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Bad Debt: The Politics of Financial Reform in Indonesia

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Indonesia�s transition from authoritarianism to democracy is taking place amidst widespread poverty, unemployment and social dislocation which fosters political instability. There is a pressing need for robust and sustained economic growth to reduce these problems, ease the strain on the state budget and smooth the political transition. The country�s financial difficulties threaten to hinder this growth, with a serious potential knock-on effect to large-scale violence.

This report examines the measures agreed by Indonesia and its external lenders to reduce the public debt that is central to and symptomatic of those financial difficulties. It attempts to explain in political and institutional terms why the implementation of these measures has often run into difficulty and suggests ways in which the process might be made more effective and transparent.

The financial crisis that triggered the fall of the Soeharto regime in mid-1998 left the country with huge public debts, equal in size to its gross domestic product. This debt, totalling about U.S.$ 154 billion, exacts a major human cost by absorbing funds that could be used to foster growth and alleviate mass poverty . Some economists fear that it could eventually prove unsustainable, forcing the government into a politically damaging default.

Indonesia and its creditors, notably the International Monetary Fund (IMF), have agreed on a number of policy measures for reducing the public debt to more manageable levels. Through a series of Letters of Intent since October 1997, Indonesia and the IMF have agreed on renegotiating debt repayment schedules, cutting subsidies, increasing tax revenues, selling government-owned commercial assets, and restructuring private debt to the state. Indonesia has also committed itself to structural reforms of its legal and banking systems in order to sustain economic recovery, bring back the private investment that has largely forsaken the country, and reduce the risk of another financial crisis. But despite the consensus between Indonesia and the IMF on what needs to be done and significant progress in some areas, the domestic implementation of certain key elements of this financial reform agenda has not been pursued with the necessary consistency or commitment.

The IMF�s frustration with the slow progress of financial reform has led it to suspend its loans to Indonesia four times since 1997. IMF loans were being withheld as this report was written. The World Bank warns that further policy slippage could contribute to a �crisis scenario� which would cause it to cease new lending. While there are signs that agreement could be close on some of Indonesia�s current differences with the IMF, the experience of the last three years suggests that tensions could rapidly re-emerge.

The slow and halting progress of financial reform can be partly blamed on the difficulties that any government would face in the midst of a wrenching political transition and on the arguably over-optimistic expectations of external lenders like the IMF. Reform has also been distorted, however, by the fragmentation of Indonesian politics since Soeharto�s fall, a malfunctioning legal system and a political culture in which patronage and corruption play a key role. The problem is not a shortage of policy options, but the government�s inability or unwillingness to implement fully a policy agenda that it has already agreed with its external creditors.

For implementation to move forward, there will have to be progress on a range of wider issues, including the reduction of corruption in politics and the legal system; greater cohesion within the government and a less adversarial relationship between the government and parliament. Indonesia�s external lenders can have little direct influence over these issues, and it is probably not realistic, at a time when Indonesia�s government is under heavy political attack from domestic opponents, to expect rapid progress on the financial reform agenda. Nonetheless, even incremental progress on implementing the fundamental reform measures agreed between Indonesia and its external lenders, which are discussed in detail in this report, is better than none at all.


To the IMF:

Scale back the program outlined in the Letters of Intent by favouring broad targets over unduly specific commitments where there is a high risk of delay for reasons beyond the Indonesian government�s control.

Make deadlines for corporate debt restructuring more flexible to allow more time for reviews that increase transparency.

To Bilateral Donors:

Consider further rescheduling or easing of terms on Indonesia�s debt should its financial position weaken for reasons beyond the government�s control.

Help parliament to make informed decisions on financial reform by offering funding and expertise to improve parliament�s research capability.

To the Indonesian Government:

Give highest political priority to reforming the legal system so as to reduce the impact of corruption on financial reform.

Avoid politically motivated targeting of tax and corruption investigations.

Enhance transparency by requiring that all transactions of the Indonesian Bank Restructuring Agency (IBRA) above an agreed size be reviewed independently, with the results made publicly available.

Consult systematically and routinely with all stakeholders in asset sales and privatisations, covering political and social as well as commercial issues.

Set recovery rates for asset sales that reflect market realities rather than politically derived assumptions.

Jakarta/Brussels 13 March 2001

 PDF version of Bad Debt: The Politics of Financial Reform in Indonesia Download the report as a PDF file in A4 format

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