A better economic outlook possible in the year ahead<\/p>\n
Umar Juoro
\nJakarta<\/p>\n
Eventually, the government decided to put a brake on fuel
\nsubsidy spending by raising fuel prices on average by 126 percent
\non Oct. 1. As a consequence, inflation in that month rose to 8.7
\npercent, much higher than anybody expected.<\/p>\n
By the end of 2005, inflation is expected to be around 18
\npercent as firms make price adjustments in line with higher
\nprices for energy, transportation, credit, wages and intermediate
\ngoods. However, Bank Indonesia has not responded to high
\ninflation by raising interest rates higher than inflation. BI has
\nkept its key rate (SBI) below inflation, at the moment at 12.75
\npercent, for the reason that forecast inflation in 2006 will be
\naround 8 percent so that there is no reason to raise interest
\nrates higher at this time.<\/p>\n
Fortunately, the change of the government's economic team,
\nbringing back the highly respected Boediono to the position of
\nCoordinating Minister for the Economy, and Sri Mulyani as
\nMinister of Finance, has greatly helped to restore confidence in
\nthe rupiah so that negative real interest rate does not correlate
\nto the depreciation in the rupiah's value. The foreign buying of
\ndomestic bonds has increased foreign exchange reserves and this
\nhas helped strengthen the rupiah.<\/p>\n
The government policy of halting the rise in fuel subsidy
\nspending is good from a rational economic point of view. However,
\nin a practical sense it makes things very difficult for
\nbusinesses and households in general to adjust to the change. The
\nbanking sector has to increase both deposit and lending rates to
\nfollow the BI policy, and as a consequence is experiencing a
\ndecline in revenue.<\/p>\n
Firms in general have to deal with various price increases
\nthat force them to increase their product prices sooner and
\nhigher than they had originally planned. This is the reason why
\ninflation will remain high at least until the first half of 2006.<\/p>\n
Growth in consumer spending will decline as purchasing power
\nis reduced by high inflation. Investment as the locomotive for
\neconomic growth cannot be expected to increase given that
\ninvestors will wait until the economy stabilizes and the hurdles
\nto investment are reduced. The growth in exports will be moderate
\nas exporters will also have to increase their prices in line with
\nhigher production costs. Given these circumstances, economic growth in
\n2005 will be between 5.2 percent and 5.5 percent, while
\nunemployment might rise to an alarming 11 percent.<\/p>\n
The challenge facing policy makers now is how to stabilize the
\neconomy, and particularly deal with high inflation. BI will not
\nraise its interest rates much higher as it does not want to choke
\nthe economy. Meanwhile, the government will have to increase
\nspending to stimulate the economy and to finance its social
\nwelfare programs.<\/p>\n
At the same time, continuing high oil prices and a higher Fed
\nrate will place additional pressures on the economy. Given this
\nsituation, the economic policy makers face a delicate balance
\nthat means being conservative on the one hand, and allowing the
\neconomy to grow on the other hand in order to reduce
\nunemployment.<\/p>\n
BI and the government would like to see single digit
\ninflation at around 8 percent, and relatively high economic
\ngrowth of 6.2 percent in 2006. However, there is a doubt whether
\nthese targets will be achieved as there is a policy contradiction
\nbetween reducing inflation and spurring growth.<\/p>\n
Negative real interest rates will likely persist for some
\ntime, and it will be hoped that no major disturbances will affect
\nthe rupiah. As long as there is no such disturbance, the rupiah can be
\nexpected to be stable. But, if there is a disturbance, the rupiah
\ncould come under strong pressure. Negative real interest rates
\nwill also significantly influence the way in which the banks
\noperate.<\/p>\n
On the inflation side, it is typical that when prices go up,
\nthey do not come down again easily. Price increases will likely
\ncontinue through the first half of 2006 so that we can expect
\ninflation year-on-year to still be around 15-17 percent by that
\ntime.<\/p>\n
Whether inflation declines sharply after that, as BI expects,
\nwill depend on the policies adopted and the responses of
\nbusinesses and consumers. Even if inflation comes down, average
\ninflation could still remain high at around 10 percent in 2006. It is a
\ncharacteristic of the economy to have relatively high inflation,
