INDONESIA'S EXTERNAL FINANCES AND DOMESTIC STABILITY: THE THREAT FROM LOW OIL PRICES

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP04T00794R000200690001-2
• Release Decision: RIPPUB
• Original Classification: S
• Document Page Count: 21
• Document Creation Date: December 22, 2016
• Document Release Date: May 27, 2011
• Sequence Number: 1
• Publication Date: April 1, 1986
• Content Type: REPORT

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Directorate -Seffet-
Indonesia's External Finances and
Domestic Stability: The Threat
From Low Oil Prices
-
EA 86-10016
April 1986
Copy 19 8
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Directorate of Secret
Intelligence
Indonesia's External Finances and
Domestic Stability: The Threat
From Low Oil Prices
This paper was prepared by
Office of East Asian Analysis and coordinated with
the Office of Global Issues. Comments and queries
are welcome and may be addressed to the Chief,
Southeast Asia Division, OEA,
Secret
EA 86-10016
April 1986
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Domestic Stability: The Threat
From Low Oil Prices
Key Judgments A key problem facing Jakarta during the remainder of the decade, we
Information available believe, will be to maintain economic growth so as to dampen social
as of 21 March 1986 discontent without jeopardizing Indonesia's sound external finances and
was used in this report.
strong international credit rating. US commercial banks play a major role
in lending to Indonesia, holding about 10 percent of that country's $37
billion medium- and long-term foreign debt. The Soeharto government's
reluctance to allow foreign investors to move significantly beyond the
petroleum industry to play a larger role in the economy, we believe, means
that Jakarta will be relying even more on US and other foreign commercial
creditors to sustain growth in the next few years in the face of low oil
prices. In our view:
? Financial austerity and other prudent economic policies would enable
Jakarta to cope with oil price declines to as low as $10 to $15 per barrel
without having to reschedule its foreign debt during the next few years.
? However, even oil at $20 per barrel would create serious problems since
low oil prices will dramatically slow growth while the growth of the labor
force is accelerating, thereby intensifying an already serious unemploy-
ment problem.
? A faltering economy and rising unemployment bode ill for domestic
stability, although these conditions do not directly pose a serious threat to
the Soeharto government. Local suspicions of the Chinese-dominated
business class-with its lucrative ties to key government officials-will
intensify, and radical Muslim leaders will continue to exploit deteriorat-
ing economic conditions.
We expect the Soeharto government to continue its policy of austerity in
the near term, despite parliamentary elections in 1987 and a presidential
election in 1988. We believe the regime is willing to run the risk that more
fiscal austerity could lead to social unrest because it is confident it can
quell any outbreaks before they spread. This confidence stems from
Jakarta's control of the country's key political institutions-including
political parties, organized labor, and major religious groups-and the
reliability of the military and security forces. Entrenched government
interests in heavy industry, in our view, make it unlikely that Jakarta will
significantly shift its development strategy toward more labor-oriented,
export-led growth. Instead, we expect Jakarta to intensify its efforts to
expand nonoil exports-even though this course, in our judgment, is flawed
because of stiff competition from other regional exporters and incipient
trade protectionism in industrial markets.
iii Secret
EA 86-10016
April 1986
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Key Judgments
Can Jakarta Steer Clear of Rescheduling? 7
The Economic Policy Options 7
Predicting the Probability of Debt Rescheduling 11
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Figure 1
Indonesia: Selected Economic Indicators, 1980-85
Real Economic Growth
Percent
Net External Assets a
Billion US $
Debt Service Ratiob
Percent
Net Foreign Debt to Exports Ratioc
Percent
a External assets include official and unofficial international reserves.
b The ratio of interest payments and principal repayments of foreign debt
to exports of goods and services.
c The ratio of long- and short-term foreign debt less external assets to
exports of goods and services.
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Domestic Stability: The Threat
From Low Oil Prices
Falling oil prices and anemic export revenues are
making it difficult for Indonesia to sustain economic
growth, generate employment opportunities, and re-
strain its massive foreign debt, which we estimate
reacnea 13 / Dllllon Dy January l92 b ana placea
Indonesia fifth among the largest LDC debtors.'
Since 1981, the country's external accounts have
reeled following oil price declines amounting to $6 per
barrel through the end of 1985. As a result of the
declines, export revenues have been trimmed signifi-
cantly, resulting in foreign trade deficits totaling
about $13 billion in just four years. A further deterio-
ration of export performance is certain this year
following the sharp declines in world oil prices.
