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p. 23 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia : Southeast Asia

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Indonesia

GDP growth improved modestly in 2003. Private and government consumption provided the impetus, but investment remained weak. The Government outlined a series of reforms to follow on from its IMF program exit. Although slightly faster GDP growth is expected in the next 2 years, to achieve higher growth rates and create employment over the longer term, the Government needs to improve the investment climate, strengthen its judicial and regulatory institutions, overcome infrastructure constraints, and resolve outstanding decentralization issues.

Economic Assessment

GDP growth picked up to 4.1% in 2003, a modest improvement over 3.7% the previous year, even though the country was hit by another terrorist attack (in Jakarta), and faced the regional problems caused by SARS and the conflict in Iraq. Inflation slowed to a year-end 5.1%, the reference interest rate fell, and the rupiah firmed against the dollar.

Private and government consumption remained the principal drivers of growth in 2003, as they have been since the 1997-98 Asian financial crisis. In particular, private consumption accounted for 2.8 percentage points of the GDP expansion in 2003, supported by declining interest rates and increasing bank credit for consumption spending. Such credit rose to one third of total lending from one quarter in 2002. The lending facilitated a 25% jump in purchases of cars and motorcycles during 2003. Government consumption accounted for 0.8 percentage point of the GDP expansion, while net exports added 0.7 percentage point, and net investments subtracted 0.2 percentage point.

Investment spending, measured by gross domestic fixed capital formation, has stayed at 20-25% of GDP over the past 5 years, down significantly from above 30% before the crisis. The National Development Planning Agency estimates that the efficiency of investments has declined, too, in that a given amount of investment produces a smaller increase in GDP now than before the crisis. The composition of investment has also been changing, with the share of investment in property rising over the past 3 years to over 80% of the total, while investment in capital goods declined to less than 18% in 2003. Although robust investment in construction may provide short-term gains in growth and employment, it is not likely to generate jobs in the longer term.

Net FDI continued to slide in 2003, by $2.1 billion, after falling by $7.1 billion in 2002. The Capital Investments Coordinating Board approved $13.2 billion of foreign investment projects in 2003, up from $9.8 billion in 2002, although only 38% of these investments were realized. In the first 2 months of 2004, FDI approvals fell by 66% from the year-earlier period, possibly a result of investors holding off ahead of Indonesian elections in 2004.

In terms of sector performance, the industry and services sectors together accelerated to 4.4% growth in 2003 from 4.0% the previous year. Manufacturing grew by 3.5%, continuing the slow trend seen since 2000. Growth in agriculture picked up to 2.5%, its best rate for several years. The overall modest expansion, especially in manufacturing, resulted in about 1 million new jobs, though this was not enough to stop the unemployment rate rising to 9.8% from 9.3% in 2002. Agriculture, which accounts for 15.8% of GDP, provides jobs for about 44% of the work force, and manufacturing 13.2%.

The incidence of poverty fell in 2002 to near precrisis levels of 18.2%, and declined further to 17.4% in 2003, with low inflation supporting this trend. These figures are based on a measure of income needed for a person to meet a daily minimum food requirement of 2,100 calories and on other locally accepted requirements for shelter and clothing. Poverty has pockets of concentration, and varies widely within and across regions, with 57% of the poor living in Java and Bali, and 66% in rural areas. Changes in real wages, as an indicator of improvements in welfare, have been modest. Manufacturing wages have picked up to precrisis levels, but agricultural wages stand at only three quarters of the 1996 levels.

Growth challenges notwithstanding, the Government has made advances in terms of fiscal consolidation, through revenue as well as expenditure reforms. It aims to balance the budget by 2006. The overall fiscal deficit widened to 2.1% of GDP in 2003 from 1.7% in 2002, slightly greater than the planned target of 2%, largely as a result of higher spending and lower than anticipated tax revenues. In terms of resources, domestic bank financing and privatization resulted in budgetary inflows equivalent to about 2% of GDP, with the partial divestment of stakes in four companies providing a record Rp7.5 trillion. The stock of total external debt at end-2003 leveled off at about 65% of GDP, at around $135 billion, with public external debt equivalent to 38.5% of GDP. The level of debt is well below that reached during the crisis and is scheduled to gradually decline to sustainable levels over 2005-2007.

