'Next year, 2010, will be very important for Indonesia. Peaceful general elections and successful navigation through the global financial crisis have raised expectations that Indonesia can become one of the strongest performing emerging markets. But it is not just a question of how strongly Indonesia will rebound from the crisis and how high will be its rate of growth in 2010.
If key initial measures to remove infrastructure bottlenecks, as well as to accelerate bureaucratic and investment climate reform (“soft infrastructure”), are implemented, they could provide benefits many times over and open the way for a rapid increase in income over the medium-term.
At the same time, careful macroeconomic management will be needed to maintain macroeconomic and financial stability in what promises to still be a difficult global environment.
Specifically, while the IMF’s view is that the worst of the global crisis is over, the recovery is expected to be sluggish. After falling 1 percent in 2009, global GDP is projected to rise by just over 3 percent in 2010 and about 4 percent beyond that, compared with growth of about 5 percent in 2003-2007.
Moreover, with the projected rise in public debt in the major advanced economies, and the expected need to drain excess financial sector liquidity, increases in key interest rates are likely, possibly accompanied by investors moving away from “riskier” assets.
Thus, while emerging markets are currently having to deal with large capital inflows, a reversal of these flows and renewed financial market turbulence are possible.
So what should be the macroeconomic policy mix in Indonesia in view of the still difficult global conditions? What needs to be done for the government to achieve its ambitious growth targets of 5.5 percent in 2010 and 7 percent by 2014, accompanied by sharp reductions in poverty and unemployment?
With external demand expected to remain weak, the focus should still be on supporting economic growth, while maintaining macroeconomic and financial stability.
In our annual Article IV report on Indonesia which was issued in July 2009, we suggested a gradual withdrawal of the fiscal stimulus, keeping the deficit at 2 percent of GDP in 2010 (compared with an estimated 2.2-2.3 percent in 2009).
Moreover, a deficit of around 2 percent beyond 2010 would still ensure maintaining the public debt to GDP ratio in the 30-35 percent range, which is low by international standards.
Monetary policy is currently providing support to the economy. Lending rates have declined, though not quite as much as the Bank Indonesia (BI) policy and deposit rates. Rupiah credit has risen by almost 10 percent in the first nine months of the year, more than nominal GDP.
Nevertheless, an up tick in inflation from current low levels is likely as international commodity and possibly some domestic utility prices rise. In case such price hikes start spilling over to other prices, BI will need to raise interest rates and withdraw the stimulus.
BI’s goal of ensuring price stability is being helped by the strong rupiah. Indeed, the flexibility of the rupiah has served Indonesia well - to absorb the impact of capital outflows during the worse of the global crisis, and to cushion the inflationary impact of current capital inflows. Of course, BI has rightly intervened to limit volatility.
While the Indonesian banking system came through the global crisis remarkably well, maintaining financial stability also calls for improved bank regulation and supervision.
One of the lessons from the crisis is that it is not sufficient to only supervise individual institutions, but also to look for systemic vulnerabilities, especially excessive credit growth and the build-up of debt in particular sectors of the economy.
The challenge is that more rapid credit growth as the economy accelerates is not accompanied by a relaxation of loan origination and risk assessment standards. In addition, the approval of the Financial Safety Net law is essential to deal with possible future bank problems.
Notwithstanding the importance of macrofinancial stability, the real challenge for the government will be to put in place the hard and soft infrastructure needed to support stronger growth and reduce poverty. Indonesia has strong long term-drivers of growth - large and still rapidly growing population, abundant natural resources, low debt levels throughout the economy - but the infrastructure and business environment lag behind most countries (see the rankings by the World Economic Forum Global Competitiveness Report).
The government’s 100-day program seems to address the key constraints and would represent a major down payment on the reforms that the second administration of President Yudhoyono is planning.
The availability of financing should not be a constraint to increasing public investment in infrastructure. With continued improvement in tax administration, the government should have the resources to increase capital expenditures.
Equally important is the gradual reduction of budget subsidies (especially energy) which in 2010 will total over 2.5 percent of GDP, while further sharpening targeting mechanisms.
But there are still significant external risks to this generally bright economic outlook. First, the global recovery is fragile and if growth is weaker than expected, net exports could become a significant drag on Indonesia’s growth. Investment, especially in the export sectors, would also be deterred.
Second, another round of capital outflows from emerging markets is possible. This would reduce the availability of foreign capital to finance private and public investment projects and would renew caution among domestic banks in extending credit.
Finally, spikes in international food and energy prices, once they spill over to Indonesian markets and increase headline inflation, tend in Indonesia to substantially slow personal consumption - which has anchored economic growth in the recent past.
In summary, Indonesia has an excellent opportunity to record strong growth and reach government targets even in the current difficult global environment.
Achieving this will require moving quickly to “de-bottleneck” the economy by improving the infrastructure and the business climate, while maintaining overall economic stability. A challenging task, but one that can certainly be accomplished with a determined and comprehensive effort.
The writer is IMF Senior Resident Representative, Jakarta.
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