Indonesia Monitor

Created on 02 May 2012 Page 1 of 25

Country Intelligence: Report

Indonesia REPORT PRINTED ON 02 MAY 2012


This information was last updated on 24 APR 2012, 1:49 PM EDT (17:49 GMT)

Outlook and Assumptions: OutlookExternal headwinds will marginally soften growth momentum this year. Weaker external demand growth in2012 will shave a few tenths of a percentage point off Indonesia’s growth, but the impact will be much less severethan in most other Asian economies. Thanks to stable macroeconomic conditions domestically, improved businessconditions, and easier access to credit, both consumer and investment spending should hold up well in comingquarters. One downside risk to the outlook is that proposed energy price increases by the government could dampenconsumer spending in the year ahead. In recent years, Indonesia has repeatedly impressed observers with itssteady progress along the path of macroeconomic reforms and this is now bearing fruit in the form of record-highforeign-direct-investment inflows and improved sovereign credit ratings. These will help minimize downside risksfrom ongoing sovereign debt problems in Europe and should help keep overall GDP growth in the 6.2% range in2012.The window has essentially closed on the latest monetary easing cycle. Since October 2011, Bank Indonesiahas lowered interest rates by a total of 100 basis points (the last cut being delivered at the February 2012 meeting).This was driven by a combination of worsening external conditions and high degree of confidence that inflationtargets would be met. However, we think the current easing cycle has run its course and unless external conditionsdeteriorate far more than currently expected, we expect no further rate cuts. In fact, there are reasons to believe thatglobal economic activity and commodity prices will lift during the second half of the year, so the downshift inIndonesian inflation will similarly begin to reverse. Furthermore, the central bank will have to contend with thegovernment’s plans to reduce fuel subsidies from April 2012 and raise electricity tariffs over the remainder of 2012.The changes will cause inflation to spike from its current lows, and the central bank will have to monitor pricesclosely in coming months for evidence of second-round effects gaining too much momentum. The central bank willinitially look through the policy-induced spike, and is expected to use monetary tools such as the deposit facility rateto help contain inflation before resorting to raising the policy interest rate. We nonetheless think that the Februaryrate cut will be reversed before the year is over and that the policy rate is likely to end 2012 at 6%, the same rate atwhich it started the year.Reform efforts will pay off over the medium term via higher foreign direct investment (FDI). Quietly andwithout fanfare, Indonesia has taken important steps to improve its business climate over the last few years. Givenreduced corporate tax rates, less red tape, and an improved reputation as a favorable investment destination,Indonesia is well positioned to grab a larger share of global FDI inflows in coming years. We anticipate a steadyincrease in FDI inflows to Indonesia over the medium term, particularly in areas such as mining and hydrocarbons,infrastructure development, and manufacturing.

Outlook and Assumptions: Domestic AssumptionsThere is no double-dip recession in the United States and no hard landing in China.The Eurozone sovereign debt crisis is contained with considerable difficulty; Greece avoids a disorderly default on itsforeign debts but remains within the common currency zone. European policymakers manage to ring-fence the othervulnerable economies.The strength and sustainability of the global economic recovery over the medium term remain in question given thatunderlying global imbalances are still in place. Past over-consumption in many developed economies and theassociated household-debt accumulation will weigh heavily on these countries' ability to resume pre-crisisconsumption levels and support Asia's export-oriented development model.


Inflation is expected to spike temporarily owing to the government’s planned changes to energy prices, but theincrease does not destabilize the currency. Profit taking following two years of excellent stock market returns doesnot evolve into large-scale capital flight.Domestic political stability is maintained over the forecast horizon; there will be no major outbreak of ethnic orreligious violence.

Outlook and Assumptions: Alternative ScenariosThe probability of a double-dip recession in the United States stands at 20% as of March 2012 (down from theJanuary–February reading of 30% and 40%, respectively, in October–November 2011).Renewed panic in financial markets might not necessarily hit Indonesia’s growth particularly hard, but it could causea massive sell-off in the stock market (which, after two years of strong returns is ripe for profit-taking) and ingovernment bonds. The rupiah could depreciate sharply, although we think such weakness would be temporary.A global recession or a sharp downturn in China would lead to a decline in global commodity prices, including coal,metals, and hydrocarbons. Since a large share of foreign direct investment inflows into Indonesia target these verysectors, we would see investment flows from abroad as well as domestic investment spending weaken under such ascenario.A major terrorist incident in Bali, Jakarta, or in another economically sensitive center would undermine our growthforecast.Rising protectionism worldwide could undermine the speed and sustainability of the recovery phase, possibly leadingto below-potential global growth over the medium term.

Economic Growth: Outlook

External headwinds will marginally soften growth momentum in 2012. Weak external demand growth in 2012 willshave a few tenths of a percentage point off Indonesia’s growth, but the impact will be modest. Thanks to stablemacroeconomic conditions domestically, improved business conditions, and easier access to credit, both consumer andinvestment spending should hold up well in coming quarters. One risk to the consumer spending outlook is thegovernment’s proposed changes to fuel subsidies and electricity tariffs, since they would reduce disposable incomes. Inrecent years, Indonesia has repeatedly impressed observers with its steady progress along the path of macroeconomicreforms and this is now bearing fruit in the form of record-high foreign-direct-investment inflows and improved sovereigncredit ratings. These will help minimize downside risks from ongoing sovereign debt problems in Europe and should helpkeep overall GDP growth in the 6.2% range this year.


