INDONESIA ECONOMIC PROSPECTS IEP December 2023 CLIMATE ACTION FOR DEVELOPMENT © 2023 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions, and is supported by funding from the Australian Government under the Australia-World Bank Indonesia Partnership (ABIP) program. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent, or the Australian Government. 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Indonesia Economic Prospects December 2023 Ta bl e of C o n te n ts Contents Table of Summary Executive LIST OF FIGURES, TABLES AND BOXES IV PREFACE VI Developments A.1. Recent Economic ABBREVIATION VII EXECUTIVE SUMMARY 1 I. Economic Update 1 A.2. Policy Stance II. Climate Action As A Catalyst For Development 3 A. ECONOMIC UPDATE 7 A.3. Outlook and Risks 1. Recent Economic Developments 7 2. The Policy Stance 18 3. The Outlook and Risks 26 B.1. Preface B. CLIMATE ACTION AS A CATALYST FOR DEVELOPMENT 30 1. Preface 30 Development in B.2. Climate & Indonesia 2. Climate and Development in Indonesia 31 3. A Virtous Cycle of Decarbonization, Resilience, and Growth, Building on Existing 34 Reforms 4. Economic Policy Foundations for a Low-Carbon and Climate-Resilient Future 37 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 5. The Impacts and Side-Effects of Climate Actions 44 6. A Climate and Development Policy Framework 48 REFERENCES 52 B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework CLICK THE SIDE BUTTONS TO GO TO THE SECTION YOU WISH iii TO READ. Indonesia Economic Prospects December 2023 LIST OF FIGURES, TABLES, BOXES Contents Table of FIGURES Summary Executive Figure A.1: GDP continues to post solid quarterly results, underpinned by a strong household sector 8 Figure A.2: Sectoral contributions to net foreign direct investment: before, during, and after the pandemic 8 Figure A.3: Average monthly arrivals by five largest source countries, January-September 2019-23 8 Figure A.4: Pre-pandemic GDP trend versus actual 8 Developments A.1. Recent Economic Figure A.5: Inflation remains on a downward trend… 10 Figure A.6: …but challenged by volatile commodities 10 Figure A.7: Tightening global financial conditions have led to significant capital outflows from EMs 13 Figure A.8: Outflows from the current and financial accounts have pressured the rupiah 13 A.2. Policy Stance Figure A.9: Weakness in goods trade has flipped the current account into negative territory 14 Figure A.10: …. and have impacted FX reserves 14 Figure A.11: Goods trade growth returned to pre-pandemic levels 15 Figure A.12: Intermediates have contributed little to recent import growth, while capital and consumer 15 A.3. Outlook and Risks goods imports also moderated Figure A.13: Constrained public spending despite strong revenues, has kept the budget in surplus 18 Figure A.14: Revenues grew marginally, largely due to high collections already being achieved last year 18 B.1. Preface Figure A.15: Spending growth in the first ten months of 2023 was relatively suppressed 19 Figure A.16: Public investment is relatively stable with a notable share financed through SOEs 19 Figure A.17: Debt-to-GDP continued to decline, consistent with the tight fiscal stance 19 Figure A.18: Yields on Indonesia’s sovereign debt have been increasing recently 19 Development in B.2. Climate & Figure A.19: RRR incentives initiated in October 22 Indonesia Figure A.20: NPL, CAR, Tier-1 capital and provisioning 26 Figure A.21: Lending to the private sector is healthy 26 Figure B.1: Per capita emissions remain below those of major industrialized economies and in line with 32 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle developing country peers Figure B.2: Forest and peat-related emissions historically accounted for about 42 percent of emissions 32 and are slowing Figure B.3: The rate of deforestation has fallen in recent years 32 Figure B.4: Rising incidence of climate-related disasters 34 Figure B.5: Lending exposure of Indonesian banks to transition-sensitive sectors is high 34 B.4. Economic Foundations Figure B.6: Dynamics between resource supply and demand, emissions, and growth 34 Policy Figure B.7: Conditional and unconditional 2030 NDC targets 35 Figure B.8: Per capita emissions of major economies under stated targets 35 Figure B.9: The land use policy framework: a chronology 36 & Side-Effects of B.5. The Impacts Climate Actions Figure B.10: High but decreasing fossil fuel support 38 Figure B.11: Low petrol end-user prices 38 Figure B.12: Low residential electricity prices 38 Figure B.13: Green debt market size 41 Development Policy Figure B.14: Types of green debt 41 B.6. A Climate & Framework Figure B.15: Tariffs on green goods are low 42 Figure B.16: But NTMs can be burdensome 42 iv Indonesia Economic Prospects December 2023 Figure B.17: Contributing to higher import costs 43 Contents Table of Figure B.18: And loss of competitiveness 43 Figure B.19: Achieving decarbonization objectives 45 Figure B.20: With potential positive growth payoffs 45 Summary Executive Figure B.21: Foreign investments can alleviate trade-offs in more ambitious scenarios 46 Figure B.22: There will be gains and losses across sectors 46 Figure B.23: Impacts on employment 47 Figure B.24: Impact on prices 47 Developments A.1. Recent Economic Figure B.25: Impact on household expenditure 47 Figure B.26: Impact on expenditure by worker type 47 Figure B.27: Drivers of expenditure change 47 Figure B.28: Impact on poverty 47 A.2. Policy Figure B.29: Building blocks for the transition 48 Stance Figure B.30: Prioritization approach for recommendations 48 TABLE A.3. Outlook and Risks Table A.1: Selected macroeconomic indicators 28 B.1. Preface BOXES Box A.1: Indonesia's affordability divide 11 Development in Box A.2: Growth and Indonesia’s declining appetite for imports 16 B.2. Climate & Indonesia Box A.3: Review of Indonesia’s long-term fiscal policy performance 20 Box A.4: Earnings retention requirement for Indonesian commodity exporters 23 Box A.5: Multiple monetary instruments to balance inflation, growth, and external stability 24 Box B.1: Retargeting energy subsidies: consequences of the September 2022 fuel price hike 38 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework v Indonesia Economic Prospects December 2023 Preface Contents Table of Summary Executive The Indonesia Economic Prospects (IEP) is a bi-annual World Bank report that assesses recent macroeconomic developments, the outlook, and risks, as well as specific development challenges for the Indonesian economy. In doing so, the IEP aims to inform the public policy debate and is geared towards a wide audience, including the general public, Developments A.1. Recent Economic the government, the private sector, civil society organizations, and other domestic and international stakeholders. The IEP is a product of the World Bank Jakarta office and receives strategic guidance from an editorial board chaired by Satu Kahkonen, Country Director for Indonesia and Timor-Leste. The report is prepared by the Macroeconomics, Trade and Investment (MTI) Global Practice team, under the guidance of Lars Christian Moller (Practice Manager), Ann Jeannette Glauber (Practice Manager) and Habib Rab (Lead Economist). The report is co-led by Wael Mansour (Senior A.2. Policy Stance Economist), Anthony Obeyesekere (Economist), and David James Kaczan (Senior Economist). Deviana Djalil provided administrative support and coordinated the organization of the report launch event. The dissemination is organized by Gb Surya Ningnagara and Maulyati N. Slamet under the guidance of Lestari Boediono A.3. Outlook and Risks Qureshi. The report was designed and typeset by Arsianti. Part A was prepared by Wael Mansour and Anthony Obeyesekere (report leads), Csilla Lakatos, Dwi Endah Abriningrum, Indira Maulani Hapsari, Jana Mirjam Silberring, Mochamad Pasha, Ratih Dwi Rahmadanti and Rong Qian. Inputs were provided by Anastasiya Denisova, Shreya Chatterjee (social protection and labor markets), Francesco Strobbe, Ou Nie B.1. Preface (financial sector), William Hutchins Seitz (poverty), and Daniel Riera-Crichton (fiscal policy). Part A benefitted from the comments of Habib Rab, as well as Ergys Islamaj and Samuel Christopher Hill as peer reviewers. Part B was prepared by Habib Rab (Lead Economist) and David Kaczan (Senior Economist). Part B is taken from the Development in B.2. Climate & Indonesia Country Climate and Development Report (CCDR), which was prepared by an extended technical team (see Indonesia CCDR for details). Part B benefitted from the comments of Anthony Obeyesekere (Economist), Wael Mansour (Senior Economist), and Stavros Papageorgiou (Senior Natural Resources Management Specialist). Box B.1. was developed by Bambang Sjahrir (Senior Economist). Elisabeth Yunita Ekasari (Program Assistant) and Sandra Sari (Program Assistant) provided administrative support. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle This report is available for download in English and Indonesian via: www.worldbank.org/iep Previous report editions: • June 2023: The Invisible Toll of COVID-19 on Learning • December 2022: Trade for Growth and Economic Transformation • June 2022: Financial Deepening for Stronger Growth and Sustainable Recovery B.4. Economic Foundations Policy To receive the IEP and related publications by email, please email ddjalil@worldbank.org. For questions and comments, please email wmansour@worldbank.org and aobeyesekere@worldbank.org. For information about the World Bank and its activities in Indonesia, please visit: & Side-Effects of B.5. The Impacts Climate Actions www.worldbank.org/id instagram.com/worldbank @BankDunia #IEPBankDunia www.linkedin.com/company/the-world-bank Development Policy B.6. A Climate &   Framework BankDunia vi Indonesia Economic Prospects December 2023 Abbreviations Contents Table of Summary Executive ADB Asian Development Bank LCRs Local Content Requirements AEs Advanced Economies LTS-LCCR Long-Term Strategy for Low Carbon and Developments A.1. Recent Economic AFC Asian Financial Crisis Climate Resilience BAPANAS Badan Pangan Nasional LTV Loan-To-Valuation Bappenas Badan Perencanaan Pembangunan MoEMR Ministry of Energy, Mineral Resources Nasional MoEF Ministry of Environment and Forestry BAU Bsiness-As-Usual MoF Ministry of Finance A.2. Policy BI Bank Indonesia MTI Macroeconomics, Trade and Investment Stance BLT BBM Bantuan Langsung Tunai Bahan MSMEs Micro, Small and Medium-Sized Bakar Minyak Enterprises BoP Balance of Payments NDC Nationally Determined Contribution BPS Badan Pusat Statistik NEER Nominal Effective Exchange Rate A.3. Outlook and Risks BRGM Badan Restorasi Gambut dan Mangrove, NPLs Non-Performing Loans CAR Capital Adequacy Ratio NTM Non-Tariff Measures CCDR Country Climate and Development OECD Organisation for Economic Co-operation Report and Development B.1. Preface CEQ Commitment-To-Equity OJK Otoritas Jasa Keuangan CGE Computable General Equilibrium OPEC Organization of the Petroleum Exporting CO2eq Carbon Dioxide Equivalent Countries CPI Consumer Price Index PLN Perusahaan Listrik Negara DTKS Data Terpadu Kesejahteraan Sosial Ppts Percentage Points Development in B.2. Climate & EAP East Asia and Pacific Region PSIs Pre-Shipment Inspections Indonesia ECM Error Correction Mechanism PSO Public Service Obligation EMs Emerging Markets PV Photovoltaic ESG Environmental, Social, and Governance RCA Revealed Comparative Advantage ETS Emissions Trading Scheme ROA Return-On-Assets FDI Foreign Direct Investment ROE Return-On-Equity Resilience & Growth of Decarbonization, B.3. A Virtous Cycle FOLU Forest and Other Land Uses RRR Reserve Requirement Ratio FSOL Financial Sector Omnibus Law SAL Accumulated Cash Savings FX Foreign Currency SNI Standar Nasional Indonesia GDP Gross Domestic Product SPHP Stabilisasi Pasokan dan GFC Global Financial Crisis Harga Pangan GHG Greenhouse Gas SSE Sustainable Stock Exchanges B.4. Economic Foundations GoI Government of Indonesia THL Tax Harmonization Law Policy IEP Indonesia Economic Prospects VAT Value-Added Tax IFPRI International Food Policy Research WBG World Bank Group Institute WTO World Trade Organization IMF International Monetary Fund Yoy Year-on-year & Side-Effects of B.5. The Impacts JCOL Jobs Creation Omnibus Law 3mma Three-Month Moving Average Climate Actions LAR Loan-At-Risk LCDI Low Carbon Development Indonesia Development Policy B.6. A Climate & Framework vii Executive Summary Indonesia Economic Prospects December 2023 E xe cut i ve Su m m a r y Contents Table of Summary Executive I. Economic and Fiscal Update Developments Indonesia has been successful in navigating the Between 2019-2023, the employment shares of both A.1. Recent Economic macroeconomic fallout from asynchronous global self-employed and informal workers has increased, shocks. Growth remains resilient, inflation is on a while the share of the wage-employed declined. declining trend, and the currency volatility manageable. Nevertheless, the end of the commodity cycle boom Inflation has been brought under control following and higher-for-longer global interest rates prospects the effects of the energy price shocks in 2022, A.2. Policy Stance exhibit strong headwinds going forward and limits the though new pressures are emerging from food macro policy space. As the economy moves into this supply risks and renewed oil price rises. Headline new normal, structural reforms to boost growth and inflation declined for seven successive months to 2.6 create jobs gain renewed importance. percent yoy in October. Nonetheless, the prices of A.3. Outlook and Risks some basic food items (rice, sugar, and chicken meat) GDP growth remains strong though the economy is have been rising lately owing to a combined effect yet to fully recover to its pre-pandemic trajectory. of supply and feed shortages. Food inflation rose to Indonesia has maintained seven consecutive quarters 5.5 percent in October, despite favorable horticulture B.1. Preface of growth above 5 percent (year-on-year), slowing very harvests. Prolonged unfavorable climatic conditions moderately to 4.9 percent in Q3-2023 (third quarter of from El Niño have affected the production of staple 2023). Much of this activity has been driven by strong crops among others. To contain domestic food prices private consumption as well as services particularly and soften the impact on the poor, the government of Development in in the wholesale and retail trade, transportation and Indonesia (GoI) introduced several price stabilization B.2. Climate & Indonesia tourism, and information and communication sectors. measures and food aid programs. At the same time, output remains below its pre- pandemic trajectory. The country’s economy is larger External pressures have risen due to tight global today than at any time before. Yet, it is still 6.9 percent financing conditions, which have triggered capital Resilience & Growth of Decarbonization, B.3. A Virtous Cycle smaller than it might have been had the recovery outflows and currency pressures across emerging been strong enough to return the economy to its pre- markets including Indonesia. Net portfolio outflows pandemic trend. This reflects scarring effects from the accelerated in the second half of the year and pandemic. recorded 0.3 percent of GDP in 3Q-23, contributing to the financial account deficit which was sustained This is consistent with labor market trends, which for a second consecutive year. These outflows were show a recovery in labor force participation and only partially offset by net foreign direct investment B.4. Economic Foundations Policy employment but a possible deterioration in jobs (1.1 percent of GDP). Moreover, there was also added quality. The labor force participation rate rose by pressure from the current account, which switched into 0.9 percentage point (ppt) between 2022-2023 to a small deficit of 0.01 percent of GDP, on the back of a 69.8 percent, with an additional 4.6 million workers softening trade surplus. This signals a potential end to & Side-Effects of B.5. The Impacts Climate Actions being employed since 2022. Unemployment has been the commodity boom cycle and a return to status quo steadily declining to 5.3 percent, converging to pre- for Indonesia, which recorded consistent deficits from pandemic levels (5.2 percent in 2019). However, the 2012 to 2019. As a result, FX reserves at Bank Indonesia prevalence of middle-class jobs has dropped from 14 (BI) dropped from a peak of US$145 billion in March to 9 percent of total employment between 2019-2022.1 2023 to US$133 billion in October. Reserves remain Development Policy B.6. A Climate & Framework 1 Middle-class jobs are those earning a monthly household consumption > 3.5 times the poverty line (Wihardja and Cunningham, 2021). 1 Indonesia Economic Prospects December 2023 adequate though and cover 6 months of goods and Indonesia is projected to post robust growth services imports. The rupiah has also fallen under throughout the outlook, but downside risks are Contents Table of pressure and depreciated by 8.1 percent against the intensifying. The economy is projected to grow at US dollar year-to-October. an annual average of 4.9 percent over 2024-2026, reflecting softer terms of trade and a normalization Summary Executive External pressures prompted more proactive towards trend growth. Inflation will ease to a 3.1 monetary interventions. From August to November, percent average and remain within BI’s revised target the authorities combined capital flow measures band. Challenges to the external position are expected requiring 30 percent of commodity export earnings to intensify. The current account deficit will gradually to be retained in domestic banks with a 25-bps expand to 1.4 percent of GDP by 2026, as lower Developments A.1. Recent Economic increase in the policy rate; and introduced new FX- commodity prices and weaker global growth hamper denominated instruments. To balance the impact of exports. The outlook is subject to several downside higher policy rates on domestic demand, a series of risks. Higher-for-longer interest rates could weigh liquidity measures were introduced: (i) reducing the on borrowing costs and tighten access to external reserve requirement ratio for banks lending to eligible financing. Geopolitical uncertainty and climate change A.2. Policy Stance sectors such as mineral downstreaming, tourism, and related shocks could disrupt global value chains and MSMEs; (ii) extending looser prudential requirements induce a sharper decline in the terms of trade, resulting for mortgages and car loans (effective starting January possibly in lower revenues and a tighter fiscal position 2024); and (iii) lowering the macroprudential liquidity for Indonesia. Domestically, the elections in 2024 could A.3. Outlook and Risks buffer on IDR-denominated assets for banks. With slow down the momentum for growth-supporting interest-rate passthrough constrained by a shallow reforms. financial sector, BI’s use of liquidity tools has proven to be a more effective monetary policy instrument. With resilient macroeconomic underpinnings and B.1. Preface the end of the post-COVID recovery cycle, the policy Fiscal policy remains prudent with an acceleration in focus turns again to the growth agenda. Indonesia revenue collection on the one hand and moderation has a credible policy track record of navigating in spending on the other. Revenues reached 10.6 downside risks and maintaining macroeconomic percent of GDP (January-to-October), one of the stability. The country’s small twin deficits, low public Development in B.2. Climate & Indonesia highest levels since 2015. This was primarily driven debt, adequate FX reserves, stable external financing, by VAT, following a 1 ppt increase in the VAT rate in and steady growth performance constitute robust April 2022. Primary expenditures remained suppressed macroeconomic buffers for responding to shocks. despite a notable pick-up in public investment. Total Going forward, the challenge is to build on these expenditure growth contracted in January-to-October strong macroeconomic fundamentals to deliver Resilience & Growth of Decarbonization, B.3. A Virtous Cycle yoy resulting in the lowest spending-to-GDP ratio faster, greener, and more inclusive economic growth. in at least a decade (10.6 percent of GDP). Interest A core pillar of such a growth agenda are reforms payments stabilized at 1.5 percent of GDP, in line with that address structural bottlenecks in the economy rising financing costs. Subsidy expenditures contracted that limit efficiency, competitiveness, and productivity since the 2022 hike in administered fuel and electricity growth. Among those are the complex flagship laws: prices. The public debt ratio continued to decline and the jobs creation omnibus, the tax harmonization, and B.4. Economic Foundations stood at 37.7 percent of GDP. Most of the debt stock the financial sector omnibus. Ensuring continuity and Policy is denominated in domestic currency (72.1 percent of accelerating the implementation of these reforms, total) and is long-term (87.6 percent). By end-2023, among others, will be essential if Indonesia is to have the fiscal deficit is expected to tighten to 2.1 percent of a chance at achieving its vision of becoming a high- & Side-Effects of GDP, down from 2.4 percent in 2022. income country by 2045. B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 2 Indonesia Economic Prospects December 2023 II. Climate Action as a Catalyst for Development Contents Table of Part B of the Indonesia Economic Prospects looks fossil fuels, namely coal (43 percent), oil (31 percent), at how Indonesia could address climate change and gas (19 percent), with coal contributing to a rising while achieving higher GDP growth over the long- share of electricity generation over this period. Summary Executive term. Indonesia has made important commitments as well as progress towards meeting its climate and Emissions aside, Indonesia is vulnerable to climate development targets. Actions in the forest and land use shocks. Between 1990-2021, Indonesia experienced (FOLU) sector have significantly reduced greenhouse more than 300 natural disasters—including 200 Developments gas (GHG) emissions, whilst commitments and flooding events affecting more than 11 million people. A.1. Recent Economic actions in the energy sector are helping to increase Climate-related disasters account for approximately renewables and phase down coal. Fiscal, financial, and 70 percent of the total, and their frequency has other economy-wide reforms are complementing increased. These trends are expected to continue. these efforts while also promoting growth. There are Rising sea surface temperature is associated with signs of relative decoupling between Indonesia’s per greater severity of tropical cyclones, while heavier A.2. Policy Stance capita GHG emissions and per capita income growth. rainfall will exacerbate floods and landslides. More Indonesia’s low-carbon and climate resilient transition frequent El Niño events are likely to increase drought, could potentially define the next stage of its economic fire, and water supply risks. Important adaptation transformation. measures such as a disaster risk pooling fund are A.3. Outlook and Risks being taken in response. Indonesia’s strong growth and poverty reduction over the past 20 years have moved in parallel with Indonesia has made important commitments and rising GHG emissions, consistent with the country’s progress towards tackling these challenges. In the B.1. Preface stage of development. Expansion of infrastructure, forest and land use sector, deforestation has slowed universal access to electricity, urbanization, and from an average of 1.08 million hectares (ha) per year non-agricultural employment have contributed to between 2000-07 to an average of 0.11 million ha per around 5 percent per year growth on average over year in 2019-2022, the lowest rates since 1990. The Development in this period. The poverty rate fell from 19 percent in Government of Indonesia (GoI) aims to make FOLU B.2. Climate & Indonesia 2000 to 9.5 percent by 2022. Economic gains have a carbon sink by 2030 (i.e., negative net emissions) also meant rising emissions. Indonesia’s emissions— under its flagship FOLU Net Sink 2030 Plan.4 On at 3.5 percent of the global total—are high compared energy, the GoI has committed to transition away to structural peers2 in absolute terms, although per from coal. Presidential Regulation No. 112/2022 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle capita emissions are in line with those of other large removed price caps for renewable energy and set developing economies, and lower than those of out higher prices differentiated by renewable energy developed economies. technologies, size, and location. It also established competitive principles for procurement of renewable The bulk of Indonesia’s GHG emissions come energy technologies such as Solar PV and provides from land-based sources, followed by energy. for direct fiscal support for the state-owned electricity Deforestation and fires accounted for about 42 company PLN for new renewable capacity. B.4. Economic Foundations Policy percent of total emissions between 2000-2020.3 Agriculture and forestry activities such as timber While sector-specific policies for mitigation extraction and palm oil cultivation were significant are necessary, they will be most effective if drivers of deforestation, although policy actions have complemented by enabling fiscal, financial, and & Side-Effects of B.5. The Impacts Climate Actions significantly lessened their impacts in recent years. trade policies. The fiscal framework can be used to Primary energy supply (i.e., coal, oil, gas) is the second address market failures in mitigation and adaptation, largest source of emissions, accounting for about 39 raise revenues, and provide buffers during the low- percent of emissions between 2000-2020. About 93 carbon and climate-resilient transitions. The financial percent of the primary energy supply comes from system can be used to raise and channel savings to Development Policy B.6. A Climate & Framework 2 Analysis for this IEP uses a standard set of peers where data is available: Nigeria, China, India, Ukraine, Thailand, the Philippines, Mexico, the Arab Republic of Egypt, the Russian Federation, and Brazil. They are selected based on their statistical similarity in terms of population, GDP per capita, and total GDP. An additional set of aspirational peers is also used when relevant: Republic of Korea, Chile, Poland, and the Czech Republic. In some instances, industrialized countries are also used as comparisons when discussing emissions levels and targets. 