Testimony by Adam Schwarz before the Senate Foreign Relations Committee

March 24, 1998

Testimony by CFR fellows and experts before Congress.

Thank you, Mr. Chairman, for inviting me to speak today at the hearing on current developments in Indonesia. I am the Edward R. Murrow Fellow at the Council on Foreign Relations, specializing in Southeast Asian studies. I spent ten years as a foreign correspondent in Southeast Asia, including the period 1987-92 in Indonesia. I have recently returned from a three-week trip to Jakarta.

The economic crisis now afflicting Indonesia is reaching tragic proportions. Millions of Indonesians have already been put out of work or seen their incomes sharply curtailed. Many millions more will suffer the same fate if the crisis continues. A nation that until nine months ago had every reason to view the future with optimism and hope has been plunged into despair and anxiety.

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Like their counterparts in Thailand, South Korea, and other Asian nations, Indonesians are grappling with the causes of the crisis and the effects of the remedies they are being urged to implement. As we have discussed today, the causes are multifaceted: a sudden, sharp swing in global capital flows out of the Asian region both exposed weaknesses and inefficiencies in the domestic economies of certain Asian nations as well as contributed to a deepening of the crisis.

The crisis in Indonesia has been particularly deep and, at least to date, uniquely resistant to solution. My own view is that this state of affairs in due primarily to weaknesses in Indonesia's political system rather than shortcomings in the economy. The weaknesses in Indonesia's economy are significant but not insurmountable. They are not dissimilar to the problems affecting some other Asian nations. What sets Indonesia apart is the poor handling of the crisis by its political leadership. Alone among the group of nations most seriously affected by the crisis, Indonesia seem unable to grasp the message being communicated by the market regarding the competitiveness of the Indonesian economy.

I would like to return to this point later on, with a discussion of the some of the reasons explaining the non-responsiveness of the political system. First, however, I would like make a few comments regarding Indonesia's importance to the region and on the possible consequences of Indonesia's continued economic deterioration.

Indonesia is the most important country of Southeast Asia. As the world's fourth-largest country, with a population of 207 million, and as home to the world's largest Muslim community, Indonesia is the dominant player in the region. Throughout the 32-year tenure of President Suharto, Indonesia has been a powerful force for regional stability and cooperation. It has played a key role in turning the Association of Southeast Asian Nations (ASEAN) into one of the most successful regional groupings in the world. Its geographical breadth of over 3,500 miles, its location containing the main sea-lanes linking the Pacific and Indian Oceans, and its rich reserves of mineral and natural resources give Indonesia political, geostrategic and economic importance in the region.

Some commentators have argued recently that the "contagion" risk in Asia is declining, as markets are learning to distinguish the particularities of individual Asian nations. While there is some evidence supporting this view, it would be a mistake to think the risk of contagion has been eliminated. The recovery underway elsewhere in Asia is fragile and not irreversible. It would be unwise not to expect further setbacks. And, because of Indonesia's dominant position in Southeast Asia, its recovery is a prerequisite for Southeast Asia regaining its economic momentum and for ASEAN to put back on track its plans for economic integration.

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It is in the United States' interests that both of these goals are achieved. U.S. trade and investment with Southeast Asia has grown dramatically in the past decade, and a protracted stagnation of Southeast Asian economies will have a negative effect both on the U.S. companies that have invested in the region as well as on the U.S. trade balance. ASEAN has been an important dialogue partner to the United States in both the economic and security fields. ASEAN is an important component of the Asia-Pacific Economic Cooperation (APEC) forum, on which the Clinton administration has placed high hopes for keeping the U.S. economy tightly integrated with the Asian continent. ASEAN also plays a key role in the ASEAN Regional Forum, the only venue in which regional powers meet to discuss security concerns. The effectiveness of both of the these arenas for dialogue will be constrained until Southeast Asia recovers its economic footing.

Returning to Indonesia, any discussion of the solutions to current crisis must begin with an understanding of how severely the economy has already been affected. After two months of exchange rate volatility, Indonesia's economy is grinding to a halt. Unemployment is expected to increase by some 50 percent this year alone, leaving a total of 13 million out of work. Many more millions are underemployed. The cost of living in January and February rose at an annualized rate of over 200 percent, with inflationary pressures expected to accelerate in March and April. The prices of many basic goods have risen by multiples: a pre-crisis egg costing Rp. 200 now sells for Rp. 600. The price of powdered milk has risen by over 400 percent. The worst drought in a half a century has slashed rice production, requiring Indonesia to import at least 4 million tons of rice this year.