On the monetary side, Bank Indonesia’s policy stance has helped contain inflationary pressures (Figure 2.7). The appreciating rupiah and lower inflationary pressures enabled the central bank to reduce the interest rates on its 1-month certificates (SBI) by more than 4.5 percentage points over the course of 2003 to 8.4% at year-end. The rate reductions, in turn, helped the Jakarta share price index rise by 62% over the year.

The impact of the lower official interest rate on lending rates for investment and working capital, however, was limited. Banks give priority attention to consumer and small and medium enterprise financing, considering lending to the corporate sector too risky. Further, some of the bigger banks hold in their portfolios large amounts of tradable restructuring bonds issued in 1998 as part of the banking sector reform initiatives, which have provided a source of risk-free returns.

Progress was made in 2003 to restructure and privatize banks. Their overall capital structure has improved, with capital adequacy ratios exceeding 20% as against the minimum 8% requirement. Gross NPLs appear to have stabilized at around 8%, and average net NPLs were reported at 1.8% as of December 2003, although a relatively large share of restructured loans in the portfolios of some of the largest banks may mean that this figure will be revised upward as such loans mature. The Government sold 20% of its stake in Bank Mandiri in July 2003 and 40% in Bank Rakyat Indonesia in November 2003.

Weak governance in state-owned commercial banks continues, though, to be a source of concern. Fraudulent loan transactions at Bank Negara Indonesia and Bank Rakyat Indonesia in 2003 prompted Bank Indonesia to demand tighter internal controls in all banks, and the Government, as the major shareholder in Bank Negara Indonesia, reconstituted that bank’s boards of directors and commissioners.

On the external front, the overall trade surplus rose by 3.9% to $24.4 billion in 2003. Relatively strong international oil prices contributed to 7.2% growth in merchandise exports. However, imports of oil and gas rose by 19.9%. Imports of capital goods increased by 7.6%, indicating a pickup in the machinery replacement rate. Indonesia, as with some other countries in the region, faces increasing competition in labor-intensive export products from countries such as the PRC and Viet Nam. On the other hand, the rapid development of the PRC and its role as a regional production hub in many sectors also provide Indonesia with a new export market-non-oil and gas exports to that country in 2003 rose by an estimated 25% from a year earlier.

Trade in services produced a deficit estimated at $16.7 billion, wider than the 2002 level of $15.9 billion. Earnings from tourism fell as a result of security-related concerns and of the impact of SARS on regional travel. International reserves grew by $4.2 billion to reach $36.2 billion at year-end.

Policy Developments

Indonesia was the last of the Asian crisis-affected countries to exit an IMF extended fund facility, in December 2003. In order to bridge the likely credibility gap that may emerge, in September 2003 the Government unveiled an economic policy package, better known as the White Paper, to consolidate and monitor ongoing and planned reforms under three planks: prudent macroeconomic management; financial sector restructuring; and real sector reforms aimed at increasing investment, exports, and employment. The White Paper’s broad thrust has generally been well received by domestic and foreign investors, although its depth and breadth will require significant human and financial resources to ensure satisfactory implementation. While about three quarters of the measures have been completed, according to the Government, the content of the initiatives as well as their likely impacts are being debated.

With regard to macroeconomic management, measures are under way to achieve fiscal consolidation, particularly in expanding the revenue base. Delinquent taxpayers, especially those owing large amounts, are being pursued, customs operations are being strengthened, and a program to curb evasion of excise taxes is operational. Significant progress was made with the adoption of the State Finance Law in March 2003 and the State Treasury Law in December 2003. These two laws, together with proposed laws governing state audits, contain general principles aimed at strengthening budgetary processes, improving public expenditure and financial management, and enhancing public sector accountability. The new legal framework also paves the way for the separation of budget and treasury administration and consolidation of public debt management functions.

The Ministry of Finance also proposed amendments to the Tax Law, which have generated an intense debate in the business community because some of the proposals are seen as coercive. Further public consultations are expected on these amendments. Fiscal decentralization is being strengthened through revisions to laws on regional autonomy, fiscal balances, and regional revenues. The revised laws will aim to clarify the role of the provinces and gradually achieve fiscal equalization. However, there have been concerns over inadequate consultation with local governments.

