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.