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p. 16 of 81 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia Cambodia Indonesia Lao People's Democratic Republic Malaysia Myanmar Philippines Singapore Thailand Viet Nam South Asia Central Asian Republics The Pacific III. Preferential Trade Agreements in Asia and the Pacific

Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Indonesia

Economic growth slowed in 2001 as investment spending and exports reflected weaker external markets and continued internal political uncertainties. The ongoing conflicts in different regions of the country, burdensome public sector debt, and lack of progress on necessary economic reforms are constraining higher growth rates. Growth is expected to continue at a moderate rate in 2002–2003, sustained by private consumption spending and the anticipated recovery of international markets.

Macroeconomic Assessment

GDP growth in 2001 at 3.3% was considerably lower than the strong 4.8% expansion in 2000. The 2000 experience represented a delayed rebound from the Asian financial crisis, but this relatively good performance could not be maintained given investor uncertainty and weakening external markets. Strong growth in private consumption and public expenditures accounted for most of the growth in 2001. Business spending was muted in response to recurrent political difficulties, although the relatively peaceful change in the presidency in July provided for a moment of calm before the events of September 11th in the US and the subsequent rise in tension that again unnerved businesses. Investment in plant and equipment in the first two quarters of 2001 grew at an average rate of just under 18% (on a four-quarter basis). Though spending declined thereafter, the year as a whole showed only a 4% increase. The figures for exports and imports displayed a similar pattern of growing weakness during 2001. On a national accounts basis, net exports were down 26% during the year.

Private consumption rose by about 6% in 2001—the sharpest rise since 1997—with consumers responding to income increases in 2000 and early 2001. Although consumer spending remained strong throughout 2001, it is unlikely that this trend can continue as spending increased faster than overall income during the second half of the year. Likewise, the 8.2% growth in general government expenditures seen in 2001 is probably unsustainable, given the size and recent expansion of the public debt burden. Last year’s deficit spending partly reflected efforts by the central Government to ensure a smooth transition under the decentralization process initiated at the beginning of the year.

By sector, manufacturing output grew by 4.3% in 2001, and utilities and some services sectors also showed strong growth. Manufacturing benefited from a high level of investment early in the year as well as sustained consumer spending. In contrast, agriculture continued to reflect weak productivity growth and other problems in the rural sector, and managed less than 1% growth in 2001.

Preliminary data for 2001 show a softening in labor market demand resulting from slower economic growth. Employment edged up by 1.1% in 2001, but this rise was insufficient to offset the population increase and the labor force participation rate. Increased employment was reported mainly in the formal sector, which accounts for about one third of the economy, while little jobs growth was reported in the informal sector, which depends heavily on employment in the poorly performing agriculture sector.

Real wage data support the above picture, with significant increases seen in manufacturing but stagnation in agriculture. Administratively mandated rises in the minimum wage may have been important in manufacturing wage movements late in 2001. Real wages in manufacturing appear to have risen enough to make up for the declines that occurred during the financial crisis.

In 2001, total government revenues equaled 20.3% of GDP, slightly under the 20.7% in 2000. (The 2000 figures are estimated on an annualized basis because the fiscal year ran from April to December to allow for the transition to a calendar-based fiscal year in 2001. Therefore, comparisons between the 2000 and 2001 fiscal years are uncertain due to seasonal factors that may differ in the two periods.) Revenues from public activities in the oil and gas sector rose from 6.9% to 7.1% of GDP despite a softening of international prices, while tax collections fell by roughly 1 percentage point of GDP in 2001. The inability of the Government to meet targets for its privatization activities hindered revenue enhancement efforts. Total government expenditures rose by more than 1 percentage point to 22.6% of GDP. An important component of this was the increase in interest payments on public debt: these payments equaled 5.9% of GDP in 2001 and were the single largest line item in the central government budget.

The external debt had ballooned during the financial crisis, rising from less than one half of GDP in 1996 to 88% of GDP at the end of 2001. Domestic debt increased likewise, rising from 21% of GDP in 1998 to 80% in 2001, largely due to bank recapitalization and refinancing exercises. Another large item in the routine budget—subsidies for energy and other services and operations by SOEs—fell from 6.4% of GDP in 2000 to 5.2% in 2001. This reflected the Government’s moves to increase final consumer prices, especially for electricity and petroleum products.

The rupiah weakened during 2001, depreciating by roughly 8.3% against the dollar. Political events appeared to dominate exchange rate movements during the year.

On an annual basis, the consumer price index rose by 11.5% in 2001, a sharply higher figure than the 3.7% rate of inflation recorded in the previous year. The increase in aggregate demand during 2000 and early 2001 underlay much of the price movement, but the depreciating currency, increases in administered energy prices, and accommodative monetary policy were also important general factors in rising inflation. Transport prices in particular rose by over 15% during 2001. Food prices were quite volatile from month to month and increased by 12% over the year.

