Indonesia: What lies ahead?

"INDONESIA: WHAT LIES AHEAD?"

Mr. Mark Baird
World Bank's Country Director for Indonesia

ASIALINK SEMINAR
MELBOURNE - 16 August 2001

The peaceful transfer of power to President Megawati Soekarnoputri will hopefully signal a new period of political stability in Indonesia. This is good for financial markets and the short term economic outlook. The appointment of a strong economic team, led by Coordinating Minister Dorodjatum, also signals the Government’s commitment to tackle the many problems confronting the economy. This is encouraging news. At the same time, we should not underestimate the challenges that lie ahead. Recovery is slowing, while inflation is on the rise. High levels of debt constrain the government’s maneuverability. Many judicial, administrative and financial institutions are weakened by rampant corruption. And about half the population is poor or vulnerable to poverty. Against this backdrop, I would like to review the policy issues and priorities facing the new government in three key areas: sustaining recovery, improving governance and reducing poverty. I will conclude with a few comments on the implications for the World Bank and how we might assist Indonesia during this critical period.

Sustaining Recovery

The Inodnesian economy grew by 4.8% in 2000. This was better than expected and signaled the start of recovery from the devastating impact of the Asian financial crisis. But growth has clearly slowed again this year. Non-oil exports in particular have leveled off and in the first half of this year were slightly lower than a year ago. GDP growth is now expected to be about 3% in 2001. This slowdown is in line with developments in other countries in the East region. But, unlike in other countries, the slowdown in Indonesia leaves the economy well below pre-crisis levels. The current annual growth rate is also well below the 5-6% needed to absorb new entrants to the labor force and make a real dent in poverty. Indonesia’s economic performance has undoubtedly been affected by the unstable domestic situation. The peaceful political transition provides some initial relief. But investors are unlikely to return until they see a serious effort to implement sound economic policies and to start the process of rebuilding economic institutions.

The process of economic and institutional reform will obviously take many years to complete. We all have to be patient and expect setbacks along the way. But we also need clear signals that things are heading in the right direction. On the economic front, urgent action is needed in three key areas:

These three issues are central to the Letter of Intent (LOI) with the IMF. It’s no secret that the IMF has had a rocky relationship with Indonesia over the past year. This reflected some genuine difference of opinion (e.g., the transparency of IBRA asset sales and the independence of Bank Indonesia) as well as problems of implementation, as the Government has struggled to deliver on its commitments in a very difficult political environment. However, the process got back on track in July, when the latest IMF review mission reached agreement on a somewhat simpler and more streamlined draft LOI, including the revised budget for 2001. There are still more outstanding issues to be addressed by the Government. But with quick action by the economic team, the LOI could be ready for approval by the Fund Board early next month. This would send a very positive message to financial markets and investors alike. It would also pave the way for a successful Paris Club meeting of the Consultative Group on Indonesia (CGI) later in the year.

Improving Governance

Governance is Indonesia’s key medium-term development challenge. Weak governance at least aggravated, if not caused, the economic crisis out of which Indonesia is just now emerging. The crisis brought to the surface the lack of accountability, transparency and rule of law in Indonesia, compounded by weak institutions unresponsive to the population at large, and the poor in particular. Indonesia scores consistently low in surveys on the rule of law, corruption and corporate governance. Illegal gains from corruption have mainly benefited the rich, and were a major factor in the downfall of the Soeharto regime. Subsequently political developments have helped expose the problems of corruption through the more active roles of the media and civil society, and parliamentary debate. But accountability still remains very weak. This widening gap between expectations and actions is feeding popular discontent and could undermine the credibility of the democratic process itself. Some Indonesians (and foreign investors) are already starting to long for the greater certainty and authority of the past. Strong leadership by leaders who model political and financial integrity, and show determination to fight corruption will be needed to turn this situation around.

Two areas requiring particular attention are the justice sector and the civil service:

