Regions and Countries

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p. 1 of 16 BACK | NEXT Executive Summary Map I. Recent Economic Developments II. Short- and Medium-Term Economic Prospects and Policy Issues III. Risks and Uncertainties Appendix

Country Economic Review - Indonesia

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Executive Summary

Indonesia continues to experience modest growth. Real GDP grew at 3.7% in 2002, the second year in succession, although slower than the 4.8% growth in 2000. Growth has been supported by strong household consumption stimulated by the rise in real wages for selected segments of the population as nominal wages rose and inflationary pressures subsided. However, despite some increases in agricultural productivity, the rural population has not benefited from any real income gains.

Improvements in macroeconomic management were notable in 2002, with the fiscal deficit declining to 1.7% of GDP, down from 2.3% in 2001. The revised budget for 2003 envisages a slightly higher deficit of 1.9% of GDP, necessitated by lower revenues and higher expenditure needs. Good progress has been achieved with regard to decentralization. Fiscal reporting from the lower level governments has been strengthened, with more than 85% of the regions reporting on their 2002 budget performance. A blueprint on restructuring of the Ministry of Finance (MOF) has been finalized, aimed at strengthening the budget and treasury functions. The Government has also achieved good progress with regard to tax and customs administration reforms with support from the IMF, aimed at stabilizing and enhancing non-oil tax revenues.

The ongoing reforms are yet to result in revenue stability. As a result, and given the Government’s conservative fiscal stance, public expenditure has declined over 1999-2002. The reduction in the fiscal deficit has been accomplished primarily through cuts or delays in social and other infrastructure spending and oil subsidies. The curb on development spending has in turn affected growth. As a consequence, there would only be limited maneuverability on the expenditure side, as further cuts in development expenditures could jeopardize long-term economic welfare.

From January to December 2002, the nominal exchange rates of the rupiah appreciated by 13% to Rp.8,950. The terrorist attacks in Bali had only a brief impact on the value of the rupiah, with the exchange rate returning to its former level within a month. It appreciated further in early 2003 and has held stable in the Rp.8,400-Rp.8,500 range even after the August 2003 Marriott Hotel bombing.

While inflationary pressures initially strengthened in 2002 compared to 2001, tight control over effective demand and rupiah appreciation helped inflation rate fall from roughly 15% at the beginning of 2002 to 10% at the year-end. This was despite cost-push factors such as the impact of floods and the rise in fuel, utility and other administered prices. Inflation performance has been impressive during 2003, with overall annual inflation expected to end in the range of 5-6% by December 2003. The foreign exchange and domestic interest rates stabilized, easing domestic and external borrowing pressures. The interest rate on the one- month Bank Indonesia (BI) certificates has declined significantly from over 13% in 2002 to 8.7% as of September 2003. A key challenge facing the Government is to prudently manage monetary growth and the interest rates to ensure price stability.

The Government has followed a proactive policy to reduce external debt and has made some headway in this direction. Measures have included a tight program of fiscal consolidation, privatization of state owned enterprises and asset sales by the Indonesian Bank Restructuring Agency (IBRA), some recourse to domestic bond flotation and effective rescheduling of external debt.

On the external front, Indonesia improved its balance of payments position in 2002, despite the decline in tourism revenues stemming from the terrorist attacks in Bali. The trade balance has been maintained at about $20 billion over the last 3 years. While the current increasing trend in the prices of Indonesia’s principal agricultural exports and the relatively high oil prices can help boost exports, Indonesia is likely to face stiffer global competition, including regional competitors. Recent moves to increase minimum wages and uncertainties over the enforcement of labor regulations threaten Indonesia’s competitiveness.

Overall, moderate progress has been made in 2002 and in the first half of 2003. However, significant structural constraints remain. The foremost among them is the continuing low investor confidence. Besides the recent concerns relating to security, long-standing weaknesses remain in the area of legal and judicial governance. Significant delays in the enactment of the Investment Law and absence of sound alternative dispute resolution mechanisms have led to strong reservations regarding the certainty and predictability of the investment climate. At close to 16.5% of GDP, investment remains among the lowest in Asia.

Medium term economic prospects depend on a smooth political transition following elections scheduled for April 2004. The Government announced in July 2003 its decision to exit from the International Monetary Fund (IMF) program, when the current Extended Fund Facility (EFF) ends in December 2003 with the expected draw down of the last two tranches of $955 million. The President of Indonesia approved an Exit Program on 15 September 2003, aimed at managing the “credibility gap” that is likely to emerge after the end of the EFF. The Exit Program focuses on: (i) maintaining macroeconomic stability; (ii) continuing the restructuring of the financial sector; and (iii) promoting investment, growth and employment.

Looking forward, limited financial sector lending and development spending can restrict growth and curtail poverty reduction. The continuing acts of terrorism, ongoing conflicts in different regions, and slow progress of some necessary reforms, especially those related to governance, will constrain growth as well, unless effectively resolved. The large household sector will continue to cushion the economy from these impacts, provided that the pre-election political situation is stable and security does not worsen. Growth in 2003 is expected to continue at a slightly slower pace than in 2002 but may pick up in 2004. Overall, growth is expected to remain in the 3-4% range for the next few years.

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