Thu, 25 Dec 2003

Slight growth acceleration facing head wind

Muhammad Chatib Basri Institute for Economic and Social Research University of Indonesia (LPEM-FEUI) Jakarta

I was sitting in a small coffee shop in Jakarta when a friend of mine, a foreign economist, asked me how we reconcile the good macroeconomic indicators on the one hand with various structural problems in trade and industry on the other.

This is not an easy question. Over the last couple of years, we have been haunted by the decoupling of macroeconomic and industry performance in trade and manufacturing.

Look at the macroeconomic performance: The economy grew by 3.7 percent from the first to the third quarter of 2003; the rupiah has stabilized at around Rp 8,500; inflation has been decelerating and it is predicted to hit below 5 percent by the end of 2003.

Parallel with this, the Bank Indonesia interest rate continues to decline. In addition, the debt ratio to gross domestic product (GDP) is steadily declining and the fiscal deficit shows a similar trend as well.

I think even the most cynical observer of the Indonesian economy would admit that macroeconomic performance has shown improvement. In spite of the global conditions that have been affected by the threat of terrorism, the U.S. invasion of Iraq and health issues such as SARS, most of Indonesia's macroeconomic indicators improved during 2003.

However, in contrast, little has been achieved in the trade and investment sector, particularly in manufacturing. Trade and investment are the main medium-term issues for the Indonesian economy.

Although there has been improvement in the non-oil and gas export growth -- 3.4 percent from January to October -- compared to 2002, it is still modest and far from the pre-crisis growth. It is worth noting that despite various concerns about growing import competition from China, Indonesia's growth in non-oil exports to China is the highest among other destination countries.

What is the economic prospect for 2004? Economic growth continues to rely largely on consumption, while investment is still lagging and exports remains modest. Food consumption is expected to continue to increase in 2004 due to positive impacts of the 2004 elections. In the last elections in 1999, strong consumption growth was evident, of which food consumption growth reached around 5 percent.

While economic growth is expected to accelerate slightly next year, it does not bode much progress in reducing unemployment, poverty and social conflicts in the near future. Investments and exports remain slow, showing that serious problems persist in the manufacturing sector.

The non-oil manufacturing sector only grew 2.3 percent in the first three quarters. An annual survey conducted by the Central Statistics Agency (BPS) illustrates the poor condition of the manufacturing sector, particularly in textile, garments and footwear. Meanwhile, the percentage of manufacturing firms that downsized and closed down continued to increase from 2000 to 2002. As a result, the job absorption rate in these sectors also declined.

On the export front, Indonesia seems to have been shifting into resource-intensive products since 1995, whereas the competitiveness of manufacturing is in decline. A study carried out by Basri and Syahrial from the School of Economics at the University of Indonesia shows that from 1985 to 1995, most manufacturing products experienced a rise in competitiveness.

Nevertheless, from 1995 to 2001, the competitiveness of some of these products -- including plywood, textiles, footwear and garments -- showed a declining trend. These findings suggest that export growth was mainly driven by the supply side, or competitiveness, rather than the demand side from 1985 to 1995, but not from 1995 to 2001.

To make things worse, the declining competitiveness of Indonesian exports is combined with creeping protectionism. Protectionism is not the answer to the hindrances to making progress at the multilateral level, such as the World Trade Organization, and does not provide a sustainable basis for growth.

While there is no conclusive relationship between trade openness and growth in many countries, there is also no evidence that trade protection is systematically associated with high economic growth. This is particularly true for Indonesia. A protectionist policy will undermine the current open trade regime that has served the country so well in the past. The continuing signs of increasing protectionism imply that the government has tried to overcome inefficiency on the supply side through trade policy.

But the government does not address the problem of lagging productivity through increasing efficiency. Instead, it tends to defend inefficient industries by increasing protectionism, thus coming out with various ad hoc trade policies.

Since 2001, the protectionist trend has continued to increase, as evident in the increase in tariffs on wheat flour and trade regulations, or tata niaga, on textiles, steel, sugar and clove.

More in-depth observation shows that the negative growth of investment was mainly caused by foreign events, whereas domestic investment growth remained positive.

One of the possible explanations as to why domestic investment and foreign investment recorded inverse growth is the appreciation of the rupiah, which caused imported capital goods to become more expensive and led foreign investment to decline.

It is true that there is a trend of capital inflow as reflected by the strengthening of the rupiah, but it is limited to portfolio investment. As a result, short-term capital inflow does not have significant impact on investment in the real sector.

In fact, the government should be aware of the possibility of reverse capital flow when there is an economic and/or political shock. It is worth noting, however, that thus far the government has been able to maintain political stability, and the currency and capital market is becoming less sensitive to political issues -- proven in the limited impact of the Bali blast and Marriott bombing on the exchange rate and stock market.

Looking at the severity of the economic crisis and the shortcomings in institutional reform, immediate recovery is not to be expected in the short term. In addition, other factors, such as political uncertainty, have also hampered economic recovery during the last five years.

The investment climate remains bleak due to various labor and institutional problems. Looking at government performance and the obstacles faced in implementing good governance, it certainly is difficult to expect that the climate will improve soon.

The implication, therefore, is that foreign investment will not return unless significant reforms are made in politics as well as the judiciary. Coupled with business uncertainty, labor problems and local taxes, these factors will influence economic growth during 2004. The University of Indonesia's School of Economics predicts that the economy will grow by an average 5 percent per annum until 2007. Under such conditions, the road to economic recovery is still long and bumpy, although it is not unpromising.