\nand that means high interest rates. Before the crisis, this was
\naccompanied by a high level of growth.<\/p>\n
The real challenge for the policy makers is whether to focus
\non bringing back stability, which means bringing inflation down
\nwhile not focusing much on growth, or trying to strike a delicate
\nbalance to reduce interest rates as inflation starts to ebb in
\norder to spur growth. The policy makers might be tempted to
\nchoose the second option considering the political pressure for
\nhigher growth to reduce unemployment.<\/p>\n
However, this choice of policy entails the risk that economic
\nstability might not be optimal, while economic growth might not
\nbe capable of being jacked up to the level the government wants
\nif the necessary improvements to the investment climate are not
\nfulfilled.<\/p>\n
Meanwhile on the macroeconomic stability front, the solution
\nis very clear. It is just a matter of focusing. At the sectoral
\npolicy level, the challenges remain the same and these will be
\nvery difficult to solve. It has been shown that although the
\nmacro policy is correct, sectoral policy does not always follow,
\nespecially when this is related to bureaucratic inertia.<\/p>\n
The issue of taxation is certainly a crucial one. After the
\ncurrent proposed taxation law amendments that controversially
\ngive wide-ranging powers to the fiscal authorities have been
\nwithdrawn, the government should come up with draft legislation
\nthat not only accommodates business, but also revenue generation.
\nThis is obviously a difficult balance to strike. Custom and
\nexcise are other areas that are particularly tied up in red tape
\nand smuggling.<\/p>\n
The mining and oil and gas sectors, which should be buoyant
\ngiven the current high prices on the international market, and
\nwhich are governed by the same minister and department, might not
\nbe that keen on suddenly embracing reform and progress.<\/p>\n
There is no question that Minister Boediono is highly
\nrespected by the financial markets, but he still has to show his
\ncapability at producing a better investment climate, not to
\nmention resolving sectoral conflicts, such as between the
\nforestry and mining authorities over the issue of mining
\nconcessions in protected forest.<\/p>\n
The experience of the contractual dispute between Pertamina
\nand Exxon over the Cepu block is an example of just how daunting
\nit can be to resolve such problems. This experience also shows
\nthat the President himself should get directly involved in
\nresolving the important issues affecting major investment
\nprojects.<\/p>\n
The labor question is another classic problem that seems to
\nstill be far removed from resolution. Bew Minister of Manpower
\nErman Suparno does not have enough experience on dealing with
\nlabor issues. Moreover, given high unemployment, the government
\ntends to discourage layoffs for fear of labor unrest. Similarly,
\nit seems that local governments are unable to handle demands from
\nlabor unions for higher minimum wages.<\/p>\n
Last but not least is the issue of decentralization. Despite
\nthe promise of the government to reduce the obstacles to
\ninvestment at the local level, in practice this has not been
\nprogressing much.<\/p>\n
Given the above description, the sectors that have been
\ngrowing relatively quickly to date, such as communications,
\ntrade, construction and finance, might continue to grow
\nrelatively quickly. But with the decline in purchasing power, we
\ncannot expect growth to be higher than in 2005. The growth of these
\nsectors is strongly related to the purchasing power of the
\nconsumer. A reasonable target for growth is therefore no more
\nthan 5.5 percent.<\/p>\n
Given these circumstances, the focus of the policy makers
\nshould be to bring back macroeconomic stability first without
\nbeing too ambitious about achieving high growth. It is certainly
\nironic going into the second year of this administration that the
\nfocus is back to macroeconomic stability instead of solving the
\nreal problems that people face, especially unemployment and a
\nhigher cost of living.<\/p>\n
Nevertheless, if the government can make progress in
\nminimizing the hurdles hampering investment and bring about
\nbureaucratic reform, condition could turn out to be much better.
\nBy restoring macroeconomic stability and making progress as
\nregards structural problem, the economic outlook will become
\nconsiderably brighter.<\/p>\n
The writer is chairman of CIDES (Center for Information and
\nDevelopment Studies), and a senior fellow at the Habibie Center.<\/p>",
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