Monday, December 20, 2010

Indonesia’s economic prospect in 2011

Milan Zavadjil, Jakarta | Mon, 12/20/2010 12:27 PM | Review & Outlook
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The year 2011 should be another very good one for the Indonesian economy. Even against the background of a muted global recovery, we expect growth of 6.2 percent, compared with 4.5 percent in 2009 and 6 percent in 2010.

This positive scenario assumes the risks from volatile capital flows and inflation are managed effectively. Looking further ahead, 2011 could be the first of a series of truly great years for the economy if the government implements forcefully its program of improving the infrastructure and the business climate, as well as making progress toward developing a basic social safety net.

We expect investment to spearhead growth in 2011, continuing this year’s trend. Net foreign direct investment more than tripled in January-September 2010 compared with 2009, with increases across all sectors, especially manufacturing. Capital equipment purchases represent an increasing share of investment which augurs well for productivity and income growth.

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Looking ahead, investment prospects appear even brighter. With opportunities in the US, Europe, and Japan limited by deleveraging, unemployment, and weak housing markets, investors from both mature economies and emerging markets are increasingly looking at Indonesia.

They appreciate its rapid demographic growth, proximity to the world’s strongest growing economies, and low government, household, and corporate debt.

For now, many investors seem willing to put up with the costs of Indonesia’s poor infrastructure and weak investment climate. However, their patience may eventually run out — especially once prospects for the mature economies improve. This is why it is urgent for the government to address these problems forcefully.

During the global recession, growth in Indonesia was sustained by robust private consumption. However, reduced agricultural output and elevated food prices as a result of bad weather depressed household spending in the third quarter of 2010. We expect strong private consumption growth to resume in 2011 on the back of 10-15 percent public sector and minimum wage rises, a gradual increase in employment, and tight labor markets for managerial, technical and financial workers.

The key risk is inflation which has traditionally had an immediate negative impact on consumer confidence and the spending of poorer households. Bank Indonesia (BI) and the government can mitigate this risk through monetary policy measures and by addressing supply bottlenecks in key food markets. Over the medium-term, the development of a basic social safety net could also help strengthen to private consumption by reducing the need for precautionary savings.

The central government fiscal stance should have a broadly neutral impact on growth in 2011. Taking into account the usual shortfalls in expenditure, the deficit next year should not differ too much from the 1.2-1.3 percent currently estimated for 2010 (a deficit of 1.8 percent is budgeted for 2011). Indonesia’s fiscal position is very comfortable compared with most other countries and the government should take advantage of this opportunity in 2011 to begin to deal with some of the structural constraints to growth.

Accelerating key infrastructure projects should be a priority. In addition to increased budget allocations, legislation to facilitate land acquisition for infrastructure is badly needed as well as more effective coordination between the central and local governments and between central government departments. To be able to sustain higher capital and social expenditure in the future, it is essential to improve tax compliance and reduce subsidies, as the government has begun to do.

The contribution of external demand to growth should be reduced in 2011, but still positive — the current account is expected to stay in (very) small surplus. Driven by rising investment and output, imports will continue to rise strongly. But export prospects also remain favorable.

The IMF is projecting only a moderate growth slowdown in Asia, including China, in 2011 so demand for Indonesia’s commodities should remain strong. The coming online reports of new investments in coal, palm oil, natural gas, as well as segments of the manufacturing sector, will propel exports.

The main macroeconomic risks in 2011 are related to volatile capital flows and inflation. We believe the authorities have handled the inflows appropriately so far and that Indonesia has benefitted from the migration of capital from advanced to emerging markets — inflows have increasingly been of a long-term nature and the borrowing costs of the private and public sectors have been reduced.

The rupiah has strengthened, but remains fairly valued, based on the IMF’s assessment of medium-term fundamentals. Moreover, Indonesia has built-up its foreign exchange reserves and they should be sufficient to help deal with a possible reversal of the inflows.

Credit growth has ticked-up but overall corporate and household indebtedness has barely increased as a share of GDP. Stocks and bonds have risen sharply and are considered as “pricey” by some analysts, but others see the moves as a “rerating” in response to Indonesia’s strong growth potential and reduced fiscal and external vulnerabilities.

So far, so good, but under the weight of capital inflows, monetary conditions have recently eased considerably. Even though the BI policy rate has remained unchanged, market interest rates have dropped, raising the possibility of accelerated credit growth, inflation and asset price bubbles in the
future.

Moreover, strong growth and double digit wage awards suggest core inflation (which excludes energy and volatile food prices) is set to pick-up. Thus, BI needs to tighten monetary conditions soon, especially given the long lags in monetary policy transmission in Indonesia. A combination of measures could be considered, including a higher policy rate and/or reserve requirements, increased sales of open market instruments, and a strengthening of the rupiah. With credit growth accelerating, bank supervisors need to be extremely vigilant. Further regulatory measures to boost credit growth should be avoided.

In conclusion, economic growth should accelerate modestly in 2011. However, the macroeconomic risks facing Indonesia in a challenging global environment should not be underestimated. Policymakers need to remain attuned to the risks that volatile capital flows may present to macroeconomic management, and inflation should be kept within the 4-6 percent target range. An even greater challenge is to ensure that strong growth is sustained into the medium-term through the implementation of structural measures envisaged under the Five Year Plan.

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