INDONESIA: FOOD PRICES DIM ECONOMIC PROSPECTS

UNCLAS SECTION 01 OF 04 JAKARTA 000780 SIPDIS SIPDIS SENSITIVE DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-SETH SEARLS COMMERCE FOR 4430/KELLY DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN DEPARTMENT PASS EXIM BANK SINGAPORE FOR SBAKER TOKYO FOR MGREWE USDA/FAS/OA YOST, MILLER, JACKSON USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER USDA/FAS/OGA CHAUDRY, DWYER USTR WEISEL, EHLERS E.O. 12598: N/A TAGS: EFIN EINV ECON EAGR ID SUBJECT: INDONESIA: FOOD PRICES DIM ECONOMIC PROSPECTS A) Jakarta 762 B) Jakarta 684 C) Jakarta 286 ¶1. (SBU) Summary. Economists continue to lower their projected 2008 growth rate for Indonesia due to concerns that inflation and global uncertainty will decrease economic performance more seriously than previous expected. Soaring food prices, which have lowered purchasing power among Indonesian households, threaten to drive down domestic demand. The price of rice, which represents the largest share of the food budget, could rise significantly this year. International rice prices are now close to $700 per metric ton (MT) higher than the price in Indonesia. External demand for Indonesia's manufactured goods is expected to slow this year as world growth decelerates, limiting the scope for new job creation. While few analysts predict a full-blown economic crisis, the economic and social policy focus has become increasingly short-term, diminishing Indonesia's medium-term growth potential. Investors are also increasingly concerned about fiscal sustainability and macroeconomic management in Indonesia, highlighting the importance of policy decisions in the coming months. End Summary. Food Prices Continue to Soar -------------- ¶2. (SBU) Inflation continues to accelerate in Indonesia due in large part to rapidly rising food prices. Table 1 illustrates the magnitude of the problem in Indonesia. The retail price of flour and soybeans have risen 70% and 44%, respectively, in the past 12 months. The price of cooking oil and instant noodles are up roughly 30% in the past year. High prices for these Indonesian staple foods are likely to persist given that poor harvests, growing demand from emerging markets, and increased use of food to produce alternative sources of energy continue to push up international prices. The high price of soybean meal, which farmers use as poultry feed, has also helped drive up the price of chicken and eggs, a key source of protein in Indonesia, by roughly 30% over the past year. The rise in food prices has already translated into higher overall inflation in Indonesia. The CPI inflation rate jumped to 8.2% (YoY) in March, well outside the central bank's 4-6% percent target range. Some analysts predict the rate could rise as high as 10% before the end of the year. Table 1: Food Price Increases as of February 2008 -------------- -------------- Year-on-Year Change Rice* -4.1% Flour 69.1% Soybeans 43.7% Palm oil 29.2% Instant Noodles 29.5% Poultry 32.9% Eggs 34.5% -------------- -------------- Source: Foreign Agriculture Service Survey *Note: Rice prices rose significantly in 2006 -------------- -------------- Rice Presents Biggest Risk -------------- ¶3. (SBU) The rise in food prices has not yet incited widespread protests from the poor or significantly reduced domestic consumption, but that may change if rice prices begin to rise. Rice accounts for roughly one-third of poor household spending. With roughly 50% of Indonesia's population at or near the poverty line, a rise in the price of rice could substantially reduce the standard of living of over 100 million Indonesians. The World Bank estimates JAKARTA 00000780 002 OF 004 that every 10% rise in the price of rice puts an additional 2 million people below the poverty line (income of $1.55 a day or less). In contrast to the international price, the cost of rice has declined in Indonesia over the past year, as rice prices were already high relative to international prices in 2007. But the international price is now $700 per metric ton (MT) higher than the price in Indonesia, creating a significant incentive to smuggle rice out of the country and raising the risk that prices will climb again rapidly this year. ¶4. (SBU) High rice and other food prices are expected to hit hardest in Java, where income and job growth remain limited. According to executives at Indofoods, sales of wheat base products fell most dramatically in Central Java when the price of wheat began to rise, providing support for the view that purchasing power is lowest in that area. Java is also likely to be the source of most rice smuggling efforts as roads and transportation links there are superior to most other parts of the country, making it easier for illegal traders to move goods. According to discussions with local traders, inter-island trade is up substantially this month, from around 200-250 MT/month to around 500-600 MT month. Traders note that the increase in activity reflects pre-positioning in rice deficit regions in anticipation of local price increases. However, experts also worry this could be an early sign of smuggling. ¶5. (SBU) Indonesia's ability to thwart rice price increases is limited by several internal and external factors. First, pressures on global prices are unlikely to abate and are outside of GOI control. Experts estimate that there is currently a 4 million MT shortfall in rice stock available to the international market, which will push rice prices significantly higher throughout the year. (Reftel A) The shortfall is mainly the consequence of export restrictions in India and Vietnam that are unlikely to be removed in the near term. Strong demand from rapidly growing developing countries is also a factor. Second, the GOI has failed to meaningfully invest in the agriculture sector over the past decade, resulting in deterioration in agriculture productivity. Experts note that Indonesia's fertilizer and seed technology is 30-40 years old, while irrigation systems continue to age without funds for repair. Third, Indonesia's fuel and electricity subsidy scheme