3 Total of forest, land use, and peat fire emissions between 2000-20 as a proportion of total emissions (MoEF 2021 data). 4 Ministerial Decree No. 168/Menlhk/PKTL/PLA.1/2/2022, the Operational Plan for Indonesia’s FOLU Net Sink 2030. 3 Indonesia Economic Prospects December 2023 mitigation and adaptation activities, provided that survey reveals the need for standards, transparency, structural constraints and exposure to climate and and capacity-building in sustainable investing, Contents Table of stranded-assets risks can be alleviated. Trade policies emphasizing the importance of clear definitions and can be used to facilitate green exports and imports, reporting standards to ensure investor confidence. move Indonesia toward the green technology frontier, Summary Executive and modify incentives for carbon-intensive commodity Trade policies can be used to lower the cost of production. climate actions. Indonesia maintains low average tariffs on imports of green goods and technologies. The fiscal framework can be used to increase However, non-tariff measures (NTMs) pose significant economic efficiencies and disincentivize fossil fuel costs, equivalent to an average 20 percent tariff. Import Developments A.1. Recent Economic use. Incentives for fossil fuel use are partly a function approvals, compliance with national standards, and of taxes and subsidies. While still elevated relative to pre-shipment inspections impact products needed for peer countries, support for fossil fuels as a share of tax climate-change adaptation and mitigation, surpassing revenue in Indonesia has declined, with a sharp drop in the impact seen in regional peers. Local content 2015. There are opportunities for further reduction of requirements designed to boost local manufacturing, A.2. Policy Stance fossil fuel support, which would generate savings that particularly in the renewable energy sector, may can be redirected to targeted social assistance for the hinder short-term adoption due to higher costs and poor and improve the budget position. This outcome reduced competitiveness against fossil fuels. Yet there was evident in the 2022 adjustments to fuel prices. In are opportunities to benefit from the global low- A.3. Outlook and Risks addition, further carbon pricing measures, potentially carbon transition. Green goods exports accounted building on the recently established emissions for 3.6 percent of total goods exports in 2020. There trading scheme among electricity generators, can be is potential for growth in environmentally preferable used to disincentivize emissions in other emissions- products, waste management, recycling, and resource- B.1. Preface intensive sectors (e.g., industrial processes, other efficient technologies/products. Enhancing access power generators). There are also opportunities to to green technologies through trade can improve promote greater consistency across fiscal instruments productivity, lower production costs, and enhance for stronger overall incentives to decarbonize (in some international competitiveness. instances, fiscal instruments within the same sector Development in B.2. Climate & Indonesia have countervailing effects). Climate action, as analyzed through computable general equilibrium (CGE) modeling, could reduce The financial system can be used to address two GHG emissions and promote higher growth. The interconnected climate-related challenges: modeling presented in this IEP explores three scenarios of increasing climate ambition: the redirection of Resilience & Growth of Decarbonization, B.3. A Virtous Cycle a. Managing climate-related risks: Climate risks electricity and fuel subsidies, a Nationally Determined can disrupt the financial system, reducing investment Contribution (NDC) scenario with new policies and a appetite. In Indonesia, efforts to address these carbon tax, and a more ambitious NDC+ scenario with challenges include the Financial Services Authority’s higher carbon tax rates. Results show that emissions Sustainable Finance Umbrella Policy and roadmaps reduction will be driven by combined sectoral and focusing on green taxonomy, sustainability disclosure, fiscal policies, with Scenario 3 (NDC+) projecting a B.4. Economic Foundations climate risk management, and innovative financing 63 percent reduction in greenhouse gas emissions by Policy instruments. More detailed guidance and stress- 2040 compared to Business as Usual (BAU). The power testing can improve the financial sector’s ability to sector exhibits substantial emissions reductions across handle climate risks. all scenarios, while manufacturing and transport also & Side-Effects of contribute. The net impact on long-term GDP depends B.5. The Impacts Climate Actions b. Mobilizing finance for climate mitigation and on how carbon tax receipts and reduced subsidies adaptation: The GoI aims to green the financial system are recycled, with positive effects projected under all through regulations mandating sustainable practices scenarios, especially in Scenario 2 (NDC). However, in and promoting instruments like green bonds. While the ambitious Scenario 3 (NDC+), external financing Indonesia has raised around US$6.4 billion through becomes crucial for sustaining positive impacts beyond Development Policy B.6. A Climate & green bonds and loans, private sector involvement 2035. The coal sector faces significant output drops, Framework remains limited. Challenges include increasing market while other sectors like construction, financial services, awareness, reducing issuance costs, and addressing hospitality, and retail trade are projected to expand supply-side issues like a lack of assets. A World Bank and offset losses in the long term. The modeling 4 Indonesia Economic Prospects December 2023 analysis includes specific assumptions and highlights 4. Develop further guidance on risk management the need for caution in interpretation due to factors approaches and disclosure requirements for banks. Contents Table of like market frictions, fixed money supply assumptions, Guidance would include stress testing and scenario and potential political economy obstacles to reforms. analysis methodologies, risk identification and management approaches, and procedures for Summary Executive Building on ongoing progress, the report presents disclosure of climate risks. options to advance Indonesia’s green transition. The IEP focuses on fiscal, financial and trade policy 5. Further incentivize the use of green bonds. This could ‘enablers’, which the analysis suggests provide include aggregation and securitization so that green important opportunities for realizing synergies bonds can reach the size that investors are demanding, Developments A.1. Recent Economic between climate action and growth. They aim to potentially through standardized contract templates create favorable conditions for reallocating resources and procedures; and reduced listing requirements for from carbon-intensive to greener sectors and from labeled bonds. low to high-productivity areas, while also mobilizing new financing. It is important to note that the list of 6. Review and streamline NTMs on green goods. Some A.2. Policy Stance policy options is thus partial, and the Indonesia CCDR NTMs could be simplified such as import approvals provides additional options covering sectoral reforms and compliance with SNI. Some NTMs could be and adaptation measures. Options include: considered for removal, such as PSIs and port of entry restrictions. Over time, some NTMs could be phased A.3. Outlook and Risks 1. Develop a roadmap to complete transport fuel out as a robust national single window and integrated subsidy reforms. Rising global oil prices make it risk management system is developed. politically difficult to eliminate fuel subsidies in the short term, however, planning for reform could begin 7. Reduce the stringency of local content requirements B.1. Preface now in anticipation of more favorable medium-term (LCR) until demand can sustain local economies of scale. conditions. Reduced LCRs can promote industry development, decrease prices for renewable power investors, and 2. Convert the electricity price subsidy (PLN’s PSO) into promote international technology transfer. targeted cash transfers. This would allow the charging Development in B.2. Climate & Indonesia of tariffs that cover generation costs while using cash Through these and other reforms, Indonesia can transfers to compensate the poor and vulnerable for boost underlying drivers of productivity and efficiency, price rises. helping to reduce the short-term costs of emissions cuts and adaptation, while strengthening long-run 3. Develop an integrated roadmap for carbon pricing. growth. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Develop a roadmap for expanded carbon pricing based on a review of the impact, cost, and feasibility of alternative instruments for sectors beyond 2024. B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 5 A. Economic Update Indonesia Economic Prospects December 2023 A. Economic Update Contents Table of Summary Executive 1. Recent Economic Developments Developments A.1. Recent Economic Amid global uncertainty, Indonesia’s growth and declining commodity prices have weighed on is resilient, supported by rebounding domestic international trade and softened commodity windfalls demand and services, but the economy has yet to to Indonesia throughout the year. As a result, the net return to its pre-pandemic trajectory. export contribution to growth declined to 13.8 percent of 3Q growth, down from 15.2 percent in full-year 2022. A.2. Policy Stance The world economy is grappling with geopolitical uncertainty, high cost of finance, and renewed Investment’s contribution to growth has yet pressures on inflation, which weigh on global to return to its pre-pandemic trend as foreign growth and international trade. While the United direct investment (FDI) levels remain stable and A.3. Outlook and Risks States (USA) is growing at a faster pace than anticipated, concentrated in few sectors. Investment growth has economic activity remains weak in the euro area and yet to return to pre-pandemic trends. Between 2015 in China. Aggressive monetary tightening to curb and 2019, overall investment contributed an average inflation has significantly raised the cost of financing of 1.8 ppts per annum to GDP growth. This fell to B.1. Preface and put pressure on portfolio flows and exchange 1.3 ppts over 2021-2023, in part due to softer FDI rates in emerging markets (EMs). Recent political contribution. During the pandemic years of 2020-2021, tensions in the Middle East have compounded the FDI contracted sharply. It rebounded in 2022, almost impact of the OPEC+ oil production cuts on global solely on account of a sharp rise in manufacturing FDI, energy prices, while the climatic effects of El Nino which is largely linked to the downstreaming industries. Development in B.2. Climate & Indonesia are disrupting global food supply chains. The East In 10 out of 15 sectors though, FDI contracted in 2022, Asia and Pacific region (EAP) has so far been more and declined again in 7 sectors in 3Q-23 (Figure A.2). resilient and is growing at a faster pace than other The softer contribution to growth from foreign activity regions, though growth is also beginning to slow. Key in the post-pandemic recovery has so far been offset by sturdier domestic investment supported by rising Resilience & Growth drivers of regional economic developments include of Decarbonization, B.3. A Virtous Cycle softening global trade, tightening financial conditions, domestic liquidity and private sector credit. and structural reforms aimed at raising productivity and reversing the economic scarring effects from the From a sectoral perspective, manufacturing and pandemic.5 services have been the main drivers of growth. Manufacturing contributed 19.6 percent of 3Q-23 Indonesia’s growth remains resilient in 2023, GDP growth, while wholesale and retail trade (13.1 B.4. Economic Foundations prolonging its post-pandemic recovery. After seven percent), transport (12.4 percent), and information and Policy consecutive quarters of growth above 5 percent, GDP communications (10.0 percent) were also important. grew by 4.9 percent yoy in Q3-23. This brings total Together, these have accounted for 54 percent of GDP growth to 5.1 percent in the first three quarters all growth during the recovery years (3Q-2021 to & Side-Effects of 3Q-2023). The most notable outsized contributor B.5. The Impacts of 2023 (3Q-23). Private consumption was the main Climate Actions driving force, contributing 2.7 percentage points (ppts) during this period has been the transportation sector, to growth so far this year (Figure A.1), and half of all accounting for 13.1 percent of growth from just an growth over the past two years. Consumer confidence initial 3.6 percent share of GDP. The sharp pickup in has been elevated, hovering around pre-pandemic that sector is attributed to the recent completion of levels, and buoyed by declining inflation. Meanwhile, major infrastructure projects like the Jakarta Light Rail Development Policy B.6. A Climate & government consumption remains sluggish (4.1 Train and the Jakarta-Bandung high speed train, as Framework percent of 3Q-23 growth) on the back of slow well as the removal of COVID-era mobility restrictions budget execution. Furthermore, global uncertainty and the reinvigoration of tourism. 5 World Bank Services for Development: East Asia and Pacific Economic Update, October 2023. 7 Indonesia Economic Prospects December 2023 Figure A.1: GDP continues to post solid quarterly results, Figure A.2: Sectoral contributions to net foreign direct Contents Table of underpinned by a strong household sector investment: before, during, and after the pandemic (percent, yoy) (percent, yoy) Private cons. Government cons. Pre-COVID Pandemic Rebound Year to date Investment Net exports 2016-2019 2020-2021 2022 2023* Summary Executive Stat. discrepancy Change in inventories 50 GDP 40 8 30 5.2 5.0 5.3 6 4.9 5.0 5.1 5.1 20 20.6 3.7 10 Developments 9.5 A.1. Recent 4 Economic 0 -5.9 2 -10 -20 -18.8 0 -30 Agriculture, Hunting, & Forestry Fishing Mining & Quarrying Manufacturing -2 -40 (2.1) Electricity, Gas & Water Supply Construction A.2. Policy Whls & Retail; Pers. & HH goods; etc Hotel & Restaurant Stance -4 Transport, Storage, & Comms Financial Intermediation Real Estate, Renting & Bus. Acts. Education 2015 2017 2019 2021 2023* Health and Social Work Other Comm., Social, & Pers. Serv. Acts. SSource: BPS, CEIC, World Bank staff calculations. Source: BPS, CEIC, World Bank staff calculations. Note: 2023 result is for the first 3 quarters of 2023. Note: 2023 result is for the first 3 quarters of 2023. A.3. Outlook and Risks Figure A.3: Average monthly arrivals by five largest Figure A.4: Pre-pandemic GDP trend versus actual source countries, January-September 2019-23 (index, Q4:2019 = 100) (thousands) B.1. Preface Malaysia Singapore 120 1,000 4,000 Real GDP - Pre-COVID trend China Timor Leste Real GDP - Actual Australia Domestic (RHS) 110 800 3,200 Development in B.2. Climate & Indonesia 100 600 2,400 400 1,600 90 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 200 800 80 0 0 70 2019 2020 2021 2022 2023 Sep-13 Sep-15 Sep-17 Sep-19 Sep-21 Sep-23 Source: CEIC; World Bank staff calculations. Source: CEIC, World Bank staff calculations. B.4. Economic Foundations Note: Domestic data is total domestic arrivals. International data is Note: Pre-COVID trend is constructed based on the average growth Policy only for five largest source countries. rate from Q4:2012 to Q4:2019. Tourism, an important service sector and source until early 2022. While international tourists have of foreign currency, is gradually recovering but rebounded since then—reaching 1.1 million visitors in & Side-Effects of B.5. The Impacts Climate Actions international tourists remain below previous highs. September 2023—the monthly average for 2023 is With overseas border restrictions in place, domestic still 30 percent below that for 2019 (Figure A.3). This tourism was naturally the first to bounce back. A solid can be largely attributed to reduced arrivals from the start in mid-2020 was briefly derailed in mid-2021 by top three source countries for visitors: China, Malaysia, the new COVID-19 Delta strain, but activity rebounded and Singapore. Despite these shortfalls, nominal travel Development Policy soon after. In recent months, domestic tourists have services exports are now converging to pre-pandemic B.6. A Climate & reached levels seen in 2019—an average of 3.1 million levels, while travel services imports have already Framework persons per month in January-August 2023 versus recovered in full. 3.2 million per month for the same period in 2019. By contrast, Indonesia was closed to international tourism 8 Indonesia Economic Prospects December 2023 The recovery has seen Indonesia reclaim its status Labor markets have strongly recovered, but as an upper-middle income country but, like many the impact is moderated by fewer middle-class Contents Table of other countries, the economy has not returned to paying jobs. its pre-pandemic trajectory due to scarring from multiple shocks and ongoing external challenges. The labor market continues to show a strong Summary Executive The pandemic held back Indonesia’s economic growth recovery. The labor force participation rate rose by for over a year. By Q2-21 that GDP finally surpassed 0.9 ppt between 2022-2023 to 69.8 percent, with an its pre-COVID level. Returning to the pre-pandemic additional 4.6 million workers being employed since growth trajectory will require a structural shift in 2022. Unemployment has been steadily declining GDP to help close a 6.9 percent gap between where to 5.3 percent, converging to pre-pandemic levels Developments A.1. Recent Economic output is today and where it would have been in the (5.2 percent in 2019). While not fully recovered, absence of COVID related shocks (Figure A.4). At underemployment has also declined from its peak in current exchange rates, this GDP gap translates into an 2020. average loss of around US$360 per person per year. A similar pattern is evident at the provincial level, where Nevertheless, the share of jobs paying middle-class A.2. Policy Stance 31 out of 34 provinces have fallen behind their pre- wages6 has dropped over time potential due to pandemic growth paths. Only East Kalimantan, North rising underemployment in high-earning sectors, Maluku, and Papua have successfully caught up and especially in services. The prevalence of middle- exceeded their pre-COVID trajectories. class jobs has dropped from 14 to 9 percent of total A.3. Outlook and Risks employment between 2019-2022. Such jobs have Deviations between an economy’s long-term been typically concentrated in: (i) manufacturing, (ii) growth path and actual outcomes might point to wholesale and retail trade, (iii) finance, insurance, and economic slack that can be redeployed during the real estate, and (iv) community, social, and personal B.1. Preface recovery. For instance, during the pandemic, GDP services sectors. While most of these sectors recovered declined as workers were retrenched, worker hours after the pandemic, the number of middle-class wage were reduced, factories operated at lower capacity, paying jobs in manufacturing as well as community, and businesses temporarily shut their doors. However, social, and personal services continued to drop (by 1 this underutilized capacity did not just disappear and 10 percent, respectively).7 Underemployment also Development in B.2. Climate & Indonesia right away. Under the right conditions, it might be rose in all of the above sectors in 2022.8 Moreover, quickly redeployed, providing a sharp boost to GDP. between 2019-2023, the share of self-employed Unfortunately, more than two years into the recovery, workers rose from 20 to 23 percent, the incidence of the persistent gap with Indonesia’s earlier GDP trend worker informality was up from 56 to 59 percent, while path cannot be explained by such economic slack. This the share of the wage-employed declined from 40 to Resilience & Growth of Decarbonization, B.3. A Virtous Cycle report estimates that there is limited idle capacity in 38 percent. Overall, these point to rising employment the economy at present, with demand-side inflationary in household enterprises and gig work that do not pressures anticipated in 2024. Instead, Indonesia’s typically create middle-class wage jobs. off-trend growth performance likely reflects long- term economic scarring from the pandemic. This The gendered and urban polarization of middle- may be the result of several factors such as delays in class wage jobs has also worsened. Middle-class B.4. Economic Foundations productive investments, declining productivity, and jobs have been predominantly located in urban areas, Policy erosion of intangible business and worker capital. held by males, and accessible to high- and mid-skilled Accommodative macro policies, stimulus packages to workers. In 2022, the share of middle-class jobs held targeted beneficiaries, and structural reforms to boost by women fell from 30 to 27 percent, while the share & Side-Effects of productivity could close this gap going forward. of such jobs available in non-urban areas fell from 22 B.5. The Impacts Climate Actions to 17 percent. As such, there is rising inequity in access to better-paying jobs. Development Policy B.6. A Climate & Framework 6 Middle-class jobs are those earning a monthly household consumption > 3.5 times the poverty line (Wihardja and Cunningham (2021)). 7 Data on middle-class jobs in 2023 is not available. 8 Latest available data. From 20 percent to 23 percent in manufacturing; 21 percent to 26 percent in wholesale retail and trade, 13 percent to 18 percent in finance, insurance and real estate, and 28 percent to 31 percent in community, social and personal services. 9 Indonesia Economic Prospects December 2023 The impact of the recovery on worker incomes has Inflation has softened as prices normalize been moderated by the slow pace of real wage following last year’s fuel price hike, but new Contents Table of growth. Real wages fell sharply during the early stages pressures are emerging notably from El Nino of the pandemic but, since 2021, have been converging which continues to impact food production. towards pre-COVID levels. Despite this improvement, Summary Executive real wage growth has not kept pace with increases in Inflation softened and returned within Bank GDP per capita during the recovery, indicating that Indonesia’s (BI) inflation target band. Headline some of Indonesia’s recent economic gains have not inflation declined for seven successive months to 2.6 transmitted proportionately to labor income. percent yoy in October (Figure A.5). Several categories of goods and services had slower price growth in 2023, Developments A.1. Recent Economic Workers experiencing the largest real wage losses particularly food, utilities, fuels, and transport. Unlike in during COVID-19, have not yet fully recovered. 2022, there were no major hikes in administered fuel During the pandemic, self-employed and informal or electricity prices this year. This dampened overall workers experienced larger decreases in real wages inflation and, more recently, limited the passthrough (14 and 12 percent respectively) compared to wage- of global oil price pressures. As a result, administered A.2. Policy Stance employed and formal workers (6 percent for both). prices subsided to 2.1 percent yoy in October. Headline In 2022, while most workers were on the path to inflation has now returned within BI’s inflation target recovery, self-employed and informal workers were band of 3 percent ±1. With tightening monetary policy, still earning, on average, only 92 and 95 percent of anchored inflation expectations, and normalizing A.3. Outlook and Risks their real wages in 2019, respectively. Comparatively, domestic demand, core inflation also eased to 1.9 both wage-employed and formal workers were percent yoy in October. earning 98 percent. A multitude of factors could be driving this outcome including lower-skilled workers Nonetheless, the prices of some basic food items B.1. Preface returning to employment and driving average wages (rice, sugar, and chicken meat) have been rising down or a continued reduction in hours worked. Thus, lately owing to a combined effect of supply and while the labor market appears to be recovering after feed shortages. Food inflation rose to 5.5 percent the pandemic, there remains a need for policies and in October, despite favorable horticulture harvests.9 programs that can boost the creation of, and access to, Prolonged unfavorable climatic conditions from El Development in B.2. Climate & Indonesia more productive middle-class jobs. This includes active Nino have affected the production of staple crops labor market, training and education programs from among others, putting pressure on global food the demand side, and supply-side policies such as supply chains. The situation was aggravated by trade those supporting access to finance for SMEs and digital disruptions following export restrictions from major technologies adoption to boost firms’ productivity. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Figure A.5: Inflation remains on a downward trend… Figure A.6: …but challenged by volatile commodities (percent change, yoy) (percent change, yoy, 3mma) 16 60 World's rice price 1.2 Headline IDN rice price 50 14 World's sugar price Core 1 B.4. Economic Foundations Volatile Food 12 40 IDN sugar price Policy Administered 10 30 0.8 8 20 0.6 6 10 & Side-Effects of B.5. The Impacts Climate Actions 4 0 0.4 2 -10 0.2 0 -20 -2 -30 0 Jul-21 Jul-22 Jul-23 Jan-21 Jan-22 Jan-23 Oct-21 Jan-23 Apr-23 Apr-21 Apr-22 Oct-22 Apr-23 Oct-23 Jan-21 Apr-21 Jan-22 Apr-22 Oct-22 Oct-23 Oct-21 Jul-21 Jul-22 Jul-23 Development Policy B.6. A Climate & Framework Source: CEIC, BPS, World Bank Commodity Price Pink Sheet, World Bank staff calculations. Note: IDN rice price is the price of Indonesia’s premium rice from Ministry of Trade, which is equivalent to the quality of Thailand’s 5% broken rice. World’s rice price (i.e Thailand’s 5% broken rice) and world’s sugar price are from World Bank Commodity Price Pink Sheet. 