INDONESIA: FOOD PRICES DIM ECONOMIC PROSPECTS

UNCLAS SECTION 01 OF 04 JAKARTA 000780

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USDA/FAS/OA YOST, MILLER, JACKSON
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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
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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%

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Source: Foreign Agriculture Service Survey
*Note: Rice prices rose significantly in 2006
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Rice Presents Biggest Risk
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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

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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.

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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

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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