Economic Growth Indicators

2009 2010 2011 2012 2013 2014 2015 2016

Real GDP (% change) 4.6 6.1 6.6 6.2 6.2 6.3 5.9 5.7

Real Consumer Spending (% change) 4.9 4.6 4.8 5.2 5.1 5.3 5.5 5.4

Real Government Consumption (% change) 15.7 0.3 3.2 2.8 3.1 3.1 4.2 4.5

Real Fixed Capital Formation (% change) 3.3 8.5 8.8 9.8 9.0 8.6 7.9 7.3

Real Exports of Goods and Services (% change) -9.7 14.9 13.9 7.6 7.8 7.7 5.8 5.6

Real Imports of Goods and Services (% change) -15.0 17.3 13.4 7.6 7.6 7.1 6.4 6.2

Nominal GDP (US$ bil.) 539.4 706.6 846.9 917.3 1,067.6 1,229.4 1,358.7 1,477.6

Nominal GDP Per Capita (US$) 2,272 2,946 3,495 3,748 4,319 4,926 5,394 5,814

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the

15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release

of the GIIF bank.


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Economic Growth: Recent Developments

Economic growth hit a fifteen-year high in 2011. Newly released official data show Indonesia's economy expanded by6.6% year-on-year (y/y) during the last quarter of 2011. Marginal upward revisions to the January–September figuresbrought the annual 2011 average to a similar 6.6% rate—the highest since 1996. This is just the latest in a string ofpositive developments related to the Indonesian economy over the course of 2011. The country also recently regained itsinvestment-grade status in sovereign credit markets, which it lost 14 years ago, thanks to an upgrade by Fitch inDecember 2011 and a similar move by Moody's in January 2012. Both were preceded by IHS Global Insight's similarupgrade in June 2011.

Domestic demand was key to improved performance. During the fourth quarter and over the course of 2011 as awhole, the key to Indonesia's strong growth has been its resilient domestic demand. Consumer spending accelerated atthe end of the year, up 5.4% from a year earlier, while fixed investment rose 11.5% y/y. These were the strongestexpansion rates for these sectors since early 2009 and late 2008, respectively. Declining inflation and more affordablecredit (Bank Indonesia cut interest rates twice in October and November) have buoyed households' purchasing power,while the prospect of a growing market, alongside improvements in the business environment, have supported the upturnin investment spending. Indeed, foreign direct investment (FDI) flows are estimated to have reached a new record high ofabout USD19 billion last year. Given the disproportionately high share of total investment that is financed via FDI flows,this upturn has been the critical force behind the recent pick-up in investment spending. The downside to strong domesticdemand has been the relatively faster import growth in recent months: during the fourth quarter, real exports grew 8.3%y/y, but imports jumped 10.3% y/y. Performance was more balanced for the year as a whole, but net exports made a farsmaller contribution to growth in 2011 than they did in 2010. This may actually prove to be a positive development at atime when prospects for external demand continue to dim under the shadow of the Eurozone sovereign crisis.

Manufacturing competitiveness is improving. From a supply standpoint, it is worth noting that the manufacturing sectorexperienced a steady pick-up in growth over the course of 2011 and expanded by 7.1% y/y during October–December.This is highly encouraging. Between 2005 and 2010, Indonesia's manufacturing sector grew by an annual average of only4.0%—considerably below rates seen elsewhere in Southeast Asia. So the fact that growth in the sector quickened to thefastest pace since 1996 raises hopes that a steady, sustained improvement in Indonesia's manufacturing competitivenessis under way. This would facilitate the government's goal of raising the value-added profile of the export sector, which iscurrently still heavily skewed towards various agricultural and mineral resources.


Economic Growth: Consumer Demand - Outlook

Consumer spending growth remains robust, but sharp acceleration is unlikely. Political stability, improving laborincomes, stable prices, and broadening access to consumer credit will support private consumption in Indonesia over themedium term. Some uncertainty has been introduced in the near-term outlook by worsening global economic conditionsthat have the potential to sap confidence, but the impact should be fairly modest. One additional risk to our outlook is thegovernment’s plans to reduce fuel subsidies from April 2012, which will negatively impact the country’s inflationaryenvironment and weigh on household disposable incomes. Real private consumption is expected to grow by 5% during2012, with high-ticket items such as car sales anticipated to remain strong and potentially reach new records.

Economic Growth: Consumer Demand - Recent Developments

Demand for consumer durables has surged in recent years. Over the past couple of years, consumer sentiment hasbeen supported by improving economic conditions, stable inflation, and an appreciating currency. Demand for consumerdurables, in particular, has been very strong. This momentum extended into 2011 as well, with vehicle sales up about28%, despite poor sales in March–May (likely related to shortages of Japanese imports) and November (because of theThai floods). This came after car sales surged some 61% to an all-time high of about 765,000 units in 2010.

Despite the recession, household consumption continued to grow in 2009. Despite headwinds from the globalrecession, consumer spending in Indonesia held up remarkably well in 2009, growing 4.9%. Two main factors facilitatedthis performance. On one hand, consumer price inflation moderated rapidly over the course 2009, falling from 9.2% y/y inJanuary to an average of 2.7% between July and December. This was in sharp contrast to 2008, when inflationarypressures were steadily intensifying in response to rising commodity prices. Another favorable factor has been theelectoral cycle, with both legislative and presidential elections taking place smoothly and having outcomes perceived asfavorable by the majority of the population. As a result, consumer confidence had shot up to multi-year highs before takinga slight step back during the second half of 2009.


Economic Growth: Capital Investment - Outlook

Investment spending will accelerate over the medium term, thanks to better fundamentals and higher foreigndirect investment (FDI) inflows. Stable domestic economic conditions and easier credit availability are boostinginvestment spending. Improved investor perceptions about the country's business climate, political stability, and lowercorporate-tax rates should help maintain inflows of FDI, despite the lingering effects of the global recession. In late 2011,parliament approved a much-awaited land acquisition law that should substantially speed up and ease the process forland acquisition for public projects. This action should facilitate much-needed investment in transportation infrastructurethrough public-private partnerships in coming years. Nevertheless, implementation rules will likely take months to befinalized, so the beneficial impact of this piece of legislation may not really be felt until 2013. All in all, investment spendingshould grow at a robust 9.0%-plus pace annually in 2012–13.

