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p. 21 of 54 BACK | NEXT I. Developing Asia and the World - Economic Developments and Prospects II. Economic Trends and Prospects in Developing Asia Newly Industrialized Economies Central Asian Republics, Azerbaijan, and Mongolia People’s Republic of China Southeast Asia Cambodia Indonesia Lao People’s Democratic Republic Malaysia Myanmar Philippines Thailand Viet Nam South Asia The Pacific III. Asia's Globalization Challenge

Asian Development Outlook 2001 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Indonesia

Economic growth recovered in 2000, due to increased external demand for manufactured goods and natural resource-based products. Although growth is forecast to continue in 2001 and 2002, the fragility of peace and order, high levels of public and private debt, slow progress in governance reform, and a weak banking system, cast a shadow over future economic prospects.

Recent Trends and Prospects

Economic growth resumed at a rate of 4.8 percent in 2000 after a sharp recession in 1998 when GDP contracted by 13.1 percent, and 0.8 percent growth in 1999. The major area of strength was exports, which rebounded strongly in 2000 from a decline in 1998 and weak growth in 1999 when exporters struggled with a lack of financing and general banking services in the wake of the Asian financial crisis (see Figure 2.8). In contrast to surging exports, domestic spending by businesses, households, and the public sector recorded only modest growth. Household income recovered from the recent recession, but weaknesses in the labor market and in agriculture continued to hold back spending. Agricultural output was affected by poor weather, natural disasters, and civil unrest.

The uncertain political situation also hindered investment, though there are some signs that enterprise spending is recovering from the low point of the recession. New foreign direct investment (FDI) commitments in 2000 rose by 60 percent above 1999 levels. However, despite the sharp increase in 2000, FDI is still nearly one third below precrisis levels and is largely confined to export-oriented areas. The huge depreciation of the rupiah against currencies such as the dollar and yen provided large incentives for exports of garments, as well as of agricultural and natural resource-based products. To provide a broader perspective, Indonesia may have been the only country in the region to experience “negative FDI” or net divestment in 1998 and 1999. In addition to political uncertainties, foreign investors cite corruption and complex tax and regulatory systems as discouraging to investment. Domestic investment is also running at a small fraction of the precrisis level.

On a national income basis, gross domestic investment—covering plant, equipment, infrastructure, and inventories—stabilized in 2000 at 17.9 percent of GDP. This is well below the over 30 percent share preceding the financial crisis. Reflecting the strong trade surplus, gross domestic savings are estimated to have amounted to 22.0 percent of GDP in 2000.

Spending in fiscal year (FY) 2000 (which covered the period April to December to allow for a transition to a calendar-based fixed year in 2001) reflected the need to contain the budget deficit—necessitated by the increasingly difficult debt burden—with maintaining aggregate demand and encouraging a more sustainable recovery. Budgeted spending (including transfers to local governments) in FY2000 increased from the previous fiscal year by slightly more than 4 percentage points to 21.6 percent of GDP. Against this, revenues improved by approximately 2 percentage points to 16.8 percent of GDP. The overall budget deficit worsened to 4.8 percent of GDP in FY2000 from 2.3 percent in FY1999.

The largest single public expenditure component consists of interest payments on domestic debt. In FY2000, these amounted to 4.2 percent of GDP, accounting for nearly one fifth of total expenditures. In contrast, interest payments on external debt are less than one half the domestic debt burden. The emergence of a serious public debt burden reflects the costs of the financial crisis, especially the use of public funds to recapitalize the banking sector.

Personnel expenditures and subsidies are the next largest items of central government spending, both accounting for 3.4 percent of GDP. Personnel expenditures increased by more than 21 percent in FY2000, reflecting efforts made to raise civil service compensation. Among subsidies, the largest item is for petroleum products, while smaller amounts are given for food and electricity. The subsidies stem from earlier programs to contain the cost of living for the poor. It is generally acknowledged that the subsidies have been ineffective in reaching the poor and they are being phased out.