Indonesia's private foreign debt is estimated at around $75 billion, and most of it is unhedged. Almost all banks are technically insolvent, as are most big businesses. This is true at an exchange rate of Rp. 10,000 to the dollar and will be largely true even at exchange rate of Rp. 7,000 to Rp. 8,000. Exporters canÕt get letters of credit to import needed raw materials, even though Indonesia's central bank has guaranteed all bank liabilities. Reserves at the central bank have fallen too low to make such a guarantee credible.

A recent report by a leading brokerage house analyzed the financial health of Astra, often cited as Indonesia's best-run firm. The report estimated that Astra's debt servicing obligations this year could reach as much as 90 percent of the company's operational cash flow, an obviously unsustainable level. The pressure on the government's budget is also severe. Given falling tax revenues, mounting debt service obligations, and the need to continue subsidizing basic commodities, there is little left over for investment and social expenditures.

Stocks of a number of basic commodities are declining rapidly. Chicken feed is becoming scarce, raising the prospect of chickens and eggs disappearing from store shelves in the not too distant future. Malaysia and Singapore are growing increasingly alarmed at the prospect of waves of Indonesian refugees washing up on their shores.

The social impact will come later but will be equally severe. Experts predict 10 to 20 percent declines in enrolment at all levels of schooling this year. Declining nutritional intake, especially among the poor, is expected to cause higher rates of child sickness and infant mortality. The population growth rate is set to start inching up again as the cost of imported contraceptives rises. Blood banks are suffering quantity and quality problems: the unavailability of imported chemicals to screen blood supplies has raised fears of blood-transmitted diseases, including HIV. The environment is expected to come under renewed pressure, as Indonesia relies on exploitation of primary resources to make up for its revenue shortfall.

As Indonesia's economic troubles mount, President Suharto and others close to him have aggravated the situation by a number of missteps and miscalculations. Suharto's choice of B.J. Habibie, the controversial former minister for research and technology, as his new vice president; inflammatory remarks by leading military figures about the countryÕs ethnic Chinese minority; Suharto's suggestion that parts of the International Monetary Fund (IMF) package violate IndonesiaÕs constitution; his continued flirtation with the idea of a currency board; and his recent cabinet selections have all had the effect of convincing foreign investors and lenders that the president is not sincere about reform or that he does not understand what is being asked of him.

It is my view that the latter reason goes a long way in explaining why Suharto, whose renowned political skills have served him well over three decades of power, has so far failed to confront the economic crisis effectively. The process of globalization has made the world a more competitive place, and the power and speed of global capital movements permits the market to punish quickly and severely those economies which fail to address their weaknesses. The inefficiencies inherent in SuhartoÕs Indonesia— due to rampant corruption and a lack of accountability and transparency— are no longer affordable in a more competitive age. Unfortunately, appreciating this dynamic requires a degree of understanding of global economics and international finance that appears to be in little evidence in the top reaches of the Indonesian leadership.

The IMF package signed on January 15, 1998, is flawed in some respects but it contains many of the steps Indonesia needs to take if it is to regain the confidence of the market. It recognizes that there is much more ailing Indonesia than an insolvent banking sector. The package attempts to hack away at a variety of monopolies, cartels and other privileged treatment doled out to SuhartoÕs friends and family; it frees up trade and distribution of several important agricultural and industrial goods; it calls for banking reform, a more autonomous central bank, and for an international audit of the seven state-owned banks, all of which have lent liberally to SuhartoÕs inner circle, although not always on the expectation of being repaid. More broadly, the package seeks to inject more transparency into IndonesiaÕs economy, limit the opportunities for graft, give more say to market forces in allocating resources, and establish a more arms-length relationship between the government and the corporate community. Put differently, if the letter of the IMF agreement aims to eliminate specific existing monopolies, the spirit of the agreement is to limitÕs SuhartoÕs capacity to distribute new monopolies to the favored few. These are of course broadly political goals and their purpose has not been lost on Suharto.

The Indonesian leader takes a very different view of the crisis. He has backtracked on certain IMF commitments and half-heartedly implemented others. Though, as is his wont, he has been sparse with details on his own thinking about the origins of the crisis, he has made it abundantly clear that he views neither himself, his family, or the political system that he has created as part of the problem. SuhartoÕs style of rule has not changed and, as he rightly notes, his leadership has brought many tangible benefits to Indonesia: growth has averaged almost 7 percent a year since he took power in 1966, while the number of Indonesians living in poverty has declined dramatically. His government has built thousands of schools, roads, health clinics, and mosques, and brought about substantial improvement in a variety of social indicators. Although he would not put it this way himself, nepotism and corruption have long been a hallmark of his administration and, until very recently, neither western bankers, investors, fund managers, or governments made a fuss about it.

