INDONESIA MACROECONOMY - STRONG 2006 BUT CHALLENGES LOOM IN

UNCLAS SECTION 01 OF 04 JAKARTA 000653

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E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: INDONESIA MACROECONOMY - STRONG 2006 BUT CHALLENGES LOOM IN
2007

A) Jakarta 13326 B) Jakarta 00309 C) Jakarta 00031


1. (SBU) Summary. The Government of Indonesia (GOI) successfully
restored macroeconomic stability in 2006, implementing prudent
monetary and fiscal policies and paving the way for a rebound in
gross domestic product (GDP) growth. These policies contributed to
stable prices, a strong currency, lower public debt and increased
investor confidence. Real GDP growth rose to 6.1% on a year-on-year
(YoY) basis during the final quarter of 2006, boosting GDP growth
for the full year to 5.5% (YoY). Although exports rose strongly
during the year, employment growth lagged in large part due to
limited growth in labor-intensive manufacturing. Most analysts
expect Indonesia's cyclical economic recovery to continue in 2007,
with increases in domestic demand and investment, but risks to
longer term stability and sustained growth have increased. Growth
in net exports, the primary driver of GDP growth in 2006, is likely
to slow in 2007, in response to a likely flattening out of world
commodity prices and increased demand for imports. Despite a strong
GOI budget position, very slow progress on the GOI's infrastructure
policy initiatives make the outlook for a significant increase in
infrastructure spending in 2007 poor. The GOI's key medium term
challenge will be finding ways to boost growth after the current
cyclical upswing begins to wane or if the international economic
environment turns less supportive. Ramping up anti-poverty spending
in 2008-09 may be the GOI's best bet. End summary.

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Table 1: 2006 Real GDP Growth, Year-on-Year
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Full
Q1 Q2 Q3 Q4 Year
-------------- --------------
Private Consumption 3.2 3.0 3.0 3.8 3.2

Government Consumption 14.2 31.6 1.8 2.2 9.6

Fixed Capital
Formation 2.9 -1.0 -0.3 8.2 2.9

Exports of Goods and
Services 10.8 11.3 12.1 6.1 9.2

Imports of Goods and
Services 5.0 8.3 9.7 9.7 7.6
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GDP 4.6 5.2 5.5 6.1 5.5
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Source: Central Bureau of Statistics

Macroeconomic Stability Returns in 2006
--------------


2. (SBU) 2006 was a good year for the Indonesian economy. The GOI
and BI took effective action to restore macroeconomic stability
during the year by implementing prudent monetary and fiscal
policies. In addition to slowly easing rates in 2006 in line with
lower inflationary expectations, BI issued a series of policy
statements signaling an independent and prudent approach to monetary
policy. The GOI ran a cautious fiscal policy during the year, with
the budget deficit remaining close to 1% of GDP. As Table 1
indicates, YoY GDP growth rates accelerated in four consecutive
quarters during the year largely in response to the stable
macroeconomic environment.


3. (U) Prudent GOI policies also contributed to stable prices, a
strong rupiah, lower public debt and increased investor confidence.
After climbing to 17.1% in 2005 due to the October 2005 fuel subsidy
cuts, Indonesia's YoY headline inflation rate slowed again in 2006,
ending the year at 6.6%. The rupiah/USD exchange rate remained in
the 9000-9200 range for most of 2006, recovering from a low of
approximately Rp 11,000/USD in August 2005. The public debt to GDP
ratio continued to decline in 2006 to about 35%, down from 54% in

2004. Rating agencies also signaled renewed confidence in the
Indonesian economy, with both Fitch and Moody's moving their
sovereign debt outlook from stable to positive. Portfolio
investment continued to flow to Indonesia in 2006 driving the market
capitalization of the Jakarta Stock Exchange up 55.6% (YoY) and the

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risk premium on Indonesian debt down to roughly 100 basis points.
Foreign exchange reserves grew by $7.4 billion during the year to
$42.6 billion at the end of December, despite Indonesia's early
repayment of $6.9 billion in IMF loans.


