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James J. Przystup and John T. Dori 1
Produced by
The Asian Studies Center

The Heritage Foundation
214 Massachusetts Ave., N.E.
Washington, D.C.
(202) 546-4400
No. 1184 May 28, 1998

Protests against President Suharto's decades-long authoritarian rule in Indonesia began relatively peacefully but degenerated into violence and looting last week. Massive student-led demonstrations, reports of dissension among the ruling elite, and reports of splits within the army over support for the embattled president led Suharto to resign on May 20. But Indonesia's political and economic crisis is far from over, and difficult decisions lie ahead for the new government under Suharto's hand-picked successor, B. J. Habibie.

Three agreements for assistance from the International Monetary Fund (IMF) since 1997 have failed to stop Indonesia's economic and political turmoil. Moreover, in the current unstable environment, additional IMF funding will do little to help Indonesia regain stability or promote future economic growth. What Indonesia needs is serious economic and political reform. The United States can play a key role in helping the new government implement such reform by:

Urging restraint on the part of all parties involved and peaceful resolution of the immediate crisis;

Promoting political reforms that will lead to open democratic elections and economic reforms based on a commitment to end crony capitalism; and

Rebuilding close ties with Indonesia's military once the present crisis is resolved.

Indonesia's immediate problems began in July 1997 when it was caught up in the East Asian economic crisis. In Indonesia, as in Thailand and South Korea, international skepticism about the fundamental health of the economy rapidly eroded the confidence of investors and currency traders in the value of Indonesia's currency, the rupiah. Unable to maintain the value of the rupiah, Indonesia abolished its crawling peg exchange rate system, under which the rupiah was depreciated 7 percent a year against the U.S. dollar, and allowed the rupiah to float freely in international markets--a move long advocated by the IMF. This action revealed the weakness in the currency and undermined investor confidence, leading to a free-fall in the value of the rupiah.

Indonesia requested IMF assistance in October 1997, and the IMF announced a plan to provide up to $40 billion in financial assistance. In exchange for this assistance, Indonesia agreed to close its failed banks, reduce its barriers to trade, deregulate several controlled commodities, open its domestic markets, postpone several large infrastructure projects, and undertake additional economic reforms. Suharto accepted the assistance, but subsequently made little effort to implement the reforms. The rupiah continued to fall in the face of international fears that Suharto would not fulfill the IMF commitments and that the IMF would suspend funding.

The IMF agreed in January 1998 to restore assistance to Indonesia to stem the continued fall of the rupiah. But without good-faith efforts by Suharto to implement the IMF's planned reforms, the rupiah continued its slide. This resulted in the third IMF package, concluded last April. The last agreement outlined plans to restructure Indonesia's banking system, eliminate restrictions on foreign ownership, modernize and strengthen bankruptcy laws, rationalize monetary policy, develop a procedure for repaying foreign debt, and attract investment by selling ownership in state-owned companies. Suharto at last began to comply with IMF demands; in early May, he removed government subsidies on certain commodities. Angered by the skyrocketing price hikes, Indonesians took to the streets and Suharto's rule imploded.

The collapse of the rupiah--falling below 17,000 to the dollar in January compared with a pre-crisis level of around 2,300 to the dollar and about 10,500 on May 27--has had several devastating effects on the Indonesian economy. First, it imposed an enormous burden on average Indonesians; almost overnight, everyday staples and foodstuffs became so expensive that they were out of reach for many people. Second, the prices of raw materials and other inputs for business and manufacturing also skyrocketed. In an attempt to stabilize the rupiah and attract international investment, Suharto followed the IMF's advice to raise interest rates. This resulted in a steep rise in the nominal cost of capital, which tightened the straitjacket on Indonesia's commerce and industry. Economic activity plunged and the entire economy essentially ground to a halt as unemployment soared.

Political and Economic Roots of Turmoil
Indonesia's economic problems are exacerbated by the lack of democratic political legitimacy. In 1966, Suharto came to power in a coup d'etat. He was returned to office seven times by a vote of the People's Consultative Assembly--a body that he basically selected and controlled. Before the 1997 economic crisis, Suharto's claim to legitimacy was buttressed by Indonesia's rapid economic growth, averaging over 6 percent per year and bringing with it modernization and the promise of Indonesia's becoming one of Asia's "tiger economies."

