Indonesia's economic challenges<\/p>\n
Stephen Schwartz
\nJakarta<\/p>\n
Judging by the stock and foreign exchange markets over the
\npast few weeks, the coming of the New Year and a recent cabinet
\nreshuffle have brought fresh hope to Indonesian market-watchers
\nthat macroeconomic stability will endure, and that economic
\ngrowth will continue to rise toward its enormous potential.<\/p>\n
However, while prospects are bright, especially over the
\nmedium term, the economy at present is showing signs of a
\nslowdown and inflation is high. Consequently, projections for
\n2006 are subject to more than the usual range of uncertainty, and
\nimportant challenges confront the new economic team and Bank
\nIndonesia in the year ahead.<\/p>\n
While GDP growth has been picking up in recent years, to over
\n5 percent in 2004 and most likely in 2005 as well, the government
\nrecognizes that an even stronger pickup to at least the 6 percent
\nrange will be needed over the medium term if Indonesia's high
\nunemployment and poverty rates are to be addressed effectively.
\nTo achieve this goal and to counter the current slowdown, the new
\neconomic team will need to accelerate regulatory, institutional,
\nand other reforms to improve the investment climate.<\/p>\n
But before turning to the challenges confronting policymakers,
\nit is useful to remind ourselves just how far Indonesia has come
\nsince the Asian financial crisis of 1997-1998, and to reflect on
\ndevelopments over the past year. When the financial crisis
\nengulfed much of Asia, Indonesia was the hardest hit, with real
\nGDP falling by 13 percent in 1998, the rupiah undergoing a
\nmassive depreciation, and inflation soaring to more than 70
\npercent.<\/p>\n
With the implementation of sound policies since those
\nturbulent times, per capita GDP has risen to well above pre-
\ncrisis levels, the banking system -- while in need of further
\nstrengthening, particularly in the state bank sector -- has been
\nrestored to reasonable health, and the public debt-to-GDP ratio
\nis on a sustainable and declining path. All of this has occurred
\neven as Indonesia underwent a historic political transition,
\nculminating in last year's peaceful direct Presidential election.<\/p>\n
Nevertheless, the government has had to manage a number of
\nshocks to the economy over the past year, including the aftermath
\nof the tragic tsunami, the second Bali bombing, and the steep
\nrise in international oil prices and interest rates (and most
\nrecently, the threat of Avian Flu). Macroeconomic stability,
\nwhich had increasingly (and perhaps prematurely) been taken as
\ngiven, came under strain, particularly last August and September
\nwhen the rupiah depreciated sharply and foreign exchange reserves
\ndeclined.<\/p>\n
The situation stabilized quickly once Bank Indonesia (BI)
\nraised interest rates in a convincing manner -- thereby catching
\nup with global interest rate developments over the previous
\nmonths -- and the government announced its bold decision to reign
\nin fuel subsidies through an adjustment in domestic fuel prices.
\nThe previous economic team and BI deserve credit for navigating
\nthe economy through the many shocks, and for implementing policy
\nadjustments convincingly, if somewhat belatedly.<\/p>\n
The episode serves as a reminder that preserving macroeconomic
\nstability is a day-to-day challenge, and of the importance of
\ntaking early policy action when needed in response to a changing
\ninternational economic environment.<\/p>\n
As the calendar year comes to a close, financial market
\nconfidence remains reasonably strong and the economy is on a
\nsound footing. Nevertheless, as noted above, the near-term
\neconomic outlook for 2006 is subject to uncertainty. Inflation
\naccelerated sharply following the October fuel price increase,
\nand currently stands above 18 percent (year-on-year).<\/p>\n
Bank Indonesia has, appropriately, raised interest rates
\nfurther to contain inflationary pressures. While the rise in
\ninflation is largely due to the impact of the fuel price
\nincrease, underlying (or \"core\") inflation, which excludes food,
\nenergy, and administrative price changes, had been picking up
\nsince late 2004 and is still high.<\/p>\n
Inevitably, the impact of the rise in interest rates,
\nOctober's fuel price increase, and the associated erosion of
\nconsumer purchasing power are likely to result in some slowing of
\ngrowth during the final quarter of 2005 and first half of 2006.
\nSigns of a slowdown are already evident in data on retail sales
\nand surveys of consumer and business confidence, although
\nadmittedly the picture is mixed, with some indicators such as
\nmotorcycle sales holding up, and some businesses still reporting
\nrobust sales.<\/p>\n
The good news is that, with a continued supportive global
\nenvironment (which is, however, subject to risks) and with sound
\npolicies, prospects are good for a pickup in private consumption
\nand investment later in the year. As such, IMF staff believe that
\nfor the year as a whole growth in the 5 percent range is feasible
\nfor 2006.<\/p>\n
Moreover, if BI is successful in containing inflationary
\nexpectations, an important determinant in wage and price setting,
\ninflation by end year could well decline to the 8 percent range,
\nin line with BI's latest projections. (Measured on a year-on-year
\nbasis, inflation is expected to remain in the 16-18 percent range
\nfor some time due to the base effect of the fuel price increase,
\nalthough the month-to-month inflation rates should moderate.)<\/p>\n
But achieving even a 5 percent level of growth in 2006 will
\nrequire determined efforts by policy makers in the areas of both
\nmacroeconomic management and structural reforms. On the
\nmacroeconomic front, as mentioned above, Bank Indonesia faces the
\nchallenge of balancing its interest rate increases to contain
\ninflation, within its recently adopted inflation targeting
\nframework, without unduly weakening consumption and investment
\ngrowth.<\/p>\n
At the same time, with overall expenditure in 2005 running
\nbelow budgeted levels, the government will need to ensure that
\nadministrative bottlenecks are removed so that spending --
\nincluding some carryover of unspent funds in 2005 that would
\nstill leave the overall deficit within a prudent level -- is
\nexecuted in a timely way. In so doing, the government should
\nfocus on high priority areas, including education, health, and
\ninfrastructure projects.<\/p>\n
The previous economic team rightly emphasized reforms to
\nenhance the investment climate as key to stimulating growth. With
\nprivate investment growth now showing some signs of weakening,
\nthe challenge for the new economic team will be to reinvigorate
\nthe reform process, whose implementation momentum appears to have
\nslowed in recent months.<\/p>\n
The list of needed reforms is well known: They include efforts
\nto improve tax administration, both to enhance revenue collection
\nand provide fairness to taxpayers; a more flexible labor market;
\nupgrades to Indonesia's lagging infrastructure; and strengthening
\nlegal certainty and governance.<\/p>\n
The government has been making progress in all of these areas,
\nbut will need to ensure that the momentum is maintained, for
\nexample, by resolving differences over the tax laws now in
\nParliament. In addition, continued efforts to strengthen the
\nfinancial sector, including sound banking supervision and
\nimprovements in the asset quality of state-owned banks, would
\nhelp reduce vulnerabilities and enhance the ability of the
\nbanking sector to support private economic activity. To implement
\nthis agenda effectively, coordination and prioritization will be
\ncritical.<\/p>\n
The market's favorable response to the installation of the new
\neconomic team is an indication that hopes are high. But the
\nchallenges before the new team are difficult, and it would be
\nunfair to expect one or two Ministers alone to be able to turn
\naround a slowing economy.<\/p>\n
To succeed, the new team will need to maintain an unfailing
\ncommitment to the reform process, but they will also need the
\nfull support of their fellow Ministers, Parliamentarians, and the
\ninternational community.<\/p>\n
The writer is Senior Resident Representative, IMF Jakarta
\nOffice.<\/p>",
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