Democracy Lab

Indonesia: Stop Chopping, Start Learning

Indonesia has been coasting on its natural wealth for too long. Now it's time to start investing in the country's people.

The Indonesian economy, which for so long had been an also-ran in the Asian growth derby, is getting good press these days. There's no mystery why. While much of the world is struggling in the aftermath of the global financial meltdown, Indonesia continues to post annual economic growth rates in excess of six per cent. What's more, public debt is now less than 25 percent of GDP -- down from 96 percent in 1999. And it is still falling relative to GDP: The budget deficit is only about two percent of GDP, among the lowest in the region.

It should have been no surprise when the McKinsey Global Institute, part of the eponymous management consulting company, concluded that Indonesia "is larger, more stable and more advanced than many companies and investors around the world realize." Rapid economic growth will likely be sustained until 2030 at minimum, MGI concluded, when the economy will be the seventh largest in the world.

But lurking behind such optimistic scenarios is a troubling reality. Indonesia has (literally) burned through much of its generous endowment of natural resources in getting this far, and is on a path to consume much of the rest. To continue to grow rapidly for the decades needed to build a sustainable high-income economy, Indonesia will need to sharply increase investment in fixed assets, knowledge and skills and/or sharply cut natural resource depletion.

Resource economists use a simple rule of thumb -- known as Hartwick Rule's after the Canadian economist who first came up with it -- to assess the sustainability of non-renewable resource use. The "economic rents" -- that is, the market value minus the cost of production -- generated in the exploitation of those resources should be offset by an equal (or larger) investment in physical and human capital.

The logic is straightforward. Natural resources in the ground are like money in the bank. If you simply withdraw money for consumption, it's gone for good. But if you invest the cash, there's a good chance it will yield returns that offset depletion of the nestegg. Investment can take the form of physical capital -- factories, roads, telecom systems and the like -- or human capital (education, research, etc.)

The Hartwick Rule has gained currency over the years as countries that have consumed the proceeds from natural resource exploitation have gone from boom to bust. The most notorious case is the Pacific island of Nauru, which was made of phosphate rock (used for fertilizer) that was strip-mined into wasteland in a generation. The World Bank now similarly estimates "genuine saving," defined as gross domestic saving minus depreciation and depletion of natural resources, for a wide range of countries.

Unfortunately, the World Bank lacked data to include deforestation -- Indonesia is home to huge tracts of valuable hard woods -- in its estimate. So, to arrive at a ballpark figure for Indonesia's genuine savings, I have used the conservative consensus estimate that Indonesia is currently losing about 600,000 hectares (1.5 million acres) per year in primary forests. Further, I have very conservatively assumed that the market value lost with each hectare is $30,000 (using the value of the dollar in 2000 to control for inflation).

As the graph below shows, Indonesia's gross savings rate is about 30 percent of national income -- a very respectable figure close to that of Thailand, Vietnam and the Philippines. The problem is that Indonesia is depleting natural resources at such a high rate that genuine savings amounts to just seven percent of national income. (By the way, Malaysia, another resource-rich country, is not doing much better, despite a reported gross saving rate of more than 35 percent.)

Indonesia Savings Graph  

It's worth noting that there is a somewhat reassuring trend in Indonesia's genuine saving rate. Gross domestic saving has risen sharply in recent years. This gain, combined with a decrease in energy depletion as oil reserves are used up, has pushed Indonesia's genuine saving into positive territory after many years of negative net saving. But the trend is vulnerable to reversal as Indonesia ramps up natural gas production and world commodity prices come down from their recent peaks.

Natural resource depletion also puts Indonesia's currently healthy government finances at risk. Oil and gas sales generate more than one-fifth of total government revenue, reducing pressure on politicians to develop more sustainable sources of income. Indonesians were not forced to pay much in taxes during the authoritarian Suharto years, which, in a sense, was a wasted opportunity since well-entrenched military-backed governments have the luxury of promulgating unpopular policies. Today, Indonesia is a democracy, and the reluctance of successive administrations to pare down wasteful fuel subsidies from the budget or to raise taxes suggests how difficult it is for a country long accustomed to easing its fiscal problems by pumping oil to pull up its socks.