9 Improved production of horticulture products—chilies and shallots—were supported by favorable seasons in their production centers in Central Java, Sumatera, and West Nusa Tenggara. 10 Indonesia Economic Prospects December 2023 food-producing countries (e.g., India on exports of rice of cooking oil,13 distributing rice to 21.4 million and sugar). As a result, rice prices in Indonesia reached vulnerable households,14 supplying traditional and Contents Table of their highest level in five years,10 while sugar prices also modern markets with staple crops in case of shortage,15 rose (Figure A.6).11 and re-activating price caps for rice and sugar.16 These measures have been successful so far with food price Summary Executive Food price pressures have prompted price inflation trending below global and peers’ averages. stabilization efforts. To contain domestic food prices The consequence of inflation is however not felt equally and soften the impact on the poor, the government of across households as geography, logistics, and policy Indonesia (GoI) introduced several price stabilization combine to raise prices in the country’s poorest districts measures. This included: promoting rice and garlic (see Box A.1). Developments A.1. Recent Economic importation,13 increasing domestic market obligations BOX A.1 Indonesia’s affordability divide17 A.2. Policy Stance A significant gap between Indonesia’s most affordable and least affordable districts exists. The cost disparity of consumer goods and services among regions in Indonesia has grown. In 2022, the cost in less populated areas was calculated to be up to two to three times higher than that of populated regions (Figure Box A.1.1). While this is not a new challenge for Indonesia, globally such large disparities are rare within the same country. A.3. Outlook and Risks Figure Box A.1.1: National cost-of-living index, with the national average set as the mid-point B.1. Preface Development in B.2. Climate & Indonesia Source: SUSENAS, World Bank staff calculations. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle The poor feel the consequences of high living costs most acutely. For every rupiah earned in a typical district of Indonesia, a poor person must earn 1.7 rupiah to escape poverty in the most unaffordable areas. And when it comes to social programs, the impact of each rupiah spent in high-cost districts is offset by expenses. Indonesia’s geography contributes to the affordability divide. About 60 percent of Indonesians live in Java and Bali. Together with parts of Sumatra, these areas enjoy much lower costs than the national average. But conditions B.4. Economic vary substantially outside of this densely populated core. With more than 17,000 islands spanning over 6 million square Foundations Policy kilometers, Indonesia covers a vast territory and is the world’s largest archipelagic nation. This raises the risk of market fragmentation, with profound challenges to integrating the economic center together with distant provinces into a single domestic market. & Side-Effects of B.5. The Impacts Climate Actions 10 This is also partly due to a seasonal trend of lower domestic rice production following the peak harvest in earlier months of the year. 11 Sugar is typically used in food processing and hence sugar price increases lead to price rises in many other food items. For example, Indonesia’s food and beverage producers expect the sugar price increase will continue next year, thereby raising domestic refined sugar and sugar-sweetened food and beverage prices in 2024 by 10 percent. Development Policy 12 The government secured and increased the quantity of imported garlic. B.6. A Climate & 13 The domestic market obligation for cooking oil was adjusted to 1:4 from 1:6. Thus, local producers can now only export a maximum of four times the Framework amount of cooking oil they supply to the domestic market (instead of six times). 14 The rice social aid package was first distributed between March and May. The authorities commenced a second round of distribution in September and have extended the program into the first half of 2024. 15 The stock and market price stabilization or SPHP (Stabilisasi Pasokan dan Harga Pangan) is a government program which ensures that markets are stocked with staple crops like rice and sugar. In case of bottlenecks, distribution to markets occurs through the state. 16 The National Food Agency (BAPANAS) was authorized to set price ranges for rice and sugar (BAPANAS Regulation #7 and 17/2023). 17 The box is based on World Bank (forthcoming), Indonesia Affordability Divide, World Bank working paper. 11 Indonesia Economic Prospects December 2023 Higher transport costs in the least integrated regions hinder domestic market integration and price convergence. Contents Table of For many goods and services (including medicines, LPG, and transport costs for instance), prices are consistently highest in Papua and Maluku (Figure Box A.1.2). Costs of air and sea cargo in less-integrated areas can be double that found in Java. Because the cost of trading within the domestic market can be prohibitively high, high prices are not enough to bring in additional supply. Such price anomalies are most common in tradable goods, but in some cases extend to local services Summary as well. For example, in 2022 a standard hospital fee in Papua Barat was 239 percent higher than in Java. Executive Regulations also contribute to Indonesia’s affordability gap. The national cabotage policy—which requires domestic transportation of goods and passengers be undertaken solely by Indonesian-flagged vessels with Indonesian crews— places strict limits on sea logistics capacity. By hindering domestic and international connectivity, the policies add pressure Developments for market segmentation and higher consumer prices. Restrictive cabotage regulations aim to protect domestic shipping A.1. Recent Economic operators from competition, but also result in higher consumer prices and weaker integration with global markets. In recognition of similar efficiency costs, both China and India recently lifted their own cabotage restrictions. Restrictions also require the use of domestic shipping services for export of specific strategic commodities (Trade Minister Regulation 40/2020). In addition, targeted regulations limit foreign investment in the shipping and logistics sector, with a cap of 49 percent foreign ownership in marine shipping activities (Presidential Regulation 10/2021). A.2. Policy Stance Figure Box A.1.2: High-priced goods and services in Maluku and Papua (rupiah, thousands) Sanitary Napkins Sea Freight Fare Cough Medicine 350 LPG 25 A.3. Outlook and Risks 12 National 1050 300 10 Java 20 900 Papua & Maluku 250 8 750 15 200 6 B.1. Preface 600 10 150 4 450 100 5 2 300 50 0 150 0 0 Development in B.2. Climate & 2010 2012 2014 2016 2020 2022 2010 2012 2014 2017 2019 2021 2010 2012 2014 2016 2018 2020 2022 2012 2014 2016 2018 2020 2022 Indonesia Source: World Bank staff calculations. Cabotage regulations are especially costly for markets physically distant from the economic center of the country in which they are applied. This phenomenon has been documented elsewhere in the world (for instance, Hawaii and Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Alaska18). In Indonesia, this effect likely translates into less shipping traffic to the eastern island groups of Papua, the Maluku Islands, and Nusa Tenggara. Between January 2019 and May 2023, Papua accounted for just 3 percent, Nusa Tenggara 3.3, and Maluku Islands 0.6 percent of domestic bulk carrier ship arrivals.19 Adjusting for population differences, Indonesia’s three poorest island groups received the lowest number of bulk carrier ship arrivals per resident over the same period. Compared to a national annual average of 5.3 domestic cargo ship arrivals per million people, 2.8 ships arrived in Papua and Nusa Tenggara, and just 0.5 ships in the Maluku Islands. B.4. Economic Foundations The same three island groups were strongly underrepresented among ‘international’ arriving cargo ships. Compared Policy to a national average of 5.6 bulk cargo carrier ships arriving from foreign ports, about 3.8 arrived in Papua, 0.7 arrived in Nusa Tenggara, and no large cargo carrier ships arrived in the Maluku Islands. Compounding the connectivity challenge for these relatively distant island groups is the lack of ports authorized to accept foreign ships. Indonesia had only 17 international connections for container shipping in 2023, fewer than Papua New Guinea and below most peers (such as 70 & Side-Effects of B.5. The Impacts Climate Actions in Malaysia, 92 in China, and 33 in Thailand). One exception is the Philippines (with just 15), which also maintains cabotage restrictions. Pursuing better market integration through improved logistics is critical to raise welfare, especially in Indonesia’s poorest areas. Indonesia has rapidly improved connectivity with better physical infrastructure in recent years. This has brought down logistics costs from 18.6 percent of GDP in 2010 to 14.5 percent in 202120. Yet, logistics remain an impediment Development Policy B.6. A Climate & to domestic trade. An ADB (2016) simulation of gains from reduced trade costs suggests that a 5 percent reduction in Framework domestic trade costs could generate high returns, boosting by as much as 5 percent. 18 Grassroot Institute of Hawaii Policy Brief (2020) and Alaska Policy Forum (2021). 19 As recorded in the Automatic Identification System, a global reporting requirement for ships of significant size. 20 World Bank (forthcoming), Measuring Logistics Costs in Indonesia, World Bank working paper. 12 Indonesia Economic Prospects December 2023 Worsening global financing conditions are exchange rates, Indonesia included (Figure A.7). US putting renewed pressure on Indonesia’s external financial tightness have slightly unwound in November Contents Table of financing position, foreign currency reserves, and with yields falling back slightly following the release the rupiah. of recent US labor market and inflation data, however interest rates are still expected to remain high for Summary Executive The prospect of higher-for-longer interest rates in longer. advanced economies (AEs) has heightened pressure on EM portfolio flows and exchange rates. With core Global monetary tightening has triggered portfolio inflation still high and declining only slowly in many outflows turning the financial account into a deficit. AEs, central banks may need to keep monetary policy Portfolio capital, which is particularly susceptible Developments A.1. Recent Economic tighter for longer. In July, the US Federal Reserve, the to shifts in short-term investor sentiment, changed European Central Bank, the Bank of England, and the course in the second half of the year and recorded Bank of Canada all raised their policy rates. In the a net outflow of 0.3 percent of GDP in 3Q-23. This following months, although the Fed held its benchmark trend accelerated recently, with non-resident investors rate steady, it indicated the possibility of further rate offloading US$2.7 billion in Indonesian public debt and A.2. Policy Stance hikes in the future. Rate hikes in AEs, while a necessary US$1.8 billion in equities between July-October. Other response to rising domestic inflationary pressures, investments22 also registered a sizeable net outflow have resulted in substantial global financial tightening. of 0.9 percent of GDP. This primarily reflects rising In the second half of the year, AEs’ government bond asset purchases abroad by residents as well as local A.3. Outlook and Risks yields started increasing sharply. The UST 10-year companies deleveraging external debt23. Outflows yields reached a 16-year high of 5 percent in October, were partially offset by net FDI (1.1 percent of GDP in rising more than 100 basis points in three months. 3Q-23), which remain a stable long-term financing As a result, global risk sentiment—proxied by the source for Indonesia. In sum, the overall financial B.1. Preface VIX index21 —has been soaring and EMs have seen account remained in deficit for a second consecutive broad-based portfolio outflows and pressures on their year (Figure A.8). Figure A.7: Tightening global financial conditions have Figure A.8: Outflows from the current and financial Development in B.2. Climate & led to significant capital outflows from EMs accounts have pressured the rupiah Indonesia (US$ billion, LHS; index, RHS) (percent of GDP, yoy) 4 4 30 Portfolio flows Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 2 25 2 0 20 0 -2 15 Current account B.4. Economic Foundations VIX (RHS) -2 Capital account Policy Net financial account -4 10 Errors & omissions Overall balance Aug-23 Mar-23 May-23 Jun-23 Jun-23 Jan-23 Jan-23 Apr-23 Sep-23 Feb-23 Oct-23 Jul-23 -4 2017 2018 2019 2020 2021 2022 2023* & Side-Effects of B.5. The Impacts Climate Actions Source: IIF, Bloomberg, World Bank staff calculations. Source: BPS, CEIC, World Bank staff calculations. Note: Portfolio flows are the 7-day moving average. Note: 2023 data is year to date. Development Policy B.6. A Climate & Framework 21 The VIX index, also known as Volatility Index, is a real-time market index that represents the market’s expectations of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. 22 Other investments include financial flows such as loan transactions, trade credits, and currency and deposits. 23 Given rising global borrowing costs, local companies are amortizing foreign currency debt rather than rolling-it over or borrowing more. 13 Indonesia Economic Prospects December 2023 After two years of surpluses, the current account The balance of payments (BoP) deficit weighs balance also switched into a small deficit of US$107 on BI’s foreign currency (FX) reserves and on the Contents Table of million, or 0.01 percent of GDP, in 3Q-23 (Figure rupiah. The BoP has turned into a deficit in 3Q-23 A.9). This signals a likely end to the commodity boom (-0.2 percent of GDP). As a result, FX reserves at the cycle and the return to status quo for Indonesia, which central bank dropped from a peak of US$145 billion in Summary Executive recorded consistent current account deficits from 2012 March 2023 to US$133 billion in October (Figure A.10). to 2019. The reversal is the result of a softening trade Nevertheless, reserves continue to be adequate and surplus, with net income24 flows remaining in a steady cover 6 months of good and services imports. The deficit of 2.1 percent of GDP ytd. Primary income25 rupiah has also fallen under pressure and depreciated deficits are common among resource-rich developing by 5.9 percent against the US dollar between May and Developments A.1. Recent Economic countries. It mostly reflects repatriation of foreign October. However, the nominal effective exchange companies’ profits especially those in the commodities rate (NEER)—a measure of the rupiah against a trade- sector as is the case in Indonesia. With the current weighted basket of currencies—appreciated a modest account turning into a deficit, albeit small, Indonesia 0.6 percent over the same period. The stronger NEER must source additional foreign currency (rising external reflects the simultaneous depreciation of several other A.2. Policy Stance financing needs) amidst challenging global financing trading-partner currencies against the US dollar, conditions. including Asian peers’ currencies which have seen sharper declines than the rupiah. A.3. Outlook and Risks Figure A..9: Weakness in goods trade has flipped the Figure A.10: …. and have impacted FX reserves current account into negative territory (US$ billion, LHS; IDR/US$ (Jan 2020=100), RHS) (percent of GDP, yoy) 160000 110 B.1. Preface 4 Income balance FX reserves Trade balance Current account balance 140000 2 100 120000 Development in B.2. Climate & Indonesia 0 100000 90 80000 IDR/USD (Jan 2020 = 100), RHS -2 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 60000 80 2/2020 6/2020 10/2020 2/2021 6/2021 10/2021 2/2022 6/2022 10/2022 2/2023 6/2023 10/2023 -4 2016 2017 2018 2019 2021 2022 2023* Source: BPS, CEIC, World Bank staff calculations. Source: Source: Bank Indonesia, CEIC, World Bank staff calculations. Note: 2023 data is year-to-date. B.4. Economic Foundations Indonesia’s trade in goods has been declining amid -10.4 and -2.4 percent yoy in October 2023 (Figure 11). Policy global uncertainty and moderating commodity As a result, the trade balance in goods has deteriorated prices, while services trade remains more resilient but remains positive at 2.7 percent of GDP year-to-date and supportive of growth. (ytd), supported by relatively stable export volumes of coal. & Side-Effects of B.5. The Impacts Climate Actions Trade in goods growth mirrored the global slowdown. Weak global demand, slow recovery Intermediate goods imports have fueled this in China and moderating commodity prices have downward trend as commodity prices and weighed on Indonesia’s trade in goods. Both exports domestic demand normalize. The growth of imports and imports of goods continue to contract, reaching has been rapidly decelerating, notably those linked Development Policy B.6. A Climate & Framework 24 The income account comprises of international flows such as earnings from overseas investments, overseas employment income of Indonesian resi- dents, and current transfers such as remittances, grants and foreign aid. 25 Primary income comprises flows of investment earnings, interest payments on debt, and compensation of non-resident workers. 14 Indonesia Economic Prospects December 2023 to raw and processed intermediate goods (Figure 12). 23 (yoy). As a result, the share of services trade rose This deceleration can be attributed to several factors to 15.1 percent of total trade in 3Q-23, up from 10 Contents Table of including the softening of oil imports as prices drop26, percent over the same period last year. The increase normalizing domestic demand, softening exports, and in imports is primarily driven by travel and tourism, sluggish investment recovery. Intermediate and capital transportation—linked to recent major transport Summary Executive goods are pivotal for domestic production and exports. infrastructure projects—and to commercial services The long-term decline in their imports has been playing such as business, telecom, computer, and information into the enduring trend of a limited contribution of services. These services had benefitted from changing trade to Indonesia’s overall economic growth (see Box consumer preferences and technology advancements A.2). during the pandemic years. Hence, services imports Developments A.1. Recent Economic can also help boost competitiveness and have positive Imports of services on the other hand remain benefits on exports and the overall trade balance robust and have been gaining importance in trade. (goods and services) which remains in surplus at 2.1 In contrast to imports of goods, services imports percent of GDP). experienced substantial growth of 11.8 percent in Q2 A.2. Policy Stance Figure A.11: Goods trade growth returned to pre- Figure A.12: Intermediates have contributed little to pandemic levels recent import growth, while capital and consumer (percent yoy growth (LHS) and US$ billion (RHS)) goods imports also moderated A.3. Outlook and Risks (contribution to percent yoy growth) Capital Goods Consumer Goods 80 8 Primary Intermediate Goods Processed Intermediate Goods 80 B.1. Preface 60 6 60 40 4 40 20 2 20 0 0 Development in B.2. Climate & 0 Indonesia -20 Trade Balance -2 -20 Exports -40 -4 -40 Imports -60 -6 -60 Resilience & Growth of Decarbonization, May-20 May-21 May-22 May-23 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 B.3. A Virtous Cycle May-20 May-21 May-22 May-23 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 Source: BPS and Bank Indonesia; World Bank staff calculations; Ministry of Trade. Note: Due to data constraints, the distinction between primary and processed intermediate goods for Aug-Oct 2023 is an estimate. B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework The average brent crude oil price was on average 106 dollars per barrel in the first six months of 2022 compared to 80 dollars per barrel in the first six 26 months of 2023 (see also World Bank Commodity Markets Outlook October 2023). 15 Indonesia Economic Prospects December 2023 BOX A.2 Contents Table of Growth and Indonesia’s declining appetite for imports Imports and growth have been largely intertwined in Indonesia. Periods of strong growth were generally associated with strong imports. Yet, the contribution of trade to overall growth has been on a decline, reflecting Summary Executive structural changes to the economy and the importance to deepen trade reforms. Indonesia’s trade performance has provided strong evidence of structural reform contributions to trade-led growth. In the 1990s, Indonesia grew at a fast pace of 6 percent per year. This boosted demand for imports Developments (Figure Box A.2.1), of which a large share was capital and intermediate goods. As a result, lower-end manufacturing A.1. Recent Economic activities (e.g., textiles, apparel, footwear) and some higher-end manufacturing (e.g., electronics and automotive) flourished. The Asian Financial Crisis (AFC) was a turning point, leading to several years of relatively subdued imports. Demand for imports grew fast in the early 2010s, followed by a subsequent slowdown towards the close of the decade as well as in recent years. A.2. Policy Figure Box A.2.1: Share of import volume to GDP Stance (index, 1990 = 100) 170 1990-1997 2000-2006 2009-2019 Average growth 6% p.a. Average growth 4% p.a. Average growth 6% p.a. 2020: Covid-19 A.3. Outlook 160 1997-1998: Asian and Risks Pandemic Financial Crisis 150 140 2007-2008: Global 130 Financial Crisis B.1. Preface 120 110 100 Development in B.2. Climate & Indonesia 90 1990 1994 1998 2002 2006 2010 2014 2018 2022 Source: World Bank and UN Comtrade. Throughout the three decades, there has been a one-to-one relationship between income and import Resilience & Growth of Decarbonization, B.3. A Virtous Cycle growth. Estimates of long-run income elasticity of imports—which measure the long-run relationship between imports and income27—suggest that a 1 percent increase in real GDP is associated with a 1 percent increase in the total volume of imports. Interestingly, imports of productive assets respond particularly strongly to income changes. A 1 percent increase in real GDP implies a 1.3 percent increase in the volume of intermediate goods imports and a 1.4 percent increase in the volume of capital goods. In contrast, import elasticities for raw materials and consumption goods are only 0.7 and 1.1, respectively. The short-run elasticities for intermediate and capital goods imports are also high, suggesting that an increase in income in the short-run translates to higher imports B.4. Economic Foundations of productive assets. Policy Nevertheless, the responsiveness of imports to income changes has declined over the years, by more than half since the early 1990s. The long-run import elasticity was high at 1.6 over the early 1990s (1990-1996), then declined to 0.9 after the AFC (2000-2006) and further to 0.7, though not statistically significant, post Global & Side-Effects of B.5. The Impacts Climate Actions Financial Crisis (GFC) (2009-2019) (Figure Box A.2.2). On average, the long-run import elasticity for intermediate goods is estimated at 1.7 percent in the 1990s. This figure decreased to 0.16 percent after AFC but not statistically significant. Post GFC, the import elasticity bounced back to 1.3 percent. The long-run import elasticity for consumer goods is the largest though among the type of import goods28 at 3.2 percent, though only statistically significant in 1990-1996. Development Policy B.6. A Climate & Framework 27 The box computes elasticity estimations using an Error Correction Mechanism (ECM) model in Constantinescu, Matto, and Ruta (2015). A limitation of this model is that it assumes a one-way relationship between real GDP and import volume, despite the fact that both variables influence each other. The estimates should be interpreted as illustrations of the correlation between the two variables, and do not capture the complex and structural relationship between real GDP and imports. The analysis is based on annual data on import volumes and real GDP for the period 1990-2021. 28 The product categories or type of imports goods are: imports of raw materials, intermediate goods, capital goods, and consumer goods. 