But Suharto's rule also brought with it a unique brand of nepotism, characterized by the awarding of monopolistic government concessions to his friends and relatives. The Suharto family took full advantage of this system and has amassed a fortune reportedly in the tens of billions of dollars. Although Indonesians may have been willing to tolerate cronyism and corruption, a controlled press, and a closed political system when times were good, they quickly withdrew their support for the president when their economic fortunes declined. What began in the fall and winter of 1997 as localized, sporadic demonstrations against rising food prices evolved by February 1998 into a nationwide campaign of peaceful, usually student-led demonstrations calling for Suharto's ouster and a more inclusive political system. Violent demonstrations and incidents of looting grew more frequent, however, as Indonesians saw little improvement in their economic condition.

Two developments in May fused the protest movements into a political critical mass. First, Suharto removed the government subsidy on fuel prices in accordance with IMF bailout plans to phase out such subsidies. The drastic price increase that followed sparked more demonstrations. Second, Suharto's security forces shot and killed six student demonstrators on May 12, causing the demonstrations to escalate into full-scale rioting and looting that left hundreds dead in just a matter of days.

Suharto's Role in Indonesia's Fall
Unlike the governments in Thailand and South Korea following IMF bailouts, Suharto did little or nothing to prepare his people for the difficult, austere times that lay ahead. After accepting an IMF bailout package that reached $43 billion, Suharto appeared more intent on evading its terms than honoring them. For example, he submitted a government budget with wildly optimistic assumptions about economic growth, government revenue, and the level of inflation. He selected a vice president and a cabinet comprised of economic nationalists, cronies, and family members with questionable professional qualifications. And he used subterfuge and economic sleight of hand to try to reconstitute monopoly enterprises owned by his family and friends that were designated for closure under the IMF agreement. These actions undermined Indonesia's credibility with the international financial community.

As the economic crisis deepened and the calls for political reform intensified, Suharto steadfastly resisted political reform, insisting that any change would have to wait until the end of his term in 2003. Even after the worst rioting since the mid-1960s resulted in the death of more than 500 Indonesians, Suharto's response was limited to a nebulous promise of a cabinet reshuffle. Ultimately, not until a mass protest occurred on May 20 did Suharto understand and accept that he must step down.

The United States has a significant stake in Indonesia, and therefore has a reason to be concerned by the upheaval taking place in that country. Economically, Indonesia is among America's top 25 trading partners. Indonesians purchased about $4 billion in U.S. exports in 1996, providing jobs for at least 60,000 American workers. Additionally, the United States invested almost $7.6 billion in Indonesia in 1996 (the most recent year for which figures are available).

Before the onset of the current economic turmoil, Indonesia was a regional economic powerhouse with an economy more than twice as large as Singapore's and almost 50 percent larger than Hong Kong's. Indonesia may resume its role as an economic dynamo once it implements the reforms necessary to revive political and economic stability, but its current economic plight has the potential to wreak havoc across Southeast Asia. Indonesia's 210 million people could generate waves of refugees, threatening the political stability in neighboring Malaysia and Singapore. Its large Muslim population--larger than that of all the Arab countries of the Middle East combined--has been a moderate Islamic force in the world. But Islamic fervor in Indonesia has grown over the past decade, encouraged by the economic crisis and a repressive political system. The rise of a virulent, anti-American form of Islamic fundamentalism in Indonesia could prevent democratic reforms from taking root and harm U.S. security interests by exacerbating tensions in the region.

In strategic terms, Indonesia is an important regional player whose fate has global implications. It sits astride sea lanes connecting the Indian and Pacific Oceans through which passes 40 percent of the world's shipping, including 80 percent of Japan's oil supply and 70 percent of South Korea's. An economically weak and politically unstable Indonesia could tempt China to become more involved there, especially considering Indonesia's historic mistreatment of the four million ethnic Chinese who live there.