This much is clear, however: Indonesia cannot get rich by eating its seed corn. This doesn't mean, however, that Indonesia must necessarily slow the exploitation of all natural resources. On one hand, the gains from protecting primary rainforests are particularly large given the massive social and political costs of forest destruction. On the other, mineral depletion still makes up a relatively small proportion of dissaving. What is clear is that the country must break the habit of financing consumption growth from natural resource rents, and that economic growth in the long run depends on sustained increases in investment in physical and human capital. The immediate goal then, should be containment of deforestation plus the phase-out of fuel subsidies -- in particular, fuel subsidies to the affluent -- and to create incentives for investment in productive capacity and skills.

Indonesia is hardly the only resource-rich emerging market country that is using its natural wealth in unsustainable ways. Saudi Arabia's genuine savings rate was negative in 2008 (the latest year for which figures are available) and is probably in worse shape today. Failed states in Africa -- think of Congo or Equitorial Guinea -- save almost nothing and produce almost nothing other fast-depleting minerals. But Indonesia is an especially important case, a large country that in many ways appears ready for rapid development. It would be very sad, indeed, if a legacy of resource profligacy slowed it down.   

Photo by SUTANTA ADITYA/AFP/Getty Images


Don't Engage Kim Jong Un -- Bankrupt Him

It's time to play hardball with North Korea's new leader.

Barack Obama and Sen. John McCain clearly agree on one thing: Bill Richardson and Eric Schmidt should not have visited Pyongyang this week. A State Department spokeswoman said last week that the timing, coming just four weeks after a rocket launch that violated three U.N. Security Council Resolutions, was not helpful. McCain tweeted that Richardson and Schmidt were "useful idiots." Richardson is among the staunchest advocates of appeasing North Korea after billions of dollars in U.S. and South Korean aid have bought little more than attacks, provocations, threats, and broken promises to disarm.

This could be the Hermit Kingdom's year of living provocatively. North Korea's dynastic ruler, Kim Jong Un, who turned 29 (or possibly 30) on Jan. 8, is very likely to act aggressively toward his neighbors in 2013 to burnish his leadership credentials at home and to deal with the new South Korean president-elect, Park Geun Hye, from a position of strength. New administrations in Washington, Beijing, Tokyo, Seoul, and Moscow will seek to avoid foreign crises as they consolidate their power domestically, creating a less confrontational and more appeasement-prone neighborhood in 2013.

The provocations have already begun. North Korea's rocket launch in December was calculated to intimidate the U.S. and South Korean governments: The rocket was theoretically capable of reaching the United States, and North Korea carried out the test on Dec. 12, seven days before South Korea's presidential election. Pyongyang's announcements that it might postpone the test due to technical difficulties in the days leading up to the launch appear to have caught Obama's Asia team off guard.

So far, the Obama administration's response to the North Korean test has been to return to the United Nations to ask for more Security Council sanctions, but the test already violated three Security Council resolutions that China won't enforce. Despite prior U.N. condemnations, North Korea followed its 2006 and 2009 missile tests with nuclear tests three and two months later, respectively. Beijing's new leadership will likely keep funding the Kim regime and letting it smuggle missile parts and sanctioned luxury goods through Chinese ports. (China claims to "resolutely" oppose North Korea's nuclear programs, but probably sees its behavior as useful in keeping the United States distracted and Korea divided, while it pursues territorial ambitions elsewhere in the Pacific.) If the pattern holds, North Korea's next nuclear test could occur around the time of the late Kim Jong Il's Feb. 16 birthday, or president-elect Park's Feb. 25 inauguration.

This does not mean, however, that Obama lacks non-military options. Pyongyang has vulnerabilities that Washington can exploit without resorting to force. Although the sectors of the North Korean economy that feed most of its people collapsed in the 1990s, the privileged elite in Pyongyang continue to live in luxury. The regime can afford to maintain its nuclear and missile programs, and relatively luxurious lifestyles for its ruling class, thanks to a "palace economy" financed through a global network of shady bankers and businesspeople. This palace economy not only sustains the North's military and internal security forces; it finances a system of class privilege that stands in appalling contrast to the deprivation imposed on North Korea's lower classes. The central role of this shadow economy in regime preservation makes the Kim dynasty particularly vulnerable to tools designed to combat international money laundering.

