Around the mid-1960s Indonesia's economic situation had reached an alarmingly bad condition. The economy suffered from the chaotic political course set out by president Soekarno, Indonesia's first president. Economic matters took a back seat for Soekarno who had spent a lifetime fighting in the political arena. Some examples of his policies that negatively affected the economy were the cutting off of links with the West (thus isolating Indonesia from the world economy and barring the country from receiving much needed foreign aid money) and deficit spending through the printing of money, resulting in an out-of-hand hyperinflation. But after Suharto took over from Soekarno in the mid-1960s economic policies underwent a radical change of course.
Indonesia's economic development during Suharto's New Order government can be divided into three periods, each characterized by specific policies aimed at specific economic contexts. These periods are:
• Economic recovery (1966-1973)
• Rapid economic growth and increasing government intervention (1974-1982)
• Export-led growth and deregulation (1983-1996)
Economic Recovery (1966-1973)
The essential mission of Suharto's New Order government was economic development; the first step being the reintegration of Indonesia back into the world economy by rejoining the International Monetary Fund (IMF), the United Nations (UN) and the World Bank in the second half of the 1960s. This started up the flow of badly needed financial assistance and foreign aid from the Western countries and Japan into Indonesia. Hostilities with Malaysia (Soekarno's confrontation politics) were stopped as well. The second step was curtailing the hyperinflation. Suharto turned to a group of economic technocrats (most of whom were educated in the USA) to come up with a plan for economic recovery. In the late 1960s price stability had been established through a policy which prohibited domestic financing in the form of domestic debt or money creation. Subsequently a free market mechanism was restored by decontrol measures, followed by the implementation of the Foreign Investment Law (1967) and Domestic Investment Law (1968). These laws contained attractive incentives for investors to invest in the country resulting in double-digit economic growth in 1968.
Rapid Economic Growth and Increasing Government Intervention (1974-1982)
Until 1982 rapid annual economic growth of at least five percent was maintained. Not unimportant, Indonesia benefited significantly from two oil booms that emerged in the 1970s. The first one began in 1973/1974 when the Organization of Petroleum-Exporting Countries (OPEC), of which Indonesia was a member, cut its exports drastically, causing a major rise in oil prices. The second oil boom took place in 1978/1979 when the Iranian revolution disrupted oil production causing another massive price increase. Due to these oil booms the New Order's export earnings as well as government revenues rose steeply. This enabled the public sector to play a greater role in the economy by undertaking substantial public investments in regional development, social development, infrastructure and through the establishment of large-scale (basic) industries, among which were the import-substitution industries. Capital goods and raw materials could be imported due to increased foreign exchange earnings, giving rise to a developing manufacturing sector. However, major riots broke out during a visit of Japan's prime minister in 1974 because of the perceived over-presence of foreign investment projects in the country. Indonesians were frustrated that the indigenous people seemed to be excluded from the fruits of the economy. The government was shocked because of this violent event (that became known as the Malari affair) and introduced more restrictive measures on foreign investment and replacing it with preferential policies favouring the indigenous businessmen. Increased government revenue brought on by the first oil boom meant that the government was no longer dependent on foreign investments, therefore an interventionist approach could be started.
Export-Led Growth and Deregulation (1983-1996)
In the early 1980s the price of oil began to fall again and currency realignments in 1985 aggravated Indonesia's foreign debt. The government had to take new measures to restore macroeconomic stability. The rupiah was devalued in 1983 to ease the rising current account deficit, a new tax law was introduced to increase revenue from non-oil taxes and bank deregulation measures were taken (credit ceilings on interest rates were lifted and banks were allowed to set these rates freely). Moreover, the economy had to be redirected from an economy dependent on oil to an economy containing a competitive private sector oriented towards export markets. This implied new deregulation measures to improve the investment climate for private investors. When the oil price fell again in the mid-1980s, the government increased measures to accompany export-led growth (such as the exemption of import duties and another devaluation of the rupiah). These policy changes (in combination with deregulation packages in the 1990s) also affected foreign investments in Indonesia. Especially export-oriented foreign investments were welcomed.
Another sector that was affected by far-reaching deregulation measures was the Indonesian financial sector. New private banks were allowed to be established, existing banks could open up branches across the country and foreign banks were free to operate outside Jakarta. These financial reforms would later turn out to be a problem that intensified the crisis in Indonesia in the late 1990s. But in the meantime, however, these rigorous measures had a positive impact on Indonesia's economy. Manufactured exports began to become the engine of the Indonesian economy. Between 1988 and 1991 Indonesia's Gross Domestic Product grew by an average of nine percent per year, slowing down to an average of 'just' 7.3 percent during the period of 1991 to 1994 and rising again in the following two years.
Problems at the Horizon
The text above paints a rather positive picture of the economy during the New Order. Indeed the economy grew rapidly and with it came improvements in its social development (although at a slower pace). In particular the reduction in absolute poverty was a remarkable achievement of the government. In the mid-1960s over half of the Indonesian population lived below the poverty line but by 1996 this number had been reduced to 11 percent of the total Indonesian population. However, the style of rule of the New Order government entailed a couple of dangerous consequences that would come to a climax during the Asian Financial Crisis in the late 1990s.
First of all the essence of the New Order's government's nature. It was a military-backed authoritarian regime that did not respect human rights. During its course for over three decades the government seemed to become more and more out of tune with its citizens. Politics and economics were basically taken away from the public and kept within a small elite around Suharto. But as Indonesians became more educated due to increasing social developments, its educated circles naturally wanted to let their voices heard and participate in politics as well as the economy. Suharto, however, was not in favour of this and reacted by placing more restrictions on Indonesian society (for example the confinement of student demonstrations to university campuses only). This political standstill caused a lot of frustration in a large part of Indonesia's population.
Secondly - and related to the previous paragraph - the New Order was based on a system of nepotism and corruption in which a small group around Suharto benefited tremendously from the economic fruits of the country. This group consisted mainly of ethnic Chinese business partners (fueling ethnic sentiments) and was later joined by Suharto's children. Promises of openness and transparency of government policy were never complied with. Moreover, corruption prevents an economy from functioning effectively. This would be exposed during the Asian Crisis that emerged in 1997.
Thirdly - again related to the previous paragraphs - the financial system had begun to run out of control after the deregulation measures in the banking sector in the late 1980s. With little restrictions to open banks and branches it became more and more difficult to monitor the money flows within the Indonesian banking system. A serious lack of financial data, a weak regulatory and legal framework and illegal money flows all contributed to the fact that Indonesia would be hit hardest during the Asian Financial Crisis.
Read a detailed account about the Asian Financial Crisis.