4. (SBU) After falling below 5.0% during the first quarter of 2006,
real GDP growth rebounded to 6.1% (YoY) during the final quarter of
the year, boosting GDP growth for all of 2006 to 5.5% (YoY). A
strong expansion in commodity exports was the primary driver of
growth during the year (Ref B). A moderate increase in domestic
demand and the almost 10% growth (YoY) in government spending also
supported GDP expansion. Although the pace of domestic investment
growth improved in the fourth quarter of 2004, expanding 8.3%(YoY),
investment growth remained below 3.0% (YoY) during the full year
2006, in contrast to 14.1% (YoY) and 9.9% growth (YoY) in 2004 and
2005, respectively. (Note: Indonesia's official investment
statistics may understate investment growth due to difficulties in
compiling statistics. Actual investment growth in 2006 may have
been closer to the rate of growth of GDP. End note.)

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Table 2: 2006 GDP Growth by Industry (percent)
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Growth Share
Rate GDP Grow.

Agriculture/Livestock/Forestry
and Fishery 3.0 7.3
Mining and Quarrying 2.2 3.6
Manufacturing 4.6 23.6
Electricity/Gas/Water 5.9 1.8
Construction 9.0 9.1
Trade/Hotel/Restaurant 6.1 18.2
Transport/Communication 13.6 16.4
Financial/Bus. Service 5.7 9.1
Services 6.2 10.9
-------------- --------------
GDP 5.5 100.0
-------------- --------------
Note: Share of GDP Growth (Share GDP Grow.)
Source: Central Bureau of Statistics


5. (SBU) The most vibrant industries in the economy in 2006 were
transportation/communications and construction, which grew 13.6% and
9.0% (YoY),respectively. Growth in these sectors comprised a
combined 25% of overall GDP growth. Manufacturing growth, which
comprises the largest single industrial component of the GDP,
expanded a modest 4.6 percent in 2006, contributing slightly less to
growth than transportation/communications and construction combined.
Growth in financial and business services as well as trade, hotel
and restaurant services was moderate, but growth in those industries
contributed a combined 35% of overall GDP growth.


6. (SBU) Despite accelerating growth during the year, Indonesia's
open unemployment rate barely budged, remaining at about 10.3%.
Most analysts believe lagging growth in labor-intensive agriculture
and manufacturing industries is to blame for Indonesia's stubborn
unemployment problem. Despite several policy packages designed to
improve the climate for investment, excessive red tape (especially
relating to customs clearance and taxation),corruption, and limited
access to capital continue to hold back growth in the manufacturing
sector.

Investment and Household Demand to Rise in 2007
-------------- --


7. (SBU) Most analysts expect a modest increase in domestic demand
and investment during 2007, in line with Indonesia's current
cyclical economic recovery. Indicators of strengthening domestic
demand include rising non-oil imports, faster expansion of domestic
credit, and improved auto sales. Non-oil imports grew almost 20%
YoY in January 2007. After growing less than 3% during the first
half of the year, domestic credit expansion accelerated during the
fourth quarter of 2006, bringing the YoY growth in credit for 2006
to 10.7% on a nominal basis. After rising to a record 50,000 a
month in August 2005, monthly auto sales plummeted to an average of
roughly 25,000 a month from November 2005 to October 2006. However,

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beginning in November 2006, auto sales began to slowly recover,
averaging 32,200 a month during the final two months of 2006. Yet
not all indicators of domestic demand point to stronger growth.
BI's consumer confidence index declined in January 2007 for the
second consecutive month due to increased pessimism over job
availability and decreased optimism about the future direction of
economic conditions and wage rates.


8. (U) Observers expect overall investment to continue to recover
during at least the first half of 2007, again in line with
Indonesia's cyclical recovery. In line with this expectation,
capital goods imports doubled from October to November 2006, jumping
from $500 million to $1 billion. Capital goods imports were roughly
$700 million per month in December and January 2006. Moreover, BI's
fourth quarter 2006 Business Survey, 27.5% of respondents plan to
increase investment in the first half of 2007, compared to 26.6%
during the latter half of 2006.