Because oil and liquefied natural gas account for
nearly 70 percent of total export earnings and almost
60 percent of government revenues, a key casualty of
weak oil revenues is the country's economic growth,
which has declined from an average of 8 percent
annually in the period 1973-81 to an average of only 4
percent during 1982-85, according to our estimates.
Riots in Jakarta's port district in September 1984 and
a spate of terrorist bombings and fires since then,
moreover, have put the government on notice that
rising unemployment translates quickly into popular
dissatisfaction. Unofficial estimates placed the full-
time urban unemployment rate in 1984 at over 20
percent and underemployment (workers who are em-
ployed fewer than 35 hours per week) at 30 to 40
percent. Of particular concern to Jakarta,
is that, as in the port riots,
Table 1
Indonesia: Current Account Balance a
Billion US $
(f.o.b.) of which
Crude petroleum
12.0
11.9
10.2
9.0
Petroleum products
0.6
1.0
1.3
1.5
Liquefied natural gas
2.9
2.6
3.5
4.0
Wood and wood
products
0.8
1.1
1.2
1.2
Rubber
0.6
0.8
0.9
1.0
Coffee
0.3
0.4
0.6
0.7
Textiles and garments
0.2
0.3
0.5
0.6
Merchandise imports
(f.o.b.) of which
17.9
17.7
15.3
14.0
Consumer goods
1.2
1.7
0.8
1.0
Raw materials
12.5
11.7
10.5
10.6
Fuels
2.7
3.1
2.3
2.5
Current account -5.3 -
balance
6.3 -2.1 -3.0
unemployment can combine with Islamic fundamen-
talism to produce sudden and spectacular political
fallout
a Because of rounding, components may not add to the totals shown.
b Estimate.
Secret
EA 86-10016
April 1986
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Indonesia's Foreign Debt: Assessing the Burden
Although Indonesia's foreign debt ranks it as the fifth
most heavily indebted developing nation in the world,
the servicing and repayment burden is, by most
standards, relatively manageable. In terms of the
ratio of total foreign debt to exports, for example,
Indonesia ranks 13th of the 20 most heavily indebted
developing nations. Unlike non-oil-producing develop-
ing countries, Indonesia's foreign debt exploded in the
wake of the first and second oil price shocks in the
middle and late 1970s as government development
expenditures outpaced surging petroleum revenues.
New foreign borrowings were targeted for investment
purposes to build up the country's production base,
thereby laying the groundwork for economic growth
and further increases in exports.
The burden of servicing the debt is nevertheless
heavy. In 1985, we estimate that Indonesia's total
debt service payments amounted to $5.6 billion,
almost twice what was registered just five years
earlier. Although this increase was not out of line
with the rise in the country's total external debt,
there has been some deterioration in Indonesia's
overall repayment profile. In 1980, for example, 52
percent of the country's medium- and long-term debt
The path the economy takes will continue to reflect
both the international oil market and economic policy
decisions made in Jakarta. To gauge how rapidly the
Indonesian economy can grow in different interna-
tional economic environments and to estimate the
likelihood that Jakarta will seek to reschedule its
external debt-rather than engage in radical depar-
tures in economic policy-we have examined three oil
price scenarios.' Our conclusions are based on econo-
metric simulations of the Indonesian economy
' We assume in each scenario that Jakarta will continue its course
of debt management, tax policy, and financial reform, and pursue a
conservative foreign exchange rate policy in which the value of the
rupiah against the US dollar is allowed to depreciate by an average
of 7 percent annually through 1989. We suppose modest real
increases in total capital expenditures over the next four years in
response to sharply reduced government investment expenditures in
1984 and 1985. In addition, we assume modest growth in nonoil
exports and global economic recovery by mid-to-late 1987.
was in the form of concessional financing from offi-
cial sources-multilateral and government-to-
government borrowing. By 1985 this figure had fallen
to 45 percent. By comparison, in the four largest LDC
debtor nations in 1984 (Brazil, Mexico, South Korea,
and Argentina), the percentage of medium- and long-
term debt from official sources was 13, 7, 32, and 6
percent, respectively.
