I o Board of investment and capital market regulations, easing of infrastructure bottlenecks, and institutional reforms, especially in the legal framework and accounting. Such policies, discussed in more detail in subsequent Chapters, will not only make Indonesia more attractive to foreign investors, but will also provide the kind of environment domestic investors need for efficient, sustained growth. 2.48 Overall, private capital flows will provide about half of Indonesia's financing in the 1990s, compared with negligible amounts in the 1980s. This shift calls for careful attention to debt management and policies that ensure efficient use of resources, especially given Indonesia's already large stock of external debt. Three points need to be kept in mind in implementing this scenario. First, the incentive framework needs to ensure that these external resources flow into efficient uses, generating rapid, high returns, especially in export-oriented, labor-intensive activities. In this regard, large, capital-intensive projects need particularly careful scrutiny because such projects can add rapidly to Indonesia's debt, while 50 Chapter 2 crowding out smaller, potentially more profitable investments. Second, the availability of private financing at the projected levels cannot be taken for granted. It will depend on perceptions of Indonesia's creditworthiness and attractiveness as a home for foreign investment. Third, the projected shift in the composition of Indonesia's debt will raise the average borrowing cost and shorten the maturity structure of debt. 2.49 Within this overall financing plan, concessional assistance will play a strategically important role, even though such assistance is projected to decline significantly in net terms and in relation to the size of the economy throughout the 1990s. An adequate flow of concessional assistance is an essential part of Indonesia's transition to the more diversified financing pattern projected above. First, such assistance will continue to support projects and sectors-such as human resource development and infrastructure-that will enhance Indonesia's productivity, competitiveness, and attractiveness to foreign investors. This in turn will improve perceptions of Indonesia's creditworthiness. Second, it will ensure the net flow of concessional external resources does not fall too rapidly as amortization payments rise. Finally, by maintaining an adequate degree of concessionality, it will make the rising borrowing costs noted above more manageable. All these factors will work together to keep total borrowing costs manageable and to maintain Indonesia's access to international capital markets. This will increase the probability that the projected commercial flows will be available as needed. 2.50 This financing plan implies that concessional financing flows remain at about current levels, with disbursements of official concessional assistance from Indonesia's Consultative Group (CGI), including grants, continuing at about their 1992/93 level of $3.8-3.9 billion. With an appropriate mix of project and sector assistance and further progress in improving project implementation, CGI commitments of about the same level as last year ($4.9 billion) would generate the projected concessional flows in 1993/94. As discussed at last year's CGI meeting, human resource development and infrastructure remain the priority areas for this assistance. This financing plan also assumes that other financing outside the normal donor framework remains at about last year's levels. 2.51 For the recommended level of commitments to generate the projected disbursements, the level and form of commitments need to be optimized, with continued improvements in project and program design and implementation and with disbursement mechanisms well-suited to the requirements of the activities being assisted. This will prevent an excessive, disruptive drop in disbursements. Sector operations are likely to provide a particularly appropriate lending instrument since such operations support efficiency-enhancing sectoral programs and policies while disbursing in line with the overall pace of activity in the sector. The projected level of concessional assistance will mean that a substantial, though declining, share of Indonesia's debt will remain on concessional terms, keeping the rising overall borrowing costs within manageable limits. Continued concessional assistance, in combination with prudent macroeconomic management, will work together to bring about sustained improvements in indicators of Indonesia's debt and creditworthiness. 