It is in the best interests of both Indonesia and the United States to promote the development of democracy in Indonesia. Only through free and open democratic elections can a national consensus be reached that will support the kinds of fundamental but difficult reforms necessary for reviving Indonesia's economy. Suharto's authoritarian rule consistently short-circuited such a national consensus.

United States policy toward Indonesia should focus first on the peaceful resolution of Indonesia's internal political and economic problems. There could have been no lasting solution to the current crisis under President Suharto as long as he continued resisting the necessary reforms. His decision to step down opens the door to peaceful political and economic reform. Suharto, however, remains a politically powerful and well-connected figure--he retains, for example, the support of key elements of Indonesia's army. His support, therefore, will be important if reform is to be successful.

U.S. options in helping Indonesia are limited. For one thing, the United States lacks a strong alliance-based relationship with Indonesia of the sort it enjoys with the Philippines, South Korea, and Thailand, and no solution to Indonesia's current problems will be implemented without the support of the military. Throughout Indonesia's history, the military has played a special and important role, serving as a national unifying force for this culturally diverse and geographically broad archipelago. The military also controls unelected blocs of seats in the national parliament as well as provincial and district parliaments. Current or former military officers are found in key government positions.

For these reasons, a coherent U.S. approach to Indonesia during this unsettled period should include efforts to:

Urge restraint and the peaceful resolution of differences between all parties involved, including the government, the military, and the opposition. Violence will only make the evolution of democracy more difficult and inhibit the implementation of the necessary economic reforms.

Urge the new government to implement economic and political reforms. Indonesia must undergo fundamental change before it can stabilize its economy. Given the wariness of international investors, it is important that the new government give a clear indication of its commitment to political reform and the direction political change will take.

President Habibie, in addition to announcing his commitment to political reform, already has taken the welcome step of releasing two prominent political prisoners and promises to release more. Habibie also has called for new elections. Constitutional technicalities make this unlikely before next year, but the government should not use this as an excuse for not holding elections as quickly as possible. In addition, the government must allow real opposition parties to evolve; this is a prerequisite for the creation of a truly democratic legislature. A constitutional change, moreover, is needed to institutionalize an orderly presidential succession. Together, these steps can begin to lay the foundation for building a national consensus capable of supporting the challenging tasks of economic reform.

At the same time, Washington should urge the new government to demonstrate its commitment to structural reforms in the Indonesian economy. These reforms should include implementing measures for greater transparency and removing from the government all vestiges of the flagrant Suharto-style cronyism that caused Indonesia's economic collapse. Unlike Suharto, the government must be honest with the Indonesian people and prepare them for the difficult times ahead. The United States should promote the benefits of increased privatization, deregulation, and the liberalization of trade and investment, both of which would reassure the international business and financial community that Indonesia's economic prospects will improve.

Signal its intent to rebuild close ties with Indonesia's military once the present crisis is resolved. One way to rebuild ties would be to restore the U.S. International Military Education and Training Program (IMET). This program allows foreign military officers to study in the United States and witness firsthand the relationship between the U.S. military and civilian society. Suharto suspended participation in this program in June 1997 because of U.S. congressional criticisms of human rights abuses in East Timor and a State Department official's statement regarding Indonesia's tightly controlled political system. Both the Administration and Congress should make clear their interest in resuming this program.

Indonesia's fate holds serious consequences for East Asia, the United States, and international political and economic stability. In this time of uncertainty in Indonesia, the United States should encourage the new government to move quickly to implement political and economic reform. A peaceful, democratic, and economically prosperous Indonesia is in America's national interest. Washington's support for fundamental reform could produce handsome dividends for both Indonesians and Americans when Indonesia finally emerges from this crisis and resumes its place as a powerhouse in Southeast Asia.

--James J. Przystup is Director of The Asian Studies Center at The Heritage Foundation.

--John T. Dori is a Research Associate for The Asian Studies Center at The Heritage Foundation.

Brett D. Schaefer, Jay Kingham Fellow in International Regulatory Affairs at The Heritage Foundation, assisted in the preparation of this study.

(c) Copyright: The Heritage Foundation

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