POST CRISIS:WHY WE NEED TO REFORMSTATE OWNED ENTERPRISE

IN INDONESIA

Mochammad Hadi PratomoNational Graduate Institute for Policy Studies

Tokyo2007

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A. Theoretical Framework

Theories about why reformation of state owned enterprise (SOE) might be beneficial to an economy are basically laid on public choice assumption that government consists of normal, imperfect and self-interested individuals. These theories fit with the condition in developing countries. Empirical studies indicate that state-owned enterprises have been used to finance politically infeasible projects or provide subsidies to particular elite groups (Kikeri, Nellis, and Shirley 1992)1.

Less competition, greater political intervention and weaker good corporate governance are strong theoretical arguments against state ownership and empirical studies showed that reformation thru privatization of SOE improved performances even in poor regulatory environments (for example Megginson (2001) and Clarke (2003)).

Generally there are three objectives of privatization2:1. Enhancing efficiency of asset use through the creation of private ownership2. Reducing budgetary burdens3. Privatization as a socio-political goal (especially in transition economy countries)

B. Overview of Indonesia’s SOE post monetary crisis

State owned enterprises (SOE) historically have long played significance role in Indonesia's economy, accounts for around 70% of GNP by the early 1980s and partly due to impact of monetary crisis, is for around 40% in 2001 (World Bank 2001). In general, according to Law No. 9/1969, there are four main types of SOEs:

(i) perusahaan jawatan (perjan), government departmental agencies established to fulfill public service obligations (PSO), do not have separate legal existence, their employees are civil servants3.

(ii) perusahaan umum (perum), were established as separate legal entities under a special purpose government regulation, their capital is owned by the government and not divided into shares,

(iii) perusahaan persero (persero) is a limited liability company, and at least 51 percent of its sharesare owned directly by the government;

(iv) other types of SOEs can be established under special laws; (i.e. Pertamina).

In 1999, total assets of the 113 SOEs4 (book value) were $39 billion (Rp391 trillion), equivalent to 42 percent of the total assets of Indonesia’s producing sector and SOEs employed 655,000 persons on a full-time basis. However, including their subsidiaries and the contract and subcontract workers, the total workforce of SOEs was close to 1.4 million, or 18 percent of the workforce in large and medium enterprises. The contribution of SOEs to the country's GDP was estimated at 12 percent, indicating a relatively low efficiency in the use of labor and assets (ADB 1999). In 2000, total asset of whole SOE’s were $ 86 billion (Rp 861 trillion) but only generating $ 1.3 billion (Rp 13.34 trillion) as net profit with Return on Asset (ROA) rate 1.55%. This table below illustrate the range of ROA rate of Indonesia’s SOE during of 1997-2001 which only about 1.55%-3.25%.5

Table 1.SOE performance from profitablity measurement view (millions rupiah)

1 See Table 2 in attachment for detailed empirical studies for relationship between privatization and performance/efficiencies.2 Lecture Note No. 8 Dec 7, 2006.3 This perjan type is no longer existed in Indonesia nowadays.4 See Table 3 in attachment for Indonesia SOE classifications.5 See Table 4.1-4. in attachment for detailed financial condition of SOE during 1997-2003

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Year Total Asset Net Profit ROA1997 425,971,407 7,310,092 1.72%1998 437,756,394 14,226,201 3.25%1999 607,022,845 14,271,101 2.35%2000 861,520,494 13,336,582 1.55%2001 845,186,151 20,186,469 2.39%

Source: SOE Performance Development report – Dirjen Pembinaan BUMN, 2001

Within this context, the implementation of a rigorous system of corporate governance for SOEs is critical and is viewed to lead the reforms for the overall corporate sector 6. Successful corporate restructuring, especially debt restructuring of SOEs will provide models to accelerate related efforts in the private sector. For example, privatizations through stock exchange listing will promote capital market development. Furthermore, SOE reforms will also establish the best practices in managing labor redundancies.

Second critical reason why SOE need to be immediately privatized is based on the budget deficit occurred post monetary crisis. The economic slowdown in country during the first half of 2001 has imposed severe contraction on the budget. It is critical to deal with the issue of the massive public debt up to $127 billion. About half of the debt is owed to foreign creditors, including $20 billion to multilateral institutions, $43 billion to bilateral creditors, and $2.4 billion to foreign banks and bondholders. Interest payments alone currently absorb 31 percent of budgetary revenues, reducing the availability of resources to address social development priorities (ADB 2001). To overcome this condition, it is becomes critical that government should launching an aggressive privatization of SOEs to mobilize the required resources for debt repayments7. In view of the important role of privatizations for future budgets, the Government should place a high priority on SOE reform.