2.52 Debt Management. The macroeconomic scenario, including the financing strategy, outlined above, leads to a significant improvement in creditworthiness, with the debt-service ratio falling below 20% by the end of the decade (Table 2.9). As noted, this will help ensure that the private capital inflows, which become increasingly important, materialize. Improvements in debt indicators alone, while necessary, are insufficient to ensure this. The economic and political environment for private investment must be attractive. The Government can help by maintaining macroeconomic stability, sustaining the momentum of trade, finance and institutional reforms, and reducing infrastructure bottlenecks that hamper private sector development. Investor confidence would be helped by institutional developments to make the business environment more transparent and predictable. The list of areas where work is needed includes the legal and accounting framework, foreign investment regulation, and land-use and ownership. The Macroeconomic Foundation 51 Table 2.9: Medium- and Long-Term Debt Indicators, 1987-2000 (percent) Actual Est. Projected a 1987-89 1990 1991 1992 1993 1995 2000 DOD/GNP 62.7 57.8 59.0 57.9 54.6 47.2 35.1 Public 55.8 47.5 47.0 45.9 44.2 39.9 29.2 Private 7.0 10.3 12.0 11.9 10.5 7.2 5.9 DOD/exports b 222.6 187.6 196.5 176.4 163.5 137.3 92.4 Public 197.9 154.2 156.6 140.0 132.2 116.3 76.8 Private 24.6 33.4 39.8 36.4 31.3 21.1 15.6 Debt service/exports b, c 36.1 29.7 31.6 30.0 29.7 25.5 17.6 Public 30.4 23.7 23.2 21.3 19.9 16.4 11.7 Private 5.7 6.0 8.4 8.7 9.7 9.1 5.9 Interest/exports b 14.0 11.0 11.5 10.0 9.2 8.1 5.4 Public 12.1 9.0 8.9 8.0 7.3 6.4 4.1 Private 1.9 2.0 2.5 2.0 2.0 1.7 1.2 a Based on exchange rates of December 31, 1992. b Denominator is gross exports of goods and services. c Debt service excludes prepayments. Source: Bank Indonesia and World Bank staff estimates. 2.53 Indonesia could also consider implementing a strategy of market diversification. Such a strategy would include: (i) assessing Indonesia's financing requirements by volume, timing and use; (ii) considering potential sources and instruments, including the international bond market; and (iii) developing institutional capacity to carry out the strategy. In view of the dollar denominated burden of Indonesia's debt and the fact that exchange rate fluctuations have added significantly to the debt in the past, the use of specialized financial instruments and integrated asset-liability management techniques to reduce Indonesia's exposure to external financing and debt management risks deserves consideration. An array of financial instruments has emerged that allows governments, among others, to reduce exposure to currency, interest rate and commodity price risk. 2.54 Another debt management issue is how the Commercial Offshore Loan Team (COLT) should evolve. Rapid growth of private borrowing in 1989-90 and the reemergence of a number of large, capital-intensive public and publicly-related investment projects that were about to seek external loans led to the establishment of the COLT. The COLT was empowered to: (a) coordinate all public commercial borrowing, including state enterprise borrowing and private sector borrowing for projects involving the Government or its agencies; (b) set annual ceilings on external commercial borrowing by public and quasi-public entities and establish guidelines for loan terms; (c) determine the priority order and timing of approved loans; and (d) improve reporting and information from public and private entities on external commercial borrowing. The COLT later issued regulations for a prudent level of private borrowing that have tended to contain such borrowing. The regulations: (a) cap total public sector foreign exchange borrowing from international commercial banks in each fiscal year to FY95; (b) extend the restriction on commercial banks' net open position to include off-balance sheet transactions; and (c) limit commercial banks' short-term foreign liabilities to 30% of capital. 52 Chapter 2 2.55 Further development of the institutional framework to manage external borrowing is called for to keep it within prudent, sustainable limits in the context of an open capital account. Continued vigilance is needed to ensure that the ceilings on external borrowing for public and publicly-related projects are maintained. Efforts to circumvent such ceilings indicate the need for careful monitoring, and for increasing reliance on indirect means of managing external debt-macroeconomic restraint, regular scrutiny of public enterprise investment programs, and financial sector and institutional reforms that encourage financial prudence by firms and banks. Subsequent chapters discuss public enterprise investments (Chapters 4 and 5) and measures to improve the financial discipline of banks and firms (Chapter 3). It would be useful to establish a debt policy body (possibly by extending the scope of