With regard to the financial sector restructuring plank of the White Paper, the Government closed the Indonesian Bank Restructuring Agency (IBRA) at end-February 2004. IBRA recovered about 28% of the $60 billion of assets it inherited, comparing favorably to similar agencies in the region. An asset management company will be established to manage and recover the corporate assets unsold by IBRA, which are valued at Rp43 trillion.

At the broader sector level, Bank Indonesia launched a study on the banking system in 2003, to formulate a new banking structure for the future. The study envisages consolidation of banks over the next 5 years, leading to two or three large financial institutions with a regional and international presence, three to five nationwide banks with a broad scope of business, and 30-50 specialized banks operating in different market segments and areas of Indonesia.

A draft law on a deposit insurance plan is under consideration by Parliament and a financial safety net framework is being formulated to support financial stability, particularly in times of systemic crisis. Amendments in December 2003 to the Central Bank Law will lead to the establishment of a new supervisory board to enhance the accountability of the central bank. The Government has also strengthened the regulatory framework for pension, insurance, and capital market institutions, which will enable the regulatory authorities to impose sanctions for noncompliance. In other significant financial sector developments, Indonesia adopted an amended Antimoney Laundering Law, established a Center for Financial Transaction Analysis and Reporting, and set up a National Committee on Antimoney Laundering to formulate policies in this area.

The third component of the White Paper-reforms aimed at increasing investment, exports, and employment-faces significant implementation challenges given its complexity. Progress in some areas is evident through the adoption of new labor laws, a State-Owned Enterprises Law, an amended Water Resources Law paving the way for the commercialization of the water sector, and a new regulatory framework for the telecommunications sector. A policy to issue land certificates through the conversion of informal titles has been stepped up to facilitate access to bank credits. The Supreme Court has finalized a blueprint on judicial reform, and the Government has established an Anticorruption Commission. The Government also completed the first stage of a Poverty Reduction Strategy Paper, which outlines measures to achieve the Millennium Development Goals. However, it is unlikely that the strategy paper will be finalized by May 2004, the date to which the White Paper committed.

Investment promotion is a key priority of the Government under the third plank of the White Paper. The Government labeled 2003 as the Year of Investments, but there was little tangible headway in facilitating direct investment. After considerable delay, a revised Law on Investments with provisions for equal treatment of foreign and domestic investment, simplified licensing, and clearer investment incentives is being finalized. The Government established a high-level National Team on Investment and Exports Promotion to resolve interministerial issues and address investor concerns. Proposals are being finalized for a one-stop facility for investment approvals and a revised, narrower list of sectors reserved for domestic investment. Despite these measures though, domestic and foreign investors alike remain concerned about regulatory uncertainties, lack of transparency in tax and customs procedures, and multiple layers of bureaucracy that have expanded the scope for corruption.

The decentralization program adopted by the Government in 1999 represents another concern for investors, because the regions are failing to coordinate with regard to investment incentives and regulations. Most important, investors view the Government as having adopted a culture of approvals and controls, rather than as having made a coordinated attempt to promote Indonesia as a regional investment destination. While extractive industries may retain their competitiveness because of the country’s natural resources, traditional industry sectors have seen productivity and efficiency eroded due to lack of investment.

Outlook for 2004-2005

With macroeconomic stability restored after the crisis, the key challenge facing policy makers is to achieve and sustain higher levels of economic growth, especially through greater domestic and foreign direct investment. That there is long-term investor interest in portfolio investments in Indonesia was evident when the country returned to the international debt markets early in 2004, for the first time in 8 years. On the back of strong global demand estimated at over $4 billion, the $1.0 billion 10-year bond was priced at a yield of 6.85%, or 227 basis points over the US Treasury rate. This compares favorably with a recent debt issue by the Philippines at a yield of 8.8%.

The 2004 budget approved by Parliament in November 2003 targets a deficit of 1.3% of GDP, narrower than the planned 2003 deficit of 2.0%. The budget assumes GDP growth of 4.8%, average inflation of 6.5%, and a steady exchange rate. The Government plans to reduce primary spending by 0.9% of GDP, partly by cutting nonfuel subsidies and transfers to the regions. This, together with lower interest payments, would reduce total expenditures by 1.6% of GDP. (However, it seems unlikely that subsidies and transfers can be reduced significantly in an election year.) Paris Club debt rescheduling provided annual relief equivalent to about $3 billion in debt service payments, but exit from the IMF loan program means that the country is no longer eligible for such rescheduling. Without this debt relief, the 2004 budget projects a gross financing need of 4.7% of GDP, the same level as in 2003, but with a greater amortization of debt, at 3.4% of GDP against 2.8% in 2003. Gross external financing is projected at 1.4% of GDP in 2004 (equivalent to $3.3 billion), compared with 0.9% of GDP in 2003.

