MEMORANDUM ON INDONESIAN STABILIZATION

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T00875R001900010103-3
• Release Decision: RIPPUB
• Original Classification: U
• Document Page Count: 17
• Document Creation Date: December 19, 2016
• Document Release Date: May 23, 2006
• Sequence Number: 103
• Publication Date: January 9, 1974
• Content Type: MF

STAT
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 STAT
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DL is-ms to-7Lf
Memorandum on Indone Sian Stabilization
I
In response to your request of mid-December,
of this branch has put together the attached blind
memorandum on the inuoncsian stabilization experience. I STAT
believe, given my understanding of the use to which you
intend to put it, that this is about the appropriate scope
2. There has been considerable published research on
aspects of stabilization policies for Asian and other countries,
For
examn e, the matter o t positive interest rates on savings
has been dealt with in some detail by Robert Emery of the
Federal Reserve Bank, as have facets of the control of money
supply expansion in the private sector. The IMF Staff Papers
(available by subscription) have included numerous articles
on stabilization experience in pa::ticular countries throughout
the world, as have issues of the IMF's free publication
Finance and Development. You may want to check into these
items.
Chief
fstn 'TT-1 p
..1)~.I:.Ui X3.11
STAT
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STAT OEII/S /1;,C:
Orig & 1 - Addressee
1 - I)/OER
2 - Ch/D/S
1 - St/P
1 - St/cs
1 - SA/ER
2 - S/EC
ci Jauua1:y 1974 (5-51310)
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Stabilization in Post-Sukarno Indono!;ia: 1.96G-73
Introduction
1. Price inflation was a chronic problem in Sukarno's
Indonesia during most of the years from 1949, when Indonesia
achieved independence from the Dutch, until 1966. The rate
of inflation became mo:;t severe during the last years of the
Sukarno administration and the years immediately following
the accession to power of General -- now President -- Suharto
in 1966. Although the overall rate of inflation is difficult
to quantify in the years prior to 1965 because of insufficient
data, the prices of four major ::oasumer goods categories
(food, fuel, clothing, housing) at least doubled in each year
from 1962 to 1965. The aggregate consumer price index for
Indonesia as compiled by the IMF rose from a level. of 76 at
the beginning of 1966 (September 1966 = 100) to 206 in 1967
and 470 in 1968. By 1969, the policies instituted by the
Suharto government had begun to take effect anc3, inflation
began to level off.
2. Government policies during the Sukarno administration
were the principal fuel of inflation. A swollen national
budget, unsupported by any significant increases in real
domestic saving, reflected the expenses necessary for keeping
the various political factions in line; and this led to
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ce%travacniit? military cxpend.i.Lure; and the c:a:..y oxtolisi.on of
credit through an cxpandcd money supply Tho .level of govern-
ment deficits was also increased by the government policy of
attempting to keep the prices of curtain consumer commodities
(notah'y rice, fuel, and transportation service s) at a level
below what would have been reflected by their cost of production.
3. Complicating the attempts to control inflation in
Indonesia was the underdeveloped banking system and the
thinness of monetization. In a way, this facet of underdevelop-
ment was an implicit "strength" of the Sukarno era because it
meant that many of those living in rural areas were attuned
to staying out of the rapidly inflating monetary sector and
bartering for their needs.* Errors in national policy judgment,
however, could -- and did -- produce prompt, large changes in
prices; and the small base of financial savings provided no
substantial recourse for subsequent adjustments. When the
new government took the rein, it was faced with rationalizing
the financial and monetary system in such a way that more of
the nation's production and commerce was linked to monetary
transactions, a process that, given Indonesia's relative
backwardness, was necessarily difficult and slow.
* Of course, even the farmers suffered the effects of inflation
because it: r'=_quired sporadic efforts to reduce imports, and
this cut off some of the goods they would otherwise have been
able to buy.
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4. At the sank time, the ab iunco of real growth in the
countryside -- caused in part by thu disintegration of national
commerce under rapid inflation -- combined with increasing
public provision of underpriced serviccs to lure many more
people into the cities. Given the unattractiveness of
`
Indonesian politics for foreign investors and the paucity of
domestic saving, this urbanization only exacerbated the problem
of getting production growth in line with that of population.
In these circumstances, any sudden move away from consumer
subsidies and toward greater saving from income was inevitably
going to be a wrench that would cause considerable grumbling
against the reformers.