the COLT) responsible for overall debt management. The body would need a secretariat with adequate full- time staff and resources to provide data and analysis needed for debt management. Improving the reliability and coverage of debt data, and systems for debt analysis would assist this effort. Consistent Macroeconomic Policies for Sustained Growth 2.56 The sustainable growth path outlined above is an objective. Macroeconomic policy is an important instrument the Government can use to achieve this objective. Recent experience illustrates that macroeconomic policies-fiscal, monetary and exchange rate policies-need to be used in a coordinated fashion to keep the economy on an even keel. Rapid monetary growth in 1990 raised inflation and expectations of exchange rate depreciation that pushed up nominal domestic interest rates. A more supportive fiscal stance in 1991/92 would have reduced the burden of adjustment on private investment. A more supportive fiscal stance in 1992/93 could have helped achieve a quicker alignment of domestic and offshore interest rates by improving confidence in price and exchange rate stability, and would have created more scope for an increase in private investment. Close coordination of macroeconomic policies will be needed to keep aggregate demand along a path that is consistent with robust growth with low inflation and manageable levels of external borrowing. 2.57 Exchange rate policy-the managed float-is projected to maintain the real effective exchange rate close to the present level. In view of the crucial role of non-oil export growth in the projected macroeconomic scenario, a competitive exchange rate would be essential. Under the managed float, the Government sets bilateral exchange rates for the rupiah vis-a-vis a basket of currencies. The U.s. dollar has a heavy weight in the basket. Fluctuations in the u.s. dollar against major currencies therefore affect Indonesia's competitiveness because of the exchange rate policy. Recent large fluctuations in the u.s. dollar exchange rate may continue and the Government may wish to consider managing the rupiah against a basket in which the dollar has a lower weight. Recent experience also highlights the importance of expectations of exchange rate change. Changes in expectations of depreciation can quickly lead to capital inflows and outflows through Indonesia's open capital account. Policy inconsistency can raise such expectations. Therefore, adherence to the managed float exchange rate policy is easiest when there is a simultaneous commitment to a stable price level in conducting monetary policy. If the private sector perceives an inconsistency between the exchange rate policy and the goals of monetary policy, as occurred in early 1990, confidence will erode and quickly lead to capital outflows. 2.58 Monetary policy in 1992/93 faced the formidable task of sterilizing large inflows of capital using only one instrument, the SBI. As noted above, sterilization operations are estimated to have cost BI nearly $1 billion in 1992/93. Developing alternatives to SBIs for BI to sterilize capital inflows could relieve the strain on BRI's income. This would be advisable because a large drop in BI's profits could erode confidence and trigger capital outflows. Alternative ways of sterilizing capital inflows include prepayment of public debt, and increasing commercial bank required reserves or liquidity requirements. To encourage the development of a secondary market in sBIs and commercial bank debt instruments The Macroeconomic Foundation 53 (SBPUs), BI could coordinate balanced purchases and sales of these instruments. Over time the markets would become deeper and broader to permit BI to sterilize capital flows by intervening in the secondary market for these instruments. 2.59 An issue for near-term monetary management is the renewal of the special SBIs that were exchanged for deposits of public enterprises in February 1991 as part of the contractionary measures to withdraw liquidity (para 2.4). The Rp.7.1 trillion outstanding stock was renewed for another 6 months in February 1993. To avoid a destabilizing injection of liquidity, these special SBIs should be carefully phased to mature over time. This could be accomplished by renewing them upon maturity in August 1993 at staggered maturities of 1-2 months to several months, with some rolled over longer as needed. Another near-term issue is the orderly unwinding of the large stock of ordinary SBIs. BI should also review the need for its continued involvement in operations that can be better left to commercial banks, such as discounting of export bills. As the experience of 1992/93 demonstrates, such operations can make it difficult to keep the monetary aggregates on track. The effectiveness of monetary policy would also increase by accelerating the phasing out of subsidized liquidity credits. By insulating special classes of borrowers, these credits reduce the effectiveness of monetary policy and, within a given ceiling for credit growth, reduce credit to efficient private borrowers. 