Hendri Tanjung, Islamabad | Opinion | Mon, March 19 2012, 8:39 AM
The Indonesian oil sector raises an interesting question about the strength of the overall economy: Is the nation’s growth led by oil? If so, we cannot say that the economy is healthy, since today Indonesia is a net oil importer. If the economy is unhealthy, then it is pressing that we find another strategy to sustain economic growth for the next generation.
To answer the question, economists usually employ models of causation, or mathematical equations that explain which variables are responsible for particular indicators. The most famous of these is the vector auto regression (VAR) model.
The problem of VAR is that different economists can arrive at different results using the same data. For instance, Dr Lau, an economist at the University Malaysia Sarawak finds that export growth leads to economic growth in Indonesia. Prof. Oskoee, an economist from the University of Wisconsin in the US, finds just the opposite, that economic growth has led to export growth in Indonesia.
To set the record straight, Prof. Zaman, an economist from the International Islamic University, Islamabad, Pakistan, in his research articles published by Munich Personal RePEc Archive, proposes natural experiments to ascertain causality — or in other words, by using the knowledge of history outside purely statistical data.
Why should history provide clarity where statistical data cannot? It is because causality in economics is not like causality in physics. Causality in physics is “asymmetric”.
Although the real causality is asymmetric, the existence of reaction functions distinguishes economics from physics.
Reaction function is a function specifying the choice of a strategic variable by one economic agent as a function of the choice of another agent. Hence, causality in economics can be “symmetric”.
The importance of causality in economics is to adopt economic policy. For example, if favorable exchange rates cause exports and exports cause economic growth, obviously favorable exchange rates are maintained as a policy of economic growth. To answer our question about Indonesia’s oil sector, we can use Zaman’s approach. He decides to use natural experiments by using the history of data. This first means determining which variable “moves first.”
If we see an increase in exports and then GDP rises, we reach one conclusion: export-led growth. If we see GDP rise prior to an increase in exports, we reach the other: growth-led exports. The same applies to the business cycle: If we see an increase in money demand and then output surges, we reach one conclusion (Monetary Business Cycle), and if we see output swell prior to an increase in money demand, we reach the other conclusion (Real Business Cycle).
If we see an increase in the oil sector then GDP rises, we may say that minerals lead economic growth. For this, we should look at the Indonesian economy in a chronological manner.
The path of development in Indonesia is different from that of Japan, Taiwan and South Korea. These three countries built up their foreign currency reserves from exports of agriculture products. With that money, they imported machinery for light industry, and then exported the products of that light industry. In Indonesia’s case, the nation had rich natural resources in oil, which led to the export of that commodity.
Prior to 1973, Indonesia earned money from oil exports, but not much. The opportunity of the oil price hike from US$2 to $12 per barrel came in 1973 and the government saw an increase in oil-exports revenues. The money was utilized for development in the fields of education, health, investment as well as to import manufactured goods.
The annual growth of Indonesian GDP fluctuated around 7 percent in the 30 years from 1967 to 1996. When the Asian financial crisis hit in 1997, GDP declined by 13.1 percent in 1997-98 from 4.7 percent growth a year earlier. The following years it would climb to 0.8 percent and 4.9 percent.
In August 1973, international crude oil prices began to rise steeply. The price jumped from $2 to $12 per barrel over the next six months. As a result, Indonesia’s net oil revenues jumped from $0.4 billion in 1973 to $2.6 billion in 1975 and Indonesian real economic growth reached 11.2 percent. (Real GDP is GDP at constant price, not current price to eliminate the effect of inflation). The reason for using real GDP is to eliminate the effect of inflation.
The windfall in oil revenues caused a surplus in the current account and increased budgetary revenues. In the four years from 1973 to 1977, government consumption rose at rates of 9.8 percent and private consumption grew at rates of 7 percent. The Consumer Price Index inflation averaged 24 percent.
In February 1975, the Pertamina crisis began. Pertamina was unable to repay or refinance its short-term debt. Total debt was over $10 billion. Between 1973 and 1975, Pertamina had taken on some $10 billion in foreign debt to expand its production plants. Bank Indonesia was compelled to pay Pertamina’s debts in March 1975. This caused real economic growth to plunge to 4.9 percent in 1975.
Oil prices experienced a second jump due to the chaos in Iran in 1978 and resulted in net oil revenues of $4.4 billion. The revenue from oil increased 11-fold in only 5 years. Then, this money was spent in improving the education and health sectors. This caused real economic growth to increase to 9.8 percent in 1980.
In the 1980s, Indonesia tried to solve a problem caused by a rapid decline in oil revenues. This caused real economic growth to decrease to 2.3 percent in 1982. The policy of macroeconomic balance was reinstated.
The policy is a combination of fiscal and external policies. This combination comprised cut backs on public expenditure for large projects, the introduction of major tax reform to increase non-oil tax revenues, and a national income tax and reform in property tax collection.
The rise in oil prices and other primary commodity prices in the 70s became a stimulus for economic growth in Indonesia. This increased state revenues from oil exports. Consequently, the government played an active role economically. Several major projects were established such as the Cilacap oil refinery, the Krakatau Steel mill and Asahan aluminum mill.
Once the oil boom ended in 1982, an Indonesian economist, Thee Kian Wie, states that the Indonesian government could not afford to pursue this import-substituting pattern of industrializing, as it now had to pursue a more outward-looking, export-promoting industrialization strategy.
For Indonesia, history shows that the oil sector has led to economic growth. If the oil price jumped, GDP growth increased, and when the oil price plunged, GDP growth fell along with it. With this finding, we might say that the growth of the Indonesian economy in the past depended on the oil sector too much.
So, in a situation where Indonesia is a net oil importer, we have to think seriously about what is to be done to maintain economic growth. The first step maybe is to diversify our exports. We should export more renewable resources like agriculture products.
The writer is a PhD economic scholar at the International Institute of Islamic Economics, Islamabad.
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