Justice sector reform. Indonesia’s legal system, the courts, the Office of the Attorney General, and the police all share a reputation for corruption, inefficiency and incompetence. Recent high-profile cases such as Bank Baliu, Manulife and Tommy Soeharto have brought these issues to the surface. Yet, despite many promising initiatives over the past two years, including the appointment of a credible National Law Commission, there has been little real progress on this front. Of the many reasons for these failures, three need special attention. First, no consensus in Indonesia has emerged about how to deal with the past. The fact that so many Indonesians are compromised is a major factor here. As a result, anti-corruption efforts have proved highly resistant to reform, partly because there are no strong “sticks” or “carrots” to make it worthwhile. The recent assassination of a Supreme Court judge is sad reminder of the high stakes involved and the strong vested interests to be overcome.
Civil service reform. The rhetoric of civil service reform has been on Indonesia’s development agenda for years. But, in the past, high growth and a dramatic reduction in poverty masked the problems of the inefficient and unaccountable civil service. There was consequently little incentive to reform the way the Government worked. That has all changed since the crisis, which exposed weakness in the civil service and the social costs of mediocre or corrupt governance. While the civil service had effectively delivered top-down services to the public, the crisis revealed that it had failed to deliver the services needed to support a rapidly globalizing economy and more democratic society. Democratic reforms have increased demands for transparency, accountability and performance, while fiscal constraints require greater cost effectiveness. Moreover, decentralization will fundamentally change the nature of the civil service. The short-term priorities for civil service reform rightly focus on managing the process of decentralization (as noted above). But more fundamental issues on the size of the civil service, recruitment policy, performance management, remuneration and probity still need to be addressed. Civil service pay scales have been increased significantly over the past two years. But recent analysis suggests that higher pay is unlikely to reduce corruption without corresponding action to reduce the opportunities and raise the penalties for improper behavior.

These governance issues are nowhere more apparent than in the forestry sector. Illegal logging is flourishing in Indonesia’s forests. With an estimated annual volume of 30 million cubic metres of round wood, it exceeds legal logging. And the combined logging volume is three times the sustainable yield of the natural forests. The immediate cost is the loss of US$400-600 million in uncollected royalties on illegally-harvested timber. The longer-term cost in terms of forest degradation and loss of biodiversity is immeasurable. Good governance is fundamental to any solution, because illegal logging is rooted in government failure. Wood processing industries have expanded beyond the limits of sustainable log supply, abetted by favorable regulations that insulated them from market forces. Past government policies and procedures for forest use have also alienated local communities ensure there is a supply of labor for illegal logging. But, fundamentally, illegal logging is big business: it attracts investors with ample capital, and the means and influence to protect themselves from prosecution. Public officials are involved not only as protectors but also patrons and investors. Illegal logging could not prosper without the active support and involvement of the police and military.

Given the severe impact of weak governance and corruption on the Indonesian economy, it would be nice if the World Bank and other donors could wave a magic wand (or a big stick) and make it go away. Indeed, governance issues, especially in the forestry sector, have dominated recent meetings of the Consultative Group on Indonesia (CGI). But, ultimately, the drive for reform must come from within Indonesia. Progress to date has been handicapped by the lack of a clear focal point within the Government, which sees itself as responsible or the governance agenda. The agenda has been left largely to a few key reformers, whose efforts appear ad hoc and often flounder under resistance from well-entrenched vested interests. First and foremost, the Government needs to articulate a clear statement of where it wants to go in this area and how it wants to get there. A process of national dialogue is needed to help bring a shared understanding among all the stakeholders of the complexity of the reform effort and is intrinsically long-term nature, while also enabling coalescence around some “quick wins” that help to manage public expectations. The donor community can then mobilize resources and expertise to support these efforts. The partnership for Governance Reform, in which Australia participates, has been established for this purpose. But strong Indonesian leadership remains the key to achieving real and lasting results.

Reducing Poverty

Sustained economic recovery and improvements in governance are also central to reducing poverty. Under the Soeharto regime, with a strong focus on economic growth and top-down development, Indonesia achieved remarkable progress on reducing poverty and improving social conditions throughout the country. Indeed, according to the UNDP’s Human Development Index, Indonesia made more rapid progress in poverty reduction than any other country during this period. But this progress was not matched by the development of institutions to empower the poor or to protect them against official abuse. These weaknesses were laid bare by the financial crisis of 1997-98. The poverty rate roughly doubled to around 27% by early 1999. The impact was particularly severe in Java and urban areas. More recently, higher wages and lower rice prices have helped to reduce the poverty rate somewhat. Even so, most Indonesians continue to confront a wide range of deprivations such as losing a job, unexpected illness or family emergency which can easily push them below the poverty line. Recent analysis suggests that around half of all Indonesians now face a greater than 50-50 chance of experiencing an episode of poverty every three years.

The Government launched several social safety net (JPS) programs in 1998 to help protect the poor from the worst effects of the financial crisis. These programs were designed to ensure the availability of food at affordable prices, create jobs and supplement incomes, and preserve access to critical social services. Several programs including those for rice distribution (OPK) and school grants and scholarships largely achieved their objectives. The Government also achieved significant gains in improving the transparency of JPS programs, including the use of clear targets and performance indicators, and much wider public dissemination of information. But there were also widespread concerns about the implementation of some of the more complex programs, especially those requiring local discretion, and conflicts with “informal” safety nets developed by individuals and communities to cope with the crisis. Efforts to strengthen civil society consultations and complaint resolution mechanisms also fell short of expectations. This made it difficulty to ensure that public concerns about corruption were effectively addressed.4