The smaller percentage of Indonesia's foreign bor-
rowings from official sources is mirrored in the
pattern of its debt servicing obligations. The average
term to maturity on medium- and long-term debt in
1985 was just under five years, compared with over
six years in 1980. In addition to accelerated principal
repayments, there has also been an increase in the
percentage of total debt servicing devoted to interest
payments-despite the generally downward trend in
nominal international interest rates since 1980. As a
result, we judge that in 1985 Indonesia's debt servic-
ing requirements reached 28 percent of its goods and
services exports, almost twice that of three years
earlier. Net external debt (total external debt less net
international reserves) climbed to one-third of GDP,
compared with one-fourth in 1982.
through 1989. We have supplemented our analysis
with a logit index of debt rescheduling (see the
appendix for a description of this index) that attempts
to quantify the probability that the government will
seek external debt relief under various oil price and
policy assumptions.
Indonesian crude oil is sold to refiners on a long-term
contracts basis; thus, in the first quarter of this year,
we estimate that Jakarta earned approximately $24
per barrel on most of its oil, substantially above
commonly quoted spot market prices. Accordingly,
our best case scenario assumes oil prices of $24 per
barrel prevail through the end of the decade.
In such a case, we judge that Indonesia would retain
considerable financial leeway managing its external
accounts. Most indicators of debt repayment capacity
would be favorable when compared with those regis-
i
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Figure 2
Indonesia: Impact of Changing Oil Prices, 1986-89
$24 per barrel oil
- $20 per barrel oil
$15 per barrel oil
Current Account
Billion US $
Foreign Debta
Billion US $
Unemployment
Percent
1
-5 0
Probability Index b
Percent
0
Net Foreign Debt to Exports Ratioc Debt Service Ratiod
Percent Percent
0 1986 87 88 89 0 1986 87 88 89 0 1986 87 88 89
a Includes long- and short-term foreign debt.
b This index is a measure of the likelihood that Indonesia will
reschedule its foreign debt.
c The ratio of long- and short-term foreign debt less total international
reserves to exports of goods and services.
d The ratio of interest payments and principal repayments on foreign debt
to exports of goods and services.
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World Oil Prices: Downward Pressures
In 1981 the average official OPEC sales price peaked
at $34.50 per barrel. Since then, prices have declined
by an average of $2 per barrel annually, so that by
the end of 1985 the average price was approximately
$28 per barrel. The sharp decline in world oil prices
at the beginning of 1986 points to continued weakness
in world oil markets this year, but the real question
from Jakarta's perspective is how far oil prices will
fall and where they will stabilize. Whatever the
outcome, Pertamina (the state oil monopoly) Presi-
dent Abdul Ramly last December ordered foreign oil
companies to boost crude oil production to its limit-
roughly 1.6 million b/d, including condensate output,
to offset lower prices, according to US Embassy
reporting. Jakarta, however, also will need to adjust
its pricing policies to remain competitive. Until Feb-
ruary 1986, Indonesia had been slow to react to the
fierce competition for market share, and this, failure
has caused oil exports to remain sluggish
Moreover, Jakarta's fail-
ure to provide adequate investment incentives to
foreign companies has reduced exploration in recent
years. As a result, Indonesia's capacity to produce
petroleum will fall rapidly to 1.2 million b/d by 1990,
according to industry estimates.
tered in 1970, Indonesia's last rescheduling episode.'
Given modest improvements in nonoil export growth,
we calculate that 4.5-percent real economic growth
would be possible through the end of the decade-
only moderately lower than the 5- to 6-percent real
growth judged necessary by the World Bank and IMF
to stem the growth of unemployment.
' Examination of numerous other, rescheduling episodes over the
past decade suggests that countries begin to encounter balance-of-
payments difficulties leading to external debt problems when the
probability of a rescheduling rises into the neighborhood of 40 to 45
percent. The critical value, however, varies somewhat depending on
the underlying economic strengths of the individual case as well as
the government's attitude toward its overseas debt commitments.
Prior Bouts With Debt Rescheduling
Indonesia has experienced four foreign debt resche-
dulings in the past two decades, each of which can be
attributed to the economic mismanagement of the
Sukarno era (1945-65). In 1965, for example, Indone-
sia's balance of payments was in shambles with the
current account deficit reaching $260 million-half
of GNP-while net official international reserves
were only $17 million-roughly equivalent to nine
days' worth of imports. Short-term debt relief mea-
sures were adopted by the country's creditors in 1966
to avoid a major rescheduling. It was recognized,
however, that the decade of the 1970s would be an
extremely difficult period without additional relief.