Interest rates increased on a nominal basis in 2001, though the rise in inflation held real rates roughly constant for key rates (Figure 2.7). The central bank’s 1 month rate (on the Sertifikat Bank Indonesia) moved from an annualized rate of 14.5% at the end of 2000 to 17.6% at the end of 2001. Adjusting for the 12-month change in the price level, the real rate stayed fixed at a relatively high 5%. Central bank interest rates did rise relative to international money rates: the spread of the 3-month Sertifikat Bank Indonesia over comparable US treasury bills widened from 8.5% at the end of 2000 to more than 15% at the end of 2001. While central bank interest rates paced inflation, commercial time-deposit rates were little changed overall in 2001, as banks struggled to improve profitability. Since time- deposit rates were little different from actual inflation, the real interest rate on commercial bank deposits was close to zero, discouraging saving.

Monetary policy was relatively accommodative and broad money supply grew at an annual rate in excess of 17.5% for the year. At the very end of the year, growth in money supply aggregates appear to slow. Even with slowing monetary growth at the end of the year, the money supply was considerably above target levels set in the Government’s macrostabilization program agreed with IMF.

The Jakarta Stock Exchange ended 2001 down only a slim 5.9% from the end of 2000. The gain in the index in the middle of the year, reflecting the relatively peaceful changeover in the presidency, was lost following the attacks in the US in September and renewed political turmoil in Jakarta.

The banking system showed some improvement over the year as a result of continued closures and reorganization. The number of banks fell from 151 at the end of 2000 to 145 in November 2001. Nonperforming loans fell in 2001, to 13.6% in November 2001 from 18.8% at the end of 2000. At the same time, intermediation activity appears to have picked up, with banks making more loans as a fraction of their deposit base and reducing their dependency on government bonds for income. However, these changes are small, and the banking system’s role in corporate finance is still a lot less important than before the financial crisis.

Although national accounts data suggest that the real value of both exports and imports rose in 2001, preliminary data suggest that both flows fell in 2001 when measured on a balance-of-payments (dollar) basis, implying a weakening of prices during the year. On such a basis, merchandise exports showed a 9.8% decline through 2001, while merchandise imports dropped by 12.2%. For the first time since the financial crisis, oil and gas trade fell with both exports and imports shrinking during the year. Although price declines largely account for the slip in dollar inflows from oil and gas trade, production problems also hampered supplies and exports.

Net services flows, which had been negative for several years, became more so in 2001. Inflows from tourism finally showed a definite recovery from the impact of the financial crisis and coincident political unrest in the country, but fell off after September 11th. Protests and threats to foreigners by extremist groups, which were widely reported in the global media, had a strong negative impact on tourism. Heightened concerns over travel safety also raised costs for insurance.

With declines in both exports and imports, the net merchandise trade surplus narrowed to $23.6 billion in 2001 from $25 billion in 2000. With continued higher net outflows from services, the current account surplus narrowed to $5.1 billion or 3.1% of GDP.

On the capital account, inflows of official assistance, which were prominent in the rescue effort after the financial crisis, fell in 2001, reflecting a decline in disbursements from policy-based adjustment loans. The net resource transfer from official creditors persisted in its steady fall from its peak in 1998 and is projected to become negative if current trends continue. Private capital continued to flow out of the country, as both FDI and other investments were strongly negative. Private capital outflows were larger than official net inflows, and as a result the balance-of-payments position turned slightly negative in 2001. The country’s net reserve position fell by approximately $1.9 billion to $28 billion at the end of the year.

Policy Developments

In 2001, fiscal and monetary policymakers faced the difficult task of encouraging economic recovery without jeopardizing a somewhat fragile macroeconomic stability. This challenge is likely to remain difficult in the coming years as fiscal freedom remains constrained and competing reform needs restrict monetary policy options.

Fiscal policy operates under increasingly tight constraints dictated by large debt service obligations and the transfer of one quarter of total public revenues to local governments under the ongoing decentralization process (Box 2.2). Domestic resource mobilization is hindered by relatively low tax collection efforts, with the tax-to-GDP ratio remaining at 12–13%, considerably below that of neighbors such as Malaysia. Improvements in tax collections can come only with across-the-board improvements in governance. Civil service and administrative reforms are necessary in tax collection agencies, but this is unlikely to have much impact until there is a concurrent strengthening of the legal and judicial system. A commitment to change is clear at the highest level of Government, but experience in other countries suggests that reform will not come quickly.

Sources of nontax revenue are also constrained, due in part to continued dependency on somewhat volatile oil- and gas-related revenues and because of difficulties that the Government faced in public asset sales and in privatization. In the fallout from the financial crisis, the Government took on a large debt burden, particularly in the finance sector as a result of bank recapitalization. The banking system as a whole was essentially nationalized as the Government assumed control and ownership of most of the banking sector that had previously been privately controlled and owned. With the government bailout, enterprise assets and outstanding loans were transferred to government asset-management agencies. Although some progress was seen in late 2001, entrenched political interests and concerns within the Government over the impact of privatization on equitable growth and economic security have obstructed asset sales and privatization efforts.

