RECENT REPORTS

Indonesia: Recovery at a Crossroads

6 March 2001

Table of Contents :

1. Summary
2. Economic Recovery Gains Steam in 2000
3. Table 1 highlights several important trends in Indonesia's real economy
4. Rural Poverty Drops
5. Monetary Developments: Much Less Positive
6. 2001: Storm Clouds on the Horizon?
7. Challenges for 2001: Restoring the Integrity of Monetary Policy
8. Establishing the Conditions for a Sustained Increase in Business Investment
9. Longer-Term Key: Fiscal Sustainability

1. Summary.  

Indonesia's real GDP growth accelerated in 2000 to a 4.8 percent rate based on a 27-percent surge in exports and more measured increases in consumption and investment.  The manufacturing, construction, transportation and communications, and retail sectors all grew between 5 and 10 percent.  This growth meant Indonesia regained some of the large amount of ground lost between 1997 and 1999.  A sharp decline in rice prices and rising real wages led to declines in poverty rates, especially among the rural poor, which had surged in 1997-1998.  However, concerns about the sustainability of Indonesia's recovery mounted as 2000 drew to a close.  During the second half of 2000, the rupiah depreciated by 25 percent against the dollar and consumer price inflation accelerated, reaching 9.35 percent for the year.  During the same period, the Wahid Administration made a concerted effort to remove Bank Indonesia (BI) Governor Syahril Sabirin from office and circumscribe the independence of the bank.  Restoring the integrity of BI and monetary policy will be a key challenge for the Government of Indonesia (GOI) in 2001.  Also critical will be the GOI's ability to improve the environment for private investment, which grew in 2000 but remains far below pre-crisis levels.  Boosting investment will require improving security, reducing political instability, and more vigorously pursuing the banking sector, corporate, and judicial reforms spelled out in Indonesia's IMF-supported economic stabilization and restructuring program.  The GOI's performance on these issues will directly affect longer-term fiscal sustainability.  End Summary.

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2. Economic Recovery Gains Steam in 2000

Indonesia's Central Bureau of Statistics (BPS) released preliminary full year 2000 data on February 20 confirming that real GDP growth accelerated in 2000.  BPS reported that real GDP grew by 4.77 percent in 2000, significantly above the 0.2 percent rate recorded in 1999.  However, GDP growth in the fourth quarter of 2000 was a negative 0.72 percent, breaking a string of six consecutive quarters of positive GDP growth.  BPS attributes the fourth quarter decline to a seasonal 12.55 percent decrease in agricultural production compared to third-quarter levels.  Table 1 outlines Indonesia's 2000 real GDP performance by production and expenditure category:

Table 1:  Indonesian Real GDP, 2000 vs. 1999

A.  By Production Category

 B.  By Expenditure Category

Source:  Central Bureau of Statistics (BPS)

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3. Table 1 highlights several important trends in Indonesia's real economy:

 --On the production side, growth was more balanced than in 1999, with strong increases in manufacturing, retail, hotel, and restaurant sales, construction, and transportation and communication.  Other recently released data confirm growing strength in the manufacturing and retail sectors.  Automobile production increased almost 300 percent in 2000 from its 1999 levels to approximately 345,000 units, only slightly below its pre-crisis level.  Retail sales also posted a strong year-on-year increase, with one major retailer reporting a 20-percent increase in sales at existing stores.

 --Although household consumption and investment also increased in 2000, exports have become Indonesia's engine of growth.  In a very favorable external economic environment, non-oil and gas exports surged to USD 47.8 billion in 2000, a 23.2 percent increase in value over 1999.  At the same time, high oil prices led to a 44.5 percent increase in oil and gas exports to USD 14.1 billion.  (Note:  These figures are raw trade data and do not correspond directly to the contribution of the export sector to GDP per Table 1 above.)  Among manufactured goods (approximately 68 percent of total exports), exports of electronics and electrical equipment more than doubled from USD 4.8 billion in 1999 to USD 10.2 billion in 2000.  Exports of wood and paper products, textiles, and garments also grew strongly in 2000.

--The rate of growth of domestic household consumption increased to 3.63 percent in 2000 from 1.48 percent in 1999.  Quarterly data show that the rate of growth in consumption spending more than doubled in the second half of the year.  Nonetheless, as a result of strong export and improved investment performance, consumption as a share of GDP fell from 73.3 percent in 1999 to 67.2 percent in 2000.

