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p. 18 of 68 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 Asia The Pacific III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Indonesia

Modest economic growth was sustained in 2002, driven largely by private consumption spending, while the Government made progress in improving both macroeconomic stability and fiscal sustainability. However, declining investment and limited advances in overcoming underlying impediments to investor confidence constrain near-term growth potential. The immediate economic disruption of the terrorist attacks in Bali in October 2002 has been generally contained, but the tragedy will negatively impact growth, which is expected to remain at modest levels in 2003 and 2004.

Macroeconomic Assessment

Following political changes in 2001, the economy benefited from macroeconomic stability and recorded modest growth of 3.7% in 2002, marginally higher than the previous year. Political stability, sound macroeconomic policies, and progress on structural reforms strengthened the currency and stock market, and later permitted interest rates and inflation to decline. However, this improving macroeconomic performance was offset by a slower recovery of the world economy, and a continuing decline in the level of investment in Indonesia. Accordingly, growth was largely sustained by consumption expenditures, which were supported by large formal sector wage increases and expansion of bank credit.

While growth accelerated over the first three quarters of 2002, it was then set back by the attacks in Bali in October. The currency and stock market reacted sharply, but quickly recovered as confidence returned when the Government took well-publicized and effective steps to ensure security. Nevertheless, the decline of visitor numbers in the aftermath of the bombings is impacting the Bali tourism industry specifically and the economy more broadly.

Manufacturing recorded growth of 3.7% in 2002. However, a slowdown was already evident by the end of the third quarter, reflecting the impact of floods early in the year and continuing softness in investment spending. Utilities and some services subsectors showed strong growth, albeit slowing somewhat over the year. Agriculture grew by 2.3%, substantially up from the recent 0.7% annual growth trend. The growth was remarkable given the flooding in the early part of the year and the dislocation to markets, including those for agricultural inputs, due to heavy rainfall. The total production of paddy (wetland and dry land) for 2002 was up by 1.8% from the 2001 level with a 0.3% increase in the harvested area and a 1.6% increase in productivity. Nonfood production benefited from increases in the prices of palm oil, rubber, and robusta coffee.

Private and government spending grew strongly in 2002, providing the major stimulus to GDP growth during the year (Figure 2.7). Private spending was relatively stronger than overall income growth, partly in a delayed response to the ending of the long recession since the Asian financial crisis. Private spending, equivalent to more than 70% of GDP, grew by 4.7%, a slightly slower pace than in 2001. Public spending in 2002 was 12.8% above the level in 2001.

Based on national accounts data, both exports and imports declined in 2002. On balance, however, net exports contributed to growth as imports fell more heavily than exports. However, on a balance-of-payment basis, data show marginally positive growth for both merchandise exports and imports, following a very sharp drop in 2001. The trade account and the current account surplus increased somewhat in 2002, thus contributing positively to growth.

A poor investment climate has resulted in a continued decline in investment since the third quarter of 2001. The level of government approvals for foreign and domestic investment provides a guide to future investment trends. In the first 8 months of 2002, such approvals were more than 60% lower than in the equivalent period in 2001—a clear negative indicator of business and investment sentiment. The Manulife case in 2002, which saw the future of a sound insurance company threatened by corruption in the judicial system, gained widespread international attention. This was one of a number of incidents reflecting weak governance that discouraged investment by both domestic and foreign firms.

The latest data on employment have not been officially confirmed, but from preliminary analysis, the level of open unemployment rose from 8.1% in 2001 to 9.1% in 2002. The labor survey, carried out in August 2002, showed that the number of unemployed increased from 8.0 million to 9.1 million over the previous 12 months. However, the data did not represent the whole national situation because security concerns prevented effective employment surveys in Aceh, Maluku, and Papua. Anecdotal evidence suggests that those working in conditions of underemployment could be triple the number of those officially unemployed.

The employment situation reflects generally the modest growth of GDP as well as the return of hundreds of thousands of illegal Indonesian workers from Malaysia during the year. Annually, in excess of 2 million young people graduate or leave school in search of employment, but the rate of economic growth achieved since the financial crisis has failed to create sufficient new jobs for them. Before the crisis, unemployment was about 4.0% and annual GDP growth was 6-7%. Unemployment has now more than doubled, with growth falling by nearly half. The previous government survey, in February 2002, indicated that more than 60% of the unemployed were young men aged 15-24 and more than one third were senior high school graduates.