C. Problems to be encountered

Though established to serve both economic and social goals, SOEs have been an inefficient supplier of both public and private services and goods. Inefficiencies arose because of indiscriminate subsidization and protection of SOEs without due regard for economic viability and competitiveness. Moreover, SOEs have been exploited for the benefit of individuals and associated interests, accompanied by growing corruption and collusion or utter fraud.

SOE performance in Indonesia has been affected by weak corporate governance such as government interference in daily operations, poor internal controls, loopholes in accounting practices, and weak auditing standards and practices. Lax supervision and insufficient accountability have distorted performance incentives for supervisors and staff. Inadequate enforcement of commercial laws and regulations, market protection, and administered prices has contributed to ineffective SOE management.

Generally there are five issues of SOEs condition considered to be urgently restored. There are corporate governance, burden as PSO facilitator, poor financial performance, excessive labor and endemic corruption8.

1. Corporate Governance

6 Ministry of SOE has been evaluating and mapping condition for SOE privatization. See chart 1. in attachment for illustration of privatization.7 See Table 5 in attachment for steps might be occurred during privatization.8 For comprehensive proposal action, see Table 6. which containing matrix of action.

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ProblemsOverall, Indonesia's corporate and commercial system is not working under a strong

system of corporate governance. Existing rules and regulations have not been rigorously enforced, in private companies or SOEs. External mechanisms and enforcement through banks and capital markets, which are a feature of corporate discipline in other countries, have not functioned well. As a result, the following mechanisms common in other countries are either unavailable or only nominally available:

(i) comprehensive disclosure in corporate reporting, independent directors or commissioners safeguarding the rights of minority shareholders, and transparency in financial dealings with related parties;

(ii) sound legal system, with a good record of enforcement by an impartial judiciary9, and;

(iii) external discipline exercised by the financial sector10.

Scenario of improvement(i) Apart from enforcement of general standards, corporate governance should

establish proper ownership and control structures for SOEs that align risk borne by owners with management control to improve their financial and operational performance. For the internal governance to be effective, the Government should enforce thorough accountability and transparency, and provide autonomy and adequate incentives to supervisors, managers, and employees to meet business objectives.

(ii) Contractual arrangements between the shareholder, BOC and BOD, where they exist, are not uniform or transparent, and do not establish clear accountability. Consequently, it is difficult to assess the performance of BOCs and BODs. Since Ministry of Finance (MOF) represents the Government as the sole shareholder in SOEs, it should have regular and unlimited access to the relevant financial, operational, and strategic information of SOEs. In particular with the following provisions on corporate governance: appointment of independent commissioners in proportion to the number of

shares held by non-controlling shareholders; establishment of an audit committee comprising at least three members, one of

whom is an independent commissioner and the others independent professionals in accounting and/or finance recruited from outside the company; and

appointment of a corporate secretary, who must be a member of the BOD or a corporate officer specifically appointed to this function.

2. Public Service Obligations (PSO)

ProblemsGovernment has proved in many cases using SOEs to provide public goods and services

to public (transportation services, education and health care services). Currently a large segment of SOEs are entrusted with PSOs, such as obligations to provide for reforestation services in Sumatra and Kalimantan, supply vaccines at below cost prices to the public health system, maintain unprofitable air and shipping services, and operate remote air and sea ports. Furthermore political interference in set-up pricing of such services has resulted in inefficient delivery mechanisms for SOEs. This practice diverts SOEs from profitable activities, lowers overall returns, and weakens the growth potential of SOEs.

Scenario of improvement

9 breaches in corporate governance, even if detected, were not pursued for judicial resolution.10 i.e. for well-connected individuals and conglomerates, capital was always available before the crisis.

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PSOs should be contracted out separately and transparently to ensure full cost recovery by their effort to provide such services. To increase transparency and achieve full management accountability for commercial success, the Government needs to separate PSOs from commercial activities in SOEs in preparation for their eventual privatization. Without such separation, SOEs cannot achieve a return on capital sufficient to attract private investors.

3. Corporate Restructuring

ProblemsDuring the 1990s, SOEs were unable to generate sufficient profit to finance expansion.

Consequently, they ended up borrowing excessively or establishing joint ventures. Many SOEs became high-cost producers of products and services as they, under political pressure, participated in nonviable ventures or served the Government's social and employment goals. For example, many SOEs were forced to take shareholding in toll road projects designed by the national toll road operator. SOE performance was affected by lack of clarity about objectives, weak incentive structures, and soft budget constraints that enabled financing of their losses and capital outlay.