--Gross fixed capital formation increased 17.9 percent in 2000, its first annual increase since the 1997-98 financial crisis.  Anecdotal data confirm the upswing in investment.  Domestic cement consumption, an indicator of construction activity, increased 13.1 percent in 2000 to 30.7 million tons (approximately 10 percent above its 1997 level).  In addition, BPS reported that imports of capital goods, an indicator of business investment, increased 40.5 percent in 2000 to USD 4.1 billion.

 --While a welcome development that shows some broadening of Indonesia's recovery, the investment rebound in 2000 comes after declines of 45.7 percent in 1998 and 20.8 percent in 1999.  Moreover, other measures of investment, such as commercial bank investment and working capital credits or investment approvals, increased only modestly in 2000 if at all.  BPS's investment figures also deviate significantly from private sector estimates.  For example, Citibank/Salomon Smith Barney reported that real gross fixed capital formation in Indonesia grew by an estimated 1.2 percent in 2000 after a 54 percent slide in 1998-99.

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4. Rural Poverty Drops

Although BPS figures for GDP growth do not directly measure poverty, 2000 was a better year for Indonesia's poor.  The key factor was a 20-percent decrease in the real price of rice in 2000 caused by a bumper domestic crop and historically low international rice prices.  These supply effects overwhelmed Government efforts to protect the income of non-subsistence rice farmers by raising the government-defended rice floor price and raising the rice import tariff.  Other staple food prices declined in real terms as well.  Economists have charted a direct correlation between rice prices and poverty in Indonesia: according to BPS surveys, the lowest quintile of Indonesia's expenditure groups spends 75 percent of its income on food and 40 percent on rice alone. 

The approximately 30-percent real depreciation of the rupiah since 1997 has also boosted rural incomes as the price of domestically produced non-tradable goods has decreased relative to the price of tradables.  Consumers have accordingly increased their purchase of domestically produced non-tradables, a development that has raised the incomes of many small-scale manufacturers.  Anecdotal evidence from rural areas suggests that Indonesia's massive informal economy has benefited as the weak rupiah has opened up export opportunities.

According to the World Bank, lower food prices and rising rural incomes have substantially reduced expenditure poverty rates in Indonesia from their peak of 27 percent in early 1999.  However, the Bank points out that a very large number of Indonesians remain vulnerable to poverty, particularly in the event of an adverse economic shock.

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5. Monetary Developments: Much Less Positive

 In contrast to the recovery in the real economy, monetary developments in 2000 were much less positive, particularly in the latter half of the year:

--From April through the end of December, the rupiah depreciated by approximately 25 percent against the dollar in nominal terms, and for the full year the currency lost almost 39 percent of its value against the dollar. 

--CPI inflation accelerated noticeably in the third and fourth quarters to 1.74 percent and 4.48 percent respectively, more than double the level in the first half of the year.  Year-on-year CPI inflation rate rose to 9.35 percent in 2000, significantly above the Government's projected 5-7 percent rate.

--Indonesia's risk premium (the spread between GOI Yankee bonds and U.S. Treasury rates) rose from less than 400 basis points in February 2000 to 675 basis points in late November.  During the same period, one and three-month forward swap rates on the rupiah more than doubled.

BI pushed up one-month interest rates on BI certificates (SBIs) from 11.13 percent in early June to 14.53 at the end of the year in an effort to reduce inflationary expectations and the demand for currency, and to support the rupiah.  Nonetheless, the year-on-year growth rate of base money rose as 2000 went on to an average of 21.4 percent for the October - December period, more than double the target rate set in Indonesia's IMF program.  Most analysts agreed that a corrosive mix of negative political developments and poor policy implementation by BI and the Government overwhelmed BI's tentative steps to tighten monetary policy.  Restoring the integrity of BI monetary policy in 2001 will be a key challenge (see below).

Preliminary balance of payments data for 2000 show a continuation of Indonesia's post-crisis pattern of large current account surpluses coupled with continuing capital account deficits.  BI estimates that Indonesia's record exports in 2000 led to a current account surplus of approximately USD 7.7 billion, but that the country's capital account deficit remained significant at about USD 4.6 billion.   