Following a debt restructuring in 1970, in which $2.1
billion in repayment obligations were deferred, Indo-
nesia undertook a conservative policy of foreign debt
management. Measures were adopted to spur eco-
nomic growth, encourage foreign investment, bolster
exports, and bring the country's inflation under con-
trol.
Probably the best remembered debt crisis, however,
was the near financial collapse in 1975 of Pertamina.
At the time of its reorganization, Pertamina ranked
among the world's 200 largest corporations. The
company had been caught in a cash bind by overcom-
mitting itself to short-term credits to finance long-
term projects. Total estimated debt of the corpora-
tion stood at about $11 billion, of which one-third
was owed to foreign banks. Although the Indonesian
Government undertook to meet all of Pertamina's
outstanding foreign obligations, the episode is not
generally viewed by international financial analysts
as a sovereign rescheduling exercise because Perta-
mina's debt problems arose from corporate misman-
agement rather than from fundamental weaknesses in
the balance-of-payments accounts.
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Figure 3
Indonesia: Official Government and
Spot Selling Prices
o Official government
selling price
o Weighted average spot
selling price (Attaka
and Minas crude)
US $ per barrel
The real squeeze on Indonesia's external accounts, in
our judgment, would begin if oil prices became stuck
at $20 per barrel. Our baseline scenario suggests that
at this price the country's petroleum earnings would
seriously erode, resulting in large and persistent cur-
rent account deficits, a rapid expansion of Indonesia's
foreign debt, and a sharply growing burden of debt
servicing. The probability of an external debt restruc-
turing would rise to 24 percent in 1987, before
exhibiting gradual improvement as nonoil exports
continue normally expected growth.' We also expect,
however, that real economic growth would begin to
slip noticeably, probably to 4 percent annually with-
out expansionary government spending policies, which
would aggravate Indonesia's already severe unem-
ployment problem.
Assuming $15 per barrel oil through the end of the
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decade, oil revenues would nose-dive, causing a fur-
ther deterioration in Indonesia's current account.
With no dramatic economic policy changes by Jakar-
ta, the result would be an abrupt increase in total
external indebtedness, a dramatic slowdown in eco-
nomic growth, and a sharp rise in the full-time
unemployment rate. Jakarta's choice of economic
policy in such a case would be between slowing the
economy to shore up its balance of payments or
risking its debt servicing ability and international
credit rating as a result of heating up the economy. In
our judgment, Jakarta would be able to cushion the
impact of falling oil prices through expansionary
fiscal policy, provided that it is willing to accumulate
additional foreign debt to fund the inevitable widen-
ing of the budget deficit. However, such a policy could
set the stage for a rescheduling crisis by the early
1990s.
How Low Is Critical?
Even Indonesia's normally sanguine Finance Depart-
ment is assessing the potential impact of $10 per
barrel oil on the government's budget accounts, ac-
cording to US Embassy reporting. In our judgment,
' These results are modest when compared with the 1982 debt
rescheduling episodes of, for example, Mexico and Brazil, when the
probabilities of a debt rescheduling were 72 percent and 68 percent,
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Table 2
Indonesia: External Debt a
Billion US $
(except where noted)
Figure 4
Indonesia: External Debt and Debt
Service Payment, 1979-85
Total external debt 26.6
(yearend)
31.2
33.6
36.6
Public and guaran- 18.5
teed
21.7
23.4
25.5
Official
lenders
11.1
12.0
13.0
14.2
Financial
markets
5.4
7.2
7.8
8.5
Other private
lenders
2.0
2.5
2.6
2.8
Private
nonguaranteed
4.3
4.8
5.7
6.2
Short term
3.8
4.6
4.5
4.9
External assets
(yearend)
7.0
8.3
9.9
10.0
Monetary authorities
4.2
4.8
5.8
5.9
Commercial banks (net)
2.8
3.5
4.1
4.1
Gold (in million ounces)
3.1
3.1
3.1
3.1
Net external debt
19.6
22.9
23.7
26.6
Total debt service
3.9
4.2
4.8
5.6
Amortization (actual)
1.8
2.0
2.4
2.9
Public long term
1.1
1.3
1.6
1.9
Official
creditors
0.5
0.6
0.7
0.8
Financial
institutions
0.4
0.5
0.6
0.7
Suppliers
0.2
0.3
0.4
0.5
Private long term
0.7
0.7
0.8
1.0
Interest
2.1
2.1
2.5
2.9
Public long term
0.6
0.6
0.7
0.8
Private long term
1.0
1.0
1.3
1.5
Short term
0.5
0.5
0.5
0.6
a Because of rounding, components may not add to the totals shown.
