Two Cheers For Jakarta.

A brutally realistic assessment.

Indonesia political distractions of recent times have left the country around a year behind its neighbors in the cyclical economic-recovery process. However, events have panned out as well as one might have hoped over the past six months. Most Indonesians, plus the international donor community, seem intent on giving President Abdurrahman Wahid (also known as Gus Dur) a honeymoon period of support. Some are complaining that Wahid's erratic leadership style is unsuited to running a government of 200 million people. Compared to the previous regime's policy paralysis, however, almost anything is an improvement. Besides, most people tend to learn on the job. Ongoing cabinet reshuffles and purges should also provide a clearer picture of who is running the show and the direction of policy. At least that is the bullish case.

The current situation provides some breathing space and reduced political risk, assuming separatist guerrillas in the province of Aceh and other simmering separatist groups are controlled. Unlike East Timor, the world appears to have no interest in supporting Aceh's separatist movement -- aside from Libya's Colonel Ghaddafi and a few other unsavory characters. Containing the tension will provide immense relief to many of Indonesia's neighbors -- most notably China -- who also have smouldering pockets of independence fighters. And assuming the U.S. economy holds together, broader global and regional themes suggest a strong economic upturn for Indonesia over the next 6 to 12 months.

Although Jakarta is starting from a worse position than all of its peers, the first shoots of recovery are appearing from the rubble. Imports and exports (oil and non-oil) are on the rise, supermarkets and shopping malls are seeing better business, and traffic jams have returned to the capital. Moreover, some progress has been made in addressing the black hole that is the banking sector, though one should remember that the starting point of an NPL ratio of 60 percent of GDP is around four times the level of the Mexico bust in 1995.

The Indonesian Bank Restructuring Agency (IBRA) has now purchased around $30 billion of the worst NPLs out of an estimated $70 billion in the system. It also holds another $30 billion or so of additional assets in the form of banks and companies under its direct control. The main progress has been made with five institutions -- BCA, Mandiri, BII, Lippo and `New' Danamon (comprised of twelve nationalized banks) -- which control around three quarters of the deposit base of the system. Depending on who one asks, somewhere between 50 to 80 percent of their bad assets have been extracted from their books and replaced by government bonds. As such, they should be nearing the position to begin lending again should credit demand reemerge. This contrasts with Thailand where only the better assets have been "restructured" and the rump of unrehabilitable assets is likely to remain a major impediment to future credit creation.

None of this is perfect, of course. Indonesia has dropped from 250 banks to 165 today, arguably 160 too many. The majority of the 140 tiny private banks, which control only a quarter of the residual deposit base, qualify as existing in the realm of the "living dead" and could further debilitate the system unless cut out. In addition, IBRA has so far extracted only the worst "Category V" loans, but it remains debatable whether many of the "Category IV" or "III" loans are of better quality and can return to health. Finally, IBRA remains deeply resistant to haircuts since it fears being seen to favor some debtors over others in an uncertain and dangerous game of elite interest bargaining, where few officials want to be seen taking sides or responsibility for difficult decisions that may come back to them. Indeed, the reluctance to accept haircuts is undermining other debt restructuring initiatives, since IBRA is often directly or indirectly a recalcitrant majority or minority creditor. Although none of this will matter over the next year, the cost will ultimately be an unpayable fiscal burden further down the line. In effect, it is a grand case of robbing Dewi and Mahdi to pay Bambang and Tommy (not to mention Hideo, Fritz and Pierre).

Why should this not matter too much over the next year? On the corporate side, higher turnover combined with a lack of investment should improve internal cash flow in many sectors, minimizing the need to source capital from financial intermediaries. As for the budget, this will be fundable due to a combination of three factors: a cyclical and oil-related revenue pick-up; lower interest expenditures following the fall in rates over the last year; and, most importantly, because the Consultative Group on Indonesia donors will get their check books out to cover any shortfall. Too many strategic military and political interests are at stake in keeping the 13,000-island archipelago stable and intact as a single entity.

However, another source of funding talked about may disappoint -- the return of a chunk of the estimated $80 billion of local capital (much of it Chinese-owned) that fled the country in recent years. Many commentators have argued the cash will start to flow back in size with the political situation stabilizing. This may happen with small entrepreneurs who now feel confident enough to re-engage in the domestic economy. But the majority of this stash is owned by individuals or families who have much to fear from the calls for revenge and retribution.