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6. 2001: Storm Clouds on the Horizon?

Despite Indonesia's stronger than expected economic performance in 2000, a steady drumbeat of negative economic and political developments in the second half of the year has led most private forecasters to reduce their forecast for GDP growth in 2001 to the 3-4 percent range.

--Declining levels of consumer and business confidence, considered barometers of future consumption and investment activity respectively.  The investment firm Danareksa's monthly consumer confidence index stood at 56.4 in December 2000, down from 58.8 in July 2000 and 68.5 in December 1999.  The future expectations component of Danareksa's bimonthly Business Sentiment Survey also declined significantly in late 2000, falling from 128.5 in September to 123.3 in November, a decline of 4.1 percent.

--Clear signs of economic slowdown in the U.S., and to a lesser extent Japan and Europe.  The U.S. and Japan are Indonesia's largest exports markets, absorbing 32.1 percent of Indonesia's non-oil exports in 2000.  Indonesia's relatively low-tech export products may be more resistant to recessions than those of its more up-market ASEAN neighbors.  Nonetheless, Indonesian exporters will clearly face a more challenging external economic environment in 2001.  Danareksa predicts that the rate of growth in Indonesia's exports will slow to approximately 10 percent in 2001.   

--In conjunction with the above, preliminary indications of a slowdown in the rate of growth of non-oil and gas exports.   While seasonal variations in Indonesia's exports are common, the value of fourth-quarter exports fell 7 percent from their third-quarter levels, a rate more than four times greater than the decline over the same period in 1999.  The year-on-year growth rate in exports also fell from 22.4 percent in the third quarter to 15.7 percent in the fourth quarter.

--Falling oil prices, which affect the value of Indonesia's oil exports as well as government budget revenues.  The average price per barrel for Sumatra Light Crude (SLC) fell to USD 24.12 in January, down from a high of USD 32.95 in September 2000.  The average SLC price in 2000 was USD 28.53 per barrel.

--Flagging progress on Indonesia's three-year, USD 5 billion IMF-supported economic reform program (see below).  Lack of GOI progress on important economic reform issues forced the IMF to postpone its third review of the program in December 2000, and as of late February 2001 no agreement with the IMF seemed imminent.

--And perhaps most important, a string of security incidents, political confrontations between the Wahid Administration and Parliament, and policy flip-flops that many analysts said created the impression of increasing governmental paralysis.  

While still well above recession levels, 3-4 percent GDP growth is only about half of the 7.2 percent average GDP growth Indonesia experienced from 1990-96.  More important from the viewpoint of social and political stability, GDP growth of 3-4 percent does not create enough job opportunities to absorb significant numbers of Indonesia's millions of unemployed and under-employed workers and new labor market entrants.  Economists calculate that Indonesia's labor force is increasing by 2.2 - 2.7 percent a year, a growth rate equivalent to 2-2.5 million new job seekers each year.  The National Development Planning Agency (BAPPENAS) in turn estimates that 4 percent GDP growth translates into an increase in the demand for labor of 2.4 percent, or 2.2 million new job opportunities per year.  These figures make it clear that in order to re-employ large numbers of workers who lost their jobs during the 1997-98 crisis and absorb new labor market entrants, Indonesia needs a sustained period of GDP growth well above 3-4 percent.       

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7. Challenges for 2001: Restoring the Integrity of Monetary Policy

Indonesia faces a score of medium- and long-term economic problems ranging from implementing regional autonomy to improving the technological mix of the country's exports.  In the short term, however, two challenges are paramount: restoring the integrity of Bank Indonesia and its conduct of monetary policy, and establishing the conditions for a sustained increase in business investment.

Bank Indonesia has been under intense institutional and policy pressure since mid-2000.  The long-running dispute over BI has severely reduced confidence in both BI and the Government's abilities to manage Indonesia's economy, a perception that badly clouds the outlook for 2001.  BI Governor Syahril Sabirin is currently on trial for corruption after spending more than five months under house arrest in 2000.  Senior Deputy Governor Anwar Nasution and four other Deputy Governors are in caretaker status after resigning in November as part of an agreement with the GOI to resolve the Bank Indonesia liquidity credit scandal.  The Government and Parliament have been discussing amendments to the Bank Indonesia Law since November that would remove the present Board of Governors and reduce the policy independence of the bank.