If Obama wants to offer a credible deterrent to North Korea's provocations, he should shift his focus away from the U.N. and ask the Treasury Department to sanction the banks and businesses that finance the Kim regime's palace economy. Because these instruments of pressure can be applied in concert with U.S. allies and without U.N. approval, China's power to obstruct them is substantially diminished. There is a precedent for this: In September 2005, Treasury declared the Macau-based Banco Delta Asia a "primary concern" for North Korean money laundering, and a haven for drug dealing and counterfeiting proceeds. Treasury's action only directly affected $25 million in deposits, but its indirect effects were far greater, causing a run on Banco Delta and damming one of North Korea's main streams of illicit revenue.

The North Koreans sought new banks elsewhere, but Treasury followed them. Senior Treasury officials visited banks throughout Asia, warned their officers of the risks of doing business with North Korea, and stated that it was "almost impossible to distinguish between the North's legitimate and illegitimate dealings." Multiple banks quickly cut their ties with the North. Stephen Haggard and Marcus Noland, economists who study North Korea, estimated that Treasury sanctions and Japan's crackdown on remittances to North Korea badly hurt Pyongyang's capacity to launder the proceeds of its illicit activities, which accounted for approximately half of the North's income in the 1990s and still made up a significant share of Pyongyang's total earnings in 2005. As a result, the regime was forced to sell off some of its gold reserves. By January 2006, Kim Jong Il was so desperate that he reportedly told Chinese President Hu Jintao that he feared that the sanctions would cause his regime to collapse.

Rather than use this pressure to demand North Korea disarm, the Bush administration in 2007 pressured Treasury to cease its enforcement of the law, signed an agreement in which North Korean merely promised to disarm, and returned the money to North Korea. Predictably, North Korea stalled and withdrew from the agreement. A few months after Obama's inauguration, North Korea tested another nuclear weapon.

In the second Obama administration, the Treasury Department should resume its enforcement and declare the North Korean government to be what's formally known as a Primary Money Laundering Concern, a legal term for entities that fail to implement adequate safeguards against money laundering. This action would allow Treasury to require U.S. banks to take precautionary "special measures" limiting the access of foreign persons, banks, entities, and even entire governments linked to the sanctioned entity to the U.S. financial system. In addition to applying these measures to North Korean entities, Treasury could also apply them to the third-country business partners that finance the palace economy. (Treasury had taken similar actions against the governments of Nauru and Ukraine, forcing both to implement significant anti-money laundering controls, and comprehensive sanctions are proving to be effective at pressuring Iran.) Obama should also ask allied governments to apply corresponding measures to third-country banks, businesses, and nationals doing business with North Korea. This would almost instantly disconnect Pyongyang from the international financial system, and have a far more debilitating effect than the sanctions of 2005.

Obama could amplify this pressure through the more aggressive use of Executive Orders 13,382 and 13,551 to freeze the assets of Chinese and third-country entities suspected of helping North Korea's proliferation activities. And suspicions that North Korea continues to engage in money laundering and other illicit activities could be a basis for criminal prosecutions. These measures would deter banks and companies whose activities undermine international sanctions and abet the Kim regime.

Destabilizing North Korea raises legitimate concerns about loose nuclear weapons, but those worries are outweighed by the proliferation risk of a stable North Korean regime -- a regime whose state agencies already use the resources, organization, and privileges of sovereignty to proliferate nuclear technology to notorious sponsors of terrorism, such as Syria and Iran. The solutions we have tried for years have failed. Sustained financial pressure would give U.S. diplomats what they have always lacked -- a credible threat of devastating consequences if North Korea refuses to disarm. This pressure must continue until the regime caves, in one sense of the word or the other. North Korea and China will not negotiate in good faith until they conclude that the United States really is prepared to induce the collapse of North Korea's palace economy -- and with it, if necessary, the Kim regime.

KNS/AFP/Getty Images