16 Indonesia Economic Prospects December 2023 Contents The steady decline in import elasticity points to underlying structural drivers. The deregulation era of the Table of late 1980s supported a policy shift from import substitution to an era of export promotion (Soesastro and Basri, 2005). These were accompanied by the expansion of intermediate imports, which has been found to be positively related with GDP growth. However, after the AFC, restrictions on trade (mainly tariffs and non-tariff measures) as Summary Executive well as on foreign investments were introduced to encourage domestic industries (Basri and Patunru, 2012). These policies have likely weighed on economic growth. The analysis on the relationship between imports and GDP over time and product categories, mirrors these evolving policy changes. In the past decade Indonesia reversed track and made important gains in infrastructure, poverty reduction, and the business environment. To maximize these gains, the policy debate needs to shift from whether the economy should be more open or closed, to how Developments A.1. Recent Economic to leverage trade and investment openness—including more appetite for imports—to enhance competitiveness, raise productivity, and boost inclusiveness. Figure Box A.2.2: Relationship between imports and real GDP growth over time periods A.2. Policy Total Imports Raw Material Imports Intermediate Good Stance Imports Short-run elasticity (1990-1996) 16.89** 10.82 -4.35 15.45* Short-run elasticity (2000-2006) 5.21 A.3. Outlook 12.37* -3.05 11.57 and Risks Short-run elasticity (2009-2019) 18.97*** Speed of adjustment (1990-1996) 1.26*** 0.72 1.68*** Speed of adjustment (2000-2006) 1.67* 0.83 0.64 Speed of adjustment (2009-2019) 0.38 0.92*** 0.24 B.1. Preface Long-run elasticity (1990-1996) 1.56*** 0.57 1.72*** Long-run elasticity (2000-2006) 0.85** 0.77 0.16 Long-run elasticity (2009-2019) 0.65 0.26 1.34* -30-20-10 0 10 20 30 40 50 -30-20-10 0 10 20 30 40 50 -30-20-10 0 10 20 30 40 50 Development in B.2. Climate & Indonesia Capital Good Imports Consumer Good Imports Short-run elasticity (1990-1996) 23.12* 29.76** Short-run elasticity (2000-2006) 13.78 19.99 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Short-run elasticity (2009-2019) 22.96** 18.12* Speed of adjustment (1990-1996) 0.78** 1.54*** Speed of adjustment (2000-2006) 0.73* 1.37*** Speed of adjustment (2009-2019) 0.69** 0.45 Long-run elasticity (1990-1996) 0.18 3.19*** B.4. Economic Foundations Long-run elasticity (2000-2006) 0.69 0.59 Policy Long-run elasticity (2009-2019) 0.98** 0.66 -30-20-10 0 10 20 30 40 50 -30-20-10 0 10 20 30 40 50 Source: World Bank staff estimates. & Side-Effects of B.5. The Impacts Climate Actions Note: *p<0.1, ** p <0.05, *** p<0.01 indicate significance at 10%, 5% and 1% confidence level Development Policy B.6. A Climate & Framework 17 Indonesia Economic Prospects December 2023 2. The Policy Stance Contents Table of The fiscal stance remains prudent with limited 9.5 percent of GDP (ytd), one of the highest levels since spending on pro-growth programs despite rising 2015. Growth in taxes was modest, up 2.3 percent. It revenue collections, but pressure is building on was primarily driven by VAT, following a 1 ppt increase Summary Executive debt service. in the VAT rate in April 2022, and income taxes on non-oil and gas sectors. International trade taxes Fiscal policy remained conservative, with no major contracted by 35.0 percent as both the volume and spending boost despite relatively high revenues. value of imports and exports declined, particularly in Developments commodity-related sectors. Non-tax receipts grew 3.7 A.1. Recent Revenue collection remained robust, supported by Economic elevated commodity prices although this windfall percent (versus 36.5 percent surge in same period last is subsiding. Yet, this has not translated into any year), mostly supported by growth in natural resources substantial increase in spending, particularly in priority revenues, particularly licenses in the mining sector. sectors,29 with the rate of disbursement returning to A.2. Policy pre-pandemic levels. Consequently, the fiscal balance Primary expenditures including remained Stance stood at a small deficit of -0.01 percent of GDP in the suppressed, though capital spending picked first ten months of 2023 (Figure A.13). The GoI projects up markedly. January-October total expenditure a full-year fiscal deficit of 2.3 percent of GDP—this contracted by 4.7 percent (Figure A.15), resulting in the report’s projection stands at 2.1 percent of GDP—well lowest spending-to-GDP ratio (10.6 percent of GDP) in A.3. Outlook and Risks below the legislated fiscal rule of 3 percent, and in line at least a decade. Capital expenditures contributed the with long-term trends (see Box A.3). most and rose by 25.3 percent yoy, with GoI boosting spending on defense and security sectors30 as well as Revenue collections remained strong despite roads and transportation facilities. Meanwhile, while B.1. Preface moderating commodity prices, weakening import investment financing—which includes capital injections values, elevated tax refunds, and the end of the to SOEs, government services units such as hospitals, voluntary asset disclosure program. January-to- and other institutions—brought overall public October revenue collections expanded 2.7 percent investment to 1.9 percent of GDP (Figure A.16). Subsidy Development in B.2. Climate & yoy, significantly slower than for the same period in expenditures31 have contracted since the 2022 hike in Indonesia 2022 (up 44.8 percent) when commodity prices were administered fuel and electricity prices by 4.0 percent booming (Figure A.14). Nevertheless, revenues reached yoy. Social spending on the other hand contracted by 10 Figure A.13: Constrained public spending despite Figure A.14: Revenues grew marginally, largely due to Resilience & Growth of Decarbonization, B.3. A Virtous Cycle strong revenues, has kept the budget in surplus high collections already being achieved last year (fiscal deficit, percent of GDP) (contribution to revenue growth, ppts, yoy) Grants 2 50 Revenues from Public Services Other Non-Tax Revenues 40 Profits of SOEs 0 Natural Resources Revenues B.4. Economic Foundations 30 Tax Revenues Policy -2 Total Revenues 20 -4 10 2018 2019 & Side-Effects of B.5. The Impacts Climate Actions 2020 2021 0 -6 2022 2023 -10 -8 -20 Jun Jul Aug Dec Jan Mar May Nov Oct Apr Sep Feb Oct-18 Oct-19 Oct-20 Oct-21 Oct-22 Oct-23 Development Policy B.6. A Climate & Source: Ministry of Finance, BPS, CEIC, World Bank staff calculations. Framework 29 Priority sectors include health, early childhood education, infrastructure. 30 This reflects mainly maintenance of the equipment for defense and security forces (Alat Utama Sistem Pertahanan/ ALUTISTA). 31 This includes both components of the subsidy: direct subsidies and compensation payments to Pertamina and PLN. 18 Indonesia Economic Prospects December 2023 percent reflecting the end of temporary cash transfers (Figure A.17). Most of the debt stock is denominated that were used to soften the impact of fuel price hikes. in domestic currency (72.1 percent of total) and is Contents Table of Instead, the GoI announced a new food and rice aid long-term (87.6 percent of total). The GoI is planning program to mitigate the impact from El Nino at a cost to spend 2.1 percent of GDP in the last two month of of IDR18.6 trillion (0.1 percent of GDP or 12.5 percent 2023. While this could push both financing needs and Summary Executive of the allocated social spending)32. Meanwhile, interest public debt up, a large part of the financing will come payment rose slightly by 0.3 percent and stabilized at through accumulated cash savings (SAL) as opposed to 1.5 percent of GDP despite rising borrowing costs. new debt issuances originally planned in the budget. Hence, public debt to GDP will remain moderate and Budget financing needs and the public debt ratio below 2022 levels (see Table A.1). Developments A.1. Recent Economic continue to decline as the fiscal balance records a small deficit. As of October, net fiscal financing The GoI continued to primarily rely on financing reached only IDR168 trillion (0.8 percent of GDP), much from domestic investors but has had to offer higher lower than last year. As a result, the public debt ratio yields amid rising global borrowing costs. More than continued to decline and stood at 37.7 percent of GDP 80 percent of government bond ownership comes from A.2. Policy Stance Figure A.15: Spending growth in the first ten months Figure A.16: Public investment is relatively stable with of 2023 was relatively suppressed a notable share financed through SOEs (contribution to expenditure growth, ppts, yoy) (public investment, percent of GDP) A.3. Outlook and Risks Primary Expenditure Capital Capital Expenditure Investment Financing Interest Payment Subsidy 2.5 Others Total Expenditure 20 2.0 0.8 B.1. Preface 10 1.5 0.7 0.5 0.7 0.4 0.8 0.3 0 1.0 1.2 1.2 1.4 1.2 0.5 1.1 1.2 1.1 -10 Development in B.2. Climate & Indonesia -20 0.0 Oct-18 Oct-19 Oct-20 Oct-21 Oct-22 Oct-23 2018 2019 2020 2021 2022 2023O 2024B Ministry of Finance, BPS, CEIC, World Bank staff calculation. Note: Figure 15: primary expenditures comprise personnel and material expenditures while other expenditures include social expenditure, Resilience & Growth of Decarbonization, B.3. A Virtous Cycle grants and transfer to subnational government. Figure 16: 2023O refers to 2023 outlook; 2024B refers to 2024 budget. Figure A.17: Debt-to-GDP continued to decline, Figure A.18: Yields on Indonesia’s sovereign debt have consistent with the tight fiscal stance been increasing recently (total debt stock, IDR trillion (LHS), percent of GDP (RHS)) (change in yield, monthly, tenors 1-30 years; blue indicates a decrease in yield from the prior month; red indicates an increase in yield; darker colors represent bigger changes) B.4. Economic Foundations Policy 1 1 30 30 Foreign Domestic Debt to GDP (RHS) Oct-23 10,000 50 Sep-23 8,000 40 Aug-23 & Side-Effects of Jul-23 B.5. The Impacts Climate Actions 6,000 30 Jun-23 May-23 4,000 20 Apr-23 Mar-23 2,000 10 Feb-23 Development Policy Jan-23 - 0 B.6. A Climate & Dec-22 Framework 2018 2019 2020 2021 2022 2023* Source: Ministry of Finance, BPS, CEIC, World Bank staff calculations. Note: Figure 17: 2023 data is as of September. 32 The program started between March and May 2023. See inflation section above for more details. 19 Indonesia Economic Prospects December 2023 domestic investors. Commercial banks hold 29 percent in AEs. A protracted episode of non-resident capital of the total while BI’s share is broadly stable at 16-17 outflows could squeeze available financing sources Contents Table of percent since the monetary financing program stopped and raise the yields demanded for newly issued public in January 2023. Nevertheless, non-resident investors debt. Rates across the first 10 years of the sovereign continue to hold just under 15 percent of Indonesia’s debt yield curve have already been rising and, as of the Summary Executive public debt. This share declined significantly during 1st of November 2023, had reached their highest levels the pandemic33, but in nominal terms remained stable. since November 2022 (Figure A.18). This raises the cost Between August and October of this year, non-resident of new and rolled-over debt going forward. holdings fell by 4.4 percent due to rising interest rates Developments A.1. Recent Economic BOX A.3 Review of Indonesia’s Long-Term Fiscal Policy Performance Over the past two decades, Indonesia has maintained fiscal conservatism, institutionalized by fiscal rules. The fiscal balance averaged approximately -0.8 percent of GDP per year from 1995 until the 2008 Global Financial Crisis A.2. Policy Stance (GFC), and this increased to an average of -1.6 percent per year in the post-2008 period up to 2019. Fiscal rules were introduced in 2003 and 2004 to enhance institutional support and ensure fiscal policy sustainability. While deficits increased following the Global Financial Crisis, the balanced budget rule served as an effective constraint on spending. A.3. Outlook and Risks Public debt levels declined steadily from the Asian Financial Crisis period thanks to early fiscal surpluses. The substantial financial bailouts following the 1998 financial crisis had caused public debt to surge to unsustainable heights, reaching peaks exceeding 80 percent of GDP. Consistent primary fiscal surpluses were important in steadily reducing public debt to around 22 percent of GDP (Figure Box A.3.1). Despite pandemic-era increases in the budget B.1. Preface deficit, which led debt to increase to 40.7 percent in 2021, public debt has started to decline again given fiscal consolidation efforts. Nevertheless, this level remains notably lower than in other emerging markets and is well below the country’s fiscal limit of 60 percent (Figure Box A.3.2). Figure Box A.3.1: Early surpluses helped bring down Figure Box A.3.2: Despite recent deficits, public debt Development in B.2. Climate & public debt to sustainable levels remains low by international standards Indonesia (percentage points) (percentage points) Government Debt Debt Rule (60% of GDP) 80 Gross Public Debt to GDP 100 4 Fiscal Balance (RHS) Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Primary Balance (RHS) 80 2 60 60 0 40 40 -2 20 B.4. Economic Foundations Policy 20 -4 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Advanced Emerging LAC East Asia Indonesia & Side-Effects of B.5. The Impacts Climate Actions Source: WEO, World Bank staff calculations. While being conservative, Indonesia’s fiscal policy has also been procyclical. This means that public spending tends to increase during economic upswings and decreases during downturns, which under certain conditions can increase macroeconomic volatility. While intended to safeguard fiscal sustainability, a budget balance rule can amplify spending procyclicality. Over the whole sample, Indonesia displays levels of procyclicality similar to other Development Policy emerging and middle-income economies (Figure Box A.3.3). Advanced economies and some regional neighbors B.6. A Climate & Framework like Thailand, Malaysia, or South Korea display countercyclical fiscal policies. The decline is largely due to BI and commercial banks absorbing the bulk of new issuances as the fiscal deficit expanded beyond the 3 percent of 33 GDP deficit ceiling to accommodate for the COVID-19 stimulus package. 20 Indonesia Economic Prospects December 2023 Figure Box A.3.3: While fiscally conservative, Indonesia’s fiscal policy is procyclical Contents Table of (correlation coefficient) 1.0 0.8 Summary Executive 0.6 0.4 0.2 Developments A.1. Recent Economic 0.0 -0.2 -0.4 -0.6 A.2. Policy Stance Advanced economies Emerging East Asia Developing economies Indonesia -0.8 Source: IMF WEO, World Bank staff calculations. Note: Correlation coefficient between cyclical component (percent difference from trend) of primary spending and the cyclical component of real GDP. A.3. Outlook and Risks After accounting for the size of its economy, Indonesia’s public sector is significantly smaller than that of its peers. Figure Box A.3.4 shows a scatter plot of government expenditures against economic development over time for a global sample. Indonesia sustains a public sector that is markedly smaller than in other countries with B.1. Preface similar levels of development, despite a small rise in the last two decades. By 2019, Indonesia had more than a 5 ppts gap with its already conservative regional neighbors, around a 12 ppts gap with EMs, and almost a 20-ppts gap with AEs. The historically low government spending is likely driven by low and declining revenue collection, and Development in B.2. Climate & institutionalized in the 2000s by the deficit ceiling. Figure Box A.3.5 shows that revenue collection in Indonesia Indonesia has been low compared to other EMs and AEs. While the expansion of public spending should ideally be complemented by public revenue increases, Indonesia presents the opposite trend. From its peak at approximately 20 percent of GDP in 2009, revenues dropped to 15 percent by 2019. This is 25 ppts less than AEs and almost 15 ppts less than other EMs. With lower revenues, the government has no choice but to also constrain spending, to Resilience & Growth of Decarbonization, B.3. A Virtous Cycle remain within the confines of its deficit ceiling. Figure Box A.3.4: While fiscally conservative, Figure Box A.3.5: Public revenue relative to income in Indonesia’s fiscal policy is procyclical Indonesia has been historically low and decreasing (primary expenditure, percent of GDP) over the last decade (percent of GDP) B.4. Economic Foundations 80 42 Policy 38 70 34 60 30 Adv Economies 26 & Side-Effects of 50 B.5. The Impacts Climate Actions 2019 Adv Economies 22 40 1995 18 Emerging LAC Emerging LAC 30 1995 14 2019 Emerging East 10 20 Emerging East Asia 2019 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 Asia 1995 Development Policy 10 Indonesia 2019 B.6. A Climate & Indonesia 1995 Indonesia Emerging Markets Framework 0 Latin America Emerging East Asia Advanced Economies 4 6 8 10 12 Source: IMF, WEO, World Bank staff calculations. 21 Indonesia Economic Prospects December 2023 Fiscal policy could play a more prominent role in achieving Vision 2045. Fiscal prudence has served the Contents Table of country in ensuring macro-fiscal stability. However, limited revenue has constrained the GoI’s ability to provide more public goods and services to boost the country’s growth potential. Fiscal policy can play a more significant role by closing the physical and human capital gap, better absorbing shocks by conducting countercyclical fiscal policy, and providing more social insurance. Efforts to increase revenue—such as the reform initiated by the Summary Executive tax harmonization law in 2021—are critical to support long-term growth objectives while ensuring short-term macroeconomic stability. Developments A.1. Recent Economic Higher-for-longer global interest rate prospects band.36 The policy rate hike is geared more towards and related external pressures have led BI to managing external pressures, by raising the policy- prioritize a tight monetary stance. rate spread against the US Fed Fund Rate after it had reached an all-time low in 2023. For this same Amid worsening global financing conditions, objective, BI also introduced two new FX-denominated A.2. Policy Stance Indonesia introduced new instruments to boost the securities in November, called SVBI and SUVBI.37 supply of FX reserves. The GoI issued a new regulation requiring that export proceeds remain onshore for In parallel, BI resorted to three liquidity measures longer. Government Regulation 36/2023, which to support credit growth and offset the impact of A.3. Outlook and Risks became effective in August, continues to encourage monetary tightening on domestic demand. First, commodity exporters to retain their export earnings34 BI reduced the reserve requirement ratio (RRR) for and adds a mandate for a retention of 30 percent of banks that lend to eligible sectors such as mineral these earnings in domestic banks for a three-month downstreaming, tourism, or MSMEs (Figure A.19). B.1. Preface period (see Box A.4). Additionally, BI also introduced a Second, BI extended the permission for 100 percent new short-term rupiah-denominated debt instrument loan-to-value ratios for mortgages and zero down in September named the SRBI (Sekuritas Rupiah Bank payments for car loans until the end of 2024. Third, BI Indonesia). This signals the end of BI’s ‘operation lowered the macroprudential liquidity buffer on IDR- denominated assets for conventional banks.38 These Development in twist’35, with the SRBI aimed at attracting liquidity (i.e. B.2. Climate & Indonesia portfolio inflows) back into short-term securities. measures are expected to help reverse the deceleration in private credit growth, which fell from 11.4 percent Building on the above efforts to attract FX inflows, (yoy) in December 2022 to 9.0 percent in September BI also raised the policy rate and introduced new 2023. BI’s use of liquidity instruments has proven to be Resilience & Growth FX-denominated instruments to the market. The highly effective (see Box A.5). of Decarbonization, B.3. A Virtous Cycle additional FX supplied by the domestic retention of export proceeds (US$1.9 billion) and SRBI issuances Figure A.19: RRR incentives initiated in October (US$0.6 billion) were not sufficient to offset recent (ppts of cut in RRR, by priority sector) capital outflows. As a result, the rupiah depreciated Maximum Lending in selected sectors despite BI FX intervention. In response, BI decided incentives (%) to raise its policy rate by 25-bps in October, taking it B.4. Economic Priority sectors (downstreaming, 2.0 Foundations to 6.0 percent. According to BI, the hike was a pre- Policy housing, tourism) emptive and forward-looking measure to mitigate Credit to MSMEs 1.0 the impact of imported inflation resulting from the Ultra-micro credit 0.5 rupiah’s depreciation. However, inflation and inflation Green property or vehicle credit 0.5 & Side-Effects of B.5. The Impacts expectations have been on a downward trajectory Climate Actions Total of max. incentives 4.0 throughout the year and well within the BI target Source: Bank Indonesia. 34 This new regulation effectively replaced an existing regulation i.e., Government Regulation 1/2019. Development Policy 35 Under operation twist, BI sold short-term and purchased long-term government securities. This was aimed at increasing short-term market rates (in B.6. A Climate & line with monetary tightening) and lowering long-term rates. Framework 36 Median inflation expectation hovered around 3.7 percent during August to October according to a survey of expert economic and financial forecast- ers in Indonesia by Consensus Economics Inc. 37 Essentially, these are the FX counterparts of SRBI. Unlike SRBI securities that are denominated in IDR, SVBI and SUVBI are denominated in US$. SVBI refers to conventional securities, while SUVBI denotes sharia-compliant securities. 38 From 6 to 5 percent of liquid assets denominated in IDR. 22 Indonesia Economic Prospects December 2023 BOX A.4 Contents Table of Earnings retention requirement for Indonesian commodity exporters The GoI recently introduced a partial export earnings retention requirement for commodity exporters. This measure requires commodity exporters to retain 30 percent of their foreign exchange earnings with the domestic Summary Executive banking sector for three months, with the goal of supporting the rupiah exchange rate and boosting available foreign reserves in Indonesia. There is no requirement to convert such foreign exchange earnings into Rupiah. However, GoI announced that non-compliance with the rule will be sanctioned by suspension of export activities. Exporters usually prefer parking earnings in offshore bank accounts, and some have expressed concerns of the Developments effect of such rules on capital mobility and cost of operation. A.1. Recent Economic Globally, surrender/expatriation requirements are an unconventional form of capital flow management and have been used sparingly by various countries during periods of stress. According to IMF classification, requirements to domestically retain export earnings are considered part of the capital flow management toolkit targeting outflows. Since 2000, there have been 15-20 instances of these requirements being deployed by a variety A.2. Policy of countries such as Argentina, The Bahamas, Congo, Iceland, Liberia, Malaysia, Sri Lanka, and Türkiye. These Stance requirements were usually deployed during periods of macroeconomic instability, capital outflows, inadequate foreign reserves, and a rapidly depreciating exchange rate. These measures come in different intensities and have different impact. The fraction of export earnings under A.3. Outlook and Risks such requirements varies and is sometimes coupled with the requirement to convert these export earnings into local currency. There is scant evidence on the effectiveness of these requirements due to their unconventional nature. However, studies of classical capital controls and related macroprudential measures have found some effects on volume and composition of flows and financial stability. There is a caveat though that these effects are not unequivocal, and evasions of controls could take many forms. It is usually advisable to withdraw such requirements B.1. Preface once the perceived macroeconomic imbalances and external pressure have subsided, and many countries have indeed only used such requirements as temporary measures. Bank Indonesia has been absorbing these retained export earnings through transaction mechanisms between BI, designated banks, and exporters. Exporters would open an account specifically for managing Development in B.2. Climate & Indonesia foreign exchange proceeds of exports at one of the 34 designated banks and place funds at BI in the form of FX term deposits through one of these banks. BI offers several incentives to attract fund placements, including FX interest rates, easing of macroprudential requirements for banks, as well as agent fees for banks. While it is unclear whether this action will affect the level of money supply, and hence entail sterilization costs, offering competitive interest rates relative to offshore bank accounts already entails costs for BI. As of October 2023, FX term deposits Resilience & Growth of Decarbonization, B.3. A Virtous Cycle worth US$1.9 billion have been recorded from 120 exporters and 16 banks, a small amount relative to the size of official foreign exchange reserves. It is important to address the root causes of exporters’ preference to hold export earnings abroad, which could include underdevelopment of the domestic financial sector. Indonesia lacks a deep and liquid market to hedge against interest rate and exchange rate fluctuations. Various legal and tax features also prevent the development of these hedging instruments. Therefore, domestic banks may find it difficult to manage currency B.4. Economic Foundations mismatches on their balance sheet and are unable to offer attractive returns to FX deposits. Exporters may also find Policy the lack of FX hedging options an obstacle to bringing export income back into the domestic financial system. The GoI has signaled a willingness to offer tax and interest rate incentives for exporters’ deposits in domestic banks. This could make the retention requirement more palatable for corporates. Nevertheless, over the medium term, tackling the root causes of the underdevelopment of the domestic financial sector will be important in attracting & Side-Effects of B.5. The Impacts Climate Actions export earnings back to Indonesia. The implementation of the financial sector omnibus law is a major step towards this objective. Development Policy B.6. A Climate & Framework 23 Indonesia Economic Prospects December 2023 Contents BOX A.5 Table of Multiple monetary instruments to balance inflation, growth, and external stability BI has used multiple instruments since last year to influence money supply. Before launching the series of rate Summary Executive hikes in August 2022, BI had raised the reserve requirement ratio for banks by 550 bps over February-September 2022. BI