Despite the generally rising level of unemployment and underemployment, formal sector wages have risen rapidly. In the first semester of 2002, workers in large and medium industrial firms received wages 15% above those of the same period in 2001. In the second semester of the year, their wages were 9% higher than in the same semester of 2001. This reflects a succession of steep rises in minimum wages, including a 30% increase in 2002. Higher wages are having a negative impact on the competitiveness of labor-intensive industries, such as textiles and electronics. Moreover, almost two thirds of the labor force are in the informal sector and do not directly benefit from minimum wage increases. The wage gap is widening between the two groups. For example, real wages of agricultural workers remain below precrisis levels, with only a 2.2% increase in the year to August 2002, while real wages in manufacturing were 35% higher in mid-2002 than in 1996.

The 2002 estimate of the incidence of poverty of 17.9% shows a continuing ebb from the peak 1998 level of 24.2%. The small decrease in the last 2 years broadly reflects the combined impacts of the moderate growth rates, especially in agriculture, an increase in population, and the appreciation of the rupiah. In the short term, the incidence of poverty in Indonesia is quite sensitive to movements in food prices.

The authorities have managed to sustain fiscal consolidation, as reflected by a progressive reduction in the planned budget deficit from 4.8% of GDP in 2000, to 2.5% in 2002, and to 1.8% in 2003. Moreover, the actual outcome has been a consistently lower deficit than budgeted: for example, in 2002 an estimated 1.7% actual deficit was lower than the original plan of 2.5%. A major contributor to the reduction in the fiscal deficit has been the progressive lowering of fuel subsidies that have been paid primarily to SOEs. In 2000, they accounted for more than 6% of GDP, but they are targeted to fall to under 1.0% in 2003.

The 2002 fiscal outturn shows tax revenues below target due to lower than projected growth, but this is more than offset by higher than planned oil revenues, lower expenditures on subsidies, and delayed development expenditures.

The fiscal burden of servicing government debt has been a major feature of the budget in the postcrisis years. Interest payments were equivalent to about 5.3% of GDP in 2002 and represented one of the major expenditure items in the budget. Nevertheless, an appreciating exchange rate against the dollar and increases in nominal GDP resulted in a rapid decline in government debt-to-GDP ratios from 98% in 2000 to about 72% at end-2002. The Government also made progress in 2002 with arrangements to make future repayment of both its external and domestic debt more manageable.

Inflation rose sharply in early 2002 in response to the impact of floods and hikes in electricity and transport prices. Thereafter, inflation rates fell from roughly 15% in early 2002, stabilizing at about 10% for most of the remainder of the year. Inflation for the year was slightly higher than in 2001. Further anti-inflation efforts may well have to contend with inflationary expectations on the basis of 10% as the annual price rise over the past 2 years.

An appreciating rupiah has enabled the monetary authorities to lower interest rates. The rate on 3-month central bank certificates declined to 12.9% in the fourth quarter of 2002, a fall of 4.7 percentage points from the comparable period in 2001. The rupiah appreciated in nominal terms during 2002 by 15% against the dollar and from January to October in real terms by 22%. The appreciation in 2002 reflected the balance-of-payments surplus, improved political stability, and the movement of other regional currencies.

The stock market responded to improving macroeconomic stability in early 2002, with the Jakarta composite stock price index rising by 44% in the first 4 months. Much of this gain was lost in the following 4 months in the face of negative sentiment on international markets, reflecting international accounting and corporate scandals, and domestic security and corruption concerns. However, the market recovered quickly and for the year as whole the index rose by 10%. The Jakarta Stock Exchange also saw growth in the number of firms listed (from 318 to 329), and in average daily trading value (up 24%) compared with the previous year.

Notwithstanding ongoing vulnerability, the banking system continued to recover and strengthen. Bank credit has risen, albeit from a limited base. Outstanding bank credit increased by 16% in the first 11 months of the year, with growth focused on consumer credit. This growth in credit is reflected in the rise of the overall loan-to-deposit ratio for the banking system from 37.6% to 43.2% over 2002. The capital-adequacy ratio for nearly 150 reporting banks in the third quarter of the year was just over 23%, significantly higher than the minimum required 8.0%. However, the ratio is deceptively high, due to a large volume of government bonds and a corresponding low volume of lending that characterize most recapitalized banks. While consumer credit has expanded, the banking system provides only modest lending support for business spending. The reduction of banks' NPLs has slowed, with the gross ratio at 10.2% in November 2002. Indonesian banks are nevertheless reasonably provisioned for bad debts.

Following the sharp decline in exports experienced during the global downturn in the latter half of 2001, some recovery took place in 2002. With higher oil prices in the second half of 2002, imports of oil and gas were 32% larger than in 2001. However, with a reduction in non-oil and gas imports of 5.6%, total imports for the year were virtually the same as in 2001. The trade balance for 2002 turned in a surplus of $23.1 billion compared with $22.7 billion 2001. The impact of the terrorist attacks in Bali on tourism inflows and revenues is still to clearly emerge, but the possible drop in visitors could depress service revenues by perhaps $1 billion in 2003 and reduce export sales as well.