Social sector spending fell a little in FY2000. Education expenditures declined from 7.3 percent of total central government expenditures in FY1999 to 6.0 percent in FY2000. This is quite worrisome because Indonesia has historically devoted a smaller fraction of the national income to education than Malaysia, Philippines, and Thailand. Expenditures for health, population, and social welfare also declined.

On the revenue side, the slight impovement in domestic resource mobilization largely stemmed from greater tax efforts. In FY2000, total domestic tax collection was 10.5 percent of GDP—the largest elements being income and value-added taxes. Much of the year-to-year increase resulted from higher oil and gas earnings, which strengthened by 30 percent in nominal annualized terms, due to higher world oil prices. The Government is committed to further increasing domestic resource mobilization; however, the major obstacle to this is weak tax collection. Government officials acknowledge that only long-term civil service and judicial reform can deal with this serious problem. The impact of higher debt service payments on the overall fiscal balance becomes apparent when one considers that the primary fiscal balance—before interest payments—was a positive 1.2 percent of GDP. Around 43 percent of the overall budget deficit was financed by foreign borrowing, nearly all of which comes from official development assistance. Roughly an equal amount was financed by asset sales—largely by the Indonesian Bank Restructuring Agency.

Monetary policy faced the same problem as fiscal policy— treading carefully between supporting recovery and maintaining macroeconomic stability, especially price stability. On balance, the net result was to lean on the side of supporting recovery. Monetary aggregates tended to grow faster than targeted and, at the end of 2000, inflation was also higher than targeted. Growth in monetary aggregates has come largely in demand for currency and more liquid bank deposits, i.e., demand deposits rather than time deposits.

Interest rates rose somewhat over the year: the one-month Bank Indonesia Certificates rate increased from 12.5 percent at the end of 1999 to 14.5 percent at the end of 2000. One-month treasury bill rates moved marginally above three-month rates, testifying to the premium on liquidity. The demand for liquidity reflected renewed lack of confidence in short-term prospects of the rupiah against the dollar as well as continued concerns over the health of the banking system.

Merchandise exports in 2000 surpassed the precrisis high of $56.3 billion to reach an estimated $65.7 billion, marking a rise of 28.2 percent during the year. Most of the increase was in non-oil and nongas exports. The sharp depreciation of the rupiah since the onset of the crisis has stimulated a wide range of exports, including in 2000 electrical equipment, textiles, and some natural resource products, particularly aluminum and nickel. (In nominal terms, the rupiah depreciated by 75 percent against the dollar from the beginning of 1996 to the end of 2000.) Agricultural products suffered from some weakness in international prices, but often showed strong volume increases. Imports rose faster than exports, but from a much smaller base, paced by raw materials purchases. Capital goods imports have yet to pick up, reflecting the lack of widespread investment spending. Overall, the merchandise trade surplus improved in 2000 to $24.9 billion. This led to a corresponding increase in the current account surplus from $5.8 billion in 1999 to $7.8 billion in 2000.

The capital account saw continued capital flight, reflecting both negative FDI as well as continued outflows of portfolio capital. Capital flight was only partially offset by higher levels of official development assistance. As the capital account deficit was smaller than the large current account surplus, net official reserves increased.

With the exception of some brief stability in the third quarter, the rupiah weakened over the year, falling to Rp9,500 to the dollar in December 2000 from Rp7,100 one year earlier. Business confidence in rupiah-denominated investments remained limited.

According to data provided by Bank Indonesia, Indonesia’s external public debt increased from $56.3 billion at the end of March 1997 to $81.5 billion at the end of June 2000 before moderating to $75.3 billion by the end of September. The sharp rise in debt reflected the public assumption of privately contracted debt following the government bailout of the financial sector and the continuing need for external funds to finance the budget deficit and meet external debt-service obligations. The fall in external public debt in the latter half of 2000 led to a corresponding decline in total external debt outstanding to $130.8 billion at the end of 2000 from $150.0 billion at the end of 1999.

Paris Club debt restructuring, through an agreement on 13 April 2000, provided significant easing of anticipated debt-service obligations. Official creditors rescheduled approximately $6 billion in principal repayments, originally falling due through early 2002. This facilitated additional rescheduling by London Club creditors. The agreements are, however, contingent upon successful annual International Monetary Fund reviews.