b Estimate.
the stabilizing of oil prices at $10 per barrel would
create critical problems for Indonesian economic poli-
cy makers. We estimate that by 1987 the probability
that Jakarta might seek to reschedule its external
debt would exceed 35 percent. Although this value
would not mean that rescheduling was imminent, it
External Debt
Billion US $
Debt Service Payment
Billion US $
0 1979 80 81
b Including short-term trade financing and short-term
borrowing by the central bank and commercial banks to
finance international reserves.
c Estimate.
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would suggest that close and constant monitoring of
Indonesian economic developments was warranted.
Real economic growth would barely exceed 1 percent,
while urban unemployment could become a social and
political time bomb. If oil prices slipped below $10 per
barrel, for example to $7 to $8 per barrel, and stayed
at that level for six months or more, then foreign debt
rescheduling, in our judgment, would be a distinct
possibility.
If Jakarta's recent policymaking record is any guide,
we believe the government is well equipped to deal
with low oil prices, to shore up the country's flagging
external accounts, to assuage the concerns of foreign
bankers, and to meet heavy debt service obligations.
Recent actions of the Soeharto government in our
judgment indicate that it is prepared to make what-
ever decisions are necessary to maintain its interna-
tional credit standing. In response to the softening of
world oil markets in 1983-84, for example, Jakarta
redefined its economic priorities and objectives:
? Policies to promote nonoil exports, such as currency
devaluation, banking deregulation, new shipping
and customs procedures, and simplified taxation.
? Rephasing large-scale capital- and import-intensive
development projects.
? Implementing trade restrictions, particularly on
consumer goods imports.
All signs from Jakarta suggest that more austerity is
in store to deal with declining oil revenues. In antici-
pation of an additional 14-percent decline in oil and
gas revenues for fiscal 1986, which begins 1 April,
President Soeharto in January 1986 announced sharp
cuts in the federal budget. At $19.4 billion, the new
budget represents a 7-percent decrease over the previ-
ous fiscal year-the most austere budget since the
early 1970s and one that includes a cut of 22 percent
in development spending, the first such cut since
1969, according to the US Embassy.
From a strictly financial perspective, we believe Ja-
karta still has some breathing room under our $10 to
$15 per barrel oil price scenarios, and, in the near
term, we judge Indonesia's balance of payments will
remain in fair shape. Although foreign exchange
earnings will suffer as a result of declining domestic
oil production and low international prices, we believe
government austerity measures should keep import
growth and current account deficits in check. More-
over, the country has ready access to foreign private
credit, amounting to about $3 billion in unused credit
commitments from commercial banks at the end of
1985. In addition, the government's financial stock-
pile is substantial with net external assets of the
banking system totaling nearly $10 billion at the end
of 1985. In our judgment, even if oil prices were to
sink to $10 to $15 per barrel, the country's foreign
debt would remain within serviceable limits, provided
that Jakarta continues to pursue a prudent economic
policy of budget cutbacks, rephasing large industrial
projects, and adjusting the foreign exchange rate.
Under these circumstances, and barring an unantici-
pated price collapse, we believe it unlikely that Indo-
nesia would request rescheduling of its foreign debt
during the next two to three years.
The Economic Policy Options
We believe Jakarta's policy options fall into two broad
categories.' On the one hand, the government can
continue to stress its high-technology import-substitu-
tion development strategy. Such a policy, however,
risks continued slow growth, rising unemployment,
and social unrest. If this policy is accompanied by
increased deficit spending to create jobs, the result
will be higher foreign borrowing, which would jeopar-
dize Jakarta's standing with its foreign creditors and
further reduce incentives to cut costs and improve
efficiency.
Jakarta's alternative is to bolster its labor-intensive
export-promotion efforts. In the long run, we believe
this would enable the government to ease the unem-
ployment situation despite falling oil prices. This
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option, however, entails costs. It would reduce the
government's ability to control the economy and
threaten inefficient domestic firms with stiff new
competition from both domestic and foreign investors.
It might also fuel protectionist pressures in industrial
country markets and pit Indonesian exporters against
firms in the more advanced developing countries that
have already gained access to these markets.