had also performed reverse repo transactions that withdrew about IDR 36.6 trillion (0.4 percent of the broad money) from banking system liquidity in 2022. This year, the announcement of RRR discounts and the SRBI as the new monetary sterilization instrument also came before the October rate hike. Developments A.1. Recent Economic After the pandemic, BI needed to absorb the liquidity created from temporary monetary financing of the budget deficit. During the pandemic, BI and the Ministry of Finance collaborated on a special burden-sharing mechanism involving BI’s purchases of government securities (SBN) in the primary market. The underlying objective was for the central bank to expand the monetary base (‘printing money’) to finance the larger fiscal needs during the COVID-19 downturn. Between 2020 and 2022, BI’s SBN purchases in the primary market amounted to IDR 973 A.2. Policy trillion (5.9 percent of GDP). Consequently, BI’s assets also expanded by the same size, from 27.7 to 33.5 percent of Stance GDP. This also translated to a rise in broad money (M2), from 38.8 percent to 43.5 percent of GDP. The economic recovery and the surge in inflation globally prompted BI to stop monetary financing and gradually mop-up excess liquidity post-COVID. A.3. Outlook Liquidity management tools complement Bank Indonesia’s policy rate decisions to influence borrowing, and Risks spending, and foreign investor decisions. The monetary transmission channel refers to how changes in the policy rate affect bank lending rates. For example, as the policy rate is reduced, bank lending rates are expected to decline as well, which should, in turn, stimulate private borrowing and investment growth. Ideally, changes in the BI 7-day reverse repo rate (BI7DRR)—as the policy rate—will be transmitted to the overnight interbank rate39, then further B.1. Preface transmitted to bank lending rates. However, empirical evidence indicates that there are constraints to interest rate passthrough in Indonesia. While policy rate changes are completely passed on to the interbank rate, banks adjust their lending rates much more slowly (longer than six months) and partially (Figure Box A.5.1). As a result, credit volumes are found to be far Development in B.2. Climate & less sensitive to changes in policy rates. Indonesia Figure Box A.5.1: The response of interest rates and lending volumes to a change in the policy rate (vector autoregression (VAR) impulse responses, monthly observations) Resilience & Growth of Decarbonization, B.3. A Virtous Cycle B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Source: Bank Indonesia and World Bank staff calculations. Note: VAR model uses monthly data between August 2016 (the start date of BI7DRR as the policy rate) to June 2023. Interest rates are nominal levels, credit volumes are in natural log. Lending rates are the weighted average of rates for working capital loans, consumer loans, and investment loans. Lag order selection: 3 months. IRF = impulse response function. Development Policy B.6. A Climate & Framework 39 The interbank rate serves as the operational target of monetary policy, as the money market is the first link in the chain of monetary transmission. This analysis uses the Overnight Jakarta Interbank Offered Rate (O/N JIBOR) as a proxy for short-term money market rate. 24 Indonesia Economic Prospects December 2023 The slow and partial interest-rate passthrough speaks to the importance of improving financial intermediation. Contents Table of Indonesia’s banking system has had historically high intermediation costs when compared to emerging market peers. Net-interest margins (NIMs)40 of commercial banks, a commonly used measure of intermediation efficiency, are structurally higher In Indonesia than in peer countries. Between 2019-2021, Indonesia’s NIMs hovered around 5.1 percent, higher than the average of EAP peers at 3.5 percent. Similarly, interest rate spreads41 in Indonesia Summary Executive have remained relatively high by international standards (see IEP June 2022). Lack of competition, weaknesses in the institutional environment, and operational inefficiencies are likely to contribute to the weak intermediation efficiency. To strengthen the intermediation efficiency, factors such as competition, institutional environment and operational efficiencies could contribute better when they are improved. Further, for the effectiveness of interest Developments instruments, informality needs to be reduced and MSMEs access to credit to be strengthened. A.1. Recent Economic Banking sector vulnerabilities remain low, occurs in tandem with the recovery in bank lending. liquidity buffers adequate, and profitability fully Growth of lending to the private sector recorded 9.0 recovered thanks to growing lending to the private percent yoy in September (Figure A.21). Although the A.2. Policy Stance sector. double-digit credit growth numbers seen between June 2022 and February 2023 are not expected to be Banking sector asset quality remains high, and sustainable given normalizing domestic demand and banks have enough buffers to withstand adverse BI’s tightening of monetary policy, the banking sector A.3. Outlook and Risks shocks. The system-wide non-performing loans is still providing healthy support to the economy. (NPL) ratio stands at 2.4 percent as of September Furthermore, as of August, lending to MSMEs stood 2023 (Figure A.20). The banking sector has adequate at IDR 1,412 trillion and accounted for 21 percent of buffers to withstand adverse shocks. The capital all bank lending. This is an increase from the lower B.1. Preface adequacy ratio (CAR) is 27.4 percent, well above the baseline of 18 percent observed during the pandemic. Basel III minimum requirement of 10.5 percent. The These developments suggest that the banking sector level of provisioning is 206.3 percent of NPLs (August has clearly moved away from the state of low profit, 2023), also providing ample loss-absorption capacity. weak lending, and excessive liquidity seen during the Development in Notably, the system-wide loan at risk (LAR) ratio—a COVID-19 period. B.2. Climate & Indonesia forward-looking indicator of bank asset quality42 —has been trending downwards since the pandemic years System-wide funding and market liquidity43 are and stands only at 12.1 percent in September. Only one ample from a supervisory perspective, although out of the nine largest banks has a LAR ratio of more funding liquidity has declined in tandem with rising Resilience & Growth of Decarbonization, B.3. A Virtous Cycle than 20 percent. Although a limited set of forbearance bank lending. The liquidity coverage ratio and the net measures are extended until March 2024, the report stable funding ratio, designed to gauge bank liquidity estimates that any vulnerabilities that remain hidden conditions in times of stress, stood at 230 percent and due to these measures can in principle be contained 136 percent respectively in June 2023. Both are above and are unlikely to be systemic for the overall banking the 100 percent regulatory minimum. Furthermore, system. These measures affect only a small portion of the government bond market is functioning properly. the loan portfolio and any potential increase in NPLs is While the loan-to-deposit ratio remains stable at 83.9 B.4. Economic Foundations small relative to the buffers. percent, the liquid asset to deposit and short funding Policy ratio has seen a consistent decline since 2021. It Banking sector profitability has fully recovered as reached 17.9 percent in August 2023, below EAP peer lending growth continues to pick up. Bank profits countries. These developments indicate that funding & Side-Effects of B.5. The Impacts Climate Actions have been recovering since late 2021 and have now and market liquidity remain ample. The decline in the recovered all lost ground. Return-on-assets (ROA) and liquid asset ratio, while reflecting banks’ increasing return-on-equity (ROE)—common indicators of bank willingness to lend instead of hoarding excess liquidity, profitability—stood at 2.7 percent as of September 2023 warrants close monitoring for potential funding stress and 15.0 percent as of August, respectively, surpassing in the event of an adverse shock. pre-pandemic levels. The recovery in profitability Development Policy B.6. A Climate & Framework 40 Defined as banks total interest income minus total interest expenses divided by total assets. 41 Defined as interest income as a proportion of loans minus interest expenses as a proportion of deposits. 42 LAR is defined as the sum of NPLs, restructured loans, and special mention loans. 43 Funding liquidity concerns the banking sector’s ability to repay deposits and other short-term liabilities and is inherent to maturity transformation. Market liquidity refers to the ability of the banking sector to sell assets in a timely fashion with significant loss of value. 25 Indonesia Economic Prospects December 2023 Figure A.20: NPL, CAR, Tier-1 capital and provisioning Figure A.21: Lending to the private sector is healthy Contents Table of (percent) (percent) Working Capital Investment NPL (LHS) CAR (LHS) 18 Consumption Total Loan Tier-1 Capital (LHS) Provision to NPL (RHS) Summary Executive 15 30 230 12 25 210 9 20 6 Developments A.1. Recent 15 190 3 Economic 10 0 170 -3 5 -6 0 150 May-20 May-21 May-22 May-23 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 A.2. Policy May-20 May-21 May-22 May-23 Jan-20 Sep-20 Jan-21 Sep-21 Jan-22 Sep-22 Jan-23 Sep-23 Stance Source: The Financial Services Authority (OJK). A.3. Outlook 3. The Outlook and Risks and Risks Indonesia is projected to post robust growth keeping inflation within their target range. Looking throughout the outlook period, though easing ahead, inflation is projected to average 3.0 percent B.1. Preface a little as the commodity boom loses steam. The during 2025-2026. economy is projected to grow by 5.0 percent in 2023, before easing slightly to an average of 4.9 percent The external position is expected to become over 2024-2026, reflecting softer terms of trade and more challenging due to slowing trade and global a normalization towards trend growth (Table A.1). financing pressures. Services exports will benefit Development in B.2. Climate & Private consumption will be the primary driver of though from a continued recovery in tourism. The Indonesia growth supported in 2024 by election-cycle spending. current account is expected to record a small deficit Public consumption growth will account for a planned in 2023 and gradually expand to -1.4 percent of GDP civil servant salary raise in 2024 and will continue by 2026, as lower commodity prices and weaker to be supported in subsequent years as the new global growth hamper exports (Table A.1). FDI will Resilience & Growth of Decarbonization, B.3. A Virtous Cycle administration programs get underway. Investment remain the largest source of external financing as is expected to pick up pace over the outlook on the competitiveness reforms yield results and recent back of earlier reforms and new government projects. industrial downstreaming efforts attract new projects. Exports and imports are expected to grow only BI’s monetary stance will continue to be geared modestly, as volumes are already elevated following towards guarding against rapid or excessive capital very strong growth over 2021-2022. outflows. It will have lesser leeway though with the B.4. Economic Foundations tighter revised inflation targets. Consequently, foreign Policy Inflation is projected to decline further and remain currency reserves are projected to remain adequate within BI’s revised target band. Headline inflation and above 6 months of imports. is projected to average 3.7 percent in 2023 and ease further to 3.2 percent in 2024 (Table A.1). This remains The fiscal stance is expected to remain conservative & Side-Effects of B.5. The Impacts Climate Actions well within BI’s inflation target band, which is being with additional spending financed by revenues revised from 3.0 percent ±1 to 2.5 percent ±1 in 2024. gains. The fiscal deficit is projected to average 2.3 Correspondingly, inflation expectations are expected to percent in 2024-2026 (Table A.1). Total revenues to remain well-anchored within this range. Falling inflation GDP will slowly pick up as the effects of tax reforms reflects broader softening in commodity prices and materialize, despite remaining below pre-pandemic Development Policy B.6. A Climate & normalizing domestic demand, notwithstanding some levels (averaging 12.6 percent of GDP for 2024-2026). Framework continued upside pressure on food prices due to El Non-tax revenues are expected to ease in line with Nino effects. Moreover, with the output gap estimated lower commodity prices. At the same time, spending is to close in 2024, the authorities remain committed to expected to remain tight but gradually return to pre- 26 Indonesia Economic Prospects December 2023 pandemic levels, averaging 14.8 percent of GDP for to EMs. While a reinvigorated Chinese economy 2024-2026. The subsidies bill is forecast to continue could temper recent trends in global supply-chain Contents Table of decreasing as assistance shifts towards more targeted diversification and sap the momentum from the recent social spending. Public investment—including manufacturing resurgence in Indonesia. Domestically, investment finance—is expected to pick up after the with a changing administration in 2024, there is Summary Executive election year with the new administration likely pushing risk of losing momentum in the implementation of to make a mark through infrastructure projects. Gross competitiveness-boosting structural reforms, which fiscal financing needs will decline and average 4.5 can impact growth. percent of GDP yearly. They are expected to be broadly met through the domestic market, but at a rising cost. With resilient macroeconomic underpinnings and Developments A.1. Recent Economic Given global prospects of higher-for-longer borrowing the end of the post-COVID recovery cycle, the policy costs, interest payments are therefore forecast to rise focus turns again to the growth agenda. Indonesia on average by 6.0 percent yearly between 2024-2026, has a credible policy track record of navigating accounting for 13.4 percent of the total expenditures.44 downside risks and maintaining macroeconomic stability. The country’s small twin deficits, low public A.2. Policy Stance The outlook is subject to several mostly external debt, adequate FX reserves, stable external financing, downside risks. Higher-for-longer interest rates could and steady growth performance constitute robust weigh on global demand, elevate borrowing costs, macroeconomic buffers for responding to shocks. and tighten access to external financing. Deteriorating Going forward, the challenge is to build on these A.3. Outlook and Risks global conditions—including geopolitical uncertainty strong macroeconomic fundamentals to deliver and climate change related shocks—could disrupt faster, greener, and more inclusive economic growth. global value chains and induce a sharper decline in the A core pillar of such a growth agenda are reforms terms of trade, resulting possibly in lower revenues and that address structural bottlenecks in the economy B.1. Preface a tighter fiscal position for Indonesia. A hard landing of that limit efficiency, competitiveness, and productivity the US economy at the end of its current monetary growth. This will be essential if Indonesia is to have tightening cycle would likewise dampen commodity a chance at achieving its vision of becoming a high- prices but could also see capital flows swing back income country by 2045. Development in B.2. Climate & Indonesia Resilience & Growth of Decarbonization, B.3. A Virtous Cycle B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 44 This is up from an average of 9 percent in 2010-2019. The share has been increasing since 2014. 27 Indonesia Economic Prospects December 2023 Table A.1: Selected Macroeconomic Indicators Contents Table of 2019 2020 2021 2022 2023 2024 2025 2026 Actual WB projection Real GDP growth and inflation, percent change Real GDP 5.0 -2.1 3.7 5.3 5.0 4.9 4.9 5.0 Summary Executive Consumer Price Index (CPI) (average, %) 2.8 2.0 1.6 4.2 3.7 3.2 3.0 3.0 Consumer Price Index (CPI) (end of period, %) 2.6 1.7 1.9 5.5 2.7 3.3 2.8 2.7 Private Consumption 5.2 -2.7 2.0 4.9 4.9 4.9 4.8 4.9 Developments Government Consumption 3.3 2.1 4.2 -4.5 5.0 4.3 3.5 3.5 A.1. Recent Economic Gross Fixed Investment 4.5 -5.0 3.8 3.9 4.6 4.5 5.4 5.9 Exports -0.5 -8.4 18.0 16.3 1.2 4.1 3.9 3.5 Imports -7.1 -17.6 24.9 14.7 -0.3 2.1 3.0 3.5 Fiscal accounts, central government, percent of GDP A.2. Policy Stance Revenues 12.4 10.7 11.8 13.5 12.6 12.4 12.6 12.7 of which Tax Revenue 9.8 8.3 9.1 10.4 10.0 10.1 10.3 10.4 Expenditures 14.6 16.8 16.4 15.8 14.7 14.6 14.8 15.0 Primary Balance -0.5 -4.1 -2.5 -0.4 -0.1 -0.3 -0.3 -0.4 A.3. Outlook and Risks Fiscal Balance -2.2 -6.1 -4.6 -2.4 -2.1 -2.3 -2.3 -2.3 Central Government Debt (a) 30.2 39.4 40.7 39.5 38.7 38.1 37.8 37.3 Balance of Payments, percent of GDP unless indicated otherwise B.1. Preface Current Account Balance -2.7 -0.4 0.3 1.0 -0.1 -0.7 -1.2 -1.4 Exports, Goods and Services 17.9 16.8 20.8 23.9 21.4 20.7 20.5 20.2 Imports, Goods and Services 18.2 15.1 18.3 20.7 19.5 19.1 18.9 18.9 Net Foreign Direct Investment 1.8 1.3 1.5 1.1 1.0 1.3 1.5 1.5 Development in Gross Reserves B.2. Climate & 9.7 7.5 6.4 6.3 6.0 6.1 6.2 6.4 Indonesia (months of imports of goods and services) Terms of Trade (index, 2018=100) 95.8 97.8 106.4 108.0 101.0 98.3 96.9 95.6 Memorandum items Nominal GDP (IDR trillion) 15,833 15,443 16,977 19,588 21,449 22,902 24,531 26,361 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Per Capita GDP (US$) 3,877 3,757 3,856 4,021 4,182 4,347 4,521 4,709 B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 28 B. Climate Action as a Catalyst for Development Indonesia Economic Prospects December 2023 Contents Table of B. Climate Action as a Catalyst for Development Summary Executive Developments A.1. Recent Economic 1. Preface Indonesia has made important commitments as policies that enable and incentivize firms and workers A.2. Policy well as progress towards reaching its climate and to participate in a greener economy. Such ‘enabling’ Stance development targets. Indonesia has a strong track actions are key underlying drivers of productivity record of growth and poverty reduction. However, and allocative efficiency. Analysis suggests that these development gains have also contributed to rising can help to reduce the short-term tradeoffs between A.3. Outlook greenhouse gas (GHG) emissions. In response, emissions cuts and economic growth, while also help and Risks Indonesia has set out a new path in its Long-Term to boost the long-run growth rate of the Indonesian Strategy for Low Carbon and Climate Resilience (LTS- economy. They include reforms to: LCCR) 2050 (Republic of Indonesia, 2022).45 As stated in the Low Carbon Development Initiative, Indonesia • The fiscal framework, which can help address B.1. Preface is looking for ways to “maintain economic and social market failures in mitigation and adaptation, raise growth through development activities with low GHG revenues, and provide buffers during the low- emissions and minimizing the exploitation of natural carbon and climate-resilient transitions. resources” (Bappenas 2021). In line with these plans, • The financial system, which can help raise and Development in B.2. Climate & ongoing efforts are helping to slow GHG emissions channel savings for mitigation and adaptation and Indonesia while maintaining economic growth and strengthening lessen financial uncertainty. resilience. • Trade policies, which can help facilitate green exports and imports, move Indonesia toward the Part B of the IEP explores options for Indonesia to green technology frontier, and modify incentives Resilience & Growth of Decarbonization, B.3. A Virtous Cycle further progress towards its climate targets whilst for carbon-intensive commodity production. achieving higher GDP growth over the long-term. Based on the World Bank’s Country Climate and Following a description of these enablers, the IEP Development Report (CCDR) for Indonesia,46 the IEP presents modelling which demonstrates growth- first presents a framework that links the supply of enabling possibilities from the low carbon transition. carbon-intensive resources (such as land and primary The IEP concludes with a set of policy options that B.4. Economic Foundations energy) to the demand for those resources by the could support reforms. The IEP does not take a Policy major drivers of growth (for example, electricity, position on what Indonesia’s climates targets should industry, transportation, urban expansion, agriculture, be. It acknowledges the principle of common but and forestry). Policies to reduce the supply of, and differentiated responsibility47 and assesses options for demand for, carbon resources will be necessary for Indonesia to efficiently meet its own targets while also & Side-Effects of B.5. The Impacts Climate Actions the low-carbon transition. Yet in addition to such furthering its development goals. sector-specific efforts, the transition requires economic Development Policy In the context of the international Paris Agreement on climate change, a long-term strategy is a formal document a country uses to communicate its B.6. A Climate & 45 Framework plans for long-term low-emission development. 46 World Bank Group (2023). Indonesia Country Climate and Development Report. Washington, D.C. (link). 47 The common but differentiated responsibilities principle is formalized within the United Nations Framework Convention on Climate Change (UNFC- CC). It recognizes that all countries have a shared obligation to address climate change but that responsibility for addressing the issue differs between countries, given different capabilities and historical contributions. 30 Indonesia Economic Prospects December 2023 2. Climate and Development in Indonesia Contents Table of 2.1. Development Transitions and Carbon Emissions Indonesia has experienced important development considerably in the past 7 years. Deforestation and transitions over the past 25 years involving rapid fires accounted for about 42 percent of total emissions Summary Executive and positive change in a short period of time. between 2000-2020 (Figure B.2).51 Agriculture Since 1997, Indonesia has seen rapid change in its and forestry activities were the primary drivers physical capital stock; access to electricity (67 percent of deforestation, notably export-oriented timber of the population in 1995 to 99 percent in 2021); extraction, and pulp and paper plantations which Developments A.1. Recent Economic urbanization (36 percent of the population in 1995 to expanded rapidly from the 1980s-90s, and oil palm, 58 percent in 2022); and non-agricultural employment which followed in the 1990s-2000s (Tsujino, et al. 2016). (57 percent of employment in 2006 to 71 percent in These activities impacted carbon-rich ecosystems such 2021). There are many other examples, including the as peatlands—partially flooded lowland areas with major political and governance changes of reformasi carbon-rich soils.52 More recently, deforestation has A.2. Policy Stance and decentralization. Economic growth over this slowed considerably thanks to government policies period averaged five percent per year—contributing such as the permanent moratorium on the clearing to income convergence relative to peer countries48 of primary forest and peatland, and investments in that accelerated rapidly since 2009. The poverty rate peatland rewetting and reforestation, among other A.3. Outlook concurrently fell from 19 percent in 2000 to 9.5 percent measures (MoEF, 2022). Deforestation fell from an and Risks by 2022.49 average of 1.08 million hectares (ha) per year between 2000-2007 to an average of 0.11 million ha per year in Indonesia’s transition to a low-carbon and climate- 2019-2022, the lowest rates since 1990 (Figure B.3). B.1. Preface resilient economy is a transformation that could define the next phase of economic growth and Primary energy supply (i.e., coal, oil, gas) is the poverty reduction. Historically, economic gains have second largest source of GHG emissions. Energy meant rising GHG emissions. Indonesia accounts for accounted for about 39 percent of emissions between about 3.5 percent of global emissions.50 Indonesia 2000 and 2020. About 93 percent of the primary Development in B.2. Climate & Indonesia has the 4th largest population and the 16th largest energy supply comes from fossil fuels, namely coal economy, and accounts for 1.25 percent of the (43 percent), oil (31 percent), and gas (19 percent). world’s gross domestic product (GDP). Indonesia’s The share of coal in Indonesia’s energy mix increased emissions—1,495 million tonnes of carbon dioxide over the two decades to 2019. About 80 percent of (CO2) equivalent (MtCO2eq) annual average in 2018- Indonesia’s coal is exported, three quarters of which Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 2020—are high compared to structural peers in is to India, China, Japan, the Philippines, and Malaysia. absolute terms, although per capita emissions in The share of renewables was low (10-15 percent) recent years have been in line with those of other over most of the past two decades but has increased large developing economies, and lower than those slightly in the past six years. Expansion of the grid of developed economies (Figure B.1). The challenge has supported electrification and the development for Indonesia and other large developing economies of the manufacturing sector (which accounts for B.4. Economic Foundations is how to decouple growth and GHG emissions. No about 40 percent of Indonesia’s total energy demand; Policy country has transitioned to high-income status while Setyawan, 2020). Growth in manufacturing and the also reducing emissions, yet this is the challenge grid’s increasing emissions intensity contributed to implicit in the low-carbon transition. increase the sector’s overall emissions. However, there are also clear trends toward greater energy efficiency & Side-Effects of B.5. The Impacts Climate Actions Historically, much of Indonesia’s GHG emissions in manufacturing which have helped mitigate larger came from land-based sources, which have slowed potential increases in emissions. 