Scenario of improvement

Financial restructuring is needed in SOEs with unsustainably high levels of debt. The methods of financial restructuring of SOEs can involve:

(i) selling subsidiaries and/or surplus assets, (ii) equity injection from third parties, (iii) mergers of SOEs, and (iv) debt restructuring

Operational restructuring is needed in SOEs which has poor operational performance, even before the crisis. Operational restructuring can involve changes in

(i) management information systems; (ii) production and logistics planning; (iii) distribution network; (iv) marketing strategy; (v) workforce number and composition; and (vi) organizational structure.

CommentsFinancial restructuring will take place within a well-defined legal framework, enforced

through newly established institutional arrangements. In cases of liquidated SOEs, commercial courts, which constitute a part of the general court system, have the mandate of hearing bankruptcy and also commercial cases relating to arbitration, competition, and security issues

The alternative for financial restructuring is by restructuring viable SOEs with the objective of eventual privatization involving overseas portfolio and strategic investors. However, where restructuring involves the injection of fresh capital, it has to be left to future private owners.

4. Labor Redundancies

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ProblemsSOEs have about 10-20 percent of excess labor and the costs for labor redundancies

across SOEs is about 10 percent of their current staff (about $170 million) (ADB 2001).

Scenario of improvementSOEs need to reduce employment by 10 to 20 percent. Support for SOEs to finance

labor retrenchment and training will improve their prospects for successful restructuring and privatization. Therefore to minimize threat of dissatisfaction from SOE employees because of liquidation, privatization, and restructuring of SOEs, government should formulate explicit labor rationalization policy which covering:

(i) severance payments and gratuity based on length of service; (ii) early retirement; (iii) assistance with re-employment, training or retraining of employees and financing of

entrepreneurial initiatives; and (iv) employee rights in assessing claims against pension funds.

5. Corruption, Collusion, and Nepotism (KKN)

ProblemsKKN is attributable to lack of transparency, availability of privileges linked to

connections, and inadequate action against malpractices. KKN in SOEs is mainly concentrated in procurement.

Scenario of improvementGovernment via Ministry of SOE should guarantee that SOEs follow procurement

procedures as prescribed by these public sector regulations. These actions will (i) require compliance of SOEs with transparent and fair procurement practices with

full accountability; (ii) commence random audits of procurement in SOEs, publish a summary of findings

to public, and initiate measures to recover losses and prosecute wrongdoer; and (iii) founded on the results of the random audits, hence improve the detailed

procedures for the procurement by SOEs.

D. Concluding comments

In general by implementing these agenda hopefully SOEs will:(i) achieved the establishment of sound policy, legal, regulatory, and operational

frameworks for improving corporate governance;(ii) improved awareness of international norms and practices in corporate and financial

governance; (iii) promoted transparency and disclosure by stipulating the regular submission of

financial, operational, and procurement audits that include financial outcomes, board compensation, and compliance with legislation (labor, environmental, and procurement);

In particular, subsequent tasks still remaining following these scenarios is government should be focused on initiatives to improve macroeconomic growth environment condition in commercial sector by addressing key issues relating to competitiveness.

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References

Asia Development Bank (November 2001). Report and Recommendation of the President to the Board of Directors on the Proposed Loan to the Republic of Indonesia for the State-Owned Enterprise Governance and Privatization. RRP: INO 32517

Clarke, G.R.G. Cull, R. & Shirley, M (November 2003). Empirical Studies of Bank Privatization: An Overview

International Monetary Fund (2006). Indonesia: Report on Observance of Standards and Codes: Fiscal Transparency Module. IMF Country Report No. 06/330

Kikeri, S. & Nellis, J (2004). An Assessment of Privatization. The World Bank Research Observer. Vol 19(1): 87-118.

Kikeri, Sunita; John Nellis and Mary M. Shirley. Privatization: the Lessons from Experience. World Bank Publication # 11104, 1992

Megginson, William L., Jeffry M. Netter, 2002. From State to Market: A Survey of Empirical Studies on Privatization. Journal of Economic Literature, 39 (2): 355-356

Ministry of SOE Indonesia (2002). SOE Masterplan 2002-2006Ministry of SOE Indonesia (2006). Hasil privatisasi BUMN 1995-2005Patriadi, P. (2003). Studi Banding Kebijakan Privatisasi BUMN di Beberapa Negara.

Kajian Ekonomi dan Keuangan. Vol. 7(4),55-103.Republic of Indonesia. Law No. 9/1969Tanaka, H (2006). Lecture Notes No 8 & 9: Structural Reform and Privatization.

GRIPS, Tokyo World Bank (January 2001). Indonesia: Private Sector Development Strategy. Report

No. 21581-IND

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