Given the growth in private and government consumption, both of which are likely to rise further in 2004 (due to the availability of credit for consumption and government spending in an election year), GDP growth is forecast to rise to 4.5% in 2004 and in 2005. This higher rate will depend both on Bank Indonesia keeping a firm hand on monetary policy in the election period and on the oil industry’s ability to ramp up oil production, which is currently below its OPEC quota. A key impediment to lifting oil production has been the delay in adopting satisfactory implementing regulations for the Oil and Gas Law enacted in 2001. The Government also needs to prudently manage its foreign reserves, as the external liquidity position is expected to deteriorate in 2004 due to the anticipated increase in the amortization of external debt to above $5 billion, in comparison with a net inflow of $1.9 billion in 2003. While the reserves position will still be adequate at about $33 billion, or equivalent to over 6 months of imports, it could become less comfortable if any unanticipated external events occur.

Looking at the risks to the outlook, in the short term growth may exceed the 2004 estimate. Political parties are expected to spend upward of Rp15 trillion ($1.8 billion) in campaigning during the year, which will have multiplier effects through greater consumption. The President signed a decree in March 2004 authorizing central and regional governments to access and disburse emergency funds to support immediate public needs. Thus, private and public spending may be stronger than projected. On the other hand, no significant new investments are expected in 2004 because of the election uncertainties, which may dampen growth. For public finance, a planned increase in domestic bond issuance by the Government may face investor resistance and may make it more difficult for companies to tap the bond market. In addition, the Government anticipates raising Rp10 trillion from privatization and asset recovery in 2004, but selling state assets might be difficult in an election year. Thus, prudent debt management will be critical as the Government has to redeem bonds worth Rp28 trillion.

In the medium term, there are continuing concerns that Indonesia may be trapped in a relatively low-level growth path, with the economy growing at less than 5%, unless certain key challenges are addressed.

The first key challenge is poor governance and inefficient and corrupt legal and regulatory environments. As the process of consensus building has become more complex in the new democratic period, the Government’s approach has been to propose simple laws to expedite approval, leaving critical issues to be addressed in implementing regulations. Lack of clarity and predictability in such regulations has hampered progress in many key areas, including decentralization, investment, and infrastructure, and has eroded overall investor and public confidence. Poor governance within tax and customs administrations is a major concern. Further, the public increasingly believes that corruption has become more pervasive and less predictable following decentralization. The Government has adopted only a few organizational measures toward improving the investment climate, without addressing the constraints in an integrated manner. The trends in 2002-2003 indicate that investment may recover only slowly over 2004-2005. In particular, the FDI environment is very weak, even in sectors where the country has a comparative advantage, including energy and mining.

The second key challenge relates to decentralization. Five years after the introduction of the ambitious decentralization agenda, significant issues and risks remain. Core concerns are the weak legal and regulatory framework governing decentralization; an inefficient intergovernmental fiscal system; and a lack of accountability at the local level. The Government’s focus at present is on the political aspects of decentralization, while no major reforms to fiscal decentralization or equalization are yet envisaged. Given the revenue dependence of most local governments on the center, the Government needs to articulate a sound implementation framework that balances the fiscal and political aspects. Other issues that need resolution include a clear assignment of functions to the local governments; a strengthening of the finances of local governments and of accountability at the local levels; and increasing regional capacity to implement decentralization. A major issue is to ensure that development spending is increased from the current low level of 3.2% of GDP, in order to reduce the serious regional inequalities and address the state of disrepair and underprovision in infrastructure (Box 2.3).

Security presents the third key challenge. While the Government has been resolute in dealing with terrorist attacks, investors still see lack of security as a major concern, which in turn places a risk premium on investments. In addition, the Government needs to resolve the politically sensitive problems in the troubled provinces.

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