October 4, 2011

• External events have dominated economic developments for Indonesia over the past quarter. The outlook for global growth has weakened and the Euro zone sovereign debt crisis has intensified. International risk aversion and market volatility have increased. Indonesia’s domestic economic performance has continued to be strong but, as in other countries in the region, its financial markets have not been immune from the impact of turbulence in international financial markets.
  
  
• Looking forward, this edition of the Indonesia Economic Quarterly examines how will the deterioration, and increased uncertainty, in the global economic environment impact Indonesia over the near-term?
  
  
• Indonesia enters this period of heightened uncertainty in a relatively strong position. Indonesia’s domestic drivers of growth, its solid fiscal position, accumulation of reserves, and strengthened financial sector performance make it relatively well-placed to deal with external shocks.
  
  
• GDP growth has been robust and inflation has declined. GDP growth in Q2 2011 was unchanged from Q1 at 6.5 percent year-on-year, driven by private consumption and investment. With food price inflation declining, headline inflation has moved down to 4.8 percent in August 2011. Notwithstanding the adverse impact of previous higher food prices on net food consumers, the strength of the domestic economy contributed to a decline in the national poverty rate to 12.5 percent in March 2011 from 13.3 percent a year earlier.
  
  
• Indonesia’s strong fiscal position contrast with the worsening situation of many countries since 2008. Indonesia’s government debt to GDP ratio is low, at around 25 percent, and on a downward trajectory. The deficit is projected to fall from 2.1 percent of GDP in the 2011 revised Budget to 1.5 percent in the Government’s 2012 proposed Budget. Energy subsidy spending remains vulnerable to higher oil prices, as seen in the increase in the deficit in the 2011 revised Budget. However, core expenditures, particularly infrastructure, are constrained by disbursement problems.
  
  
• International developments are, however, likely to affect Indonesia’s near-term growth prospects through their impact on external demand, commodity prices and capital flows. Indonesia’s direct trade exposure to the US and EU is limited but indirect effects on Indonesia through other trading partners could be more significant. Falls in global commodity prices and lower demand from major emerging economies, particularly China, present another transmission channel which could affect Indonesia’s exports and also its fiscal balances, domestic investment, consumption and inflation.
  
  
• On the financial side, Indonesia’s exposure to portfolio outflows has increased in parallel with the build-up of reserves over recent years. The volumes and direction of portfolio flows, and the cost of financing for the Government and Indonesian firms, are sensitive to international investor sentiment but also to the domestic economic situation and policy environment.
  
  
• The World Bank’s baseline growth projection for 2011 is 6.4 percent and for 2012 is 6.3 percent. The 2012 growth projection has been downgraded from the June IEQ due to a weaker outlook for major trading partner growth and commodity prices, but is still at a solid level. Under more pessimistic scenarios for the global outlook, particularly if current troubles precipitate a more broad-based slowdown, lower domestic growth could be seen.
  
  
• Indonesia’s solid macro fundamentals and existing policies are some of the strongest defenses to weather current and future turbulence. However, further strengthening of the authorities’ ability to address risks would be beneficial. The current volatility makes it even more important to avoid policy uncertainty while at the same time putting in place anticipatory policy responses.
  
  
• Continued progress on key structural reforms can also help both to boost investor confidence and to enhance Indonesia’s medium-term growth outlook. This edition of the Indonesia Economic Quarterly features a number of pieces on such medium-term issues. The first discusses how the framework for Public Private Partnerships in Indonesia and their implementation could be strengthened so as to help the Government meet its targets for private sector infrastructure investment. The second piece examines the central role of sub-national governments in public service delivery in areas such as infrastructure, health and education and the current constraints on the efficiency of sub-national spending. The final piece looks at the core development challenge of how to make growth more inclusive, as well as higher, focusing on an analysis of the province of East Java.