Average annual inflation fell considerably in 2000 although the end-December 8.7 percent increase in the consumer price index was significantly above the comparable 1.9 percent increase in 1999. Inflation was particularly noticeable in the last few months of the year as renewed rupiah weakness was matched by domestic price increases. In addition, higher fuel costs, resulting from the Government’s program to reduce subsidies, were also a factor in higher inflation. Although clearly showing progress relative to 1999, the end of year inflation rate was over the target of 5–7 percent of the International Monetary Fund-sponsored stabilization program.

Unemployment figures in Indonesia are generally lower than in many developing member countries—the relatively flexible labor market tends to provide a high level of employment. Even during the crisis, on an annual basis, the number of people reported as working increased. Changes in aggregate economic activity, even severe changes such as during the crisis, tend to be reflected in real wages rather than in aggregate employment. During 1998, a sharp decline in purchasing power occurred as price rises for basic goods outpaced wage increases. The initial impact of lower real wages helped push many near-poor people below the poverty line. As the economy recovered in 1999, greater macroeconomic stability was achieved, purchasing power and real incomes rose, rice and other food prices stabilized, and poverty rates fell back somewhat. In 2000, preliminary data suggest that real wage increases observed in late 1999 and early 2000 did not continue throughout the year. The recovery will likely have to become broader and deeper to have a significant and continued impact on poverty.

GDP growth is expected to slow slightly from 4.8 percent in 2000 to 4.2 percent in 2001 before improving to 4.5 percent in 2002. In the near term, the recovery is likely to be constrained somewhat by a less favorable domestic and external environment. Domestic demand will remain relatively weak because of low disposable incomes, sluggish credit growth, and relatively high interest rates, especially if civil unrest continues. On the external front, export growth will be adversely affected by the slowdown in the global economy. This will partly offset the positive impact of a depreciated rupiah on export competitiveness.

Toward the end of our forecast period, export growth is likely to pick up due to a recovery in global demand. Investment and construction are expected to gradually strengthen, partly on export gains. Investment, however, is likely to continue to be narrowly based and construction is unlikely to reach its precrisis robustness. Household spending will increase with improved income and employment opportunities. However, continued weakness in the banking sector, the debt overhang in both the private and public sectors, and political uncertainties limit a faster pace of recovery.

The Government projects a declining fiscal deficit trajectory from 4.8 percent of GDP in 2000 to a near balanced budget in 2004, based on relatively optimistic assumptions. The recently revised budget for 2001, projecting a deficit of 3.7 per-cent of GDP, is consistent with this plan. Tight fiscal spending within the context of a large public debt service burden will limit public expenditures on health and education. Maintaining public infrastructure will also be much more difficult. These issues make it more important that the Government has a development strategy ensuring efficient use of limited resources.

The ongoing process of decentralization of both adminis-trative and fiscal responsibilities has implications for budgetary allocations in general and development support in particular. In the 2001 budget, transfers to other levels of government will represent 25.4 percent of total outlays by the central Govern-ment, a rise of roughly two thirds from 2000.

Issues in Economic Management

A healthy banking system is a prime requirement for reducing the vulnerability of the economy to external shocks and for enabling long-term private sector growth. As in the rest of the crisis-affected Asian countries, the most severe macroeconomic impact of the crisis was felt in the financial sector. In June 1997, the banking sector in Indonesia consisted of 238 commercial banks, but by mid-2000, 66 banks had closed, 13 had been nationalized, and four of the seven state banks had merged. To support restructuring, as of October 2000 the Government had issued bonds valued at Rp650 trillion. Much has also been done to strengthen prudential regulation and banking supervision. Banks, however, remain minimally capitalized and are reluctant to lend. Current levels of lending remain far below those needed to support a vigorous recovery.