Economic Growth: Capital Investment - Recent Developments

Investment spending grows at a solid pace. Fixed investment spending grew 8.8% in 2011, in line with upbeatbusiness sentiment and increased foreign direct investment (FDI) inflows. Moreover, fixed investment growth acceleratedto a three-year high of 11.5% y/y during the fourth quarter. FDI inflows hit a fresh record high of USD19.5 billion in 2011,up from the previous record of USD13.3 billion in 2010. Over the course of 2011, foreign direct investors primarily targetedthe transport, storage, communications, and mining sectors. Other sectors attracting considerable amounts of FDI wereutilities, metals, machinery, electronics, and chemicals and pharmaceuticals.

The investment spending acceleration has been a multi-year phenomenon, reflecting the extreme declines ininvestment in the immediate post Asia-crisis period on one hand and the genuine improvement in Indonesia’s businessenvironment in recent years on the other. As a result, the share of fixed investment to GDP reached a new historical highof 32% as of 2010 (prior peaks were in the 30–31% range), having fallen to as low as 19% of GDP in 2002. We anticipatethis ratio to continue rising, though at a much slower pace, over the next decade or so, as the drive to upgrade outdatedinfrastructure continues and multinational corporations establish more substantial manufacturing facilities in the country.

Investment growth picked up considerably in 2010. Favorable base effects, improved business confidence, and easieraccess to credit steadily lifted investment spending over the course of 2010, resulting in an 8.5% expansion. Higherinflows of capital from abroad also supported investment spending as FDI inflows surged 173% in 2010 to reach USD13.3billion.


Recession slowed but did not stop investment spending. Real investment spending grew 3.3% in 2009—a far cryfrom the double-digit rates recorded during the same period in 2008, but nonetheless impressive in the context of a severeglobal recession. In fact, Indonesia was almost an exception in Southeast Asia, as investment spending in many countriesin the region plunged severely during 2009.

Labor Markets: Outlook

Unemployment is easing, but remains high by regional standards. High domestic unemployment will remain asignificant challenge for Indonesian policymakers for some time to come. Although population and labor-force growth perse are not particularly rapid, job creation is constrained by fairly rigid labor laws. Many foreign and domestic investorsoften complain about worker "protectionism" and extremely generous termination packages. While such measures appearto be worker-friendly on the surface, they have in fact stymied new hiring across the board and encouraged companies toresort to under-the-table arrangements, which then leave the workers involved without any form of protection. Yet, giventhe growing political influence of organized labor (there are some 180 unions and five national labor confederations), thistrend will be difficult to alter significantly in the future.

Labor Markets: Recent Developments

Recent declines in unemployment are encouraging but the pace of improvement remains too slow. Good economicperformance in recent years has facilitated a steady decline in the unemployment rate from 8.4% in August 2008 to 6.6%in August 2011. While the trend is encouraging, the absolute level of unemployment remains very high and is festeringsocial tensions. Moreover, official statistics also tend to underestimate the unemployment problem as large numbers ofunderemployed workers are not included in the unemployment definition. Indonesia's high unemployment can beattributed to stricter, less flexible labor laws implemented over the past several years. A recent World Bank study, forinstance, showed Indonesia to be very poorly placed in relation to other Asian countries in terms of labor competitiveness.According to the report, Indonesia's cost of laying off workers is higher than that of China and about twice that of India,being equivalent to some 108 weeks of pay. There is abundant anecdotal information suggesting that small businessesoften choose to close down rather than lay off workers and bear the associated severance costs. In addition, localgovernments have the ability to set minimum-wage rates, and populist tendencies mean that the mandated increases areoften times quite large. Although other countries such as China and Vietnam have also experienced rising labor costs, sofar productivity gains in Indonesia have lagged those elsewhere. As a result, foreign investors often cite Vietnam as thepreferred manufacturing location alternative, especially for labor-intensive industries such as textiles and footwear. Whilethis may now be changing thanks to Indonesia's more aggressive reform efforts, it will take the country many years beforeunemployment rates can be reduced in a meaningful fashion.

Inflation: Outlook

Inflation is under control, but changes to energy prices will cause inflation to rise again. Rising food and commodityprices lifted inflation during the early part of 2011, but the trend reversed during the last part of the year and moderated


further in early 2012. Earlier plans to reduce fuel subsidies have been watered down so much recently that it is nowunlikely they would be implemented until the last few months of 2012, if at all. Therefore, in the April forecast round, wehave reverted to our 4.5% 2012 inflation forecast.

Inflation Indicators

2009 2010 2011 2012 2013 2014 2015 2016

Consumer Price Index (% change) 4.8 5.1 5.4 4.5 5.3 5.8 4.0 4.2

Wholesale-Producer Price Index (% change) -1.8 4.9 7.5 4.8 5.1 5.9 2.4 3.3



of the GIIF bank.


Inflation: Recent Developments

A retreat in food prices allowed headline inflation to moderate over the course of 2011 and into early 2012. Astrong disinflation trend continued from late 2011 into early 2012: the consumer price index (CPI) rate fell to 3.6% y/y inFebruary 2012, thanks to favorable base effects from the previous year’s food price spike. Having peaked at 7.0%year-on-year (y/y) in January 2011 on account of high food prices, Indonesian inflation moderated steadily over the courseof the year and retreated to 3.8% y/y in December 2011. For 2011 as a whole, inflation averaged 5.4%.

Inflationary pressures were modest in 2010, but began rising during the fall. Both consumer and wholesale priceinflation were pretty subdued during most of 2010, with CPI and wholesale price index (WPI) inflation averaging 4.8% and4.6%, respectively, during January–September. The appreciation of the local currency, as well as Indonesia's less-intenseeconomic recovery and the persistent slack in the labor market contributed to keeping inflationary pressures in check. Byyear-end, however, a spike in food prices pushed headline inflation higher—to 7.0% y/y by December 2010. For the yearas a whole, CPI inflation averaged 5.1%.