The 2002 budget, passed in October, calls for lower expenditures as a share of GDP than in 2001, although development spending financed by the central Government will remain steady at 3.1% of GDP. Overall, the Government’s fiscal policy stance in 2002 is little different from that in 2001, with the budget targeting a primary fiscal surplus equal to about 2.5% of GDP (primary fiscal balance is defined as total revenues less all expenditures except interest payments). The Government has also announced that it will continue with plans to increase electricity prices to reduce operating losses by the state electricity company. The 2002 budget assumes that the Government will win further debt relief from the Paris Club of government creditors and that next year’s negotiations will bring a rescheduling both of interest payments and principal repayments.

Fiscal conservatism is dictated by the necessity to meet debt obligations. As noted above, public sector debt ballooned as a result of the financial crisis. With prudent debt management, including successful Paris Club renegotiations, the outlook is that the debt burden will gradually diminish. However, debt service will remain the largest single item on the public sector books in light of moderate economic growth and limited repayment capacity.

Monetary policy has been hampered by both difficult circumstances and weak political support for a tight monetary policy stance. The emerging threat of double-digit inflation has been difficult to confront through monetary instruments for fear of stifling business and consumer spending. An added constraint has been that a number of banks that received government support or rescue were dependent on fixed-income certificates. The balance sheets of these banks would suffer in a higher interest environment. Finally, political disagreements between the central bank and former President Wahid clearly undermined the central bank’s ability to impose policies likely to be unpopular.

Spurred by rising exports, increased investment was one of the factors that helped pull the economy out of recession in 2000 and early 2001. However, FDI inflows faded as global markets weakened in 2001. More important to longer-term prospects, there has been a widespread perception that the policy environment for investment in Indonesia has turned harsh and unsupportive. In the first 10 months of 2001, only $6 billion of FDI projects were approved, roughly equal to one third of the total approved during the comparable period in 2000. Because the fall in investment predates the September attacks on the US, it would seem to be part of the broader, longer-term problem of capital flight seen in Indonesia since the financial crisis. Continuing problems of financial governance, lack of credibility of the legal and judicial system, and political uncertainty have all discouraged investors from making longer-term commitments. The Capital Investment Board noted that only about 10% of previously approved projects—both domestic- and foreign-sponsored—were likely to be realized this year. The political problems hindering attempts to sell state-controlled assets are one of the symptoms of the broad negative investment sentiment. Successful execution of planned privatization of major banks and SOEs would be helpful both in restoring investor confidence by signaling the Government’s commitment to encouraging private sector development, and in convincing the investment community that needed changes will be made so that future investments are warranted.

Outlook for 2002–2003

There will likely be a modest weakening of growth, from 3.3% in 2001 to 3% in 2002, as demand falters in the early part of the year before an expected recovery takes hold in the second half. Brighter prospects in external markets in 2002–2003, continued incremental progress in economic reforms, and a prudent fiscal and monetary policy stance should ensure that the risks of recurring recession are minimized and should provide scope for a modest pickup in GDP growth in 2003. However, there seems little prospect that the economy will again experience the rapid economic growth of the order of 7–10% annually that it experienced during the decades prior to the financial crisis.

A recent poverty monitoring report, covering January–October 2001, suggests that there was no poverty reduction in this period. Basing its assessment on trends in real wages in the formal and informal sectors, including agriculture, the report found that real wages in the informal sector were steady, although this average trend hid considerable variation across regions. Real agricultural wages increased by up to 10% in four provinces, and declined by up to 10% in five other provinces. Real wages in the formal and construction sectors registered significant increases (10–12%) largely as a result of legislatively mandated increases in the legal minimum wage. However, any beneficial effects that these increases had on the poor are unclear as changes in employment levels caused by the wage rises are unknown, as is the extent of participation of the poor in formal sector employment.

Growth in the 7–10% range is necessary to reduce poverty in a sustainable fashion and to meet the Government’s long-term development goals. Looking back, poverty decreased from 40% in 1976 to just over 11% in 1996. At the 3–4% GDP growth rate currently anticipated, average income can be expected to rise by only 1–2% per year, i.e., far too little to materially affect the bulk of population that is poor or near poor. To regain high growth rates, it will be important for policymakers to work hard to convince both domestic and international investors that reforms are effectively reducing corruption and weaknesses in the legal and judicial system.

The IMF-supported program for macrostabilization calls for more aggressive targeting of inflation. However, the weaknesses of the central bank, a lack of political consensus on the advantages of higher interest rates, and the need to continue to raise energy and utility costs will mean that inflation will come down only relatively slowly. Exchange rate movements appear to follow current inflationary expectations, a trend that is likely to continue. Banking sector reforms, including privatization of banks, could provide additional scope for lowering inflation.

Although the external sector is likely to grow at higher rates in the future, current trends suggest that the large current account surpluses that have cushioned the economy from the effects of low growth and capital outflows (by providing foreign exchange for debt repayment) are likely to decline in 2002. Tightening current account surpluses means added risks from external shocks, such as dampening inflows from tourism or further capital flight. Active pursuit of government policies to improve peace and security and to encourage investment, as well as prudent debt management, will become more important .

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