Private capital outflows have slowed since the fourth quarter of 2001. By the third quarter of 2002, outflows may have been running at roughly one quarter the pace seen in 2000-2001. This reflects inflows stimulated by state-asset sales and lower debt repayments on foreign private debt. FDI remains limited, discouraged by a poor investment climate (Box 2.4). Official net capital flows were slightly negative in 2002. However, this masked substantial support from Paris Club rescheduling agreements. Official reserves rose by 9% to $31.6 billion at the end of 2002.

External debt outstanding as of September 2002 was $131.3 billion, or some 13% less than at the end of 1998 after the exchange rate shock of the financial crisis. The fall in the debt level generally reflects declining enterprise (including SOE) debt. Public sector debt, at 56% of total external debt, has changed little from its end-of-year peak in 1999. The ratio of external debt to GDP declined to 77% by end-2002, down from almost 159% in 1998. The decline stems primarily from a growing nominal GDP and stronger currency rather than a smaller debt stock. The external position thus remains vulnerable: any adverse exchange rate movement could raise debt-burden indicators and reverse the trends seen in the past few years. Moreover, short-term debt continues to be a significant fraction of gross reserves—and external debt amounted to 226% of exports in 2002.

Policy Developments

The new Government of President Megawati Soekarnoputri, formed in August 2001, carried forward and developed Indonesia's economic and structural reform program agreed with IMF under a 3-year Extended Fund Facility that had been approved in early 2000. The Government's macroeconomic program for 2002 focused on fiscal consolidation in the difficult environment of managing the major public debt burden arising from the financial crisis. At the same time, structural reforms continued to address areas that impact macroeconomic stability, such as financial sector reforms, privatization and asset recovery, and legal and governance issues.

In 2002, the framework targets underlying the budget were substantially achieved. Interim results indicate that economic growth of 3.7% was within the 3-4% target range, and a fiscal deficit outturn estimated at 1.7% was well below the target 2.5% deficit. However, inflation at 11.9% was above the target range of 9-10% and the interest rate on Bank Indonesia Certificates hovered at the top of the intended target.

The Government has made considerable progress in making both external and domestic debt more manageable. In April 2002, bilateral creditors agreed to the third Paris Club rescheduling, under which $5.4 billion of interest and principal due between April 2002 and December 2003 were rescheduled. This paved the way for agreement with commercial creditors under a London Club rescheduling of syndicated loans on equivalent terms. These measures have significantly reduced the impact of external debt servicing on the 2003 budget. However, the Government continues to face very large external repayment obligations in 2004-2005. A key policy issue will be the possible resort to further Paris Club rescheduling over this period, which would require an ongoing IMF program for Indonesia, and public debate is now addressing the implications of not extending the present program on its completion at end-2003.

In terms of domestic debt, important measures were taken in 2002 that provide new capacity to manage debt more effectively. First, enactment of the Sovereign Debt Securities Law in November 2002 provides the basis for the issue of domestic government bonds. This new capacity was utilized with the successful auction in December of Rp2 trillion of new bonds with an 8-year maturity. Regular ongoing auctions are planned as part of the development of an active market for domestic public debt. This will provide the Government with valuable flexibility to meet maturing domestic debt obligations. Second, in 2002 the Government negotiated an extension of maturities on Rp172 trillion of recapitalization bonds held by state banks. This will reduce bond redemptions by Rp35 trillion in 2004-2005. Third, arrangements have also been put into place regarding Rp160 trillion of Bank Indonesia Liquidity Credit (BLBI) bonds with the central bank arising from the liquidity credits provided to the banking system during the financial crisis. These bonds are being exchanged for a perpetual promissory note to the central bank, addressing long-outstanding uncertainty over liabilities relating to BLBI. The interest burden on the budget is effectively reduced by this action, while the financial soundness of the central bank is preserved. The overall impact of these steps has been to more than halve the scheduled domestic debt repayment in 2004-2005.

The Government also made significant progress in implementing structural reforms in 2002. Important legislation enacted during the year included the Anti-Money Laundering Law, the Sovereign Debt Securities Law, and the Law on the Anti-Corruption Commission. Despite delays and some opposition, the Government succeeded in privatizing two large banks, Bank of Central Asia and Niaga. These banks had been taken over in the crisis; the recent sales have resulted in more than 50% of equity ownership in each being returned to the private sector. While the sales proceeds are important to the budget, the transactions also represent important milestones toward the goal of reducing the Government's dominant ownership role in the banking sector stemming from the extensive bank recapitalization and nationalization undertaken during and following the crisis. The Government is planning further disposals or dilutions of bank ownership in 2003, including an initial public offering for state-owned Bank Mandiri, the country's largest bank.