The Threat to Stability
Whatever course Jakarta chooses, economic growth
and political stability will continue to be hampered by
soft world oil prices. This year the combination of
weak export performance and budget austerity might
produce a contraction of the economy to 4 to 5
percent
Beyond that, we calculate that, at best, economic
growth will average no more than 3 to 4 percent for
the remainder of the decade. This will coincide with a
period when the labor force is growing by 3 to 4
percent per year (adding 2 million new workers to the
labor force annually). The combination will result in
sharp increases in an already severe unemployment-
underemployment problem because the country needs
to grow 5 to 6 percent annually to absorb these new
workers
Although the rising tide of unemployed does
not directly pose a serious threat to the Soeharto
government, we believe it could exacerbate existing
ethnic tensions and threaten widespread social unrest.
Indeed, anti-Chinese rioting in Central and East Java
in the late 1970s and the. Tanjung Priok riots in
Jakarta in 1984 are vivid reminders of the social and
economic pressures that underlie the normally placid
veneer of Indonesian life. In the past, Jakarta reacted
to rioting and public tensions by using oil revenues to
remedy the symptoms, rather than the causes, of
Indonesia's social ills. The regime must now come to
grips with the shortcomings of an economic policy
that has done little to lay the groundwork for sus-
tained economic growth and relieve the plight of the
country's poor.
Despite the critical period Indonesia is entering, we
believe the Soeharto government calculates that now
is not the time for a major change in development
policy. For one thing, the regime almost certainly is
confident that its control of political institutions-
including political parties, organized labor, and major
religious groups-together with the reliability of the
military and security forces, would allow it to cope
with any outbreaks of domestic unrest. Consequently,
we judge that the government is willing to ride out low
oil prices and slower economic growth with financial
austerity because it probably perceives the risk of
widespread disturbances as low. The government has
indicated during the past year that it will not tolerate
dissent of any kind, according to the US Embassy=
Since mid-1985, Jakarta has tried and
sentenced a leading dissident and a former Army
general (among others) to 10 years in prison, has
executed a Communist Party official who had been
under sentence of death since the early 1970s, and has
begun in some cases
restricting, militant speakers in the mosques.
We believe the regime is also wary of a fundamental
and possibly unsettling change in development strate-
gy as it prepares for parliamentary elections in 1987
and a presidential election in 1988. The prospects for
a shift in strategy after this period of intensified
political activity also appear unlikely, in our judg-
ment, as long as Soeharto retains the presidency,
Even if basic reforms in economic policy were en-
acted, tangible results would take several years to
materialize. Instead, we believe that Soeharto will
intensify efforts to expand the country's nonoil export
markets wherever possible even though, in our judg-
ment, this is an option compromised by stiff competi-
tion from other exporters in Southeast Asia and by
' Soeharto's health is good and he gives no indication of stepping
down. We expect him to seek and obtain another five-year term in
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incipient trade protectionism in the industrial coun-
tries. Nevertheless, in the past year Indonesia has
made direct overtures to expand economic relations
with East European countries, reestablished direct
trade ties to China after a 20-year freeze
Indicators To Watch
As dim as we judge the prospects for a dramatic shift
in development policy, we cannot rule out the possibil-
ity entirely. We believe that the path the government
probably would take in such a case would include
measures to deregulate the economy on a broader
scale than it has undertaken so far. We believe this
would be a sign that Jakarta was beginning to think
more seriously about how to adjust to lower oil prices,
the rising foreign debt, and slower economic growth.
Indications of such a shift would include:
? Efforts to encourage private domestic and foreign
investment to make up for shortfalls in public
investment funds. Nonoil exports, for example, have
suffered from domestic protectionist measures-
primarily nontariff barriers such as import licensing
and quota restrictions-designed to increase local
content in selected manufactures and protect un-
competitive upstream industries.
? Efforts to remove redtape, bureaucratic inefficien-
cy, and corruption that have squeezed investment
opportunities. Despite public pronouncements to the
contrary, we anticipate little near-term improve-
ment because of latent government misgivings about
an independent private sector, ethnic resentment of
local Chinese business activities, and nationalistic
objections to foreign involvement in domestic eco-
nomic activity.