Key Prool.ems Facing the Reformers
5. The government formed under Suharto in 1966 was faced
with creating order out of the chaotic situation that had
contributed to its accession. The abortive Communist over-
throw attempt of 1965 -- in which an estimated 80,000 people
were killed -- was symptomatic of the deep-seated ills that had
long plagued Indonesia beneath the thin veneer of national
unity and mission created by the Sukarno administration. T'hs
rampant inflation that had moved out of control by the beginning
of 1966 and the pervasive lack of confidence exhibited by the
public toward the government made it imperative that the new
administration take prompt, strong measures if it were to
maintain its k-.se of support. To cope with the years of
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mismcunagemenL tinder Sukarno, the new government would have
to address itsc7.f to L?hese key economic imperatives:
1) restoring domestic confidence, pwrticularly in regard to
money and financial assets; 2) stimulating domestic production;
and 3) coping with the nation's position of international
bankruptcy.
6. The economic policies of the Sukarno era had driven
the nation's primitive monetary system into dysfunction. The
long-standing government deficits and the resulting ballooning
of the supply of money had discredited the rupiah both as an
instrument in trade and as a store of value. Moreover, as
speculation drove prices higher and higher, a serious liquidity
problem emerged for domestic producers and traders that the
banks could not handle. In this vicious circle, the first
priority of the new government was to gain control of the
budget and to reverse the deficit-spending policies of the
previous administration. This was only part of the p:.1blem,
however; of equal importance was the necessity to encourage
domestic saving to finance investment. In an inflationary
milieu such as had been created by 1966, the holding of monetary
assets was unthinkable because of the inevitability that their
value would fall. What saving did take place was in the form
of gold or other commodities expected to remain stable in value
or to depreciate at a rate somewhat below that at which the
purchasing power of the currency was falling.
'lI1UL~i\)~ 15 IL
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7. bagging clo.ncstic production -- partly a function of
the shortage of domestic investment in anything other thVtn
commodity hoards and real estate -- was a prime contributor
to inflation. With rapid growth in both population and labor
force, the acute shortage of arable land and productive invest-
ment on Java and advanced age of existing capital Aequipment
meant that the marginal productivity of labor had fallen to
close to zero in a wide range of activities. Equipment and
facilities originally installed by the Dutch had long since
deteriorated, and the foreign investment that might otherwise
have been available was kept out by the policies of the Sukarno
government and the high degree of insecurity faced by a poten-
tial. foreign investor. In agriculture and some other sectors,
unrealistic government-controlled prices had been key disin-
centives to investment and production increases. Thus, control
of government expansionary finance*, incentives for foreign
investors, inducements to domestic savers, and new price
policies stood out as key issues for policy decisions on
stimulating production.
8. Finally, the nation had backed itself into a corner
in its trading/debt position with the rest of the world and
by 1966 was essentially in a state of ir.ternational bankruptcy.
The investment problem would have been somewhat alleviated
had the government directed a significant part of its spending
to the public-sector placement of productive capital. This
did not happen, ho;:ever, and much of what the government spent
outside of civilian salaries, the military, and price-subsidi-
zation programs went to monuments and other unproductive
projects aimed at creating a facade of well-being.
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The massive foreign debt that the nation had accumulated
over the years meant that foreign exchange earning;; were
generally preempted from the purchase of much-recded capital
equipment. Rather than capital goods, most of Indonesia's
imports were foodstuffs and other consumer non-durables.
Many of these, of course, re`-'lected pure commodity speculation
by merchants and others long conditioned to inflationary
expectations. What would be needed here was some respite from
debt service and assurance of continued inflows of foreign
capital to help break into the spiral of deepening poverty
created by the years of Sukiirno-initiated mortgages on
Indonesia's future to support national union and political
adventurism.
The Indonesian Program
9. The stabilization program, instituted through measures
enacted in July and September 1966, was an ambitious, compre-
hensive clan that appeared to make good economic and social
sense. The economic aspects of the program centered around
the creation of a balanced budget, interest-rate reforms aimed
at increasing financial savings and investable funds, the
rescheduling of the foreign debt, and the introduction of a
flexible exchange regime that permitted more frequent and
realistic devaluation of the rupiah. In addition to these
measures, the program took cognizance of the necessity to
increase food production,'promote exports, and rehabilitate
public works and utilities as a vital part of the overall
attack on the inflationary problem.
6 -
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10. Budget planning for the fiscal your 1.967 provided
the first real test of tha cicterin.i.nat?ion of the new govern-
ment to counter inflation. Given the long history of
government deficits having fuelu,d inflation, fiscal/monetary
goals would be an important clue to stabilization success.
An encouraging feature, therefore, was the choic6 of a target
of only 65% for the increase in the money supply, as compared
to an actual increase of nearly 8006 between 1966 and 1967.
Real. government expenditures were projected to remain essen-
tially the same as in 1966, however, and most subsidy programs
were to remain intact.