Effective social safety net programs will continue to be needed for the chronic poor, and to help the vulnerable cope with shocks. But the recent crisis experience has also reinforced the importance of rethinking the Government’s approach to poverty reduction. The new poverty strategy will have to be take into account the following three factors:

The broader, multi-dimensional, more dynamic reality of poverty.
A narrow expenditure approach, focused on the “chronic ultra poor”, fails to capture the many deprivations, vulnerabilities and risks that many poor people face.
The impact of all government policies and programs on poverty.
What the government does with rice policy or fuel subsidies has a much larger impact on the bulk of the poor than narrowly targeted poverty programs.
The transition to a more democratic and decentralized system of government.
Poverty programs will have to draw more effectively on the ideas and capacities of local communities and civil society. Officials will also have to be more accountable for delivering results.

The Government has been moving in this direction in recent months. A new Agency for Poverty Reduction has been formally established under the Office of the Vice President. The main goal of the Agency is to “encourage Government and civil society shift from the old, government-driven poverty reduction paradigm to one in which the poor are literally and truly the main actors in the fight against poverty”. The Agency has already started to participate in the formulation of annual plans and is encouraging Government Departments to examine opportunities to mainstream poverty reduction initiatives in their planning processes. It also plans to establish a continuous process of stakeholder consultation to ensure that the voice of the poor, of civil society, of the academic community and of government agencies, at both the national and local level, is taken into consideration. The future of the Agency under the new Government is not yet clear. But high level commitment to this Agenda and process will obviously be needed to achieve real change in the Governments’ approach to poverty reduction and real results for the poor of Indonesia.

How can the World Bank Help?

In congratulating President Megawati, The World Bank President, Mr Wolfensohn, wrote:

“This is a time of great challenge and opportunity for Indonesia. You Government faces the daunting task of rebuilding the economy, tackling corruption and reducing the poverty facing many of your people. I recognize that this will take time given the many problems and constraints facing the country. But, with persistent effort, I’m confident that Indonesia will prosper under your leadership. Let me take this opportunity to assure your Government of the fullest cooperation and support from the World Bank. We look forward to working closely with your new economic team as they develop a roadmap for Indonesia’s recovery drawing on the country’s tremendous human and natural resources. We will also do our utmost to help mobilize and coordinate international support for implementing your recovery program.”

In providing this support, we will be guided by our new Country Assistance Strategy (CAS) for Indonesia, released in February 2001. The CAS is based on extensive consultations with government officials, development partners, and civil society groups. It attempts to learn from the successes and failings of the past, and to respond to the changing political and social climate in Indonesia. The over-arching objective is to “reduce poverty and vulnerability in a more open and decentralized environment.” But how best to do that given Indonesia’s high levels of debt and the pervasive impact of corruption on government programs?

In thinking about this dilemma, we considered three scenarios for Indonesia’s development over the next three years:

The base case is the so-called “muddle through” scenario with some slippage on structural reforms, but with continued macroeconomic stability that would help sustain poverty reduction. GDP growth would stay around 4% per annum. While this is not a desirable outcome, it was considered the most likely given the uncertain political environment. In this case we would lend Indonesia up to US $400 million per annum on average over the next three years. This is considerably less than during the pre-crisis years of the 1990s (US $1.3 billion per annum) reflecting the country’s limited borrowing capacity without strong economic growth. The terms of assistance would also be softened with temporary access to highly concessional IDA resources.5 IDA would fund about one third of new commitments under the base case.
The high case assumes a significant improvement in economic performance, along the lines agreed with the IMF with added measures to protect public funds from misuse and to channel them effectively to the poor. Progress in these areas would lead to higher growth (5-6% per annum), more rapid poverty reduction, and increased capacity to service debt. In this situation, World Bank leading could rise to US$1 billion a year, with a higher share of IDA resources.
The low case is the so-called “crisis” scenario where thee is a threat to macroeconomic stability or a breakdown in law and order. Under these conditions, which are not considered likely at this time, the World Bank would temporarily cease new project lending until the conditions for effective poverty programs are restored. We would stand ready to participate in another rescue package although the scope would be clearly less than in 1997 98, due to Indonesia’s high debt burden and our own exposure in the country.

We are currently in the base case. New commitments during the year-ended June 2001 totaled US$493 million, of which US$284 million was from IBRD and US$209 million from IDA. However, as important as how much we lend, is what we lend for. During the crisis, much of our assistance was in the form of budget support to protect public services from disruption and fund social safety net programs. Over the next three years, we will move back to primarily funding projects which support social services (eg primary education, health care) and basic infrastructure (eg water supply, rural roads) for the poor. While World Bank lending will continue to be channeled through the Central Government, project implementation will increasingly be managed by local governments and communities. These trends are reflected in two “flagship” projects approved on June 26 for community-driven development (KDPO II) and decentralized health services (Provincial Heath II).