A strong disinflationary trend took hold in 2009. The year 2009 brought much improved news on the inflation front. Ifone were to look for a silver lining in the cloud of global recession, it would have to be the correction in commodity pricesfrom overextended levels, which allowed inflationary pressures to diminish sharply, not just in Indonesia or Asia, butacross the world. As a result, the CPI inflation rate fell to just 2.4% y/y in November 2009—the lowest since 2000. Thisdirectly reflected trends in producer prices, which by July 2009, were experiencing double-digit declines from year-earlierlevels. For 2009 as a whole, consumer price inflation averaged 4.6% (versus 10.1% in 2008), while producer pricesactually declined 1.2% (having surged 26.2% the previous year).

Exchange Rates: Outlook

The rupiah is fundamentally well supported, but remains vulnerable to panic selling in the context of heightenedrisk aversion. Strong external balances, such as trade surpluses and higher inflows of foreign capital, offer fundamentalsupport for the rupiah. Additionally, since interest rates in both the United States and Europe are likely to remain close tozero for an extended period, there is reason to believe that the carry trade will continue to lend support to Indonesia'srupiah over the medium term. Sovereign rating upgrades since late 2011 brought Indonesia back into theinvestment-grade club after a 14-year hiatus and represent another positive for the rupiah. Nevertheless, experienceshows that fundamental factors tend to be overwhelmed by cyclical forces in determining the near-term performance forthe rupiah. The rupiah remains quite vulnerable to sudden shifts in investor risk aversion; as long as worries about thestability of the global financial system remain in the background, episodes of sudden rupiah depreciation cannot bediscounted. An additional issue to watch in the coming months is how much inflation accelerates in response to thegovernment’s planned fuel-subsidy reductions in April 2012. Investor concerns about inflation have weighed on thecurrency since the subsidy changes were first discussed.


Exchange Rate Indicators

2009 2010 2011 2012 2013 2014 2015 2016

Exchange Rate(LCU/US$, end ofperiod)

9,400.00 8,991.00 9,068.00 8,850.73 8,629.07 8,455.81 8,633.07 8,719.92

Exchange Rate(LCU/US$, period avg)

10,389.90 9,090.43 8,770.43 9,041.80 8,719.85 8,542.41 8,588.45 8,677.69

Exchange Rate(LCU/Euro, end ofperiod)

13,540.77 12,013.63 11,732.44 11,328.94 10,872.64 11,077.09 11,827.25 12,469.49

Exchange Rate(LCU/Euro, period avg)

14,438.44 12,038.71 12,194.71 11,769.95 11,010.47 10,953.49 11,506.49 12,146.82



of the GIIF bank.


Exchange Rates: Recent Developments

Rupiah remained strong during the first half of 2011, but contagion caused it to weaken in September–December.The rupiah's appreciation continued from 2010 into 2011, supported by strong economic growth, diminished risk aversion,moderate domestic inflation, and continuing support from carry trade. The appreciation was most powerful in the earlymonths of 2011, and the exchange rate ended August 2011 near a seven-year high of IDR8,578/USD1. In September2011, however, substantial portfolio capital outflows owing to increased foreign participation in the market in recent yearsinduced a 4% depreciation of the rupiah versus the US dollar. Foreign ownership of local currency government bonds, for


instance, fell from 35.7% of the total market on 9 September to 31.4% by 29 September. The large depreciation forced thecentral bank to intervene in the market and increase its own purchases of government bonds to the highest level sinceDecember 2010. Contagion from the Eurozone situation kicked up again in November, causing the exchange rate to endthe month at IDR9,170/USD1—the first close above 9,000 since January. It ended 2011 at IDR9,066/USD1 and stood atIDR9,180/USD1 at the end of March 2012.

Improved risk appetite and carry trade lifted the rupiah since spring 2009. Despite favorable fundamentals, therupiah was hard hit by the indiscriminate flight to safety that accompanied the onset of the global credit crisis in the fall of2008. Within a few weeks, the rupiah lost more than 25% of its value against the dollar. Nevertheless, once it becameevident that the world was, in fact, going to survive the recession, risk appetite began building anew. The exchange ratereached IDR9,433/USD1 at end-2009, compared with more than IDR12,000/USD1 at the height of the crisis.

The rupiah remains among the most volatile emerging-market currencies. Despite improving macroeconomicfundamentals that should support the rupiah, trading in the currency is thin, and the rupiah is seen as one of the riskiest inAsia. As such, it tends to suffer more than others in periods of market turbulence and risk aversion. Nevertheless, just as ithas historically experienced bouts of severe depreciation, it has also gone through several rapid appreciation runs.Generally, both the currency and the economy as a whole have become much more resilient to shocks, and we believethat although depreciation episodes are possible, they should be brief.

Economic Policy: Monetary Policy and Outlook

The window appears to have closed on the latest monetary easing cycle. Since October 2011, Bank Indonesia haslowered interest rates by a total of 100 basis points (the last cut being delivered at the February 2012 meeting). This wasdriven by a combination of worsening external conditions and a high degree of confidence that inflation targets will be met.However, we believe the current easing episode has run its course and unless external conditions deteriorate far morethan currently expected, we expect no further rate cuts. In fact, there are reasons to believe that global economic activityand commodity prices will lift during the second half of 2012, so the downshift in Indonesian inflation will similarly begin toreverse. Furthermore, even though effectively postponed, government plans to reduce fuel subsidies remain a key risk tothe inflation outlook. We therefore think that the February rate cut will be reversed before the year is over and that thepolicy rate is likely to end 2012 at 6%, the same rate at which it started the year.


Monetary Policy Indicators

2009 2010 2011 2012 2013 2014 2015 2016

Policy Interest Rate (%, end of period) 6.50 6.50 6.00 6.00 6.25 6.25 6.22 6.19

Short-term Interest Rate (%, end of period) 9.28 7.02 6.93 6.17 6.04 6.22 6.38 6.45



of the GIIF bank.


