Thu, 14 Feb 2008
Rizal Ramli, Jakarta

The performance of Indonesia's macroeconomy in 2007 was satisfactory from the perspective of the rate of growth and the balance of payments. International commodity price increases improved the country's terms of trade and speculative capital flows drove up share prices on the Jakarta Stock Exchange (now the Indonesia Stock Exchange, or IDX) by 52 percent.

Last year saw the formation of a financial bubble that is likely to expand in 2008. Meanwhile, consumption lending has gathered pace, creating a domestic situation analogous to the subprime mortgage problem in the United States. Hot money flows have driven up the price of domestic financial assets and strengthened the rupiah against other currencies.

As is always the case with asset bubbles, the risk is that if these flows were to reverse, asset prices would fall and investors who had borrowed to acquire expensive assets would be under financial stress. If enough investors are affected, the trouble will spread to the banks and the wider financial system.

Another effect of the inflation of asset prices that has received less attention thus far is the impact on the real economy. As the returns on investment in financial assets and property increase, investors turn away from the production of goods and services. The process feeds on itself as rising asset prices attract more investment, driving prices even higher.

Meanwhile, under-investment in manufacturing, agriculture and services slows down productivity growth in the economy and therefore future growth potential. Eventually sentiment changes, often as a result of an external shock. Sellers outnumber buyers for shares and properties, and prices fall. If banks are exposed to speculators who cannot cover their obligations, the crash can have catastrophic effects on the real economy.

American economic growth will certainly slow down in 2008, and the likelihood of a U.S. recession has increased as losses from the subprime loan crisis have mounted. We can expect the U.S. economic slowdown will have a huge impact on the Indonesian economy.

Present day Indonesia remains more vulnerable to financial instability than other East Asian countries because of Indonesia's relative dependence on high commodity prices and hot money for macroeconomic balance.

Food shortages and price increases for basic commodities will continue in Indonesia in 2008. Higher prices for rice, flour, sugar, soybeans (more than a 100-percent increase) and cooking oil will exert negative pressure on purchasing power and living standards. Pressure on household budgets will result in higher default rates on small loans.

There exists a real possibility that food shortages and price rises for basic necessities will lead to social and political instability such as that experienced during the falls of president Sukarno and president Soeharto.

ECONIT Advisory Group concludes on the basis of these observations that 2008 will be "The Year of the Bubble". Various financial sector bubbles, food price rises and an Indonesian form of the subprime lending crisis will dominate this year. The SBY government will issue "bubble policies" in the form of overly optimistic assessments of the economic situation.

The government's attention will increasingly focus on political spin as the 2009 elections approach. The bigger the bubble gets, the more dangerous it is when it finally bursts. But the political situation is more likely to be determined by the fallout from the impending economic adjustment than from the government's public relations efforts.

Economic growth will slow to 6 percent in 2008, lower than the 2007 rate of 6.2 percent, as a result of a number of external factors including a slowdown in the global rate of growth, structural weaknesses in the U.S. economy, price and supply pressure for food and energy and a drop in non-energy mineral prices.

Price increases for food and energy in 2008 will have a large impact on the world economy. Although core inflation in the major world economies is relatively stable, energy and food prices will cut into disposable income and therefore consumer demand in the world economy as in Indonesia. Oil prices in the spot market have touched US$100 per barrel. Throughout 2008, oil will hover around $90, higher than the average of $72 last year.

Prices of other commodities, including non-energy minerals such as ores and metals, peaked in 2007 and are likely to plateau or even experience a correction in 2008. Demand will weaken as the global economy slows, led by recession in the U.S. and a cooling Chinese economy.

These external factors will represent strong headwinds for the Indonesian economy in 2008. The likelihood of recession in the U.S. and slower growth in the rest of the world will reduce demand for Indonesian exports.

The absence of concrete steps to reignite growth in the agricultural sector represents a missed opportunity for Indonesia, which could have derived immense economic and social benefit from today's higher food prices. In fact the opposite has happened, with higher food global prices leading to a squeeze on household consumption in Indonesia.

An example of policies not consistent with agricultural revitalization is the decision of the ministry of trade to approve increased fertilizer exports. This policy has resulted in shortages and higher prices faced by farmers.

Rising food and energy prices, deindustrialization and the slow pace of infrastructure development represent real threats to the economy in 2008. Under these conditions, fiscal policy is an important instrument to spur economic growth and promote equality.

Unfortunately, poor management of the state budget reduced the impact of fiscal policy in 2006-2007, and is likely to do so again in 2008. In both 2006 and 2007, slow disbursements from the state budget, with expenditures bunched toward the end of the fiscal year, reduced the government's capacity to use fiscal stimulus to economic growth.

As much as 40 percent of the annual budget was disbursed in the final month of the year, representing the worst performance by an Indonesian government in more than forty years. Usually, end of year expenditures amount to 10 percent of the budget. Hasty disbursements at the end of the year rarely achieve their objectives and are liable to misuse. As a consequence of these delays, fiscal policy has not fueled growth, sacrificing one half to one full percentage point of real growth per annum.

Late implementation of fiscal plans also reduces the capacity of the government to use fiscal policy to achieve distributional objectives. In principle, taxes are paid by better-off firms and households to finance programs for the general public, specifically those that benefit middle- to lower-income groups. Late disbursement of government spending therefore reduces the equality-promoting effects of fiscal policy.

The writer, a former coordinating minister for the economy, is chairman of ECONIT Advisory Group.



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