2.60 Because of the constraints Indonesia's exchange rate policy and open capital account put on monetary policy, fiscal policy is the most effective instrument for ensuring that excess demand pressures do not arise, causing inflation to accelerate or the current account deficit to become unsustainable. This means keeping the public sector's net absorption of resources to levels that prevent overheating. To do this, the fiscal stance must be consistent with the main macroeconomic targets. Inconsistency of policies would suggest that one or more macroeconomic targets may not be met, which might erode confidence. Maintenance of confidence in macroeconomic policy is essential to keep onshore interest rates aligned closely with offshore rates and to avoid destabilizing foreign capital inflows and outflows. 2.61 The consistency approach to determining the fiscal stance involves deriving public sector financial asset and liability movements, and the implied net financial position of the public sector, that are consistent with the main macroeconomic targets. One reason for adopting this approach to assessing fiscal policy rather than the usual one of counting expenditures and revenues is the nature of Indonesia's fiscal accounts. The public sector includes the central, provincial and local government levels. In addition, off-budget transactions are significant, public enterprises produce nearly one-fifth of GDP, and BI engages in quasi-fiscal operations (para. 2.15). All these activities should be included in a measure of the impact of the consolidated public sector on the macroeconomy. Data on the stocks of public sector assets and liabilities are often more reliable and up-to-date than revenue and expenditure data. 2.62 A given net financial position of the consolidated public sector can correspond to three kinds of asset and liability movements: issuance of external debt, internal debt, and revenue from monetization. In Indonesia, the balanced budget law prohibits internal borrowing, leaving only external borrowing and money creation. The medium-term scenario projects a sustainable path for the growth of net foreign liabilities of the public sector. Continued restraint on public borrowing along with the need to increase official reserves as the value of imports rises implies no real growth of public net foreign liabilities in the near to medium term. Revenue from monetization is determined by the demand for money, which depends on real GDP and the level of interest rates. Monetization is not a significant source of revenue; furthermore, it is projected to decline as inflation falls from 7.4% in 1992/93 annual average toward 5% by 1995/96. The analysis suggests that the sustainable medium-term fiscal stance is a small overall fiscal surplus. Measures are needed to improve the Central Government overall fiscal position, which was a deficit of about 1.0% of GDP in 1992/93, by the equivalent of about 2% of GDP in the near to medium term. The Central Government budget for 1993/94 implies an improvement in the fiscal balance of about 54 Chapter 2 1.5% of GDP during the year. Meeting this ambitious target would improve the balance of demand management policies, allowing private investment to revive as interest rates subside. For consistency with sustainable growth targets, the planned improvement in 1993/94 would need to be sustained in the medium term. As already emphasized, this would promote private confidence in the stability of the rupiah and in the price level, which would hasten the reduction in domestic interest rates. 2.63 Improving the fiscal stance while funding priority public investments underscores the need to strengthen public resource mobilization and increase public savings. While there has been a trend improvement in the public savings rate in recent years (Tables 2.2 and 2.10), there remains sizable scope for further improvement by raising tax and non-tax revenues and containing expenditures. The greatest potential lies in tapping more fully sources of government non-tax revenue, including strengthening cost recovery from public services, raising revenue from forestry fees and improving the financial performance of public enterprises. Stronger revenue mobilization will need to be supplemented by improved public expenditure management to ensure that the additional resources lead to higher savings. The main tasks on the expenditure side will be to reduce subsidies, contain general administrative spending, and rationalize investment priorities. 