Following dramatic fiscal and monetary policy adjustments in late 2005, growth in the Indonesian economy slowed significantly in the first half of 2006, although recovery was underway by the third quarter.  This year’s economic slowdown was also aggravated by new natural disasters. Another devastating earthquake struck Yogyakarta and Central Java, there was another tsunami in West Java and now a mud volcano in East Java, all adding to the toll of destroyed property and displaced people.  On the plus side, reconstruction and recovery from the December 2004 tsunami in Aceh and Nias is now well underway, with thousands of houses built and more under construction. The key economic challenge involves turning the cyclical upturn in the latter part of this year into sustained longer term growth while addressing poverty and improving disaster preparedness and response. Resources on Indonesia | | Country Overviews | |
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Last year’s cuts in fuel subsidies (leading to administered fuel price increases totaling a cumulative 143 percent) effectively transferred an estimated US$10 billion dollars of disposable income from consumers to regional and central governments. This shock, combined with interest rate increases of 400 bps between August and December, brought Indonesian growth to below 5 percent in H1 2006. These adjustments were designed to put Indonesian fiscal and monetary policy on solid footing and were well received in financial markets. The exchange rate strengthened, the stock market increased over 40 percent in the year to this September. Rating upgrades were announced by Moody’s from B2 to B1 in May and by S&P from B+ to BB- in July. Monetary policy was eased and policy interest rates lowered from May, as inflation also began receding. The short-run negative impacts of last year’s policy tightening on the economy in 2006 were partly offset by growth in exports, which reached 17.2 percent in the first eight months of this year. There was also a pick up in government spending (up 38 percent over relatively low levels in 2005), including cash transfers of approximately US$30 per household per quarter to over 19 million households (which transferred approximately US$2 billion in disposable income back to the poor over the course of the year). Increases in central spending were offset to some extent by an accumulation of fiscal reserves at regional governments, which were unable to program or spend increased resource transfers to regions that averaged over 50 percent. The slowdown in private consumption in the first half was milder than expected (growth of 3.0 percent) although investment contracted (-0.1 percent) as businesses appeared to take a wait-and-see attitude. Higher exports and slowing growth in imports raised the current account balance to US$4.6 billion in the first half, up from US$0.8 billion a year earlier. Exports clearly benefited from higher international commodity prices with agriculture commodities up 12 percent and mining 46 percent, although industrial exports lagged).  Unfortunately, despite increased spending on poverty programs, poverty rose from 16 percent to 17.75 percent between 2005 and 2006. While the government’s Unconditional Cash Transfer program more than compensated the poor for higher fuel prices, a ban on rice imports contributed to a 30 percent rise in domestic rice prices by the time of the poverty survey in 2006. As the poor spend close to a quarter of their income on rice, poverty rose. In response the government reopened rice imports, allowing in some 210,000 tons, which helped stabilize domestic rice prices. The higher current account surplus and balance on the capital account 25 allowed Bank Indonesia to add substantial international reserves, which reached US$41 billion in September, despite prepayments of almost US$8 billion to the IMF. Reserves had fallen to a low of US$30 billion in September 2005. In October, as the impact of last year’s fuel price increase was removed from year-on-year comparisons, inflation fell to 6.3 percent, down from 17.1 percent at year end 2005. Annual inflation in 2006 is now expected to come in below Bank Indonesia’s target of 7-9 percent. As inflation and inflation expectations have fallen the Central Bank has reduced interest rates by two percentage points from a high of 12.75 percent, with single digits (or close to) expected by year end. The central government budget deficit is estimated to be around 1 percent of GDP, which will reduce the government debt to GDP ratio to less than 40 percent by year end.  Recent data is beginning to confirm a sharp upturn in growth. By August/September most real indicators (cars, motorcycles, cement, etc.) were turning sharply upward. Import of capital goods, which had turned down, reflecting low investment, began to recover in the third quarter. August saw the highest single month’s capital imports since September 1997 (US$855 million). The government recognizes the need to reinforce this improving macroeconomic position with investment climate reforms. Three key policy packages are being implemented: Investment climate reforms are divided into five categories: (i) general investment policies; (ii) customs; (iii) tax; (iv) labor; and (v) small and medium enterprises. Among the many measures included are completion of an investment law with new regulations designed to increase transparency and reduce red tape; cuts in corporate and personal income tax rates; business friendly revisions to tax administration; and improved procedures in customs. Infrastructure includes: (i) establishing an effective framework for policy, regulation, and new institutions; (ii) sector specific reforms; (iii) facilitating increased local government participation in infrastructure; and (iv) improved project preparation. One of the key framework measures has been the creation of a Risk Management Unit at the Ministry of Finance which can offer guarantees to private sector infrastructure providers on behalf of the Government, and specific budget allocations for the contingent liabilities taken on. The financial reform package was formulated with three broad objectives: (i) increasing access to finance; (ii) reducing the cost of finance; and (iii) diversifying the financial sector and reducing its vulnerability to shocks. This latest package has provisions that allow State Banks to provision and write down bad debts and begins the long sought after clean-up of the insurance sector among other things. Each of these packages includes important reform measures but there have been implementation problems in some areas. Measures have sometimes slipped or been dropped and the quality of the reforms enacted has not been consistent. Revisions to Labor Law 13/2003 designed to foster increased employment met a negative reaction from organized labor and were put on hold, although there is now discussion of changes to improve severance provisions. The investment law is on this year’s Parliamentary agenda but implementing decrees needed to improve transparency and reduce red tape are awaiting final enactment; the submission of business friendly tax measures was held up in Parliament and are now expected to take effect in 2008. Lack of capacity has slowed the development of model infrastructure projects. Both fiscal and monetary polices are now supportive of higher growth. Bank Indonesia should have room for further easing into 2007 as inflation continues to fall. This should spur demand for corporate investment and recovery in consumer durables. Both central and regional governments are increasing spending and have fiscal space to expand public investment into 2007 and beyond. The current policy momentum will increase investment and bring the economy to into the 6 percent growth range by early 2007 and growth for the year as a whole should be 6 to 6.5 percent. The key economic challenge is to maintain this growth through 2007 and into the longer term. This will require investment and financial sector reforms that trigger business confidence and ramping up public and private infrastructure spending to overcome binding energy and transport constraints.
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