11. Supporting the general thrust of the budgetary
measures were programs to create some order out of the chaos
of p::ivate-sector credit. The first priority in this field,
as in the public sector, went to stemming the flow of funds
into commodity speculation. At the same time, it was important
to effect 'some meaningful readjustment between banking system
interest rates for loans and the prevailing curb rates. This
necessitated a raising of loan interest rates; but, because
of the need to exercise some hold over the rate of e::pansion
of the money supply, it was not possible to raise rates on
savings at the same time. Accordingly, financial policies
instituted in October 1966 raised the interest rates on loans
from a range around 9 percent per annum to 6.5 to 9 per cent
Irt1I ttt-q
II ~t.
ter, i~.t... .LIJ
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per month and were supplemenLGd by aclmini.strative fees that
raised the effective cost to :1.4 percent per month. in
response to alleged credit needs and demands, interest rates
were subsequently reduced to the range of 3-5 percent per
month.
12. To encourage the inflow of foreign capital the
government used both monetary and legal measures. Institution
of a more flexible exchange marketing/control procedure per-
mitted effective devaluation of the rupiah during 1967 to
about 1/2 - 1/3 of the 1966 official exchange rates* and
allowed for easier subsequent adjustments to more accurately
reflect Indonesian price performance. This was an important
stimulant to exports and a clear sign of more hard'-headed
attitudes on the part of national leaders. Another important
encouragement to potential foreign investors was a law passed
in December 1966 that provided liberal incentives and assurances
to new investment from abroad**, a reversal from the previous
policy. With respect to other foreign interests, most non-Dutch,
foreign-owned industrial and trading properties that had been
nationalized in 1965 were to be returned to their owners
* Indonesia has hid a multiple-rate exchange system through-
out the period discussed in this paper.
** These included tax holidays (for corporation taxes, dividend
taxes on profits, and import duties on equipment and material
needed for the enterprise) , assurances on tenure, profit
remittances and repatriation of capital, as well as a number
of more specific incentives relating to the petroleum and
extractive industries.
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(a compurtsaLion agr.?cc,mcnL had a.1,ret y buen r:uuichcd for
nationalizuci Dutch 1, r:c,purtiu:~) .
13. The heavy burden of foreignn debt thid, Indonesia
had accumulated under. St..karno was also rescheduled. Debt
service payments to Western nations falling due, during 1.967
alone amounted to $250 million. Along with other' scheduled
payments on old debt, these wore spread out on a new time
table that extended to 1999. Additionally, the means to
facilitate new foreign aid was provided by the formation in
1966 of a consortium of nations known as the Inter-Governmental
Group for Aid to Indonesia (IGGI). The consortium closed a
foreign exchange gap estimated at $212 million in 1967 and
has since boon the principal vehicle for supplying Indonesia's
foreign exchange requirements.
Early Results
14. Many of the new measures required some recognition
time from domestic and foreign private interests or the working
out of sharp fundamental changes in the economy and society.
Under these circumstances, some lag in policy impact was
inevitable. Further, some of the most sensitive programs
were judged necessary when the government was not completely
sure of its strength at home and were only undertaken because
of pressure from creditors or foreign advisors. Inevitably,
there was some early heel-dragging, although the Indonesians
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gencra].ly :Oho-10c IUOVe cicL~ rnu.naL.iorr i.;i mal:in~J rui`w'm:~ tluui
tiny studonL of the tSu:caI'll o ura could r~.:i.,onal~l,y liavo e::peC L?ctd.
There was ample evidence that; the shorL inflaLionary spiral
duri,:g ' r;te 1.967 had been precipitated by a rice :.hor. Layc and
had been aggravated by the ur:;ua.1 panic and speculative buying.
The incident, however, was indicative of other fCctors, the
most important of which were that the government had failed
to limit the growth of money supply and had made severe mis-
calculations in its domestic rice program. Rather than the
targeted G51u increase, the money supply ended up growing by
over 1206 during fiscal year 1967.
1.5. In April 1968, the government made: its move to
terminate the policy of administering consumer commodity pri.ces.
The break was not complete, as the option was preserved to
protect the price of rice to consumers and to continue to
make wage payments for military members and government employees
in rice. The prices of petroleum products were raised sub-
stantially; and, immediately following this action, the prices
for tr-anspoication services and electricity rose. In addition,
realistic adjustments were made to the rice program. These
comprised measures to obtain accurate forecasts of yearly
production for planning purposes and to pay farmers a price
for paddy that took cognizance of current fertilizer prices
and provided sufficient incentive and the funds necessary to
purchase the inputs for production. The rice program has been
!~}tnl ~rnlr.r~
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i.nura