Because Suharto does not agree with the IMFÕs diagnosis, he has come to distrust the FundÕs prescriptions. He is moving toward the view that the IMF, with active U.S. support, is trying to dislodge him from power. This, in turn, has launched a spate of nationalist rhetoric from the president and officials close to him.

Underlying the difference in views on the nature of Indonesia's crisis is an inadequate understanding in Jakarta of the importance of foreign capital to Indonesia, and of IndonesiaÕs ability to attract it. In the mid-1980s, IndonesiaÕs oil-dependent economy suffered badly after the price of oil slumped to just $10 a barrel. Since then, Indonesia has made considerable strides in opening its economy, dropping trade barriers, allowing foreign investment in most areas, liberalizing the financial sector, and, more generally, pushing the economy into closer integration with regional and international markets. Such a shift has brought significant benefits to Indonesia: an export boom, an extended stock market rally, millions of new jobs in the export-oriented manufacturing sector, a lower dependency on oil and gas, and a much higher rate of technology transfer from abroad, including ÒsoftÓ technologies such as financial, trading, and marketing skills.

But the move to open the economy had other effects that were more difficult to identify at the time, with one being the political implications of coming to depend on foreign capital flows to fund industrial expansion. Gains brought by foreign capital have been paid for, to some extent, by a loss of sovereignty, with the providers of foreign capital becoming a new constituency whose interests need protecting. When the economy was growing at 7 to 8 percent a year, the interests of Suharto and foreign-capital providers were sufficiently well matched as to be indistinguishable. But since the crisis began, Suharto has shown repeatedly that he has a poor grasp of market sentiment and even less of the crucial role foreign capital needs to play if confidence in Indonesia is to be restored.

Several factors help explain this self-destructive behavior. One is that IndonesiaÕs conversion to an outward-looking, export-oriented economic strategy is relatively recent, at least for Suharto, who is of a generation that came of age in the struggle for independence against the Dutch. Like many of his generation, Suharto associates capitalism as the driving force behind colonialism and as such has always harbored some suspicion toward it. (It is those very suspicions which are embodied in the constitutional provision that Suharto claimed recently was being violated by the IMF.) Being pressured from the outside to do something in the name of capitalism is certain to be associated with colonial behavior by more nationalist-minded officials, and therefore resisted in principle. Some members of SuhartoÕs inner circle are already using language to describe the economic policies being pushed by the IMF in terms identical to those used a half-century ago in criticizing the exploitative agenda of the Dutch.

Another point to be kept in mind is SuhartoÕs apparent inability to distinguish between markets and the official institutions that monitor markets and dispense aid. The current fracas with the IMF notwithstanding, Suharto has had considerable success over the years in negotiating with governments and with multilateral institutions such as the IMF and the World Bank. But in Asia, as elsewhere, official flows of capital have been eclipsed by private flows. Suharto is currently focusing his attention on convincing the IMF to be more flexible in deciding whether to make the next disbursement of its bail-out package for Indonesia. But the risk of this strategy is that it fails to take into account a broader point. It is not the IMFÕs next installment of $3 billion that will turn Indonesia around; that process can only start when private capital— lenders, venture capitalists, fund managers, direct investors, and the like— are convinced that capital deployed in Indonesia will enjoy security and the promise of a return. At the moment, Suharto is offering neither.

The failures of the Indonesian political system in keeping abreast of current development is not limited to external trends. In recent years, the political system has grown increasingly out of touch with changes underway even in Indonesian society. In the rural areas, 1998 has been marked by rumblings over economic hardship and a gnawing sense of injustice. Early in the year this discontent boiled over into riots and sporadic violence aimed at the small but economically important ethnic Chinese community. Suharto was slow to condemn the violence, generating speculation that he was willing to see the ethnic Chinese become the scapegoats for the economic crisis. Whatever the reason, his silence has made the crisis worse. The ethnic Chinese are now unsure of their role in Indonesian society: richer Chinese have moved funds offshore, while poorer Chinese have migrated to urban areas, disrupting the countryÕs agricultural distribution networks in the process.