Economic Policy: Monetary Policy - Recent Developments

Monetary easing was initiated in October 2011, but the cycle may have ended with the February 2012 cut. BankIndonesia decided to hold its policy rate at 5.75% in March 2012, after kicking off its 100-basis-point loosening cycle inOctober 2011, owing to healthy domestic activity and concerns about future inflation. At its monthly policy meeting on 11October, Indonesia's central bank surprised markets with a 25-basis-point interest-rate cut, bringing the policy rate back to6.50% where it had stood between August 2009 and February 2011. The decision to initiate monetary easing rested onBank Indonesia's conviction that 2011 inflation targets would be met (which they were). The benign inflation outlook thencoupled with rising external risks to induce a further 50-basis-point cut at the November meeting. Having remained on holdin December and January, Bank Indonesia resumed its easing cycle in February 2012 with another 25-basis-point rate cut.The bank remained on hold at the March and April meetings.

February 2011 brought the first rate hike since the 2009 downturn. The first signs of a shift in Bank Indonesia's stancecame in late 2010. Reserve requirements for domestic currency loans were raised in November; shortly thereafter, thebank announced that higher reserve requirements for foreign currency deposits would be required beginning in March


2011. With supply limitations pushing consumer price index inflation to 7.0% in January 2011, Bank Indonesia finallytapped the brakes and announced a 25-basis-point interest-rate hike in early February—just as we had anticipated, butthen remained on hold through August.

The 2008–09 financial crisis necessitated a quick shift to easing. As it became clear that the global economy wasentering a serious recession, the central bank (Bank Indonesia) quickly changed course and responded to the new realityby initiating a moderately aggressive easing cycle. The extent of the rate cuts was initially limited by still high inflation(11.4% in the fourth quarter of 2008), but this was subsequently compensated by a longer easing cycle than elsewhere inthe region. Thus, between December 2008 and August 2009, the policy interest rate was lowered nine times by a total of300 basis points. It then remained at 6.50% between August 2009 and January 2011.

Inflation-targeting framework improves policy transparency. In July 2005, Bank Indonesia moved to an explicitinflation-targeting framework, replacing base money with interest rates as its operational targets. The new policyframework is believed to allow for a more transparent and effective conduct of monetary policy. With the country's bankingand financial system becoming more complex, base-money growth had become a less effective way of guiding overallcredit or money-supply growth, making inflation targeting difficult. The new monetary policy framework has been launchedconcomitantly with a new plan to further consolidate the banking sector and improve its efficiency.

Economic Policy: Fiscal Policy and Outlook

A favorable deficit picture will likely be maintained over the medium term. Generally speaking, the main problem withIndonesia's public finances is not really that of a chronic deficit, such as in India, but rather the fact that resource allocationis very inefficient. Although the debt burden has eased considerably in recent years, a big chunk of scarce resourcescontinues to be diverted into debt repayment, leaving little available for much-needed social, education, and infrastructurespending. Nonetheless, purely from a deficit point of view, Indonesia is not a problem country. More often than not, it is ina position where the actual deficit falls below budget projections on account of weak spending implementation. Therefore,although the budget calls for a deficit of 1.5% in 2012, we believe that the actual shortfall will be closer to 1.1% of GDP.High oil prices (which tend to greatly increase subsidy costs in the budget) represent a considerable risk to this otherwisebenign fiscal picture. This is why the government is seeking to reduce fuel subsidies starting on 1 April 2012, and is hopingto also boost electricity tariffs.


Economic Policy: Fiscal Situation - Recent Developments

The 2011 fiscal deficit is estimated at 1.3% of GDP, below the 2.1% budgetary target. The favorable reading wasfacilitated by stronger-than-expected revenues on one hand and lower-than-anticipated capital expenditures on the other.Total revenues came in at 1,199.5 trillion Indonesian rupiah (USD13 billion), above the budgetary target of IDR1,169trillion. On the expenditure side, subsidy costs greatly exceeded targets (by over 30%) because of high prices of oil andenergy, but capital expenditures were lower than anticipated because of perennial delays in project implementation.

Indonesia does not have large deficits, but it does face several structural fiscal challenges. From a purelynumerical standpoint, Indonesia's fiscal performance compares well with regional peers. In fact, its fiscal deficits areamong the lowest in all of Asia, and are certainly far smaller than neighboring Malaysia's, whose fiscal shortfalls averaged4.8% during 2006–10. Rather, Indonesia's fiscal challenges are of a different nature and have to do with a low level of taxpenetration, inefficient spending distribution, and poor implementation of capital spending projects. The first issue of lowtax penetration, which means that only a fraction of those supposed to pay taxes actually do so, has been on thegovernment's radar for years. Several steps to fight tax evasion have been undertaken in recent years. The latest one—anationwide tax census—was announced in September 2011. The program, which will see tax data collected door-to-dooruntil the end of 2012, is hoped to boost the number of taxpaying residents by over 25% by 2013, as well as improvecompliance in submitting tax reports. In 2010, only 20 million of 237 million Indonesians had registered as paying tax andonly 9 million people submitted their income statements. The second key issue deals with wasteful spending in the form ofcostly subsidies. In fact, subsidy costs have become a far larger drag on the budget in recent years than interestpayments. The revised 2011 budget, for instance, allotted 18% of total expenditures toward subsidies and the 2012budget calls for a similarly large 15%. Subsidy costs also dwarf the country's health and education budgets. Once again,the government has tried to gradually correct the problem through periodic increases in fuel prices, but it has now been awhile since a substantial adjustment has been implemented (in 2008). Considerable public opposition makes such movespolitically difficult to push through, although ultimately these steps will need to be taken. Finally, another structuralweakness in Indonesia's fiscal process are perennial delays in capital spending implementation. Oddly enough, these tendto improve the budgetary outcome by constraining expenditure growth, but have had a detrimental impact on infrastructureexpansion in recent years. The recent passage of a new land acquisition law is hoped to speed up project implementationgoing forward.