? Efforts to encourage financial reform. Despite at-
tempts at reform, Indonesia's financial markets
remain poorly developed-concentrating on short-
term deposits and lending, rather than the long-term
financing required for major development projects,
Bond and stock
markets, which could mobilize long-term financing
for investment, have yet to take off. Moreover,
Indonesia is vulnerable to capital flight and
must offer higher inter-
est rates to keep deposits, thereby making bank
credit expensive.
Implications for the United States
Indonesia's uncertain economic prospects bear direct-
ly on bilateral economic relations with the United
States in at least two important areas, international
finance and foreign investment. US commercial banks
would be directly effected in the unlikely event that
Jakarta seeks to reschedule its foreign debt. At the
end of 1985, these banks held roughly $3.3 billion of
Indonesia's medium- and long-term foreign debt-
equal to 25 percent of that country's foreign bank
US firms, we believe, are interested in playing a
larger investment role in Indonesia if and when the
government moves ahead to improve the investment
climate, and, in particular, the prospects for investing
in nonoil activities. Until now, US direct investment
has been concentrated almost exclusively in develop-
ing the oil industry. Nevertheless, there are other
industries that the Indonesians want to develop to
diversify the economy. One faction in the government,
for example, is pushing for a high-technology industri-
al development strategy that would encourage metal-
working industries and the development of manufac-
turing capabilities in such industries as aircraft, ships,
vehicles, and machinery. Part of the problem, howev-
er, is Jakarta's schizophrenic attitude toward foreign
investment. Despite Jakarta's oft-repeated claims of
openness to foreign investment, many Indonesians
(including high-level government officials) remain op-
posed to foreign investment
Until its domestic policy dilemma is resolved,
Indonesia, in our judgment, will remain overly depen-
dent on foreign borrowings from US and other com-
mercial creditors, although foreign investment could
ease this dependence somewhat and reduce the possi-
bility of a debt crisis later in the decade.
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Appendix
Predicting the Probability of
Debt Rescheduling
Balance-of-payments and debt analysts employ a vari-
ety of indicators to evaluate a country's overall repay-
ment ability. Traditionally, such assessments involved
two important technical steps: the selection of risk
indicators and the choice of a formula to grade or
rank economic strengths and weaknesses. Among the
most frequently used indicators are the ratio of total
debt service payments to exports of goods and services
(the debt service ratio) and the ratio of international
reserves to imports of goods and services (the liquidity
ratio). Unfortunately, criticisms have been leveled at
the arbitrary nature of the use of these indicators,
particularly the presumption that any one indicator is
capable of capturing the elements underlying poten-
tial balance-of-payments problems.
To deal with these criticisms, statistical techniques
have been developed to make the process more objec-
tive. We believe one such technique, logit analysis, is
particularly useful in objectively quantifying the like-
lihood that Indonesia will seek multilateral debt relief
arising from declines in oil prices and export revenues.
Logit analysis is an econometric technique that gener-
ates a function of economic and other variables
believed to influence countries in their decisions to
restructure their foreign debt. The advantage of logit
analysis over nonstatistical methods, in our view, is
that the sample data, rather than subjective judg-
ment, determines the statistical weights (that is, the
relative importance) that are attached to each
indicator.
The model explicitly considers the demand for re-
scheduling by the borrower as well as the risks and
financing constraints faced by the creditor. The ex-
planatory variables found to be statistically signifi-
cant include:
? The growth of real per capita income.
? The ratio of net official and net unofficial interna-
tional reserves to imports of goods and services-the
liquidity ratio.
? The ratio of total external debt less international
reserves to exports of goods and services.
? A history of previous rescheduling episodes.
Figure 5
Logit Index of Debt Rescheduling
Brazil ? Debt rescheduling
? Chile
o Indonesia
Mexico
Percent
? The ratio of amortization payments to total external
debt.
? The ratio of trade surpluses of oil-exporting coun-
tries to global imports as a proxy for the supply of
credit.
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We estimated values for these variables using data for
19 countries covering the period 1979-84; 12 resched-
uling and 95 nonrescheduling cases. The appendix
figure illustrates the output of the estimated model by
portraying the probabilities of debt rescheduling for
four countries during 1979-84.
Interpreting these values requires comparing them to
some baseline value, because the higher the logit
value the greater the likelihood that a rescheduling
will occur. Many financial analysts use 50 percent as
the baseline value, which suggests that estimates
approaching this figure warrant serious concern. Ac-
cording to this baseline, the predicted probabilities
provide a relatively favorable evaluation of Indone-
sia's financial health.
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