Substantial progress has been made in planning and drafting legislation for a consolidated supervisory regulatory agency for the financial sector. Planning for a self-funding deposit insurance protection scheme is also under way. This is expected to play an important role as the present blanket deposit guarantee by the Government is to be progressively phased out.

The Indonesian Bank Restructuring Agency has moved significantly forward in accelerating the sale of assets accumulated during crisis-related corporate rescue operations. The privatization of SOEs has made limited progress in the face of public and political challenges. However, privatization revenues met targets after the sale of equity shares in the state satellite telecommunications firm, Indosat, at the end of 2002.

Investment remains weak, though several of the reforms noted above will contribute to improving the investment environment. Further steps are necessary if investment is to recover and a return seen to the higher economic growth that can sustain greater employment generation. Key areas for improvement are strengthening the judicial system and addressing policy uncertainties—particularly those related to labor laws and regulations, and to decentralization.

Outlook for 2003-2004

Although the pace of private spending is expected to weaken somewhat, modest increases in overall GDP growth are expected in the next 2 years as the external environment improves and as some expected pickup in investment spending materializes. GDP growth in 2003 is expected to be 3.4%, strengthening to 4.0% in 2004. The 1.8% budget deficit for 2003 incorporates a 0.5% fiscal stimulus to mitigate the negative impact of the Bali bombings, but nevertheless maintains the declining trend in the planned budget deficit.

Financial sector reforms will strengthen the banking system, supporting an increase in GDP growth. Credit expansion will be based particularly on household borrowing, sustaining consumer spending. However, a tight monetary policy is expected to be able to contain price increases and inflation should moderate from 11.9% in 2002 to 10.0% in 2003 and to 8.5% in 2004.

Although the external environment will contribute to the projected recovery, exports are likely to face stiffer international competition in the region, especially from the PRC and Viet Nam. Recent moves to increase minimum wages and uncertainties over the enforcement of labor regulations threaten to reduce Indonesia's international competitiveness. Continued efforts to reduce budget subsidies for energy and utilities will lead to rising administered prices and some cost pressures, also reducing export industry prospects. On balance, the current account surplus is expected to fall in the near term, but to rise as international markets recover further in 2004.

Investment spending is expected to slowly improve, largely for cyclical reasons. However, any increased business spending is unlikely to be in response to changes in long-term prospects. Robustly higher levels of plant and equipment expenditures over the long term will have to await the resolution of issues that have discouraged investment. A stronger legal and judicial system, lower business costs due to reduced corruption, and improved certainty in the policy environment, especially at the local level, will be needed to see substantially higher levels of business investment.

The monetary authorities face a considerable challenge in working to lower inflation while meeting broader stabilization goals. Average inflation over 1998-2002 was 19.8% and the Government has targeted less than 10% over the next few years. The central bank faces a dilemma, particularly in the use of the rate of interest on its short-term bills (1- and 3-month Bank Indonesia Certificates), the primary tool available for influencing monetary policy. In the past, the central bank has maintained high interest rates to ease currency depreciation pressure and to lower inflation. However, in the future, this might weaken growth and raise public debt service needs, complicating fiscal policy. Higher interest rates might be especially discouraging for new investment. Conversely, the central bank is concerned with the health of the commercial banks and lowering interest rates will lower the profitability of some of them significantly.

The national elections scheduled for mid-2004 may involve increasingly politicized debate on economic policy. This may make it harder for the Government to take steps involving politically sensitive issues, such as privatization or increases in administered prices. In early 2003, the Government has already faced vocal opposition to planned increases in administered prices—for petroleum products, electricity, and telephone services—that had been agreed in Parliament. Nevertheless, there seems an increasing awareness of the value to Indonesia of prudent fiscal policy and it is likely that policies in this area, once agreed, will be implemented.

The country remains vulnerable to external shocks. Continued improvement in debt indicators and the capacity to service existing debt are dependent upon rupiah stability. Higher oil prices during the first quarter of 2003 provided some short-term windfall profits for the budget, but also exacerbated the political difficulties of moving administered energy prices to market levels. Stronger security measures have provided some confidence to the international community that the Government is taking what steps it can to improve security. Continued efforts may find a pay-off in a return of tourists to the country, although the SARS epidemic will affect the tourism industry in the first half of 2003.

Similarly, the Government has taken significant steps to improve regional security, in the Moluccas, but most notably in Aceh. The signing of a peace accord in early December 2002 may well bring about the conditions to allow for this rich region to meet its potential, with positive spillovers in neighboring regions and the country as a whole.

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