External Sector: Outlook

External balances will benefit from expected productivity and competitiveness improvements. We expectIndonesia to maintain trade and current-account surpluses over the next few years. A narrowing of both surpluses isexpected, and temporary reversals in the trade balance are possible. We anticipate, for instance, that stronger foreigndirect investment inflows will be accompanied by increased demand for imported investment goods. In such a scenario,however, the narrowing of trade surpluses would not be a problematic development because higher imports would be notonly financed through these investment inflows, but would also contribute to boosting productive capacity andcompetitiveness. Recognizing the inherent volatility associated with global trade and capital flows, we believe that steadyimprovements in competitiveness will allow Indonesia to retain a moderate trade surplus over the next few years.


Trade and External Accounts Indicators

2009 2010 2011 2012 2013 2014 2015 2016

Exports of Goods (US$ bil.) 119.6 158.1 201.4 216.4 251.4 298.8 319.3 340.8

Imports of Goods (US$ bil.) 88.7 127.4 172.6 192.7 222.8 268.2 290.6 314.8

Trade Balance (US$ bil.) 30.9 30.6 28.9 23.7 28.6 30.6 28.7 26.0

Trade Balance (% of GDP) 5.7 4.3 3.4 2.6 2.7 2.5 2.1 1.8

Current Account Balance (US$ bil.) 12.4 7.5 3.1 2.7 6.6 7.2 2.6 -1.3

Current Account Balance (% of GDP) 2.3 1.1 0.4 0.3 0.6 0.6 0.2 -0.1



of the GIIF bank.


External Sector: Recent Developments

Trade balances drive the current-account position, but the income account is increasingly weighing on thebalance. Over the course of 2011, preliminary data indicates that the current-account surplus progressively narrowed,particularly between the first and the second quarters. Early data also hints at the country recording a deficit for the fourthquarter. The surplus narrowed in 2011 not as much in response to a narrowing merchandise trade deficit as much asrising deficits on the services and income accounts, as growth in services imports and income outflows was stronger thangrowth of inflows. Rising income-account deficits are one risk to the country’s increased investor interest as profit-remittingby foreigners could become a larger drag on the current account going forward. The current-account balance remained insurplus in 2010, but the size of the surpluses moderated with each passing quarter. The first-quarter surplus stood atUSD1.9 billion, but fell to USD1.1 billion by the fourth quarter. This happened despite the trade balance remaining steadyover the period, and reflected a larger deficit on the income side. The external debt to GDP ratio is estimated at 29%,having registered steady improvement from 82% a decade ago.


The current-account surplus vanished in 2008, but revived in 2009. Surging import costs, particularly for food andenergy, led to Indonesia's current-account surplus to effectively disappear over the course of 2008. A roughlyUSD10-billion decline in the merchandise-trade surplus from USD32 billion to USD22 billion was translated essentiallydollar-to-dollar into the current account. The current-account surplus fell from USD10.5 billion in 2007 to a mere USD300million in 2008. In 2009, the situation improved considerably as import demand took a dive and terms of trade improved,with the current account back into surplus of USD10.7 billion, or 1.9% of GDP.

Trade surpluses widened after the 1997 Asian financial crisis. Export-oriented policies and bountiful natural resourceshave allowed Indonesia to maintain healthy trade surpluses (of about 4–5% of GDP) for most of the past 20 years. Themagnitude of these surpluses expanded greatly following the 1997 crisis, as the massive depreciation of the rupiahinhibited demand for imported capital and consumer goods. Even after the economic situation stabilized, import growthcontinued to lag exports, so the trade surplus widened from USD10 billion in 1997 to USD25 billion in 2000—equivalent to15% of GDP. Trade surpluses remained very high relative to GDP for several years thereafter, averaging 13% of GDPduring 2000–03. Growing import demand in more recent years, as domestic demand recovered, has led to a smaller tradesurplus, but it has still averaged 6.8% of GDP between 2004 and 2008.

Economic Structure and Context: Development and Strategy

Improving the investment and business environment tops the government’s agenda. With macroeconomic stabilityrestored following the crushing experience of the 1997/98 Asian financial crisis, the policy agenda is now focused onimproving the investment and business environment. Corruption, red tape, and contradictory legislation are among themost troublesome issues facing investors and are placing Indonesia at a disadvantage compared with regionalcompetitors such as China, India, or Malaysia. Thankfully, the government has made substantial progress on the path toreform in recent years. It has substantially widened the tax base, lowered corporate tax rates, reduced red tape,introduced critical new legislation, and clarified the regulatory environment. As a result, Indonesia has gradually inchedhigher in global competitiveness rankings and was recently named the most active Asian reformer in 2008/09 by the WorldBank. Its impressive performance during the great recession of 2009 (when it managed to grow 4.5%) has further boostedits international profile and investor interest.


From import substitution to export-led manufacturing. Indonesia began an industrialization process in the 1960sunder the centralized planning of Suharto's New Order. As with many developing countries at the time, policy was initiallyfocused on economic self-sufficiency through the development of import substitution industries. A wave of reform began inthe second half of the 1980s after oil receipts, which had dominated export earnings and government revenues, felldramatically. Indonesia then joined other Asian countries in encouraging export-led manufacturing sectors while domesticindustry was fostered by the state under a protective regulatory shield. Liberal investment laws were enacted, bureaucraticred tape reduced, and duty-free zones established. Foreign investment rose sharply in the late 1980s, focused mostly onlabor-intensive light manufacturing processing sectors, and Indonesia became one of the successful "tiger" economies.

Structural problems persist despite rapid economic growth. Although socioeconomic indicators improved dramaticallythrough the 1980s and early 1990s, the model was riddled with structural problems. Control over key corporations andindustries remained concentrated in a handful of politically influential families, encouraging corruption and moral hazard.State interventionism was also high (a legacy of the command economics of the New Order) undermining efficientresource allocation. Lack of an independent central bank resulted in weak oversight of the banking system, politicallymotivated landing, and a gradual deterioration of the banking sector's balance sheet.