BI now faces an increasingly difficult policy dilemma.  At the same moment it faces strong and growing political pressure, it needs to dampen inflationary expectations and reduce the demand for money to acceptable levels.  However, raising interest rates makes the operating environment more difficult for Indonesia's already weak banking and corporate sectors.  It also imposes significant fiscal costs on both the Government (in the form of higher interest payments on its Rp 226 trillion of variable-rate bank recapitalization bonds) and BI itself (through higher SBI interest costs).

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8. Establishing the Conditions for a Sustained Increase in Business Investment

Despite the increase in gross fixed capital investment noted above, by all measures business investment in Indonesia remains far below pre-crisis levels.  Private capital flows, including flows of foreign direct investment, have remained consistently negative since the fourth quarter of 1997.  As a result of the large-scale transfer of bad loans to the Indonesian Bank Restructuring Agency (IBRA), commercial bank credits stand at only 45 percent of their pre-crisis levels in nominal terms, and considerably less in real terms.  The dollar value of investment approvals in 2000 was only one-tenth of their level in 1997.

Boosting investment will not be easy.  It will require the disciplined implementation of an integrated set of policies in a number of key areas:

--Most critically, the GOI needs to more vigorously pursue the banking sector, corporate, and judicial reforms spelled out in Indonesia's IMF-supported program.  Each of these areas is crucial to improving Indonesia's attractiveness as an investment location.  Commercial banks are financially weak and unable to lend to qualified local borrowers.  Most of Indonesia's corporate sector cannot access local or international capital markets because they have not fully restructured their debt. Indonesia's unreformed judiciary makes it almost impossible to pursue legal recourse as the Manulife case illustrated.   

--The Government and Parliament need to break the political logjam over IBRA asset disposals.  Slow disposals mean that a large piece of Indonesia's productive economy languishes in state hands.

--Calm concerns about the direction and consistency of economic policy.  Recent policy decisions have contributed to a sense of policy drift, including restrictions on the offshore transfer of rupiah, new income tax laws and regulations, rising barriers to basic imports, and the announcement and subsequent partial roll-back of luxury tax increases and VAT applications.

--Also important is improving security for investors and exporters, particularly in isolated areas far from ports or major cities.  Investors report an increasing breakdown in law and order, even in areas that have not experienced sectarian violence.

--And finally, the GOI needs to find ways to reduce the uncertainty for potential investors resulting from Indonesia's ambitious regional autonomy program.  While an important political priority in its own right, the implementation of regional autonomy has left many questions unanswered.

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9. Longer-Term Key: Fiscal Sustainability

The GOI faces an unprecedented debt burden stemming largely from the Rp 670 trillion (USD 68 billion) costs of Indonesia's 1998-99 banking sector meltdown.  The Government's gross international and domestic debt stood at approximately USD 150 billion in late 2000, equal to 100 percent of GDP.  The Ministry of Finance projected that net payments on foreign and domestic debt would reach Rp 56 trillion (USD 5.7 billion) in fiscal year 2001, approximately 25 percent of central government spending or four percent of GDP.  The Government's debt servicing burden will rise significantly as large tranches of bank recapitalization bonds are scheduled for redemption starting in 2004 and Indonesia's Paris Club debt rescheduling consolidation period ends in March 2002.

When coupled with other structural rigidities in the GOI budget (subsidies, regional autonomy costs, and personnel costs), the debt burden gives the Government very little room to increase development spending.  Worrying to many analysts is the possible development of a "debt trap" in which high interest rates and inflation, a weak rupiah, and low GDP growth cause Indonesia's debt-to-GDP ratio to spiral upward.

The IMF and World Bank have outlined several scenarios for the future development of Indonesia's economy. One is a "virtuous cycle" in which solid GOI policy implementation spurs accelerated GDP growth (based on high levels of market confidence and renewed private capital inflows), rising levels of tax collections, and declining debt-to-GDP levels. Most experts agree that Indonesia's performance on the monetary policy and economic reform issues described above will largely determine whether Indonesia's future includes a debt trap or a virtuous cycle.

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