Regions and Countries

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p. 3 of 33 BACK | NEXT I. Current Development Trends and Issues A. Political Setting B. Economic Growth C. Poverty D. Governance and Institutional Capacity E. Private Sector F. Gender Assessment G. Environment H. Regional Cooperation I. Development Constraints II. The Government's Development Strategy III. ADB's Development Experience IV. ADB's Strategy V. ADB's Assistance Program VI. Risks and Performance Monitoring and Evaluation

Country Strategy and Program 2006-2009 (Draft for Consultation): Indonesia : I. Current Development Trends and Issues

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B. Economic Growth

6. Indonesia was Southeast Asia's fastest growing economy prior to the crisis. With a fairly open regime, the country attracted high levels of foreign direct investment. The private sector accounted for upwards of three-fourths of the country's GDP, despite the fact that certain key sectors were in the State domain. Indonesia was at the top end of the spectrum among its regional neighbors in terms of infrastructure provision and the delivery of essential social services. However, while growth was driven by the significant investment opportunities with fairly high returns to investors, poor governance of the economy also meant that resources were not allocated to their most productive uses. Recognizing the perils of growth driven by shortterm interests aggravated by continuous currency and maturity mismatches of imprudent borrowing, Indonesia’s post-crisis macroeconomic management focused initially on broadbased economic liberalization and restructuring, followed by fiscal consolidation, a process that still continues. Considerable progress has been made, as evident in the real Gross Domestic Product (GDP) growth steadily rising from the immediate post-crisis level of 0.8% in 1998 to 5.6% in 2005 (Figure 1). Over this period, the overall budget deficit declined from around 4% of GDP to 0.5%. The Government also reduced its outstanding debt stock from over 100% of GDP to 45%. However, higher levels of economic growth appear to be elusive due to the country's weak public sector management, many years of low public sector investments, and weak human resources.

7. Yet, the gradual post-crisis economic recovery has occurred without a significant revival in public and private sector investments. Nor has it been accompanied by any significant job creation. Sluggish investments since the crisis in turn have undermined the potential for higher economic growth. In 1996, investments were almost 30% of GDP, with public investment 7%.³ By 2000, private sector investment had fallen to 16%, and public sector investment to 4%, a level it was still at in 2005. Private sector investment has subsequently increased from a low of 13% in 2003 to an estimated 17% in 2006. A clear manifestation is the low level of development spending,⁴ which has not shown any signs of revival since the crisis (Figure 2). Total development spending was $3 billion in 2005. Health spending has been less than 0.4% of GDP, under 3% of the budget while education spending amounts to 6% of the budget (as against the 20% mandated by the Constitution). Before the crisis, infrastructure spending amounted to 5% of GDP ($10 billion per year, including $2 billion from the private sector). Now, infrastructure spending is only 1.5% of GDP, amounting to $3 billion which is mainly used for maintenance. Development spending by regional governments has been slowly increasing from a low base.

8. Private consumption has been the principal driver of growth, instead of investments. This could undermine the extend of future growth of the economy. On the supply side, agricultural productivity has declined and manufacturing has been slow to grow, while the service sectors have posted consistent growth. Open unemployment has seen a steady increase as growth was not sufficient to absorb the 2 million new entrants to the job market each year, and now stands at 10.4%. Historically, annual economic growth of 4-5% was thought to be sufficient to absorb new entrants. However recent evidence shows that between 1998 and 2004, there has been a steady rise in labor productivity, so that economic growth has not translated in to higher employment. It is estimated economy would need to grow by 7% in 2005, to absorb all new entrant.⁵ The gap between wage growth and productivity growth in manufacturing has increased from -3.5% before the crisis to over 27% in 2000-2003. The major cause for this trend has been the rapid increase in the average minimum wage.⁶ The Government has prepared a major revision to the 2003 labor law, attempting to make the hiring of staff more attractive, for example by reducing severance pay rates (which are by far the highest in the region). The revision has stalled however, following strong public opposition.

9. Indonesia is suffering from a poor investment climate which is discouraging investors.⁷ Private sector investments have started to recover hesitantly, but the enabling environment needs to be improved further for sustainable growth and to face global competition. Indonesian competitiveness in the region has declined sharply since 2000,⁸ which is associated with inadequate infrastructure, lack of skills, a rigid labor market, poor investment climate, and a weak financial sector. According to the ranking by the World Economic Forum in their Global Competitiveness Report, Indonesia is ranked 74th in 2005-2006, compared to 69th in 2004-2005 for Growth Competitiveness. State-owned enterprises continue to dominate key economic sectors, and the government role in the economy remains an important issue.⁹ The weak legal framework for land acquisition and resettlement has been a major impediment to both public and private investments.

10. The economy has been experiencing a cyclical down turn. In 2005, the Government took the bold step of increasing domestic oil prices by 29% in March, and subsequently by a further 126% in October. The fuel subsidies were largely regressive and benefited the middle class.¹⁰ The adjustment has created additional fiscal space, facilitating a reorientation of public expenditures to meet essential education, health, and infrastructure needs. However, inflation surged to over 18% immediately after the October 2005 oil price increase. The Government launched a comprehensive Fuel Subsidy Reduction Compensation Program (PKPS-BBM) to cushion the adverse impact on the poor. The inflation rate is still over 16% as of July 2006, with a core rate of around 9%. The Rupiah continued to strengthen over the same period, by 7% against the US$. Consumption stagnated. Economic performance in the second half of 2006 will be critical. Consequently, Indonesia is more likely to be in the lower end of the 6-7% average growth rate envisaged earlier. Achieving annual growth rates of 6% would be contingent on a number of impediments to growth being effectively addressed, as outlined elsewhere in the CSP. Further, the challenge that Indonesia faces is that every one percentage point increase in real GDP growth adds roughly about 800,000 new jobs, while the labor market attracts about 2 million entrants. With unemployment at 10.3% in February 2006, it is not very likely that the Government is on track to achieving the 5.1% envisaged in the RPJM.

11. Indonesia, like other emerging economies, has suffered from the changed risk perceptions of international investors. After a bout of volatility in August 2005, however, markets have regained their confidence. International rating agencies have continued to raise Indonesia’s debt rating, and the recent international and domestic bond offerings have been a success. Financial sector reforms have continued since the crisis, and in June 2006, the Government announced a comprehensive reform package. Capital markets have grown in importance in recent years, but long-term debt issuance has until recently been limited to government bonds. The Government needs to facilitate the development of local financial and capital markets by enabling insurance firms and pension funds to finance infrastructure, deepening the bond market, establishing new institutional investors such as infrastructure funds, and allowing municipal governments to borrow for infrastructure in local markets.

12. The banking sector plays a dominant role, accounting for over 82% of overall assets. It remains sound. Credit growth in 2005 was 24%, although this has declined in the first half of 2006. However, the non-performing loan ratio has increased to 8.2% in March 2006, from 4.4% in March 2005. Most of the problems are in the two largest state-owned banks. With the merger of two oversight agencies, the non-bank financial sector has a single oversight agency in place, focusing on the development of the capital markets, for which a blue print has been prepared.

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