48 Analysis in this IEP uses a standard set of peers where data is available: Nigeria, China, India, Ukraine, Thailand, the Philippines, Mexico, the Arab Development Policy B.6. A Climate & Republic of Egypt, the Russian Federation, and Brazil. They are selected based on their statistical similarity in terms of population, GDP per capita, and Framework total GDP. An additional set of aspirational peers is also used when relevant: Republic of Korea, Chile, Poland, and the Czech Republic. In some instanc- es, industrialized countries are also used as comparisons when discussing emissions levels and targets. 49 National (government) poverty rate in March, 2022. Other statistics as per World Bank databank (link). 50 Climate Watch. “Data Explorer.” Emissions values are for 2018 and include forestry and land use, and all major greenhouse gases (link). 51 Total of forest, land use, and peat fire emissions between 2000-20 as a proportion of total emissions (MoEF 2021 data). 52 Carbon stored in Indonesia’s peatlands is estimated at 13.6 to 40.5 billion tons of carbon, one of the largest biological carbon stores on Earth. Clear- ing vegetation on peatlands and draining their waterlogged soils causes fires and also allows carbon soil stocks to oxidize, releasing carbon dioxide. 31 Indonesia Economic Prospects December 2023 Figure B.1: Per capita emissions remain below those of major industrialized economies and in line with developing country peers Contents Table of Per capita GDP (PPP constant 2017) vs. Per capita emissions (all GHG, tCO2eq) (1990-2019) 25 Summary Executive United States 20 Per capita emissions Developing economies Industrialized economies 15 10 Nigeria Japan Germany Developments China A.1. Recent Italy Economic Indonesia 5 Thailand United Kingdom India Brazil France 0 Philippines Mexico 0 10,000 20,000 30,000 40,000 50,000 60,000 Per capita GDP A.2. Policy Stance Figure B.2: Forest and peat-related emissions historically accounted for about 42 percent of emissions and are slowing A.3. Outlook and Risks Indonesia GHG emissions by sector, 2000-2020 (MtCO2e) Energy IPPU 2300 Agriculture FOLU Peat Fire Waste 1800 B.1. Preface 1300 800 Development in B.2. Climate & 300 Indonesia -200 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: MoEF 2021 emissions data. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Note: FOLU = Forestry and Other Land Uses; IPPU = Industrial processes and product use. Figure B.3: The rate of deforestation has fallen in recent years 1.2 Annual Deforestation (mil.ha) B.4. Economic Foundations 1 Policy 0.8 0.6 & Side-Effects of B.5. The Impacts Climate Actions 0.4 0.2 0 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2018-19 2019-20 2020-21 2021-22 Development Policy B.6. A Climate & Framework Source: MoEF 2022 data, figure compiled by WBG staff, based on years for which annual data is available. 32 Indonesia Economic Prospects December 2023 2.2. Decarbonization and Adaptation to Deal with Climate Change and Shocks Contents Table of Building resilience through adaptation capacity is no longer record months of surplus water,56 more than also critical given the rising incidence of climate double the number in 2010. Overall, a lack of water shocks, as recognized in the authorities’ climate availability is projected to result in 2.5 percent lower Summary Executive strategies. The global nature of climate change GDP by 2045 in the absence of adaptation measures means that adaptation measures will be necessary (World Bank 2021a). Meanwhile, agriculture is also (irrespective of mitigation efforts), to avoid large vulnerable, with implications for food and nutrient drops in economic output and household welfare. security. At the national level, rising temperatures and Developments Between 1990-2021, Indonesia experienced more than shifting rainfall are projected to reduce yields of several A.1. Recent Economic 300 natural disasters—including 200 flooding events production systems key to poverty reduction and food affecting more than 11 million people. The frequency security—including rice (-0.72 percent by 2030), maize of these disasters is increasing (Figure B.4)—with (-7.1 percent) and palm oil (-1.21 percent), according climate-related disasters accounting for approximately to modelling by IFPRI, Bappenas, and ADB (2019). 70 percent of the total. These trends are expected to Yield-enhancing measures and investments in climate- A.2. Policy Stance continue. Rising sea surface temperature is associated resilient agriculture will help offset these declines. with greater severity of tropical cyclones, while heavier rainfall will exacerbate floods and landslides. More At the same time, the transition to a low-carbon frequent El Niño events are likely to increase drought economy also poses challenges. Indonesia aims to A.3. Outlook and Risks and fire risks for Indonesia’s agriculture and forestry balance a phase-down of coal use with rising electricity sectors (although Indonesia has made significant demand. International coal demand and prices have progress on fire prevention53). The Government’s risen since the start of the war in Ukraine, while Disaster Risk Pooling Fund (Pooling Fund Bencana)— tightening global monetary policy impacts the cost of B.1. Preface which helps to cover contingent liabilities from financing the low-carbon energy transition. Increased disasters—and an expanded social protection system, protection of forests and peatlands will constrain some are some of several measures that will help increase forms of agriculture—requiring a boost to yields and national resilience at a systems level. a shift of production toward already degraded land to Development in B.2. Climate & allow for continued growth. Real sector impacts will Indonesia Key impacts of climate change and climate shocks affect the banking system given that almost three- include water scarcity and agricultural productivity. quarters of Indonesia’s bank loan portfolio comprises Intensification of both rainfall and drought are sectors that will be impacted by decarbonization expected—with parts of Sumatra and Kalimantan policies (Figure B.5). These challenges are magnified by Resilience & Growth of Decarbonization, B.3. A Virtous Cycle 10-30 percent wetter by 2080 from December to the relatively small size of Indonesia’s financial sector February, and islands below the equator anticipating in terms of its total assets and private credit relative to a 15 percent decline in precipitation.54 In a context of GDP (World Bank 2022). increasing water demand55 the net effect will be one of scarcity: by 2050, 31 percent of Indonesia’s districts will B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions 53 Indonesia has made significant progress on fire prevention through reduced deforestation, zero-fire land clearing policies, extensive peat rewetting, Development Policy B.6. A Climate & and faster deployment of emergency funding in recent years. Fire incidence was much lower in 2020 and 2021 than in 2018 and 2019 (MoEF data, Framework Forest and Land Fire Early Warning and Detection System). Longer timeseries (MODIS Burned Area satellite data) also shows a declining trend in fire extent (2001-2021). 54 World Bank Climate Change Knowledge Portal: Mean Climate Projections (link). 55 Water demand is projected to increase by 31 percent between 2015 and 2045. See World Bank 2021a. 56 Months of surplus water is a key indicator of water scarcity and refers to excess water available in a system. See WBG and ADB 2021. 33 Indonesia Economic Prospects December 2023 Figure B.4: Rising incidence of climate-related disasters Figure B.5: Lending exposure of Indonesian banks to transition-sensitive sectors is high Contents Table of Meteorological, hydrological and climatological Distribution of non-transition and transition 30 disaster incidence in Indonesia, 1990-2020 sensitive loans Disaster events (number) Financial intermediaries Electricity, Gas and Water Mining and Summary Executive 5% 5% Quarrying 20 Real Estate, Business, 4% Ownership, and Business Services 7% Non-transition Transportation, sensitive sectors 10 Warehousing and 26% Developments Communications A.1. Recent Economic 8% 0 Construction 10% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 Agricultures, Hunting and Forestry Procesing Industry Drought Flood Landslide Storm Wildfire 11% 24% A.2. Policy Stance Source: Data from the international Emergency Events Database (EM- Source: IMF Climate Change Dashboard (2021). DAT), figure compiled by WBG staff. Notes: Transition-sensitive sectors are those with either high absolute emissions, high emission intensities, high exposure to emission-intensive sectors, or are expected to be directly affected by climate policies. A.3. Outlook and Risks 3. A Virtuous Cycle of Decarbonization, Resilience, and Growth, Building on Existing Reforms B.1. Preface Indonesia’s ongoing and future reforms could This will require a reduction in demand for those support a just and affordable transition through resources (for electricity, agriculture, urban expansion, positive climate and development dynamics (Figure transport, industry, and trade) that require reforms B.6). A reduction in the supply of carbon-intensive to incentivize more efficient use of resources (for Development in B.2. Climate & resources (land and non-renewable energy) can be example, through carbon pricing and spatial planning) Indonesia supported through policy and institutional reforms, or alternative resources (for example, renewable some of which are already in place or underway. energy). Complementing these measures with Figure B.6: Dynamics between resource supply and demand, emissions, and growth Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Supply Demand 4. Demand policies Primary resources Final resources Growth drivers 3. Resource demand Agriculture and Forestry B.4. Economic 7. Climate Foundations 6. Economic growth impacts Land Policy 1. Resource Urban expansion supply Electricity & Side-Effects of B.5. The Impacts Climate Actions 9. Wealth 2. Supply 8. Development Coal Industry accumulation policies costs Fossil fuels, biofuels Transportation Oil and Gas Development Policy B.6. A Climate & Framework International trade Source: Figure compiled by WBG staff. Note: The left-hand side illustrates the interactions between resource supply and demand and how these influence climate and development outcomes. The supply of carbon-rich resources (1) is influenced by supply-side policies (2). The demand for those resources (3) is influenced by demand-side policies, such as carbon pricing (4). Use of these resources drives economic growth (5) as well as emissions (6). They also contribute to factors which pose costs on development, such as air pollution (7). The net effect determines wealth accumulation (8), which is critical for long term economic growth. The right-hand side presents key economic sectors that supply and demand land and energy. 34 Indonesia Economic Prospects December 2023 enabling economic policies—the focus of the next and adaptation plans, could thus support Indonesia’s section—can help allocate resources to greener and transition from a middle- to high-income country. Contents Table of more productive parts of the economy. A combination of these measures could help decouple growth This cycle is consistent with the government’s from carbon emissions which could strengthen the policy and institutional reforms program. Indonesia Summary Executive economy’s resilience to a rising incidence of climate has committed to cutting emissions as part of its NDCs impacts (that is, higher temperatures, sea level rises, under the 2015 Paris Agreement. Indonesia’s Enhanced and flooding). This could help reduce the development NDC, released in September 2022, sets out an costs of climate shocks (for example, physical damage, unconditional 31.9 percent reduction in emissions human capital loss). against business-as-usual (BAU) projections by 2030, Developments A.1. Recent Economic and up to a 43.2 percent reduction conditional on This virtuous cycle could help accelerate growth international support (Figure B.7).57 It proposes actions in Indonesia’s national asset base, which includes across the economy, including for energy, agriculture, human capital, physical capital, and natural capital. industrial, waste, and FOLU sectors. Estimated per capita Total wealth increased between 1995 and 2018 through emissions under the Enhanced NDC’s unconditional A.2. Policy Stance a buildup of human and physical capital (World target are projected to be 6.5 tCO2eq per year in 2030, Bank, 2021b). However, comparison to structural lower than most other large economies including peers suggests that there is scope to accelerate Brazil, China, Japan, and the United States (Figure B.8). overall wealth accumulation and thus to accelerate A.3. Outlook and Risks wealth convergence with high income countries. The The government’s plans further include longer- natural capital stock has increased over this time but term emissions trajectories toward a net-zero has involved a reduction in the stock of renewable target by 2060 or earlier. The LTS-LCCR is a detailed resources on the one hand (like forests) and increased roadmap that demonstrates the technical feasibility B.1. Preface dependence on non-renewable resources on the other of a low-carbon trajectory, reaching 1.61 tCO2eq per (like coal). The accumulation of human capital stock capita emissions by 2050 under its low-carbon strategy also has scope to accelerate. Accumulation of capital scenario (aligned with the Paris Agreement).58 While stocks, including productive natural resources, human the NDC is a quantitative commitment, the LTS is a resources, and physical infrastructure are long-term longer-term vision that demonstrates possibilities and Development in B.2. Climate & Indonesia determinants of economic growth. Actions which pathways. The net-zero vision—and pathways toward contribute to capital accumulation, including many of it—are further mapped out by the government’s LCDI those which are embodied in Indonesia’s mitigation (Bappenas 2021a). Resilience & Growth of Decarbonization, Figure B.7: Conditional and unconditional 2030 NDC Figure B.8: Per capita emissions of major economies B.3. A Virtous Cycle targets under stated targets Emissions (MtCO2eq) by major emitting sector, Projected per capita emissions (tCO2eq per year) 35 2019, and 2030 (NDC targets) in line with stated commitments 2500 China 30 United States 2000 Canada EU B.4. Economic 25 Foundations 1500 India Policy Russia 1000 20 USA Japan 500 15 Russia Brazil 0 Indonesia & Side-Effects of Brazil B.5. The Impacts Climate Actions 10 South Rep. Korea Korea Unconditional Conditional -500 Canada target target 5 China Indonesia 2019 2030 0 India Energy Industry Agriculture Forestry Waste 1990 2000 2010 2020 2030 2040 2050 2060 2070 Development Policy B.6. A Climate & Source: Indonesia Enhanced NDC and MoEF data (2022). Figures compiled by WBG staff. Framework 57 The Ministry of Finance (MoF) estimates the required international support at about US$114 billion. See Ministry of Finance (2021). 58 LTS-LCCR extends the unconditional 2030 commitment through three scenarios: (i) current policies, where emissions will continue to increase after 2030; (ii) transition, where emissions will decrease but are insufficient to reach the 2050 target; and (iii) low-carbon, where emissions will decrease rapidly after 2030. See Republic of Indonesia 2021. 35 Indonesia Economic Prospects December 2023 These targets are supported in the short term Figure B.9: The Land Use Policy Framework: A through ambitious action in the FOLU sector (Figure Chronology Contents Table of B.9). The government aims to make FOLU a carbon sink by 2030 (i.e., negative net emissions) under Decentralization of many land use decisions to districts 1998 Law 41 on Forestry: Established Indonesia’s system its flagship FOLU Net Sink 2030 Plan.59 Stipulated Elimination of restrictions on plywood exports Tariff reductions on roundwood and sawn for managing forests in terms of conservation, 1999 protection, and production Summary Executive Timber exports actions to achieve these goals include restoring 2.7 million hectares (ha) of peatlands, rehabilitating 5.3 2005 InPres 4: Accelerating action against illegal logging PP 6: On forest administration, million (ha) of degraded forestlands, and continuing management, planning, and utilization 2007 PermenLHK 2: Non-tax state revenue from forest utilization recent progress in reducing deforestation and forest 2008 PermenLHK 68: on REDD demonstration activities Permentan 14: Peat for oil palm plantation degradation rates (see Figure B.3. above). MoEF Developments PermenLHK 36: Licensing procedures for carbon 2009 A.1. Recent Economic sequestration projects in production and revoked 3.1 million (ha) of forest concession licenses Protection Forests Establishment of REDD+ Task Force 2010 Establishment of ICCTF in 2022 and required concessionaires to protect high InPres 10: Moratorium on license issuance for logging 2011 and agriculture concessions in primary forests and conservation value forest areas. Restoration of 1.3 peatlands (renewed in 2013, 2015, 2017) Law 18: Strengthening forest law enforcement 2013 million (ha) of peatlands has been undertaken by PP 71: Protection and management of peat ecosystems Ratification of ASEAN Agreement on Government’s Peat and Mangrove Restoration Agency Transboundary Haze A.2. Policy 2014 Merger of Ministries of Forestry and Environment, Stance PP 57: New moratorium for land clearing on peatlands (Badan Restorasi Gambut dan Mangrove, BRGM) to establishment of DG Climate Change Law 16: Ratification of the Paris Agreement 2015 PermenLHK 83: Social forestry target (4.1 million ha) InPres 15: Improved land and forest fire control date. Approximately 5.3 million (ha) of social forestry PP 9: One Map Policy Establishment of Peat Restoration Agency (BRG) 2016 access had been granted by March 2023, ensuring PP 46: Economic instruments for the environment Four Ministerial Regulations on peatland InPres 5: Permanent moratorium of license issuance, 2017 legal and sustainable use of forest lands by more than restoration protecting over 66 million ha A.3. Outlook PermenLHK 10: Management of peat-based InPres 8: Moratorium on oil palm plantation license and Risks one million households. hydrological units (peat domes) 2018 issuance and review SIMATAG, SIPALAGA, and PRIMS initiatives by BRG Establishment of Indonesia Environment Fund PP 120: Establishment of Peat and Mangrove 2019 (BPDLH) Restoration Agency (BRGM), with mandate to restore 1.2 million ha in 7 provinces and The GoI has also established a more favorable PP 22: Environmental protection 2020 600,000 ha. in 9 provinces by 2024 InPres 3: Management of forest and land fires Permentan 38: Indonesia Sustainable Oil Palm pricing scheme for renewable technologies and PP 23 & 24: Non-tax revenue from the forestry sector 2021 Certification Transformation from BRG to BRGM B.1. Preface PP 26: Environmental considerations and coordination committed to a transition away from coal. While in the agriculture sector PP 43: Resolution of inconsistency in spatial planning, 2022 Minister’s Decree 168: Operational plan for Indone- renewable investment was previously dampened forest area, licensing, and land tenure sia’s FOLU Net Sink 2030 PermenLHK 9: Social forestry management PermenLHK 21: Procedure for implementing the by relatively low price caps on the purchase price PermenLHK 8: Reduced impact logging within concessions economic value of carbon of renewable energy, Presidential Regulation (PR) PP 28: Integrated planning for the acceleration of PerPres 98: Economic value of carbon 2023 social forestry management No. 112/2022 sets out higher prices differentiated by Development in InPres 1: mainstreaming biodiversity conservation B.2. Climate & in sustainable development Indonesia renewable energy technology, size, and location. It also Minister’s Decree 815: Acceleration of resolution process of palm oil plantation in forest area established competitive principles for procurement without licenses of renewable energy technologies, such as Solar PV, Source: Figure compiled by WBG staff. and provides for direct fiscal support for the state- Notes: PP = Peraturan Pemerintah (Government Regulation); PerPres = Peraturan Presiden (Presidential Decree); InPres = Instruksi Presiden owned electricity company PLN (PT. Perusahaan Listrik Resilience & Growth of Decarbonization, B.3. A Virtous Cycle (Presidential Instruction); UU = Undang Undang (law), Permen LMK = Negara) to be compensated if the development of new Ministerial Regulation (MoEF); BRG = Badan Restorasi Gambut (Peat renewable capacity increases its average generation Restoration Agency); ICCTF = Indonesia Climate Change Trust Fund. cost. At COP26 in 2021, Indonesia committed to the ‘Global Coal to Clean Power Transition Statement’, signaling its transition away from coal.60 It has further implemented a legally binding restriction on building B.4. Economic Foundations coal-fired power plants connected to the country’s Policy electricity grid in PR No. 112/2022. & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 59 Ministerial Decree No. 168/Menlhk/PKTL/PLA.1/2/2022, the Operational Plan for Indonesia’s FOLU Net Sink 2030. 60 Over 40 countries supported the statement in whole or in part. Like some other countries, Indonesia excluded the third point of the statement which requires no further issuance of new permits for the construction of unabated coal-fired power plants. Indonesia has stated a willingness to consider accelerating the coal phase-out into the 2040s, conditional on additional international financial and technical assistance. 36 Indonesia Economic Prospects December 2023 4. Economic Policy Foundations for a Low-Carbon and Climate-Resilient Contents Table of Future Yet these sector-specific policies are not the only stranded-assets risks can be alleviated. Trade policies building blocks that can underpin Indonesia’s can be used to facilitate green exports and imports, Summary Executive climate goals. For a transition that also delivers on move Indonesia toward the green technology frontier, Indonesia’s development ambitions, ‘enabling’ policies and modify incentives for carbon-intensive commodity can be used to complement sector-specific measures production. and accelerate growth. These enablers aim to raise and Developments A.1. Recent allocate financial, physical, and human resources for These enabling policies and institutions are Economic climate action. They are also important foundations for interrelated and mutually reinforcing. The fiscal capital accumulation and efficient resource allocation framework helps to set price signals and protect and thus underpin long-term economic growth. investments. In doing so it affects the cost and Specifically, the fiscal framework can be used to availability of financial capital for green investments. A.2. Policy address market failures in mitigation and adaptation, The financial system raises and allocates resources for Stance raise revenues, and provide buffers during the low- firms to invest. Meanwhile, trade policies support firms’ carbon and climate-resilient transitions. The financial access to green inputs and markets—facilitating green system can be used to raise and channel savings to investments. These interactions further determine the mitigation and adaptation activities, provided that incentives and opportunities for firms and workers to A.3. Outlook and Risks structural constraints and exposure to climate and participate in the green economy. 4.1. Fiscal Policy for the Climate and Development Challenge B.1. Preface The fiscal framework can be used to increase or less-subsidized tariff classes through means testing, economic efficiencies and disincentivize fossil fuel many relatively better-off households still receive the use. Incentives for fossil fuel use are partly a function benefit of the PSO tariff. Approximately 45 percent of taxes and subsidies. Support for fossil fuels as a of the PSO is used to subsidize households that do Development in B.2. Climate & share of tax revenue in Indonesia has declined, with a not fall within the database for poor and vulnerable Indonesia sharp drop in 2015 (Figure B.10). This drop was driven households. Continued reductions in fossil fuel support by ambitious transport fuel subsidy reform in 2014-15, can help provide fiscal space for increasing targeted as well as a decline in the price of crude oil. Transport welfare support, increasing the efficiency of public fuels receive around one-half of total fossil fuel spending, while also improving economic efficiency by Resilience & Growth of Decarbonization, B.3. A Virtous Cycle support. This has declined in the 20 years to 2020. Cuts incentivizing lower carbon activities. in total support (from 3.9 percent of GDP in 2000 to 1.8 percent in 2020)61 created space for higher spending While the current economic environment creates on health, infrastructure, and social assistance. Social challenges for the reduction of fossil fuel subsidies, assistance, for instance, increased from 0.3 percent of there are steps that can be taken to help gradually GDP in 2004 to 1.5 percent in 2021. move the process forward. Many governments B.4. Economic choose fuel price subsidies over targeted transfers Foundations Policy There are opportunities for further reduction in when energy prices are high because: (i) poor fossil fuel support that could enhance economic households may not receive adequate social transfers efficiencies and welfare (Box B.1). Most fossil fuel to compensate for higher fuel prices; (ii) price controls support is targeted to consumers rather than producers. may shield businesses from higher input costs; and (iii) & Side-Effects of B.5. The Impacts Climate Actions This results in low petrol end-user prices (Figure B.11) price controls may help keep inflation expectations designed to assist households; however, benefits accrue and unanticipated price shocks in check. These issues more to the better-off households as they are larger require sustained efforts by Governments globally consumers of fuel than the poor. In the power sector, to strengthen the delivery infrastructure for social electricity tariffs are set below cost recovery under a protection and to devise transfers that are consistent Development Policy public service obligation (PSO) arrangement (Figure with political imperatives—such as timebound transfers B.6. A Climate & Framework B.12). Although efforts have been made (especially to affected households. between 2015 and 2017) to reassign consumers to non- 61 As per the 2020 national budget. This includes reported direct subsidy spending and estimated implicit subsidies accruing as payment obligations to Pertamina, the state-owned oil and gas enterprise. 