2.64 A major reform of the tax system in the 1980s created a modern tax system based on the value added tax (VAT), the personal income tax and the corporate income tax. Coupled with improved tax collection, the new system raised non-oil taxes in relation to non-oil GDP from 7.2% in 1981 to an estimated 12.7% in 1992/93, an important achievement. Indonesia's tax ratio, however, remains below that of most other countries in the region (17% in Korea and Thailand, for example). Moreover, with oil revenue projected to continue to decline in relation to total revenue, mobilizing more non-oil tax revenue will remain important. The primary focus of efforts to raise tax revenues should be improving tax administration. The proportion of potential revenue actually collected remains in the 50-60% range for several major taxes, including the income tax, the VAT and the property tax. In countries with more developed tax systems, this ratio tends to be as high as 80-85%. Also, recently, there appears to have been some loss of earlier gains in customs duty collection. Besides strengthening efforts to improve tax administration, possible tax reform measures include raising the effective property tax rate from its current low level of 0.1 %, further broadening the coverage of the VAT, and taxing personal income from interest at the same rate as other personal income. Also, there is substantial scope for raising revenue from forestry fees; increasing government rent capture in the sector to 85% over the medium term could more than triple annual government forestry revenues from their present level of about Rp. 1 trillion (while also supporting environmental objectives). Other sources of improvement in public resource mobilization are discussed in the following chapters. Thus, improved public pricing policies-for fertilizer prices, power tariffs and water charges-are discussed in Chapter 3. Policies for improving the efficiency of public expenditures are discussed in Chapter 4. Also, Chapter 5 discusses measures to improve public enterprise performance, rationalize government administrative spending, and mobilize more revenues at the local government level. 2.65 Savings-Investment Balances and Sustainable Growth. The foregoing analysis of the consistency of macroeconomic policies highlights the supportive role that fiscal policy would need to play in achieving sustainable growth. To minimize risks to the medium-term macroeconomic scenario, which shows robust growth with low inflation and keeps external borrowing manageable, the Government's overall fiscal balance should move to and sustain a small surplus over the medium term. Prudence argues for targeting a somewhat larger fiscal adjustment so that unexpected shocks or demands on the Government budget do not lead to domestic demand overheating. 2.66 Keeping the fiscal stance on a sustainable path does not guarantee the underlying macroeconomic targets for growth, inflation and external balance will be met; only that the fiscal stance The Macroeconomic Foundation 55 is consistent with them. Achieving the targets also depends on the private sector saving more to help finance growing investment demand. A key challenge throughout the decade will be to raise savings-both public, as already discussed, and private-to finance the higher investment that would sustain economic growth while reducing the economy's dependence on foreign savings. With an improvement in overall investment efficiency, GDP growth fast enough to absorb labor force growth at rising levels of productivity can be achieved with a moderate increase in the investment rate (Table 2.10). Within this, public investment is projected to rise to around 10% of GDP, from about 9.5% currently. This reflects the need for increased public investment in physical infrastructure and human resource development (Chapter 4 discusses the priorities for public investment). Private investment would need to rise by more, from about 13% of GDP currently to about 14% by 1995 and further to 15% by the late 1990s. Table 2.10: Savings-Investment Balances, 1983-2000 (percent of GDP at current prices) Actual Estimate Projection 1983-88 1989 1990 1991 1992 1995 2000 Gross domestic investment 23.4 23.5 23.9 24.0 22.7 24.0 25.4 Fixed investment 20.4 21.2 22.5 22.7 22.5 23.2 24.4 Change in stocks 3.0 2.3 1.3 1.3 0.2 0.8 1.0 Gross national savings 20.1 21.8 20.9 20.3 20.1 22.1 23.5 Savings-investment gap a -3.3 -1.8 -2.9 -3.7 -2.6 -1.9 -1.9 Public sector Gross domestic investment b 8.8 8.6 9.2 9.6 9.7 9.8 10.2 Public savings 7.1 7.0 9.5 8.5 8.3 10.2 10.4 Savings-investment gap -1.7 -1.6 0.3 -1.1 -1.4 0.4 0.2 Private sector Gross domestic investment 14.6 14.9 14.7 14.4 13.0 14.2 15.2 Fixed investment 11.6 12.6 13.3 13.1 12.8 13.4 14.2 Change in stocks 3.0 2.3 1.3 1.3 0.2 0.8 1.0 Private savings 12.9 14.8 11.5 11.8 11.8 11.9 13.1 Savings-investment gap -1.6 -0.2 -3.2 -2.6 -1.2 -2.3 -2.1 a The inverse of the current account deficit expressed in calendar years. b Fixed investment only. Investment in stock changes is assumed to be financed wholly by the private sector. Source: Central Bureau of Statistics and World Bank staff estimates. 