Indonesia's economic challenges

Indonesia's economic challenges

Stephen Schwartz
Jakarta

Judging by the stock and foreign exchange markets over the
past few weeks, the coming of the New Year and a recent cabinet
reshuffle have brought fresh hope to Indonesian market-watchers
that macroeconomic stability will endure, and that economic
growth will continue to rise toward its enormous potential.

However, while prospects are bright, especially over the
medium term, the economy at present is showing signs of a
slowdown and inflation is high. Consequently, projections for
2006 are subject to more than the usual range of uncertainty, and
important challenges confront the new economic team and Bank
Indonesia in the year ahead.

While GDP growth has been picking up in recent years, to over
5 percent in 2004 and most likely in 2005 as well, the government
recognizes that an even stronger pickup to at least the 6 percent
range will be needed over the medium term if Indonesia's high
unemployment and poverty rates are to be addressed effectively.
To achieve this goal and to counter the current slowdown, the new
economic team will need to accelerate regulatory, institutional,
and other reforms to improve the investment climate.

But before turning to the challenges confronting policymakers,
it is useful to remind ourselves just how far Indonesia has come
since the Asian financial crisis of 1997-1998, and to reflect on
developments over the past year. When the financial crisis
engulfed much of Asia, Indonesia was the hardest hit, with real
GDP falling by 13 percent in 1998, the rupiah undergoing a
massive depreciation, and inflation soaring to more than 70
percent.

With the implementation of sound policies since those
turbulent times, per capita GDP has risen to well above pre-
crisis levels, the banking system -- while in need of further
strengthening, particularly in the state bank sector -- has been
restored to reasonable health, and the public debt-to-GDP ratio
is on a sustainable and declining path. All of this has occurred
even as Indonesia underwent a historic political transition,
culminating in last year's peaceful direct Presidential election.

Nevertheless, the government has had to manage a number of
shocks to the economy over the past year, including the aftermath
of the tragic tsunami, the second Bali bombing, and the steep
rise in international oil prices and interest rates (and most
recently, the threat of Avian Flu). Macroeconomic stability,
which had increasingly (and perhaps prematurely) been taken as
given, came under strain, particularly last August and September
when the rupiah depreciated sharply and foreign exchange reserves
declined.

The situation stabilized quickly once Bank Indonesia (BI)
raised interest rates in a convincing manner -- thereby catching
up with global interest rate developments over the previous
months -- and the government announced its bold decision to reign
in fuel subsidies through an adjustment in domestic fuel prices.
The previous economic team and BI deserve credit for navigating
the economy through the many shocks, and for implementing policy
adjustments convincingly, if somewhat belatedly.

The episode serves as a reminder that preserving macroeconomic
stability is a day-to-day challenge, and of the importance of
taking early policy action when needed in response to a changing
international economic environment.

As the calendar year comes to a close, financial market
confidence remains reasonably strong and the economy is on a
sound footing. Nevertheless, as noted above, the near-term
economic outlook for 2006 is subject to uncertainty. Inflation
accelerated sharply following the October fuel price increase,
and currently stands above 18 percent (year-on-year).

Bank Indonesia has, appropriately, raised interest rates
further to contain inflationary pressures. While the rise in
inflation is largely due to the impact of the fuel price
increase, underlying (or "core") inflation, which excludes food,
energy, and administrative price changes, had been picking up
since late 2004 and is still high.

Inevitably, the impact of the rise in interest rates,
October's fuel price increase, and the associated erosion of
consumer purchasing power are likely to result in some slowing of
growth during the final quarter of 2005 and first half of 2006.
Signs of a slowdown are already evident in data on retail sales
and surveys of consumer and business confidence, although
admittedly the picture is mixed, with some indicators such as
motorcycle sales holding up, and some businesses still reporting
robust sales.

The good news is that, with a continued supportive global
environment (which is, however, subject to risks) and with sound
policies, prospects are good for a pickup in private consumption
and investment later in the year. As such, IMF staff believe that
for the year as a whole growth in the 5 percent range is feasible
for 2006.

Moreover, if BI is successful in containing inflationary
expectations, an important determinant in wage and price setting,
inflation by end year could well decline to the 8 percent range,
in line with BI's latest projections. (Measured on a year-on-year
basis, inflation is expected to remain in the 16-18 percent range
for some time due to the base effect of the fuel price increase,
although the month-to-month inflation rates should moderate.)

But achieving even a 5 percent level of growth in 2006 will
require determined efforts by policy makers in the areas of both
macroeconomic management and structural reforms. On the
macroeconomic front, as mentioned above, Bank Indonesia faces the
challenge of balancing its interest rate increases to contain
inflation, within its recently adopted inflation targeting
framework, without unduly weakening consumption and investment
growth.

At the same time, with overall expenditure in 2005 running
below budgeted levels, the government will need to ensure that
administrative bottlenecks are removed so that spending --
including some carryover of unspent funds in 2005 that would
still leave the overall deficit within a prudent level -- is
executed in a timely way. In so doing, the government should
focus on high priority areas, including education, health, and
infrastructure projects.

The previous economic team rightly emphasized reforms to
enhance the investment climate as key to stimulating growth. With
private investment growth now showing some signs of weakening,
the challenge for the new economic team will be to reinvigorate
the reform process, whose implementation momentum appears to have
slowed in recent months.

The list of needed reforms is well known: They include efforts
to improve tax administration, both to enhance revenue collection
and provide fairness to taxpayers; a more flexible labor market;
upgrades to Indonesia's lagging infrastructure; and strengthening
legal certainty and governance.

The government has been making progress in all of these areas,
but will need to ensure that the momentum is maintained, for
example, by resolving differences over the tax laws now in
Parliament. In addition, continued efforts to strengthen the
financial sector, including sound banking supervision and
improvements in the asset quality of state-owned banks, would
help reduce vulnerabilities and enhance the ability of the
banking sector to support private economic activity. To implement
this agenda effectively, coordination and prioritization will be
critical.

The market's favorable response to the installation of the new
economic team is an indication that hopes are high. But the
challenges before the new team are difficult, and it would be
unfair to expect one or two Ministers alone to be able to turn
around a slowing economy.

To succeed, the new team will need to maintain an unfailing
commitment to the reform process, but they will also need the
full support of their fellow Ministers, Parliamentarians, and the
international community.

The writer is Senior Resident Representative, IMF Jakarta
Office.