37 Indonesia Economic Prospects December 2023 Figure B.10: High but decreasing Figure B.11: Low petrol end-user Figure B.12: Low residential Contents Table of fossil fuel support prices electricity prices Total fossil fuel support Petrol end-user price Residential electricity price 40 Interquartile Range 6 Interquartile range 0.6 Interquartile range Summary Executive Indonesia Indonesia % of total tax revenue Indonesia US$ per kWh US$ per litre 4 0.4 20 2 0.2 Developments A.1. Recent Economic 0 0 0 Sources: OECD Green Growth Data, figures compiled by WBG staff. A.2. Policy Note: Interquartile range refers to equivalent data for the 25th and 75th percentile of structural peers. Stance BOX B.1 Retargeting energy subsidies: consequences of the September 2022 fuel price hike62 A.3. Outlook and Risks Indonesia’s subsidies for transport fuel and electricity have been reduced over the past decade. Prior to 2022, 46 percent of fuel subsidies went to the richest 20 percent of the population while 18 percent of benefits went to the poorest 40 percent, according to World Bank analysis (Figure Box B.1.1). Nonetheless, energy accounts for a significant part of consumption among the poor. Fuel subsidies amounted to 4 percent of the market income of B.1. Preface households in the poorest decile, twice that of the richest 10 percent (who received 2 percent of their market income). Poor and vulnerable populations are thus disproportionately affected when energy subsidies are eliminated. At the same time, the surge in global commodity prices in 2022 made energy subsidies more expensive and put pressure on the budget. Between 2021 and 2022, international crude oil prices increased by 44 percent Development in while the Indonesian rupiah depreciated by 9.3 percent against the US dollar during the same period. This led to a B.2. Climate & Indonesia rise in energy subsidies from 1.7 percent of GDP in 2021 to 2.8 percent in 2022 (IDR 551.2 trillion). In response, the government introduced several policy measures to address these growing costs, starting with the phasing out of low-octane gasoline (Premium) and compensation for price increases in higher-octane gasoline (Pertalite) in the budget between March and April 2022. In September of 2022, the government increased the price of subsidized diesel and gasoline by 30 percent. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Figure Box B.1.1: Fuel subsidies tend to be poorly Figure Box B.1.2: Estimated impact of the September targeted (before September 2022 fuel price hikes) 2022 fuel price hikes on poverty (benefits as % of market income of each decile) (percentage points of International Poverty Line of US$3.20/day, 2011 PPP) 35% 0.2 B.4. Economic Foundations 30.7% 0.1 0.1 Policy 30% 0.0 25% -0.1 20% -0.2 15.5% -0.3 & Side-Effects of 15% B.5. The Impacts 11.6% Climate Actions 9.3% -0.4 7.9% 10% 6.1% 7.3% 4.1% 5.0% -0.5 -0.4 5% 2.6% -0.5 -0.6 0% Impact from BLT Impact from Net Impact 1 2 3 4 5 6 7 8 9 10 BBM Energy Subsidy Market Income Decile Removal Development Policy B.6. A Climate & Framework Source: World Bank staff estimates using Commitment-to-Equity Source: World Bank staff estimates using CEQ methodology (CEQ) methodology based on Susenas March 2019 data. based on Susenas March 2019 data. Note: the estimated impact is not an absolute increase but relative to a counterfactual in which the subsidies are remained. 62 The box is based on World Bank (forthcoming), Indonesia Energy Subsidy Reform Note, World Bank working paper. 38 Indonesia Economic Prospects December 2023 Analysis suggests that the costs of these reforms to poor and vulnerable households was offset by the GoI’s Contents Table of expanded social assistance, while simultaneously yielding net fiscal gain. The GoI accompanied the fuel price increase in September with a targeted cash compensation scheme (Bantuan Langsung Tunai Bahan Bakar Minyak, BLT BBM). Fiscal savings generated by the September 2022 fuel price increase were estimated at 0.2 percent of GDP in 2022.[1] The fuel price hikes alone would have increased the poverty rate by 0.1 percentage points in 2022.[2] This Summary Executive is because increased fuel prices are estimated to negatively affect the consumption of the bottom 40 percent of households by 0.2 percent of their market income. The targeted cash compensation, however, offset the potential negative impact on poverty (Figure Box B.1.2) while still yielding an estimated 0.1 percent net fiscal gain.[3] Further reform can be expected to deliver similar gains. Developments A.1. Recent Economic [1] The small savings are in part because the price adjustments were partial and introduced only in the last quarter (Q4) of 2022. Without price hikes, fuel subsidy spending would have been 0.2 percent of GDP higher than the actual (2.2 percent of GDP). [2] This is not an absolute increase but measured by consumption loss relative to a counterfactual in which the subsidies remained. This reflects 200,000 people falling into poverty (that is, below the international poverty line of US$3.20 per day, 2011 PPP). [3] The cost of the targeted cash compensation and expanded social programs is 0.1 percent of GDP in 2022 (Rp. 24.2 trillion) (link). A.2. Policy Stance Fiscal instruments could be used to disincentivize (ii) Agricultural sector: Fertilizers account for over 10 emissions in other emissions-intensive sectors. percent of agriculture-related emissions, implicitly A.3. Outlook and Risks Several fuels and sectors currently lack direct fiscal encouraged through fertilizer subsidies. A crude palm incentives to increase carbon efficiency, including oil oil export levy aimed at boosting domestic supply and gas, industrial processes and product use, and implicitly discourages emissions from the palm oil residential electricity. The forestry sector and plantation sector (the second largest consumer of fertilizers in B.1. Preface agriculture are subject to licenses and export levies— agriculture), yet expenditure of the levy’s proceeds on forms of fiscal instruments. A further step could be subsidizing biofuels may be increasing production and differentiating between production on land associated potentially emissions. with high emissions and production on more suitable (iii) Residential sector: Emissions are encouraged by Development in areas, given the very large emissions differential across electricity subsidies provided by below-cost retail prices B.2. Climate & Indonesia soil types.63 and a commitment to compensate PLN for losses. At the same time, carbon pricing will raise PLN’s cost for There are opportunities to promote greater supplying electricity, but not the administered retail consistency across fiscal instruments for stronger prices—thereby creating a need for larger government Resilience & Growth overall incentives to decarbonize. In some instances, subsidies. of Decarbonization, B.3. A Virtous Cycle fiscal instruments within the same sector that have (iv) Transport sector: Provincial government taxes countervailing effects could be addressed over time: on transport fuels discourage emissions but are (i) Coal sector: Coal policies encourage the use of coal, counteracted by central government subsidies on diesel such as the domestic market obligation and price cap,64 and a popular brand of low-quality, high-emission and zero-royalty policy on coal used for domestic value gasoline. The net effect of fiscal policy is to promote added-activities. This is partially offset by coal royalties transport emissions (representing approximately 25 B.4. Economic Foundations and an emissions trading scheme (ETS) covering grid- percent of energy-related emissions). Policy connected coal-fired power plants, which discourage the use of coal. & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 63 The emissions footprint of one tonne of crude palm oil varies spatially by a factor of 35 (0.7-26.0 tCO2eq-1). See Lam et al. 2019. 64 Under the domestic market obligation and domestic price cap, miners are required to sell 25 percent of their output domestically, at a price capped at a maximum of $70 per tonne for power generators (scaled according to quality) and $90 per tonne for other industrial uses. 39 Indonesia Economic Prospects December 2023 Notwithstanding the near-term challenges of high currently covered (such as those not connected to the energy prices, the eventual expansion of carbon- grid or burning other fossil fuels). Offset mechanisms Contents Table of pricing, when economic conditions allow, will (limited to set portion of total credits67) could be used complement the above fiscal reforms. In October to directly finance emissions reductions in uncapped 2021, the government enacted legislation that sectors, such as forestry, while lowering the cost of Summary Executive provides a legal basis to introduce carbon-pricing compliance on capped firms. instruments—including the ETS65 and a carbon tax66. Carbon-pricing instruments shift the costs associated Indonesia is harnessing other forms of carbon with GHG emissions from society to emitters and help pricing, including results-based payments and incentivize investments in low-carbon options. carbon credits trading. The government launched a Developments A.1. Recent Economic carbon market in September 2023, for the exchange of The ETS in the power sector is an important carbon credits. Indonesia is also harnessing international step forward and provides a useful foundation emissions reduction payments from development for gradually increasing the coverage of carbon partners to incentivize jurisdiction-wide actions in Jambi pricing. Building on the experience of a voluntary and East Kalimantan provinces. This could be scaled A.2. Policy Stance cap-and-trade system introduced in 2020 (covering to other provinces, provided international support is 84 coal-fired power plants), the Ministry of Energy and forthcoming. There are emerging opportunities to Mineral Resources (MoEMR) launched a mandatory utilize other international payment mechanisms such ETS in 2023 for the grid-connected coal-fired power as voluntary carbon credits to incentivize private sector A.3. Outlook and Risks plants (specifically, facilities with a capacity of more actions. In practice, these enable an environmentally- than 100 megawatts, or around 86 percent of coal-fired conscious overseas business—such as one that is power plants). An MoEMR regulation introduces an responding to shareholder pressure to mitigate its ‘emissions cap’ for these plants, tiered by their capacity climate impacts—to pay an Indonesian business to B.1. Preface at the unit (plant) level. By the end of the reporting undertake emissions mitigation activities that are year, units with emissions exceeding their cap need independently verified. Such transactions do not need to either purchase allowances from other units or to involve corresponding adjustments at the official through carbon offset credits (from energy efficiency national level against respective countries’ emissions or renewable energy projects), although the former reduction goals, and so can ensure that Indonesia’s Development in B.2. Climate & Indonesia will be prioritized. Over time, this could be expanded NDC progress is not compromised. to other sectors as well as power plant categories not 4.2. Deepening the Financial System for Climate and Development Action Resilience & Growth of Decarbonization, B.3. A Virtous Cycle All countries’ financial systems must respond to As is the case in many countries, the financial two important climate-related challenges: (i) the sector’s capacity to monitor and manage climate- management of climate and environmental risks to the related risks is nascent, however, there has been financial sector; and (ii) the mobilization of financial recent progress. The Financial Services Authority capital for mitigation and adaptation investments. The (Otoritas Jasa Keuangan: OJK) released a Sustainable two are interrelated. Climate-related risks, if not well- Finance Umbrella Policy in 2017, including regulations B.4. Economic Foundations managed, can cause shocks to the financial system that requiring banks to develop procedures for monitoring Policy reduce the appetite for investments, whether green or and managing environmental, social, and governance not. Fiscal policy, as discussed above, is constrained (ESG) risks. OJK has also launched two roadmaps in its ability to protect against such shocks. On the on sustainable finance.68 These outline priorities positive side, measures to expand green finance also including: (i) a green taxonomy; (ii) sustainability & Side-Effects of B.5. The Impacts Climate Actions address factors that may otherwise impede the depth, disclosure requirements; (iii) a climate financial risk efficiency, and reach of the financial sector more management framework and risk-based supervision; generally. These measures are crucial for long-term (iv) innovative green financing instruments; and (v) a efficient capital allocation and thus economic growth. National Taskforce on Sustainable Finance. Over time, Development Policy B.6. A Climate & Framework 65 Presidential Regulation No. 98/2021 on Economic Valuation of Carbon. 66 Law No. 7/2021 on Tax Harmonization. 67 Most offset programs limit the total portion of carbon offsets that may be used to ensure the incentive for within-sector mitigation is not diminished. Offsets can be used for a maximum of 5 percent of total credits in China’s emissions trading scheme. 68 Indonesia Sustainable Finance Roadmap Phase I (2015-19) and II (2021–2025). 40 Indonesia Economic Prospects December 2023 detailed guidance to financial institutions will help green bonds and syndicated loans since their first assess, manage, and price climate risks. This could issuance in 2018. The country ranked 42nd in terms Contents Table of be complemented by capacity building to conduct of amount raised (as a share of GDP) over the 2017- detailed climate-risk assessments, including on data 21 period and compares favorably to structural peers and modelling. (Figure B.13). Bonds accounted for 92 percent of the Summary Executive amount raised. Issuances by the government and Climate-risk management challenges aside, the government-backed entities accounted for a significant government is working to catalyze a broader fraction (almost 70 percent)—a contrast to structural greening of the financial system. An important peers where corporations were the dominant issuers.69 step forward was the issuance of the OJK Regulation Indonesia has issued Sovereign and Retail Green sukuk Developments A.1. Recent Economic on the Implementation of Sustainable Finance in amounting to approximately US$3.9 billion between 2017, requiring financial institutions to incorporate 2018 to 2021 (the largest issuance of any country). sustainable practices in their business operations. Nevertheless, private sector involvement is limited, OJK’s Sustainable Finance Roadmaps and the Green and total corporate green bond issuance remains low Finance Taxonomy are promoting the development at US$1.7 billion.70 A.2. Policy Stance of financial instruments such as green bonds or sukuk (Islamic bonds), along with the technology and Indonesia’s green finance system has both demand information infrastructure to ensure the integrity of the (that is, borrower) and supply-side (that is, investor) green bond market and build capacity for industry’s challenges. On the demand side there is a need to: A.3. Outlook and Risks participation. OJK has mandated financial institutions (i) increase market awareness and local knowledge to publish sustainability action plans to raise awareness of green and sustainable projects and the applicable of ESG issues among investors and issuers, and the financing instruments; (ii) reduce the high cost of Indonesian Stock Exchange joined the Sustainable issuing green bonds71; and (iii) increase the availability B.1. Preface Stock Exchanges (SSE) initiative in 2019 to strengthen of longer-term credits. Challenges on the supply side its commitment to ESG issues. include a lack of assets and projects to invest in, and reputational risks (Orbitas 2021). Greater transparency Indonesia’s green financial markets can contribute will be required within the financial sector and within to the country’s climate ambitions if sufficiently sectors targeted for green investment to increase the Development in B.2. Climate & Indonesia scaled. Approximately US$6.4 billion, or about 0.6 size of the pipeline. percent of GDP, has been raised by Indonesia through Figure B.13: Green debt market size Figure B.14: Types of green debt Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Green debt markets (amount raised as a share of Green Bond Market: Corporates vs. Govt. Issuances 1.2% GDP, 2017-2021, annual average) Share of Total Amount Raised, 2017-2021 100% 1.0% 80% 0.8% 60% 0.6% 40% B.4. Economic Foundations 20% Policy 0.4% 0% 0.2% Thailand South Korea Malaysia Vietnam Philippines Indonesia New Zealand Japan China Fiji Australia Singapore 0.0% Turkiye Thailand Nigeria Philippines Brazil Turkey China Indonesia India Ukraine Mexico Russia Egypt & Side-Effects of B.5. The Impacts Climate Actions Govt. Related Issuances Financial Corporations Non-financial Corporations Source: WBG staff analysis using Climate Bonds Initiative data. Development Policy B.6. A Climate & Framework 69 Corporations issued 80 percent or more of green bonds in Brazil, Mexico, Philippines, Thailand, and Ukraine, and about 70 percent in China and India. Indonesia has one of the lowest numbers of corporate issuers among peer countries. 70 Asian Development Bank Asia Bonds online database (link). 71 Issuances of less than US$100 million have costs above those of a comparable-sized loan from conventional sources (Climate Bonds Initiative 2019). 41 Indonesia Economic Prospects December 2023 A World Bank survey72 of Indonesian financial sustainable investing. Nevertheless, only 35 percent of institutions affirmed the need for standards, the respondents believed that ESG investments would Contents Table of information transparency, and capacity-building. drive effective change in recipient firms. Regarding Three-quarters of respondents considered laws climate investment opportunities more broadly, and regulations requiring financial institutions to asset managers and banks reported the range of Summary Executive review ESG risks being the most important drivers opportunities to be limited. Lack of information and of sustainable investing. For about one half of the insufficient expertise were considered the most binding respondents, integration of ESG principles is driven by constraints for sustainable investing. This highlights the perception that they are: (i) good for profits; (ii) the need for clear, consistent, and globally accepted mandates from the board or top management; and definitions, reporting and disclosure standards, Developments A.1. Recent Economic (iii) provide the potential for reputational gains from and analytics, to reduce uncertainty and the risk of greenwashing. 4.3. Trading in Green Trade policies can also contribute to Indonesia’s While local content requirements (LCRs) may A.2. Policy decarbonization objectives. Indonesia has low average provide incentives for local manufacturing, they Stance tariffs on imports of green goods and technologies, impact short-term uptake of renewable energy although non-tariff measures (NTMs) continue to pose technologies. LCR regulations set the level of domestic costs. At an average of 1.1 percent, Indonesia’s tariffs components for solar modules at a minimum of 40 A.3. Outlook on green goods are lower than aggregate average percent. Domestically-produced solar panels are still and Risks tariffs on all imports (Figure B.15). World Bank analysis, more expensive, and their efficiency is lower than those however, finds that NTMs on green goods have been available in foreign markets (Institute for Essential growing in number (Figure B.16) and impose costs Services Reform 2021). These incremental costs also equivalent to an average 20 percent tariff, higher than negatively weigh on the competitiveness of renewable B.1. Preface those on ‘non-green’ goods (Figure B.17). Among energy generation vis-à-vis fossil fuels. LCRs may also NTMs, import approvals, compliance with Indonesian act as barriers to international public procurement— national standards (Standar Nasional Indonesia: SNI), thereby reducing the attractiveness of major renewable and pre-shipment inspections (PSIs), have impacts on energy sector public procurement projects. Development in B.2. Climate & products critical to climate-change adaptation and Indonesia mitigation (Figure B.18). Their impact in Indonesia exceeds that seen in regional peers. Figure B.15: Tariffs on green goods are low Figure B.16: But NTMs can be burdensome Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Indonesia’s average tariffs on green goods imports (%) Indonesia’s NTMs on green goods (number) Water Supply Wastewater Management and Water Treatment 40 Waste Management, Recycling, Remediation Resources and Pollution Management 30 Renewable Energy Others B.4. Economic Foundations Noise and Vibration Abatement 20 Policy Natural Risk Management Natural Resource Protection Management of Solid and Hazardous Waste 10 Heat and Energy Management Gas Flairing Emission Reduction 0 Environmentally Preferable Products & Side-Effects of B.5. The Impacts Climate Actions 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Environmental Monitoring, Analysis Equipment Energy Efficiency Efficient Consumption of Energy Technologies SPS TBT Cleaner or More Resource Efficient Products PSI Quantity Control Clean Up or Remediation of Soil and Water Other Export-related Measures Air Pollution Control 0 1 2 3 Development Policy Average applied tariff on green goods imports B.6. A Climate & Framework 72 The CCDR surveyed 750 firms to gather information on firm-level emissions, environmental management practices, and drivers of, and constraints to, green practices. The sampled firms cover large and medium manufacturing firms based in Java (which accounts for more than 75 percent of all manufacturing firms in Indonesia). The survey was carried out for firms in six industries that have a high share of electricity and fuel in both output and the energy mix. These are the firms that will be most disrupted by the low-carbon transition and where environmental management practices will, therefore, be most relevant. 