Indonesia's Quiet Revolution

Lex Rieffel

From Foreign Affairs, September/October 2004

Summary:  Beyond headlines dominated by terrorist cells and separatist insurgencies, the world's largest majority-Muslim country has undergone a profound transformation in recent years. Reformers have quietly but brilliantly overhauled the country's long-intractable political system. The government that takes office in October will be the people's choice more than ever before-and will have an unprecedented opportunity to set Indonesia on the road to good governance and economic prosperity.

Lex Rieffel is a Visiting Fellow at the Brookings Institution.

APPROACHING A TIPPING POINT

When she became president in 2001, Megawati inherited an extremely weak economy. GDP remained below its pre-financial crisis peak, reached in 1996. Relations with the International Monetary Fund (IMF), the World Bank, and the donor consortium were strained. The country was seeking more debt relief from Paris Club and London Club creditors instead of phasing it out. And essential reforms were stalled, due to a power struggle between President Wahid and the parliament.

Since then, the turnaround has been remarkable. The economic ministers appointed by Megawati were less political and more technocratic than their predecessors. Quickly labeled the "Dream Team," they lived up to expectations in several key areas. In particular, led by Coordinating Minister Dorodjatun Kuntjoro-jakti and Finance Minister Boediono, they set the stage for a successful transition during 2004 out of IMF balance-of-payments financing and debt relief. This step signaled the end of the recovery from the 1997-98 financial crisis and the return to normal relations with official and private sources of external financing.

All of Indonesia's macroeconomic indicators improved from mid-2001 to early 2004, despite internal shocks such as the terrorist attacks on Bali in October 2002. Inflation fell from over 12 percent to 5 percent. Interest rates dropped from 17 percent to 7 percent. Foreign exchange reserves rose from $29 billion to $36 billion while the rupiah appreciated in real effective terms. The ratio of government debt to GDP declined from more than 100 percent in 2000 to less than 70 percent at the end of last year. The $1 billion international bond issue successfully floated by the Indonesian government in March 2004, barely a month before the parliamentary elections, underscores this exceptional record.

Indonesia's macroeconomic performance has been all the more surprising because it has been achieved without the active support of President Megawati and over the objections of at least two members of her economic team. The key to success was fiscal discipline, which Boediono was able to maintain with a combination of charm, pedagogy, and toughness.

Macroeconomic stability in the near term cannot be taken for granted, however. In the second quarter of this year, leading indicators began moving in unfavorable directions, presumably because of uncertainty about the elections. External factors are also now in a correction phase after an exceptionally favorable period. Rising interest rates in the United States will increase the cost of servicing external debt. The efforts of the Chinese authorities to moderate the pace of growth and the expiration of the Multi-Fiber Agreement at the end of this year could translate into weaker demand for Indonesian exports. A steep decline in oil prices could depress new investment in the oil and gas sector just as the government is clearing away the last major hurdles. The new government that takes office at the end of October will thus have to act quickly and skillfully to keep the economic transition on track through 2005.

The bigger challenge for the next government will be overcoming Indonesia's current economic malaise, which is palpable. This malaise arises from a number of fundamental questions about the country's economic potential. With a diverse array of ethnic groups scattered over 6,000 islands, can Indonesia develop the social consensus to achieve reforms to produce rapid growth over a sustained period, or will it slip into the Latin American pattern of high consumption and recurrent debt problems? Will resentment of the commercial power of the Indonesian-Chinese business community block this source of job creation? Will Indonesia be able to escape the curse of having abundant natural resources, an obstacle to broad growth in other countries that lies at the heart of the separatist movements in Aceh and Papua?

Pessimism about Indonesia stems largely from the government's inability since the financial crisis to push the GDP growth rate back above 5 percent in order to match the rapid pace maintained throughout most of the Suharto era. Consequently, a third of the labor force-40 million people-remains underemployed, and that number is growing. Most analysts blame Indonesia's sub-par growth on impediments to domestic and foreign investment, and they stress the government's slow and inconsistent approach to removing such impediments.

In the near term, economic progress will depend on Indonesia's success in tackling three devils: an unreliable judicial system, a weak banking system, and corruption. Fortunately, the starting point for the next government is further advanced in each of these areas than daily news reports suggest.