Descent into crisis and policy reaction. Liberalization of capital flows resulted in sharply higher exposure to foreign debtin the early to mid-1990s. Encouraged by the exchange-rate peg, domestic corporations financed investments byborrowing abroad in hard currencies. This currency mismatch had steadily worsened as weak banking-sector supervisionand moral hazard exacerbated systemic risk. Once the rupiah was devalued, most of these loans soured and the financialhouse of cards crumpled. In the event, recourse was made to the IMF, which responded with a USD4.3-billion bailoutprogram. The strategy involved stringent austerity measures to curb inflation, stabilize the exchange rate, and redressfiscal and external imbalances. Recapitalization of the banking sector, disposal of non-performing loans, and foreign debtforgiveness were key elements of the program.

Economic Structure and Context: Demographics and Labor Markets Although this has traditionallyWith a population of 240 million people, Indonesia enjoys a large labor-force pool.

been one of the country's competitive advantages, its lead has been eroded by a relatively low skill level and growing laborprotectionism. Indonesia continues to export labor to more affluent Asian countries (plantation workers to Malaysia andmaids to Singapore, for instance), but has generally failed to find a niche in higher-skill industries. Even manufacturingjobs are stagnating because of stronger competition from China and Vietnam. Domestic unemployment remains high,which is why the number of Indonesians working abroad has grown steadily since the Asia crisis. Often times theseworkers are undocumented, however, at times straining relations between Indonesia and the destination countries.

Labor activism has intensified notably over the past decade. Labor laws have become much more protective ofworkers. Worker benefits and severance packages are quite generous, to the point where they have become a deterrentto new investment.

Economic Structure and Context: Monetary System

Having been subject to recurrent political interference prior to the Asia Crisis, the Bank of Indonesia (BI) is nowadays anindependent institution whose reputation has improved greatly in recent years. Corruption scandals, recurrent in the yearsimmediately following the Asia crisis, have now become quite rare. The latest debacle over the bailout of Bank Centuryduring the global financial crisis appeared to be little more than a politically motivated move to discredit a highly competent


central bank governor (who has since left to join the World Bank as a managing director). The quality of monetary policyhas also increased greatly, particularly since 2006–07, as the central bank has increasingly focused on strengthening theregulatory framework to minimize exposure to sudden shifts in capital flows.

Economic Structure and Context: Financial SystemThe Jakarta Stock Exchange (JSE) is a medium-sized exchange that lists about 300 companies. It became a private entityin 1991. Securities trading began to take off in the mid-1990s, following the adoption of a new capital market law in 1996and the listing of several formerly state-owned firms. Market capitalization dried up in the aftermath of the Asian crisis, buttrading has picked up greatly in recent years, with the market repeatedly reaching new historical highs since 2005. 2009and 2010, in particular, were banner years for stock market returns in Indonesia, as the country's ability to avoid recessionduring the global economic convulsions of 2008–09 brought renewed attention to investment opportunities in SoutheastAsia's largest economy. The OCT market—the Surabaya Stock Exchange—was created in 1995 through the merger oftwo earlier exchanges.

Economic Structure and Context: Key SectorsOil and gas: This is by far Indonesia's single-largest industry, accounting for a fifth of merchandise exports.Nevertheless, it has been plagued in recent years by insufficient investments, a situation aggravated by the poorregulatory/legal environment.Tourism: Despite multiple shocks in recent years, this remains one of Indonesia's more vibrant industries, withsignificant potential for future expansion. It remains vulnerable, though, to terrorist attacks and natural disasters.Logging: Environmental concerns have reduced export volumes in recent years, but timber remains one ofIndonesia's greatest natural resources.

Indonesia: Top-10 Sectors Ranked by Value Added

2011 Level 2012 Percent Change Percent Share in GDP (2011)

(Bil. US$) (Real terms) (Nominal terms)

1. Agriculture 147.4 3.3 16.7

2. Oil and Gas Mining 95.4 3.0 10.8

3. Construction 87.6 6.4 9.9

4. Wholesale Trade 51.9 6.8 5.9

5. Public Admin. and Defense 46.2 4.7 5.2

6. Retail Trade - Total 42.0 6.5 4.8

7. Communication Services 25.9 8.3 2.9

8. Hotels and Restaurants 23.2 5.3 2.6

9. Food Products 20.0 7.1 2.3

10. Health and Social Services 18.1 5.9 2.1

Top-10 Total 557.6 63.3

Source: World Industry Service, IHS Global Insight, Inc.

Updated: 18 Apr 2012


Economic Structure and Context: Natural Resources

Indonesia is a country well-endowed with natural resources, including natural gas, petroleum, tin, nickel, timber, bauxite,and copper, as well as precious metals like gold and silver. Indonesia also exports agricultural products, such as palm oil.Indonesia used to be OPEC's only Asian member, but declining production meant the country became a net oil importer in2005. In 2008, it officially withdrew from OPEC. The country's main strength, however, lies in natural gas exports, whichare directed mainly to regional powerhouses like Japan and Singapore. Despite abundant mineral resources, however, themining and oil industries have languished in the period immediately following the Asia crisis. For several years, newinvestments had been delayed by opaque and contradictory legislation. The situation has gradually improved under theYudhoyono administration, but Indonesia is still a long way away from fully exploring its natural endowments.

Economic Structure and Context: Trade ProfileIndonesia enjoys a fairly open trade regime and few barriers to trade, being a member of both the World TradeOrganization (WTO) and the Association of Southeast Asian Nations (ASEAN). About one-fifth of Indonesia's roughlyUS$50-billion annual merchandise export earnings come from petroleum and natural gas. Manufactured goods make upthe bulk of exports, however, led by textiles, electronics, and machinery and equipment. Indonesia also exports significantquantities of timber (volumes have declined in recent years because of environmental concerns), cocoa, and coffee, aswell as tin, copper, and nickel. Service exports, mostly tourism, bring in about US$5 billion per year. Japan remains, by far,Indonesia's largest market, accounting for around a fifth of its exports, yet its share has almost halved since the early1990s. The United States is another major export market, while China has gained prominence in recent years as adestination for raw materials. Indonesia's main export destinations also tend to be its largest sources of imports.

