A better economic outlook possible in the year ahead

A better economic outlook possible in the year ahead

Umar Juoro
Jakarta

Eventually, the government decided to put a brake on fuel
subsidy spending by raising fuel prices on average by 126 percent
on Oct. 1. As a consequence, inflation in that month rose to 8.7
percent, much higher than anybody expected.

By the end of 2005, inflation is expected to be around 18
percent as firms make price adjustments in line with higher
prices for energy, transportation, credit, wages and intermediate
goods. However, Bank Indonesia has not responded to high
inflation by raising interest rates higher than inflation. BI has
kept its key rate (SBI) below inflation, at the moment at 12.75
percent, for the reason that forecast inflation in 2006 will be
around 8 percent so that there is no reason to raise interest
rates higher at this time.

Fortunately, the change of the government's economic team,
bringing back the highly respected Boediono to the position of
Coordinating Minister for the Economy, and Sri Mulyani as
Minister of Finance, has greatly helped to restore confidence in
the rupiah so that negative real interest rate does not correlate
to the depreciation in the rupiah's value. The foreign buying of
domestic bonds has increased foreign exchange reserves and this
has helped strengthen the rupiah.

The government policy of halting the rise in fuel subsidy
spending is good from a rational economic point of view. However,
in a practical sense it makes things very difficult for
businesses and households in general to adjust to the change. The
banking sector has to increase both deposit and lending rates to
follow the BI policy, and as a consequence is experiencing a
decline in revenue.

Firms in general have to deal with various price increases
that force them to increase their product prices sooner and
higher than they had originally planned. This is the reason why
inflation will remain high at least until the first half of 2006.

Growth in consumer spending will decline as purchasing power
is reduced by high inflation. Investment as the locomotive for
economic growth cannot be expected to increase given that
investors will wait until the economy stabilizes and the hurdles
to investment are reduced. The growth in exports will be moderate
as exporters will also have to increase their prices in line with
higher production costs. Given these circumstances, economic growth in
2005 will be between 5.2 percent and 5.5 percent, while
unemployment might rise to an alarming 11 percent.

The challenge facing policy makers now is how to stabilize the
economy, and particularly deal with high inflation. BI will not
raise its interest rates much higher as it does not want to choke
the economy. Meanwhile, the government will have to increase
spending to stimulate the economy and to finance its social
welfare programs.

At the same time, continuing high oil prices and a higher Fed
rate will place additional pressures on the economy. Given this
situation, the economic policy makers face a delicate balance
that means being conservative on the one hand, and allowing the
economy to grow on the other hand in order to reduce
unemployment.

BI and the government would like to see single digit
inflation at around 8 percent, and relatively high economic
growth of 6.2 percent in 2006. However, there is a doubt whether
these targets will be achieved as there is a policy contradiction
between reducing inflation and spurring growth.

Negative real interest rates will likely persist for some
time, and it will be hoped that no major disturbances will affect
the rupiah. As long as there is no such disturbance, the rupiah can be
expected to be stable. But, if there is a disturbance, the rupiah
could come under strong pressure. Negative real interest rates
will also significantly influence the way in which the banks
operate.

On the inflation side, it is typical that when prices go up,
they do not come down again easily. Price increases will likely
continue through the first half of 2006 so that we can expect
inflation year-on-year to still be around 15-17 percent by that
time.

Whether inflation declines sharply after that, as BI expects,
will depend on the policies adopted and the responses of
businesses and consumers. Even if inflation comes down, average
inflation could still remain high at around 10 percent in 2006. It is a
characteristic of the economy to have relatively high inflation,
and that means high interest rates. Before the crisis, this was
accompanied by a high level of growth.

The real challenge for the policy makers is whether to focus
on bringing back stability, which means bringing inflation down
while not focusing much on growth, or trying to strike a delicate
balance to reduce interest rates as inflation starts to ebb in
order to spur growth. The policy makers might be tempted to
choose the second option considering the political pressure for
higher growth to reduce unemployment.

However, this choice of policy entails the risk that economic
stability might not be optimal, while economic growth might not
be capable of being jacked up to the level the government wants
if the necessary improvements to the investment climate are not
fulfilled.

Meanwhile on the macroeconomic stability front, the solution
is very clear. It is just a matter of focusing. At the sectoral
policy level, the challenges remain the same and these will be
very difficult to solve. It has been shown that although the
macro policy is correct, sectoral policy does not always follow,
especially when this is related to bureaucratic inertia.

The issue of taxation is certainly a crucial one. After the
current proposed taxation law amendments that controversially
give wide-ranging powers to the fiscal authorities have been
withdrawn, the government should come up with draft legislation
that not only accommodates business, but also revenue generation.
This is obviously a difficult balance to strike. Custom and
excise are other areas that are particularly tied up in red tape
and smuggling.

The mining and oil and gas sectors, which should be buoyant
given the current high prices on the international market, and
which are governed by the same minister and department, might not
be that keen on suddenly embracing reform and progress.

There is no question that Minister Boediono is highly
respected by the financial markets, but he still has to show his
capability at producing a better investment climate, not to
mention resolving sectoral conflicts, such as between the
forestry and mining authorities over the issue of mining
concessions in protected forest.

The experience of the contractual dispute between Pertamina
and Exxon over the Cepu block is an example of just how daunting
it can be to resolve such problems. This experience also shows
that the President himself should get directly involved in
resolving the important issues affecting major investment
projects.

The labor question is another classic problem that seems to
still be far removed from resolution. Bew Minister of Manpower
Erman Suparno does not have enough experience on dealing with
labor issues. Moreover, given high unemployment, the government
tends to discourage layoffs for fear of labor unrest. Similarly,
it seems that local governments are unable to handle demands from
labor unions for higher minimum wages.

Last but not least is the issue of decentralization. Despite
the promise of the government to reduce the obstacles to
investment at the local level, in practice this has not been
progressing much.

Given the above description, the sectors that have been
growing relatively quickly to date, such as communications,
trade, construction and finance, might continue to grow
relatively quickly. But with the decline in purchasing power, we
cannot expect growth to be higher than in 2005. The growth of these
sectors is strongly related to the purchasing power of the
consumer. A reasonable target for growth is therefore no more
than 5.5 percent.

Given these circumstances, the focus of the policy makers
should be to bring back macroeconomic stability first without
being too ambitious about achieving high growth. It is certainly
ironic going into the second year of this administration that the
focus is back to macroeconomic stability instead of solving the
real problems that people face, especially unemployment and a
higher cost of living.

Nevertheless, if the government can make progress in
minimizing the hurdles hampering investment and bring about
bureaucratic reform, condition could turn out to be much better.
By restoring macroeconomic stability and making progress as
regards structural problem, the economic outlook will become
considerably brighter.

The writer is chairman of CIDES (Center for Information and
Development Studies), and a senior fellow at the Habibie Center.