Beginning in the mid-1990s, we have been working with the Government to get the country’s “bottom-up” development planning process to work. Through the Village Infrastructure Project (VIP), we innovated large-scale direct transfer of project funds to villages for priority activities identified by communities. This and other World Bank funded project have been used to show that properly designed community empowerment projects lead to higher returns, greater benefits for the poor (including better accountability for and more transparent use of funds), and more sustainable outcomes. These successes have made community-driven development activities a key part of our country strategy. In the mid 1990’s, less than 10% of new loan approvals were directed to communities. By the late 1990s this share had risen to one third and over the past three fiscal years more than 50% of new loans support community empowerment.

The newest generation of these projects works to increase communities’ capacity to make assessments of their development needs and reach up and to involve local governments and other stakeholders in solving them. At the same time, other new projects in health, education and environmental services are encouraging newly empowered local governments to reach down to community groups and become more responsive to their needs in service delivery.

Unfortunately, World Bank funded projects are not immune from the pervasive corruption in Indonesia. Recent changes in the environment including a more vocal media a civil society have helped highlight the problem. But mechanisms to hold offenders accountable are still very weak. Out new CAS attempts to address this problem at several levels:

Government fiduciary controls. We will help the Government improve its own systems for procurement and financial management, including new rules and safeguards for projects implemented by local governments. An independent National Public Procurement Office is to be responsible for formulating procurement policy and monitoring compliance. And the legal framework on state finance, treasury and audit is to be revised.
World Bank lending. Progress on improving the Government’s fiduciary controls will be one of the triggers for moving to the high-case lending program. We will also give priority, in the allocation of resources, to local governments and agencies that show genuine commitment to reducing corruption.
Project design. Our emphasis on community-driven projects helps to reduce corruption. When villagers manage funds, works are completed for as much as 30% below traditional project approaches. New projects will also focus on building the capacity of implementing agencies (including good planning, budgeting and project management systems) and give a greater role to civil society in project monitoring.
World Bank supervision. Adequate budget resources will be provided to supervise World Bank funded projects, especially those with higher fiduciary risks. Particular attention will be paid to updating annual procurement and financial plans, and conducting regular ex-post procurement and SOE reviews. Under a proposed pilot program, information on procurement and audits of World Bank funded projects will be disclosed to the public.
Complaints resolution. Procurement complaints will be actively followed up, and alleged cases of fraud and corruption will be refereed to the World Bank’s Department of Institutional Integrity for further investigation and sanctions. Currently, 36 cases are under review.

Besides our lending program, the World Bank also provides a range of analytical and advisory services to Indonesia. Over the next three years, this work will shift from crisis response to longer-term development concerns, such as governance and poverty strategy. We will continue our support for the Partnership for Governance Reforms launched jointly with the UNDP and ADB, and managed by an Indonesian-led Board. The Partnership provides grant funding to support a national policy dialogue and a range of initiatives by government, civil society and the private sector to promote governance reforms. Increasingly, our analytical and advisory work will be undertaken at the regional level, to better understand and respond to the developmental challenges and opportunities resulting from decentralization. Three regional public expenditure reviews in North Sumatra, West Java and NTB are already underway.

Finally, the World Bank helps coordinate the activities of the donor community in Indonesia. The Consultative Group on Indonesia (CGI), chaired by the World Bank, provides a forum for the Government to present its development priorities and programs for donor funding. Donors in turn outline their own views on development issues and problems to be addressed in the coming year. The formal of the CGI has changed dramatically in recent years, with participation of civil society representatives and public disclosure of all major statements (on the internet). The CGI is followed up by informal donor meetings in Jakarta, including technical groups on key development issues. Recent progress in some of these areas, including forestry and legal reform, has been disappointing. This highlights the limits on what donors can achieve without the active commitment and follow-through of the Government. The critical question therefore becomes how to develop and support domestic pressure for reform, and how to shape donor programs in response.

In conclusion, let me reaffirm that we stand ready to support the new Government as they tackle the many challenges that lie ahead. I firmly believe that the path of greater openness and decentralization, started by President’s Habibie and Wahid, offers the best prospects for economic development. Under President Megawati, we are likely to see greater political stability another key element of success. But the fundamental issues of economic and institutional reform remain as daunting as ever. At the end of the day, it will be the efforts of Indonesians which will determine whether the country meets these challenges and builds a better future. But, as a long-term partner of Indonesia, we have a responsibility to help and support those efforts. The outcome will hopefully be better news for all Indonesians in the future.

Mark Baird
Country Director
World Bank Office Jakarta
August 16, 2001

Asialink, The University of Melbourne

Indonesia: What lies ahead?