2006 as the year of economic consolidation

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.