On one level, their fears are justified. Indonesia was not quite Nigeria -- at least the Indonesian kleptocracy tended to confine its rent-seeking behavior to the domestic market and kept most of its funds at home. But almost everyone in the elite had their fingers in the till in one form or another, and they now want to ask the poorest parts of society to pick up the bill. Just how corrupt Indonesia has always been is a matter of opinion. One local contact of mine who has had postings in Russia and Eastern Europe reckons the Indonesians could run rings around their post Soviet-bloc counterparts. Still, this never stopped the foreigners and the international agencies from pouring money in during the good times....

The long-term hope for Indonesia involves yesterday's Robber Barons deciding to become tomorrow's pillars of society and supporting the institutional overhaul required to return Indonesia to a sustainable development path. But this will not happen if these actors are afraid their assets will be fully confiscated, or worse, they themselves will be strung from the nearest lamppost.

Distasteful as it may seem, therefore, some form of amnesty in return for a modicum of financial reparations based around a South African-style Truth and Reconciliation Committee may be the best way forward. Indeed, a number of countries in the region could benefit from such an approach. Of course, certain characters -- mostly members of the Suharto family -- are probably beyond the pale. For others, however, full disclosure of past actions in return for a clean slate could both help attract money back to the country and the fiscal coffers as well as provide a clearer picture of the true extent of the carnage, making repairs that much easier. A similar mechanism for examining and dealing with past military atrocities could also help appease an increasingly jumpy armed forces.

A full accounting is not unimportant, moreover. Presently, the numbers just do not add up; and so if the impasse is not broken, the country will face another payments crisis several years down the line. Consider that domestic public debt is already at 110 percent of GDP and is likely to grow further should IBRA continue to nationalize the financial system at par. Moreover, public foreign debt is a whopping 100 percent of GDP, or an even scarier 180 percent if one assumes that the IMF's indefensible dictate to the state to guarantee private sector liabilities holds. Overnight, the country has become Brazil-plus. There is no way around it: Indonesia needs debt forgiveness -- domestic and external -- or it will remain in deep trouble going forward.

How to achieve this? On the foreign side, the IMF and the other agencies have a wonderful opportunity to practice their newfound zeal (in words anyway) of bailing in private sector creditors. A 50 percent haircut across the board on private and public sector debt securitized against future oil, gas, and other natural resource revenues would be a good start. This in itself creates other moral hazards, of course, and private sector Indonesian debtors would have to share some of the burden in the form of debt-equity swaps, nationalization, and so on if they are to benefit from the scheme. However, it would be a huge improvement on the Frankfurt club and Miyazawa plan farces. This later mechanism is especially pernicious and, in my view, is primarily a conduit for extending Japan's convoy system to the international arena, that is, it allows Indonesia to repay loans to Japanese banks. For around $12 billion, Japan could afford to redenominate outstanding loans to Japanese banks into local currency at June 1997 exchange rates. Indeed, the $30 billion Miyazawa package could have sorted the whole region out this way.

As for domestic debt, Indonesia has to eventually abrogate some of its government liabilities either through a direct Argentinean-style write-down or via an inflation tax. Given that the latter is now expressly proscribed by the new Bank Indonesia Act, which prevents the central bank from underwriting government debt, some form of restructuring is required. Otherwise, a huge proportion of future government expenditures will be diverted from much needed development expenditures in order to pay for the bad loans racked up by incompetent and unaccountable bankers. Some form of selective restructuring that would result in a de facto default on government debt held by certain types of larger institutions may be one way forward.

Unfortunately, many of the above initiatives are not even on the drawing board or are only being tentatively discussed. This may not matter too much in the near-term, as the expected cyclical pick-up should generate its own internal financing and cash flow. As sure as night turns to day, however, the fiscal constraint will bite, and as is too often the case, the parts of society least able to foot the bill will be asked to pay again.

Simon Ogus, Economic Consultant for the Asia-Pacific region for Donaldson, Lufkin & Jenrette, is Founder and Chairman of the Dismal Science Group Limited, Hong Kong.