limits the amount of money available to invest in agriculture infrastructure or provide shorter term assistance to the poor. If oil prices remain near $100 per barrel, Indonesian could spend as much as $25 billion (roughly 25 percent of the budget) on subsidies this year. GOI Focuses on Short-term Solutions -------------- ¶6. (SBU) The GOI plans to combat rising food prices with short-term policy measures, such as temporary trade liberalization, export taxes, subsidies and cash transfers to the poor, which are costly and fail to address underlying weaknesses in the sector, according to government advisors. The GOI already removed import taxes on soybeans and wheat, increased export taxes on palm oil, and developed rice subsides for the poorest of the poor (Refs B and C). Yet international prices continue to rise, countering the effectiveness of these policies. ¶7. (SBU) World Bank officials who are working closely with the GOI on the issue of food prices and poverty say that the government is considering an additional cash transfer program to directly increase the purchasing poor of the poor. Yet the price of such a program is likely to be significant. There are roughly 19 million households on the government's list of poor families, according to the World Bank. Therefore, a Rupiah 50,000 ($5.50) per month per family cash transfer would cost the government Rupiah 11.4 trillion ($1.3 billion) this year. While this is likely to be an effective short-term measure, the cash transfer program fails to provide a long-term solution to poor productivity in the agriculture sector and slow job growth, which keep Indonesia extremely vulnerable to food and other price shocks. JAKARTA 00000780 003 OF 004 Investment and Domestic Demand to Slow -------------- ¶8. (SBU) The GOI's 2008 GDP growth projection of 6.4% is now well above most market forecasts, due to disparate views between the GOI and analysts on domestic demand and investment rates. The government projection is based a continuation of current domestic demand and investment trends, and only a modest decline in net exports. However, market analysts note that soaring food prices and low job growth have reduced consumer confidence, which is now at a two year low. If inflation rates remain high, Bank Indonesia (BI) will also need to raise interest rates, which could significantly slow consumer finance and investment. ¶9. (SBU) On the external side, most analysts expect Indonesian exports to continue to benefit from high commodity prices, but predict Indonesian manufacturing exports will decline this year in response to flagging demand in Japan and the United States. Some GOI advisors have also stated that BI plans to actively maintain or increase the value of the Rupiah in an effort to limit imported inflation, a move that could hurt Indonesian exporters. The cost of imported food and commodity-based finished products are also likely to lift the import bill this year, potentially reducing the trade balance. ¶10. (SBU) The expected slowdown in manufacturing exports will also disproportionately impact jobs, potentially increasing the number people vulnerable to poverty. Every $1 billion in manufacturing exports creates 242,000 jobs, whereas the same amount of exports of coal, mining, or chemical products create only 12,000, 43,000, and 8,000 jobs, respectively, according to research study by Chatib Basri of University of Indonesia and Gustav Papanek of Boston University. The same study notes there have been no new jobs produced among large and medium firms in Indonesian in the last ten years because of stagnant growth in job-creating export sectors such as manufacturing. Yet 20 million people have joined the workforce since 1997. Most of these people are currently underemployed in the agriculture sector, living on very low wages and remaining extremely susceptible to poverty, according to Basri and Papanek. No Crisis Yet, But Outlook Dims -------------- ¶11. (SBU) The current economic team is likely to avoid serious economic policy missteps, but risks to growth and macroeconomic stability are rising. Incoming BI Governor Boediono, Finance Minister Sri Mulyani Indrawati and Trade Minister Mari Pangestu have a strong track record for maintaining macroeconomic stability and are unlikely to allow GOI spending or inflation to expand unchecked. Indonesia's banking sector remains sound and BI has accumulated $57 billion in foreign exchange reserves, equivalent to 9 months of imports. Nevertheless, Indonesia faces a number of external risks beyond the control of policymakers and political pressure for short-term policy fixes are expected to increase in advance of the 2009 election. ¶12. (SBU) Analysts note that investors are increasingly worried about the ability of the GOI to control the budget in light of rising food and oil prices, underscoring the importance of prudent policy making in the current environment. Introducing a large cash transfer program without a reduction in fuel subsidies is likely to increase their concern. Markets have already declined sharply in April in response to worries that the fuel subsidy regime presents an unlimited liability to the government. The Indonesia Stock Exchange index fell 7.1% within the first week of April and the yield on 5-year Indonesian Rupiah government bonds rose to 11.6% from 10.4% over that same period, according to a recent Standard Chartered Report. ¶13. (SBU) If capital outflows accelerate, the Rupiah could come under pressure, adding fuel to the inflation fire. A recent report from HSBC cites Indonesia (along with Vietnam) as the most "behind the curve" in terms of fighting inflation, due to monetary policy JAKARTA 00000780 004 OF 004 loosening in 2007. Six months ago financial analysts expected the Indonesian economic growth to run close to 7.0% in 2008, on higher investment, domestic consumption, and strong exports. Analysts now worry that the need to aggressively fight inflation and slowing world demand will push Indonesia's growth rate below 6.0%, with limited potential for new job creation or poverty alleviation. HUME