2006 as the year of economic consolidation

David E. Sumual Jakarta

Next year's economic difficulties are already becoming apparent. Early indications of the Indonesian economy losing its momentum are seen in slower-than-expected gross domestic product (GDP) growth in the last two quarters as exports eased and investor appetite diminished.

The leading economic indicators, which typically move around six to 12 months ahead, also indicated the same thing. The Danareksa Research Institute's (DRI) Leading Economic Index fell by a substantial 3.0 percent to a 16-month low of 99.2 in October 2005. The decline was mainly attributable to the fall in the number of foreign tourist arrivals index and the surge in the consumer price index for the services sector.

Indeed, the strong performance of shares listed on the Jakarta Stock Exchange recently is a sign of economic sanguinity. Yet, despite a rally in the equity market following the Cabinet reshuffle in early December, the government bonds yield curve sends a different message. The slope of the yield curve is flattening with a tendency toward inversion, which is usually the more prescient indicator of economic slowdown about a year later.

Those indications mark the onset of the downward cycle of Indonesia's economy. As higher inflation and interest rates bite into consumer spending and persuade investors to invest less, the slowing down cycle may continue until the second quarter of 2006. Actually, this down-cycle pattern reminds us of what happened in 2000-2001. At the end of 2001, the average SBI rate peaked at 17.6 percent and the inflation rate reached 12.5 percent, triggering a reduction in the amount of credit and the increase in banks' non-performing loans.

Nonetheless, these trends may only inhibit slightly the growth of the Indonesian economy, not slash growth significantly. Indonesia's current situation is a lot better than that of 2000 to 2001. Unlike the era of 2000-2001, which was marked by political instability due to the impeachment of former president Wahid, President Susilo seems to have been successful in maintaining political support from the key parties. It should also be borne in mind that the country's fiscal position has strengthened significantly following the aggressive reduction of fuel subsidies.

Moreover, Indonesia's economy is actually a plutocratic economy; that is an economy powered by the affluent. Recent data from the Central Statistics Agency (BPS) suggests that the top 20 percent of the Indonesian population account for nearly half of the overall income and consumption. And, learning from past experiences, the spending of wealthy consumers has proven to be resilient, thus providing a cushion to overall economic growth. This notion is supported by the latest consumer confidence survey. By income level, the consumer confidence index of consumers with incomes above Rp 1 million per month has rebounded 1.2 percent from its lowest ever level of 79.9 to 80.8 in November 2005.

However, there are still some potential risks that should be noted on the external side. The biggest worry for 2006's economic outlook is the possibility of sustained high-energy prices. Nonetheless, there are indications that high oil prices may be coming to an end. So far, crude oil prices have fallen by more than US$10/barrel after peaking at $70/barrel following Hurricane Katrina.

According to the International Energy Agency, world oil production capacity could rise by 2.5 million barrels/day, while the demand for oil next year will slow down to about 2 percent or 1.7 million barrels to 85 million barrels/day. China alone accounted for a third of that growth and its demand for oil may also shrink next year as its imports have decelerated in the last 10 months. Meanwhile, U.S. consumers, who have been the basis of U.S.-centric global growth, are also in the process of cutting back discretionary spending as a result of higher lending rates and fuel prices.

At the same time, the high oil prices have encouraged more exploration and more investment by energy companies around the globe. Demonstrating the beauty of the price mechanism, high price incentives prompt new fuel efficiency measures worldwide and investment in new technologies for alternative energies. Billions of dollars have and will also be invested in petroleum production, which will certainly boost the fuel supply.

This can be seen in the skyrocketing sales of exploratory rigs around the world that hit a nine-year high, thus benefiting Singapore's economy, which makes 70 percent of the world's offshore oil rigs. Singapore's economy grew at a 7.0 percent year-on-year rate in the third quarter of 2005 as its oil-related hardware industry won billions of dollars of contracts amid surging crude oil prices.

However, although demand was to slow down a bit and investment might create an oversupply of oil, a real decrease in crude oil prices might only occur in the second-half of 2006 at the earliest. Technically speaking, it takes months of red tape and preparation of infrastructure and oil rigs on the ground before new oil wells can be drilled.

The next concern is whether the interest rate differential theme will fade in importance as the key driver of the dollar's strength. With the Federal Reserve ending its tightening, forex markets may shift their attention back to the old issue of the massive twin deficits of the U.S. economy. As Americans continue to consume more than they produce, the U.S.'s current account deficit now stands at almost 7 percent of the GDP and total net foreign liabilities are approaching a quarter of the GDP. As such, this extraordinary global imbalance may again worry global investors, prompting the resumption of the dollar's gradual decline.