2.67 Reduced reliance on foreign savings and the need to raise investment imply that national savings would need to increase by about 2% of GDP in the medium term and by 3.5% over the longer term (Table 2.10). Within this overall increase, adherence to a supportive fiscal stance would raise public saving by the equivalent of about 2% of GDP. Despite the increased savings effort from the public sector, private savings would also need to rise by close to 1.5% of GDP. The private savings rate declined sharply in 1990 and has recovered only marginally since. Saving involves postponing consumption today in order to consume more in the future, so raising in the expected return to foregoing consumption should increase saving. Improving access to, and the quality of, education and health services are ways the 56 Chapter 2 Government can help. Over the medium term, a lower dependency ratio resulting from demographic shifts should help boost saving. Sustaining strong economic growth, maintaining a stable financial environment, and promoting profitable, widespread investment opportunities through continued improvements in the incentive regime, as discussed in Chapter 3, should also contribute to higher private savings, business and household. D. Economic Management in an Uncertain External Environment 2.68 Indonesia faced a difficult and volatile environment during the 1980s. Both oil and primary commodities, which were Indonesia's principal exports, experienced large declines and considerable volatility in prices. The external environment in the 1990s is not projected to be significantly different from the second half of the 1980s. In the short term, the main uncertainties relate to oil prices and private capital flows. Indonesia also is vulnerable to currency and interest rate risks. Over the medium term, Indonesia will face two structural challenges: oil earnings in the 1990s are likely to decline because of a decline in the exportable surplus; and Indonesia needs to contain the current account deficit in relation to GDP while increasing its reliance on non-concessional sources of finance. The Main External Sources of Uncertainty 2.69 The main external risks to macroeconomic stability arise from fluctuations in: * oil prices; * non-oil commodity prices; * demand for Indonesia's manufactured exports by major trading partners; * world interest rates; and * cross-currency exchange rates-particularly between the Japanese yen and the U.s. dollar. 2.70 Oil Prices. The outlook for oil prices depends greatly on demand conditions in the large oil-importing countries. With sluggish growth in the industrial countries expected for the next few years, oil prices are likely to remain constant, implying a fall in real terms. Some improvement in real oil prices is projected toward the end of the decade, but declines in Indonesia's exportable surplus will limit the extent to which Indonesia benefits from that improvement. 2.71 Non-oil Commodity Prices. In the early 1980s, the Indonesian economy depended heavily on oil. In 1981, the oil/LNG sector accounted for over 25% of total GDP, 70% of government revenues and over 70% of total exports. However, since the mid-1980s, the non-oil sector has expanded. Non-oil exports rose from under 30% of total exports in 1983 to 63% in 1991, a six-fold rise in real terms. Despite the diversification in export structure, both oil and non-oil primary commodities remain a significant proportion of total exports. Commodities account for over 56% of total earnings (of which 37% is oil/LNG, Figure 2.9). Unlike the 1980s, world prices of non-oil commodities are not expected to show any long-term decline in real terms during the 1990s. Although projected sluggish growth in the OECD countries over the next few years can be expected to exert downward pressure on commodity prices, developing countries are expected to continue to shift away from production of non-oil commodities, which will exert upward pressure on prices. The aggregate non-oil commodity price index is expected to stabilize in real terms for the rest of the decade. Commodity prices have also been highly volatile in the past and there is no reason to expect that volatility around the projected trend will decline. The Macroeconomic Foundation 57 Figure 2.9: The Changing Composition of Indonesia's Exports Share of Total Exports