Among intellectuals and the middle class, the yearning for political change is palpable. There is a widespread consensus that the push for greater transparency inherent in the IMF program is urgently needed and long overdue and that such a transformation can only be accomplished if accompanied by significant political reform. That does not necessarily mean Suharto has to go. But it does mean his powers need to be reduced and that the system as a whole needs a stronger set of checks and balances. Student groups have been protesting daily, many of them calling for SuhartoÕs ouster. Muslim groups have been largely passive to date, but unhappiness with the composition of the new cabinet may lead at least some segments of the politically active Muslim community to join the active opposition.

Against this backdrop, Suharto appears blissfully undisturbed. To the extent that he has paid any attention to student unrest in the past, he has generally written off protestors as malcontents insufficiently grateful to him for bringing decades of development to Indonesia. His tolerance for dissent has always been low and so it is today. It would not be surprising if Suharto were to move soon against some of his critics.

Nor is it surprising that Suharto is so out of touch. He sits atop a political edifice, which itself has become disconnected from the rest of society. A little history helps put his current predicament in context. When Suharto came to power in 1966, he began putting into practice his view that Indonesia needed an extended period of stability and political peace in order to secure economic development. In this, he had the support of much of the elite which had grown weary of the constant political ferment under Sukarno, SuhartoÕs predecessor, and IndonesiaÕs founding father.

To achieve political peace, Suharto gradually made it more difficult for Indonesians to engage in any political activity, except for a carefully controlled polling exercise once every five years. For a while, this approach made the government more efficient and did indeed produce impressive economic gains. But in accumulating ever more power for himself, Suharto gradually disempowered or rendered ineffectual all of the countryÕs political institutions and created, in the end, a system entirely absent any checks or balances. The system is now so top heavy that it has become almost as dysfunctional as the one Suharto inherited from Sukarno. Neither the courts, the parliament, the bureaucracy, or the cabinet have much latitude for action; all are dependent on Suharto for direction, and this is a task far more complex for one man to handle.

The recently concluded PeopleÕs Consultative Assembly, known by the Indonesian acronym MPR, offers a good case study. Meeting once every five years, the MPR is the highest constitutional body in Indonesia. It has two tasks: to choose a new president and to approve new Òstate guidelinesÓ for the coming five years. A tightly choreographed event even in good times, the most recent MPR had a particularly surreal air to it. In 11 days of carefully scripted dialogue, the crisis that has devastated the Indonesian economy barely rated a mention. In his opening speech to the MPR, Suharto neither gave his views on how the crisis happened nor offered any meaningful detail on his plans to extricate the country from it.

It is important for the international community, especially the IMF, to recognize the prevailing political dynamics in Jakarta and to gain a better sense of how Suharto views the crisis. This is not to say that the thrust of the IMF's bailout package for Indonesia is misplaced, or that the status quo should be encouraged. Indeed, it may well be that a lasting, sustainable recovery can only be achieved after Suharto leaves power. But political change is a decision only Indonesians can make. Until they do, it behooves the international community to make every effort to ease Suharto out of the corner he has placed himself in.

This can be best achieved by encouraging IMF flexibility in areas that directly affect the hardest hit segments of society, such as permitting continued subsidies on rice, soybeans, and cooking oil. The United States should consider specific measures to help Indonesia's troubled corporate sector as well as the population at large. For the former, an export guarantee scheme, possibly undertaken with G-7 counterparts, would begin to relieve the financial crunch Indonesian companies are experiencing and help prime the pump of the Indonesian economy. For the latter, the United States should stand ready to provide large-scale food and other humanitarian assistance. If the crisis persists, hunger and malnutrition will soon become serious problems, leading to increased migration to neighboring countries and further instability in the region. In a more targeted way, the United States might consider copying measures recently introduced by Australia to lighten the financial burden on Indonesian students studying in Australia. As Canberra noted in announcing the measures, educational exchange is one of the best long-term methods for developing cross-cultural understanding and cooperation. It would be unfortunate for both Indonesia and the United States if most Indonesian students had to cut short their studies in America on account of the current crisis.

At the same time, the United States should stand firm in its view that major structural changes in the business environment in Indonesia are required if Indonesia is to overcome its current troubles. The United States should continue encouraging IMF efforts to increase transparency in the Indonesian economy and reduce graft. Eliminating wasteful cartels and monopolies should not be negotiable, nor should the strengthening of institutions, such as the central bank and the court system, needed for the proper functioning of a market economy. There are no shortcuts to regaining the long-term confidence of the international marketplace. Sugarcoating this reality will, in the long run, not be helpful to Indonesia, the region, or the United States.

Thank you for inviting me to speak today.

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