The real risk to the dollar may be when the Fed rate is on track to 4.5-4.75 percent in the first quarter of 2006 right after Bernanke takes office in February. As such, after a significant appreciation this year (16 percent against the Euro and 15 percent against the yen), the dollar may continue to perform well in the short term, but the short-term trend could be disrupted when the interest rate differential theme starts to dissipate. But again, Japan and China, as the biggest holders of U.S. dollar assets, may only make a very gradual way out of this over concentration of dollar holdings, without disrupting the market.

With the Federal Reserve still expected to raise its key rate at least until the first quarter of 2006, the Indonesian price of money and credit could still be a bit higher than as of now. However, the central bank must be wary in regard to the risks of going too far with its tightening process. To minimize the risks of stagflation -- when economic growth stagnates while prices go up -- the central bank thus needs to find the right level for interest rates, which neither jeopardizes the economy nor incites inflationary expectations.

The broad money supply should also be kept under tight control to avoid a snowball effect of inflation expectations. However, as the central bank can now dictate the Bank Indonesia key rate (SBI) benchmark rate with its BI policy rate, it could adjust the key rates rapidly when the inflation rate pressures wane.

Backed up by a currently supportive interest rate level and the disappearance of fiscal overhang, the probability of rupiah strengthening is actually higher.

During the course of 2006, pressure on the rupiah from high world oil prices may also subside with Indonesia's imports of petroleum products expected to fall after the government sharply increased fuel prices in October. Moreover, all the currency transactions related to the government's oil-related exports and imports are now carried out through the central bank.

This new arrangement will certainly benefit the rupiah as the ups and downs in oil prices will no longer affect the demands for U.S. dollars in the forex market. Besides this, the rupiah may also be supported by some new currency trading restrictions recently announced by BI that oblige market players to have an underlying business transaction before carrying out any rupiah transaction.

The question now is by how much will the rupiah appreciate or should the rupiah's high interest rate differential create a structurally strong rupiah? The answer actually depends mostly on how the government manages the already burdensome external debt repayment, the success of the infrastructure initiative, tax reform and whether the current positive sentiment can be maintained.

In any event, the government is actually already moving in the right direction. Its efforts can be deemed as a qualified success, stirring the nation's economy amid the turbulent economic environment. However, Indonesia still faces a number of economic challenges and much work needs to be done. The first priority remains how to expedite the broad-based reform of the country's notorious bureaucracy and a crackdown on endemic corruption.

In the year ahead, the government and the central bank must also work closely to maintain economic stability, budgetary discipline and, at the same time, keep inflationary expectations low. The government should also adopt a middle- to long-term strategy that allows the government to stop borrowing abroad and form a policy of substituting domestic debt for foreign debt to curtail the exchange rate risk.

The government's strategy to attract investment from countries that experience a surplus of capital ought to be continued and further expanded. So far, Indonesia has rolled out a campaign to attract investments from Asian countries like China, India, Japan and Korea. Given its large stock of reserves and its rapidly expanding economy, Asian countries are the main target for attracting investment, given their status as the world's center of economic activity.

Indonesia must also utilize wisely the gigantic windfall profits of oil exporters -- especially those in the Middle East -- as a result of high oil prices by exploring new economic opportunities with those countries. The opportunities of the petro-dollar effect are actually huge. Assuming an average oil price of $60/barrel, the International Monetary Fund estimates that oil exporters' current-account surplus could reach $400 billion in 2005.

And, unlike the oil bonanza in the 1970s, not all the windfall profit will be recycled back into dollar assets. Due to the post Sept. 11 effect, the Patriot Act regulatory requirements have frustrated Middle East investors, thus hampering Middle Eastern capital flows into dollar assets. This shows the importance of the role of former minister Alwi Shihab, who has been appointed as a special envoy and advisor for Middle East countries to attract investment and new trading opportunities.

Nonetheless, there are many pending issues that are still languishing, such as the excessive regulatory burden, investment and labor law amendments and tax reforms. Even the crucial tax reforms may only be implemented in early 2007 at the earliest due to the predicted debate in the legislature. However, we must realize that policy always makes a difference.

Actually, with the disappearance of fiscal overhang, the growth momentum will be in place in the second half of 2006. By that time, the pressures of the cost-push inflation spiral and high-interest rate environment will have started to fade away, thus providing a great opportunity for long-term investment projects.

The writer is an analyst with the Danareksa Research Institute. This article is strictly a personal view.