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.