Box 2.4 Social Safety Net Scholarship Program in Indonesia In response to the Asian financial crisis and fears of mass school dropouts, the Government, with the financial assistance of the Asian Development Bank and the World Bank, instituted a scholarship program. This ongoing program provides financial assistance to poor households with children in school. The amount generally covers the cost of school fees (Rp10,000, Rp20,000, and Rp30,000 per month for primary, lower secondary, and upper secondary school students, respectively) and can be used for that purpose or other expenses. Funds were first allocated to schools so that “poorer” schools received proportionally more scholarships. School committees (consisting of the school head teacher, the chair of the parents’ association, a teacher representative, a student representative, and the village head) then allocated scholarships to individual students. School students in all but the lowest three grades of primary school were eligible. Participating students were to be from the poorest backgrounds. If there were too many eligible students for all the poor students to receive a scholarship, then additional indicators were to be used to identify the neediest students. The additional indicators were those living far from school, those with physical handicaps, and those coming from large or single-parent families. Also, a minimum of 50 percent of scholarships, if at all pos-sible, were to be allocated to girls. The monitoring of the program was done independently of the Government by a team under British Council management with units in each province (contracted to nongovernment organizations) collecting the data through site visits. The combination of (i) schools deciding who received the scholarships, (ii) direct funds transfer to the beneficiary, and (iii) independent non-government organization monitoring helped to ensure more efficient targeting and transparent use of resources. Qualitative evidence on the impact of the program indicates that it has been well received in the villages, has been reasonably well targeted, and has played a role in keeping at least some children in school. This is backed up by quantitative evidence. The figure shows the targeting of the scheme within a random sample of 100 relatively poor villages. The scholarships seem to have been effective in reducing dropout rates by about 2.4 percentage points at the lower secondary school level.

Further financial sector reforms are needed to reduce overdependence on the banking system, through the development of nonbank financial institutions such as bond and equity markets. Reforming nonbank financial institutions, including those dealing with pensions and insurance, is also important in establishing fiscally sustainable social protection and social insurance mechanisms that can play an important role in long-term antipoverty development.

Reforms also need to be enacted to strengthen the independence of the central bank, which has been weakened by continued political infighting over loans made during the crisis to private banks. The loans were made ostensibly to maintain liquidity in the face of depositor panics; however, an investigation by the state auditor suggested that as much as $15 billion of the loans were inappropriately made. The outcome of these reforms needs to be the reassertion of central bank control over monetary policy and the strengthening of prudential regulations to prevent such practices from reoccurring.

Policy and Development Issues

Indonesia’s record in reducing poverty in the years preceding the crisis was exceptional. From a country with widespread poverty, it rose to rank as a middle-income country in two decades. The incidence of poverty fell from 40.1 percent in 1976 to 11.3 percent in early 1996. The crisis threatened to undo these long-term gains. Using a new methodology for measurement, poverty incidence soared from 17.7 percent in February 1996 to a peak of 24.2 percent in late 1998, when perhaps 15 million more people had fallen below the poverty line. The sharp descent into poverty of so many in just over a year shows the vulnerability of the poor to economic shocks. As the recession receded, the situation improved: a survey in August 1999 showed a decline in the overall incidence of poverty to near precrisis levels of 18.2 percent. The incidence of poverty is, nevertheless, high and new programs have to be developed to address these issues (see Box 2.4).

The incidence of poverty varies significantly across the country, and is notably higher in rural than urban areas. Metropolitan Jakarta, for example, with its infrastructure and its role as a center of manufacturing and high value-added services, has broader access to basic services and a much lower poverty incidence than other areas. In sharp contrast, Irian Jaya has a poverty incidence more than 10 times that of Jakarta. These disparities need to be addressed in new legislation on poverty.

Poor people living in rural areas often depend on coastal, fishery, marine, or forest resources. Excessive stress on the ecosystem has reduced income for the present generation and sharply reduced potential income for future generations. In addition, many of the poor live in environmentally sensitive areas prone to pollution, erosion, floods, and landslides, and have inadequate sanitation and clean water facilities. Efforts must be undertaken to act more decisively and effectively to manage environmental and natural resources in a sustainable fashion. Failure to do so will severely weaken the potential for poverty reduction in the coming decades.

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