Infrastructure Spending Still Very Slow
--------------


9. (SBU) Despite a strong GOI budget position and several ongoing
infrastructure policy initiatives, the outlook for a significant
increase in infrastructure spending in 2007 appears poor.
Increasing infrastructure investment is important to relieve
transportation bottlenecks that are raising the cost of producing
goods in Indonesia, and also because of the positive impact on
aggregate demand of large infrastructure projects. World Bank and
Asian Development Bank infrastructure experts are growing
increasingly pessimistic about the pace of infrastructure projects
in the GOI pipeline. They cite extremely poor coordination among
GOI infrastructure ministries, complicated legal processes necessary
to implement infrastructure projects, political interference, and
continuing corruption as critical problems impeding progress on
infrastructure investment. They note that under the current system,
the time required to move from tendering to financial closing for
most projects is roughly two years.


10. (SBU) The continuing slowness in infrastructure development is
leading the World Bank, ADB, and other institutions to rethink the
GOI's heavy reliance on private-public partnerships to attract
capital to the infrastructure sector. Instead, they are
recommending the GOI consider financing more infrastructure projects
directly from the budget or through consortia of state-owned
companies and state-owned banks.

Slowing Export Growth Raises Risks
--------------


11. (U) Most economists in the region expect growth in global
commodity prices to moderate in 2007, in line with slower growth
across the United States and other developed countries. In
addition, capital goods imports are likely to increase in 2007 in
line with Indonesia's cyclical recovery. As a result, growth in net
exports, the primary driver of GDP growth in 2006, is likely to slow
in 2007. While few predict a major slowdown in commodity exports
over the next twelve months, a significant decline in commodity
prices could have a destabilizing effect on the economy,
particularly in the context of weak manufactured goods exports. A
significant contraction in net exports could put pressure on
Indonesia's currency and balance of payments, with a possible
negative impact on Indonesia's risk premium.


12. (SBU) Perhaps chastened by the August 2005 rupiah "mini-crisis,"
BI has signaled it will move cautiously on monetary policy in 2007.
In its most recent press release on monetary policy, BI stated that
it intends to "proceed more carefully in the timing and magnitude of
changes in the BI rate to maintain existing price and exchange rate
stability." According to BI staff, concerns that excessive domestic
demand could reignite inflation and possibly macroeconomic
instability in light of the significant supply side constraints
facing Indonesia are driving this cautious stance. As a result, BI
is likely to slow the rate of interest rate cuts in the absence of
significant efforts on the part of the government to improve
Indonesia's infrastructure and investment climate and/or significant
growth in fixed capital investment in Indonesia.


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Budget Deficit to Rise Modestly
--------------


13. (SBU) The GOI's October 2005 fuel subsidy cuts, which trimmed
subsidy spending that had reached over 3% of GDP in 2005, have
provided an estimate $10-15 billion of fiscal space for the GOI to
spend on other priorities. Education and health has already
increased dramatically, but as noted above, spending on large scale
infrastructure projects has yet to accelerate. The central
government now distributes approximately one third of the national
budget to local governments. However, according to World Bank
staff, only 40% of local governments actually have a quantified
budget, while even fewer have the resources necessary to manage
public spending programs. As a result, a large number of local
governments have been slow to spend their newly expanded resources,
opting instead to deposit the funds in local banks. While most
observers expect central and local spending to rise in 2007, many
doubt that the government will be able to overcome the significant
bureaucratic hurdles needed to ramp up infrastructure spending.


Comment: What About 2008?
--------------


14. (SBU) The SBY administration and BI are unlikely to depart from
their prudent monetary and fiscal policy stance in 2007, and most
analysts expect a very good year in 2007, with growth possibly
approaching seven percent. But given the important role of export
growth as a driver of Indonesia's recent economic performance,
Indonesia's medium term growth prospects are cloudier, especially if
the external economic environment turns less supportive. In this
case, to maintain high growth rates, Indonesia would need to expand
government consumption and investment, neither of which is an easy
task. Inducing more private investment would require finding a way
to advance stalled reforms on important investment climate issues
like corruption, tax, customs, and labor issues. And with few large
infrastructure projects yet out of the gate, it is difficult to see
much infrastructure-led growth occurring before 2009. The GOI's
best hope to deliver more growth after 2007 may be to expand
aggressively several anti-poverty programs it is scheduled to roll
out in 2008-09. If the GOI can channel enough funds through these
programs to villages and poorer Indonesians, it could make for a
much more supportive macroeconomic (and political) environment for
the next election cycle in 2009.

PASCOE