Indonesia: Major Trading Partners, 2010

EXPORTS IMPORTS

Country Billions of USD Percent Share Country Billions of USD Percent Share

Japan 25.8 16.3 China 20.4 15.1

China 15.7 9.9 Singapore 20.2 14.9

United States 14.3 9.1 Japan 17.0 12.5

Singapore 13.7 8.7 United States 9.4 6.9

South Korea 12.6 8.0 Malaysia 8.6 6.4

India 9.9 6.3 South Korea 7.7 5.7


Malaysia 9.4 5.9 Thailand 7.5 5.5

Thailand 4.6 2.9 Saudi Arabia 4.4 3.2

Australia 4.2 2.7 Australia 4.1 3.0

Netherlands 3.7 2.4 India 3.3 2.4

Source: IMF, Direction of Trade

Indonesia: Major Trading Partners, 2000

EXPORTS IMPORTS

Country Billions of USD Percent Share Country Billions of USD Percent Share

Japan 14.4 23.2 Japan 5.4 16.1

United States 8.5 13.7 Singapore 3.8 11.3

Singapore 6.6 10.6 United States 3.4 10.1

South Korea 4.3 6.9 South Korea 2.1 6.2

China 2.8 4.5 China 2.0 6.0

Malaysia 2.0 3.2 Australia 1.7 5.1

Netherlands 1.8 3.0 Saudi Arabia 1.6 4.8

Hong Kong 1.6 2.5 Germany 1.2 3.7

Australia 1.5 2.4 Malaysia 1.1 3.4

United Kingdom 1.5 2.4 Thailand 1.1 3.3

Source: IMF, Direction of Trade

Medium- and Long-Term: Outlook


Indonesia’s economy is expected to grow by 4.8% annually over the long term (2012–41). This would be about twoand a half percentage points lower than the average growth rate prior to the Asian crisis, but still a respectableperformance by any standard, especially since the economy has become much larger since then. Our projection rests onseveral assumptions, of which continued economic openness and relatively stable politics are perhaps the most crucial.

The country's positive outlook is supported by superior factor endowment, including abundant natural resourcesand favorable demographics. Proximity to Asia's largest sources of capital (Japan, China, and Singapore) and to theregion's fast-growing markets is another valuable asset. Finally, economic openness has been one of the main reasons forstrong growth in the past and should remain an important advantage in the future, especially as the regulatory and legalenvironment gradually improves.

Indonesia is rich in natural wealth and has significant deposits of oil and gas, minerals, and agriculturalresources. As OPEC's only Asian member, it produces about 1.0 million barrels per day of crude oil, but proven reserveshave fallen by half over the past two decades. The country's main strength lies in natural gas exports (reserves are thesixth-largest among OPEC members), which are directed mainly to regional powerhouses like Japan and Singapore.Indonesia is also actively seeking to secure long-term contracts to supply liquid natural gas to China's growing market.Other exports include tin, nickel, timber, bauxite, and copper, as well as precious metals like gold and silver. The countryis also among the top three exporters of cocoa and natural rubber in the world.

Indonesia's insular structure (there are over 15,000 islands forming the largest archipelago in the world) meansthat most urban and manufacturing centers have easy access to ports. This tends to lower transport costs andimprove export competitiveness. Moreover, fish stocks and some of the largest coral reefs in the world add to the country'snatural resources. Many small islands are currently uninhabited, but hold tremendous tourism potential, and niche tourismcould become a growing industry in the future.

With the world's fourth-largest population, Indonesia has an abundant labor supply. In fact, it has been exportinglabor to countries like Malaysia and Singapore for many years. This could become an even greater advantage in thefuture, given graying populations in some regional economic powerhouses. At the same time, however, recentdevelopments highlight new risks. After decades of little labor-market regulation and union activism under former dictatorSuharto, labor has become increasingly organized and vocal. Sometimes violent protests over the past few years havehelped push through substantial wage increases and generous severance packages, which are among the highest in Asia.With a general shift toward more direct political participation, organized labor's political influence will probably increaseover time. This could result in excessive regulation and diminished competitiveness.

One characteristic setting Indonesia apart from other developing countries is the presence of a large and highlyentrepreneurial Chinese community within its borders. Despite a period of heightened anti-Chinese sentiment andeven violence in the second half of the 1960s, relations have improved greatly since then. Indonesia's Chinese communityhas historically been a source of innovation and entrepreneurship, and has acted as a bridge to China's businesscommunity. This has made Indonesia a preferred destination for Chinese investment, with highly beneficial effects oneconomic growth.

Yet, it was economic reform and liberalization in the aftermath of the second oil crisis that set the stage for twodecades of rapid economic growth. Under International Monetary Fund/World Bank supervision, the governmentdecided to diversify the economic base, open up most sectors to foreign participation, and limit the state's economic role.These policies have helped Indonesia avoid the fate of other OPEC countries and instead grow into one of SoutheastAsia's largest and most dynamic economies. The ability to retain openness in trade, further deregulate its markets,engender savings growth, and provide a suitable environment for technology transfer and investment will determineIndonesia's future advancement.

Some medium- and long-term constraints to growth include Islamic militancy and terrorism as well as thepotential for ethnic violence and political instability. Although considerable progress has been made in recent years,Indonesia still remains in the bottom half of countries rated by the World Bank's Surveys. The shaky legalDoing Business


system and still-opaque regulatory environment constrain growth by stymieing foreign investment and threateninginternational competitiveness. The country's shaky transition to democracy, after more than three decades of authoritarianrule, will also shape its long-term potential. So far, developments on this front have exceeded expectations in thatelections have been deemed fair and free of violence. Nonetheless, there is no room for complacency, as the risk ofreforms falling victim to entrenched vested interests remains ever present.

Analyst Contact Details: Simona Mocuta, Bree Neff

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