42 Indonesia Economic Prospects December 2023 Figure B.17: Contributing to higher import costs Figure B.18: And loss of competitiveness Contents Table of Tariff equivalents of selected NTMs (%) 140 Tariff equivalent of Most Problematic NTMs on 120 Green Goods relative to EAP (av difference) (%) 100 18 80 Summary Executive Import approvals SNI PSI 60 16 40 14 20 12 0 10 Developments 8 Resources and pollution waste mgt and recycling efficient Tech Gas flaring emission management Air pollution control A.1. Recent Economic Natural risk Solid and hazardous Resource efficient 6 reduction technology 4 2 mgt 0 Resource Port of entry PSI SNI A.2. Policy Stance Source: WBG staff calculations based on the World Bank Jakarta NTM database and Green Transition Navigator list of green goods. Note: SPS: Sanitary or phytosanitary; TBT: Technical barriers to trade; EAP: East Asia and the Pacific. A.3. Outlook Green goods imports represent an important To position itself to benefit from the global and Risks source of access and transmission of new green transition to a low-carbon economy, Indonesia technologies. Trade is a channel of diffusion for can adjust its export capabilities to growing innovation—including through imports and trade in sources of international demand and cultivate technology. Trade policies such as liberalization of new green industries. Indonesia has potential for B.1. Preface both tariff and non-tariff barriers is, therefore, a key greater exports of green goods. With exports of green channel for improving green production capabilities goods of US$5.8 billion (3.6 percent of total goods and realizing technology spillovers. Green goods tend exports) in 2020, Indonesia is below the global and to be intensive in medium and high-tech products, East Asia and Pacific (EAP) average at 12 percent and Development in B.2. Climate & with 74 percent of imports containing such products 9 percent, respectively. World Bank analysis finds that Indonesia (relative to 64 percent of green good exports). More exports of Environmentally Preferable Products; Waste broadly, Indonesia’s green goods trade has higher Management, Recycling and Remediation; and Cleaner technology-intensity than Indonesia’s overall trade in or More Resource Efficient Technologies/Products are goods. Access to technologies through green imports the green product categories that exhibit the highest Resilience & Growth of Decarbonization, B.3. A Virtous Cycle will help to improve productivity, lower production Revealed Comparative Advantage (RCA) for Indonesia, costs, and improve international competitiveness. while at the same time being the closest to current production facilities (proximity). This makes them ideal potential export growth areas. B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 43 Indonesia Economic Prospects December 2023 5. The Impacts and Side-Effects of Climate Actions Contents Table of Climate action through sector and enabling policies for investment—including in low-carbon equipment. It could reduce GHG emissions and promote higher is assumed that replacing stranded fossil fuel assets growth. The IEP provides illustrative scenarios of accounts for 25 percent of the new investment. Summary Executive possible outcomes based on computable general equilibrium (CGE) modeling of various climate actions (iii) Nationally Determined Contribution Plus (e.g., reducing supply of land and fossil fuels or (NDC+): This includes all the actions from the NDC reducing demand through fiscal policies like carbon scenario, but also includes a much higher carbon tax Developments A.1. Recent taxes). The impacts of policy reforms are difficult to rate, reaching US$200.00/tCO2 by 2040. This could Economic predict because they partially depend on factors reduce emissions twice as quickly as in the NDC like technological change and global conditions. scenario. This is a more ambitious scenario that would The modeling results do not, therefore, prioritize a involve higher net costs for Indonesia while also particular outcome above all other possibilities. The reducing global externalities. To help compensate for A.2. Policy intention is to help think through possible interactions the costs and positive externalities, a sensitivity analysis Stance between policies and economic outcomes, with a focus is added to this scenario with an increase in foreign on the implications of emissions mitigation. investment specified to be equivalent to 1 percent of GDP in Indonesia throughout the projection period.73 The modelling scenarios are based on climate action A.3. Outlook and Risks of increasing ambition; from actions that enable The modeling analysis is based on specific Indonesia to internalize benefits through to those assumptions—which suggests caution in that could even benefit other countries. Clarifying interpreting the results. First, the modelling of the how much Indonesia can internalize the benefits of its power sector focuses only on generation connected B.1. Preface climate actions is important to understanding what the to the electricity grid managed by PLN.74 Second, the country should do on its own and what it might do CGE model assumes that markets work efficiently75 if international support is forthcoming. The modelling and that the economy always operates at full capacity. exercise, therefore, looks at three levels of climate There are however many frictions that prevent markets Development in B.2. Climate & actions for Indonesia: from clearing: the model assumes that agents know Indonesia of all technological options and that there is an (i) Redirection of electricity and fuel subsidies: instant adjustment, but it takes time to adopt new Targeted rather than general subsidies lead to more technologies, so outcomes may take longer than efficient government spending. No additional land predicted. Fourth, the model assumes a fixed money Resilience & Growth of Decarbonization, B.3. A Virtous Cycle or energy policies are assumed in this scenario. This supply, so additional investment in low-carbon scenario is considered under two different sets of equipment will either crowd out other investment or assumptions on the use of fiscal savings from the require higher savings and reduced consumption. Fifth, elimination of subsidies: first, transfers to compensate the carbon tax assumptions are only used to illustrate the bottom 40 percent of the population; and, second, the range of possible economic outcomes, they are not no transfers but investment instead. The latter is only recommendations for the carbon tax rate in Indonesia. B.4. Economic Foundations illustrative as Indonesia is required by law to provide Finally, there are political economy factors that may Policy subsidies to protect the poor from rising energy prices. impede progress on reforms. The full CCDR contains further details on the scenarios modelled. (ii) Nationally Determined Contribution (NDC): This includes redirection of subsidies, new land The modeling results show that progress on GHG & Side-Effects of B.5. The Impacts Climate Actions and energy policies, and a carbon tax that reaches emissions reduction will be driven in large part by US$40.00/tCO2eq by 2040. The carbon tax is applied combined sectoral and fiscal policies. Scenario 1 to all sectors and greenhouse gas emissions except (redirection of energy subsidies) is expected to reduce for agriculture. Revenues from the carbon tax are used emissions by 3-4 percent, but the effects are limited Development Policy B.6. A Climate & Framework 73 The LCCR target is to reach 540 MtCO2eq total emissions by 2050 (LTS-LCCR 2050). The CCDR’s NDC+ scenario is less ambitious. Under the NDC+ scenario trends, Indonesia could reach 540 MtCO2eq by 2060. This is, however, just an illustrative scenario, not a prediction. Much will depend on technological progress, reforms, and investments. 74 In 2020, this represented 64 GW of a total installed capacity of 70 GW. As a result, the modelling does not cover, for example, coal-generation in captive power plants or in off-grid systems. 75 Although the CGE does assume labor market frictions. 44 Indonesia Economic Prospects December 2023 once subsidy redirection is completed (Figure B.19). In the more ambitious Scenario 3 (NDC+), the The increased sectoral policies and carbon prices are availability of external financing could play an Contents Table of projected to have a more substantial impact, with important role in determining the long-term continued emissions reduction as the carbon prices are economic growth path. Scenario 3 is projected to increased. By 2030, GHG emissions under Scenario 2 have a positive impact on GDP up to 2035. Beyond Summary Executive (NDC) could be lower by 27 percent compared to BAU; 2035, the distortionary effects of the carbon tax, which this reduction would help meet Indonesia’s conditional is much larger than in Scenario 2, outweighs these NDC target. Under Scenario 3 (NDC+), GHG emissions positive effects. A higher carbon tax could reduce are 47 percent below BAU by 2030 and 63 percent the use of fossil fuels more quickly (thereby reducing below BAU by 2040. Beyond land, the power sector growth) than the economy can offset through adoption Developments A.1. Recent Economic shows the biggest emissions reductions in all scenarios, of new technologies (which would otherwise accelerate because of the availability of technologies that can growth). It could also disincentivize investment due reduce emissions to near-zero levels. There are also to higher cost from carbon tax on the one hand and substantial emission reductions from manufacturing domestic financing constraints on the other. These and transport. constraints could be alleviated through external A.2. Policy Stance financing. An additional 1 percent of GDP financing The net impact of climate actions on long-term could lead to a positive impact on GDP (Figure B.21). GDP depends, in part, on how increased carbon tax This financing could be facilitated through continued receipts and reduced subsidies are recycled. In all reforms to the business investment climate, trade, A.3. Outlook and Risks scenarios, if savings from lower subsidies are recycled financial and fiscal policy, building on recent efforts. through transfers, then GDP could be slightly lower than in the BAU during initial years. On the other hand, There will be gains and losses across sectors. Sectors if they are channeled to investment, there could be a that are likely to be most directly affected by carbon B.1. Preface small initial reduction followed by an increase in GDP pricing and other emissions reduction measures (e.g., that is sustained throughout the projection period. In energy, power, transport, waste) are likely to experience Scenario 1 (redirection of energy subsidies to transfers), the sharpest drops in output (Figure B.22). The coal the difference in output compared to BAU is projected sector accounts for significant export earnings that to be positive (Figure B.20). This reflects the removal of have financed important developments in the real Development in B.2. Climate & Indonesia the distortionary effects of the subsidies, and possibly sector. Other sectors, which make up large shares of additional indirect air quality effects. Scenario 2 (NDC) GDP (e.g., construction, financial services, hospitality, has a stronger positive impact on GDP (assuming wholesale and retail trade) and where the impact of carbon tax receipts are channeled to investment rather transition policies is not as direct, are projected to than transfers). This result is driven by the removal of expand and offset losses in the long term. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle economic distortions from energy subsidies, higher investments financed out of carbon tax receipts, an increase in agricultural productivity, and enhanced labor productivity through improved air quality. B.4. Economic Figure B.19: Achieving decarbonization objectives Figure B.20: With potential positive growth payoffs Foundations Policy GDP Total GHG Emissions, percentage difference from BAU difference from baseline (MtCO2eq) 1.20 2021 2023 2025 2027 2029 2031 2033 2035 2037 2039 & Side-Effects of B.5. The Impacts Climate Actions 0.60 -300 -800 0.00 -1300 -1800 -0.60 Development Policy B.6. A Climate & -2300 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 Framework Minus energy subsidies NDC Minus energy subsidies NDC NDC+ NDC+ NDC+ with foreign funds Source: WBG staff analysis using the MANAGE CGE model. Note: “Minus energy subsidies” refers to scenario 1 (redirecting of electricity and fuel subsidies). 45 Indonesia Economic Prospects December 2023 Figure B.21: Foreign investments can alleviate trade- Figure B.22: There will be gains and losses across Contents Table of offs in more ambitious scenarios sectors Investments Sector Output (difference from baseline, % of GDP) % difference from BAU in 2040 2.0% 10 Summary Executive 0 -10 -20 1.0% Developments -30 A.1. Recent Economic Energy Manufacturing Waste Other Services Power Transport 0.0% 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035 2036 2037 2038 2039 2040 A.2. Policy Stance Minus energy subsidies NDC Minus energy subsidies NDC NDC+ NDC+ with foreign funds NDC+ NDC+ with foreign funds Source: WBG staff analysis using the MANAGE CGE model. Note: “Minus energy subsidies” refers to scenario 1 (redirecting of electricity and fuel subsidies). A.3. Outlook and Risks Any transition will be disruptive in the short term— in electricity, gas, and water supply sectors, by about even if beneficial over the long term; strong political 25 percent in the NDC and 215 percent in the NDC+ support for a comprehensive decarbonization scenarios relative to the BAU scenario (by 2040). Labor strategy will be essential to promote a smooth demand for renewables and gas increases, leading to B.1. Preface transition. This is challenged by political economy higher wages given labor frictions (that is, a function of conditions and stakeholders that benefit from the skill transferability of workers). engagement in fossil fuel sectors. All three scenarios, however, are within Indonesia’s reach. Although the Sectoral policies combined with the introduction of Development in redirection of fossil fuel subsidies is challenged by a carbon tax (NDC and NDC+) progressively affect B.2. Climate & Indonesia high energy prices, it is consistent with the longer- household expenditures—driven by recycling of term trend in Indonesia, will generate fiscal savings for revenues into social assistance. While the effective development, and incentivize more efficient resource tax on energy increases energy prices across scenarios, use. The NDC scenario is already consistent with the improved agricultural productivity due to land policies Resilience & Growth of Decarbonization, B.3. A Virtous Cycle government’s land and energy sector commitments. in the NDC and NDC+ scenarios helps to keep overall inflation subdued. This results from lower food prices, The economy-wide impacts of climate mitigation which are much larger components of the overall will affect households through employment and household consumption basket than energy (Figure wages.76 By redirecting energy subsidies, the first B.24). Household expenditures increase progressively scenario has only minuscule impacts on employment in absolute terms for the NDC and NDC+ scenarios growth, while the more ambitious second and third (Figure B.25). The progressive growth of household B.4. Economic Foundations scenarios (NDC and NDC+) lead to marginal impacts on expenditures is mostly driven by increased social Policy employment growth—not exceeding 0.7 percentage assistance which is generated by revenue from the points annually over the 2020 to 2040 period. Most carbon tax. Except in the first scenario, household negative impacts are felt in energy-intensive sectors expenditures in rural areas increase more than in & Side-Effects of B.5. The Impacts Climate Actions (Figure B.23) given the increase of costs due to the urban areas given the higher agricultural productivity carbon tax, but overall employment in these sectors is of land (due to the land policies) and an increase of relatively low (below 10 percent of total employment). investment in the agriculture sector (due to its lower Wage growth in most sectors is not substantially energy intensity) (Figure B.27). affected by the scenarios, except for large increases Development Policy B.6. A Climate & Framework 76 Distributional impacts are assessed using micro-economic simulations of the results from the CGE macro model. An occupational choice model re-allocates workers based on the outputs of the CGE model. Income is transformed into expenditure based on the marginal propensity to consume. Consumption shares are kept constant assuming that households do not adapt their behavior in response to changes in prices. population parameters are adjusted based on UN population growth projections, with education levels adjusted based on the aging of the youngest cohorts. 46 Indonesia Economic Prospects December 2023 While revenue recycling can mitigate adverse area, specific groups can lose from the reforms and will impacts on poverty, specific groups might still need targeted assistance. In the short term, however, Contents Table of require targeting with tailored support. The poverty poverty might be more strongly affected by price rate is hardly affected in the subsidy removal scenario. volatility undermining households’ purchasing power. Poverty is set to decline in the NDC and NDC+ A food price shock of 30 percent can increase poverty Summary Executive scenarios (Figure B.28)—driven by social assistance. by seven percentage points while a similar energy price Although poverty is not worsening in any geographic shock increases poverty by only 1.4 percentage points. Figure B.23: Impacts on employment Figure B.24: Impact on prices Developments A.1. Recent Economic Employment Relative to BAU by 2040 Price Change vs. BAU by 2040 (percentage (percentage points) 47% 162% points) Services 20% 165% Finance, Real Estate and Business Service 16% 15% Transport and Communication Trade, Hotel and Restaurant 10% A.2. Policy Construction Stance Electricity, Gas and Water Supply 5% Manufacturing Industries Mining and Quarrying 0% Agriculture -5% A.3. Outlook and Risks -40% -20% 0% 20% NDC NDC+ NDC+ (with Minus energy foreign funds) subsidies Minus energy subsidies NDC+ (with foreign funds) NDC+ NDC Energy Food Non-food Figure B.25: Impact on household expenditure Figure B.26: Impact on expenditure by worker type B.1. Preface Percent Change in Expenditure vs BAU by 2040 Percent Change in Expenditure vs. BAU by 2040 10 6 Minus energy subsidies 8 NDC NDC+ NDC+ (with foregin funds) NDC NDC+ Development in B.2. Climate & 4 6 NDC+ (with foreign funds) Indonesia 4 2 2 0 0 Resilience & Growth of Decarbonization, B.3. A Virtous Cycle -2 1 2 3 4 5 6 7 8 9 10 -2 Income decile Low-skill High-skill Men Women Figure B.27: Drivers of expenditure change Figure B.28: Impact on poverty Contributions to Expenditure Growth, by Change in Poverty Rates vs. BAU by 2040 B.4. Economic Foundations 6.0% urban/rural (percentage points) Policy 0.2% 5.0% Labor Income Social Assistance 0.0% 4.0% Purchasing Power 3.0% -0.2% & Side-Effects of B.5. The Impacts 2.0% Climate Actions -0.4% 1.0% 0.0% -0.6% LMIC / $3.2 -1.0% UMIC / $5.5 -0.8% -2.0% Rural Urban Rural Urban Rural Urban Rural Urban -1.0% Development Policy B.6. A Climate & NDC NDC+ NDC+ (with foreign Minus energy NDC NDC+ NDC+ (with Framework funds) subsidies foreign funds) Source: World Bank staff estimates based on a Microsimulation Model. Model is based on SUSENAS 2019 data projected forward to 2020 (to avoid perturbations by COVID-19 impacts). Macroeconomic projections are derived from CGE results above. 47 Indonesia Economic Prospects December 2023 6. A Climate and Development Policy Framework Contents Table of What are the implications of the above findings for when these enablers are strengthened simultaneously policy priorities going forward? To recap, Indonesia with sectoral policies. has drawn on its abundant supply of natural resources Summary Executive while achieving impressive development transitions The IEP focuses on these enabling conditions in in income, social services, infrastructure, economic this concluding section. Each policy option presented growth, and poverty reduction—particularly over is rated according to criteria of urgency and synergy the quarter-century to 2022. Yet climate change (Figure B.30). While many measures are important, Developments A.1. Recent Economic poses physical and economic risks for Indonesia, some are relatively more urgent because inaction and some aspects of the earlier growth model have will lock in carbon-intensive development patterns imposed costs on development, such as air pollution. or vulnerabilities that increase subsequent costs and In response, Indonesia has embarked on a transition financial risks. The IEP indicates urgency by suggesting toward low-carbon and climate-resilient growth each action as either a short-term priority (by 2025), a A.2. Policy (Republic of Indonesia 2021). This IEP argues that medium-term priority (by 2030), or a long-term priority Stance mitigation and adaptation efforts on the supply and (beyond 2030). Meanwhile, synergy refers to the extent demand side, along with adaptation efforts, can be to which a policy option is considered to contribute supported by economic policy enablers that are to both climate goals and broader (non-climate) A.3. Outlook themselves important for long-term growth (Figure development goals (e.g., faster long-term growth, and Risks B.29). The latter aim to create the enabling conditions poverty reduction, or wealth accumulation). It should that will facilitate a reallocation of resources from be noted that this is a partial list of recommendations. carbon-intensive to greener parts of the economy, and The Indonesia CCDR provides further options covering from low-productivity to high-productivity areas of the sectoral reforms—with a focus on the supply and B.1. Preface economy, while raising new financing. The transition is demand for energy and land—as well as adaptation expected to be more efficient—and growth positive— measures. Figure B.29: Building blocks for the transition Figure B.30: Prioritization approach for Development in B.2. Climate & recommendations Indonesia Four building blocks: Together promote: Urgency: Synergy: When to act Expected climate and Supply-side development outcomes measures • Reduced transi- tion costs Short-term priority S 3 3 High Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Adaptation • Efficient Medium-term priority M 2 2 Medium Demand-side resource allo- measures cation Long-term priority L 1 1 Low-moderate • Certainty and insurance Development Climate Enabling conditions B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 48 Indonesia Economic Prospects December 2023 (a) Fiscal measures Contents Table of Fiscal reforms can help create price signals that taxes, while realigning those fiscal instruments within promote a low-carbon transition and raise revenues the same sector that have countervailing effects on for mitigation and adaptation investments. the incentives for emissions. Expanded carbon pricing Although subsidy spending on energy consumption and fossil fuel taxes could raise revenue for climate Summary Executive has declined in recent decades, there are opportunities expenditures, social protection, or general budget for further subsidy redirection. There is scope to expenditures. Specific measures could include: increase the coverage of carbon pricing and fossil fuel Developments A.1. Recent Economic Develop a roadmap to complete transport fuel subsidy retargeting. Fuel subsidies are regressive, distort carbon price signals, and weigh on the budget. Rising global oil prices make it politically difficult to eliminate fuel subsidies in the short term, however, planning for reform could begin now in anticipation of more favorable medium-term conditions. Reform planning would include redistribution mechanisms to offset impacts on the Climate Dev. Urgency poorest. World Bank analysis suggests that removing subsidies in isolation could increase the poverty rate A.2. Policy Stance by 0.4 percentage points, but fiscal savings (from reduced fuel and electricity subsidies) can be used to offset impacts on households with net fiscal savings of 0.3 percent of GDP. Convert the electricity price subsidy (PLN’s PSO) into targeted cash transfers for eligible households. This A.3. Outlook would allow the charging of tariffs that cover generation costs while using cash transfers to compensate the and Risks poor and vulnerable for price rises. This may require updates to the social welfare regis-try list (Data Terpadu Kesejahteraan Sosial, DTKS), to ensure sufficient information for targeting, manag-ing, and monitoring cash Climate Dev. Urgency transfers. B.1. Preface Review the inventory of tax measures to optimize alignment of fiscal policy with low-carbon objectives. The review could consider: (i) opportunities to introduce an excise on fossil fuels after redirect-ing existing subsidies with compensatory measures for the poor; (ii) removing tax incentives for carbon-intensive sectors; and (iii) eliminating conflicting effects of tax policy on emissions within high-emission sectors. This would be Development in B.2. Climate & Climate Dev. Urgency Indonesia aligned with Presidential Regulation No. 98/2021 on the economic value of carbon. (b) Carbon-pricing reforms Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Fiscal reforms could include extension of Indonesia’s be subject to a carbon tax or will need to be offset important carbon-pricing reforms that were through trading of allowances. This is an important adopted in 2021.77 The government first introduced step forward. As is common with the introduction of carbon pricing through a voluntary ETS in the power new tax instruments, implementation challenges are sector. This is slated for extension to other sectors from likely to arise, including from the interaction of different B.4. Economic Foundations 2024. Any emissions above predetermined caps will carbon-pricing instruments (tax, ETS, and offsets). Policy Develop an integrated roadmap for carbon pricing. Develop a roadmap for expanded carbon pricing based on a review of the impact, cost, and feasibility of the current and/or alternative instruments for additional & Side-Effects of B.5. The Impacts Climate Actions sectors beyond 2024. Ensure alignment across different carbon-pricing instruments (ETS, carbon tax, and potential offsetting schemes). Estimate baselines disaggregated by subsector and projected annual emissions. Climate Dev. Urgency Explore options to trade carbon credits internationally. Development Policy B.6. A Climate & Framework 77 Presidential Regulation No. 98/2021 provides the legal umbrella to introduce a price on carbon through carbon trading (cap-and-trade and carbon offsets mechanisms), performance-based payments and carbon tax/levies. The Tax Harmonization Law (2021) mandates the introduction of a carbon tax. The tax’s introduction was on hold at time of writing. 49 Indonesia Economic Prospects December 2023 (c) The financial system Contents Table of The financial system is critical to Indonesia’s climate management of climate- and environment-related transition; addressing two challenges will help it do financial risks; and (ii) mobilizing savings for climate so in a pro-growth manner: (i) strengthening the mitigation and adaptation investments. Summary Executive Develop a comprehensive strategy for climate-risk assessment. Building on the recent progress on regulations and roadmaps for sustainable finance, a climate risk assessment strategy could include how au- thorities (for example, Bank Indonesia and OJK) plan to: (i) integrate climate risks in their supervisory frame- Developments A.1. Recent Economic works; (ii) address climate risks within their internal organization and governance structure (for example, Climate Dev. Urgency dedicated units to manage climate risks); and (iii) allocate the needed resources and expertise to address climate risks, including through outreach and capacity-building to key financial institutions. Develop further guidance on risk management approaches and disclosure requirements for banks. OJK A.2. Policy could draw on the Basel Committee on Banking Supervision’s principles for climate-risk man-agement (Bank Stance for International Settlements 2021). Guidance would include stress testing and scenario analysis methodologies, risk identification and management approaches, and procedures for disclosure of climate risks. Climate Dev. Urgency A.3. Outlook and Risks Develop a further climate finance strategy focused on Indonesia’s climate finance needs and opportunities. This strategy would build on the Sustainable Finance Roadmap in that it would specifically: (i) estimate the current and projected financing gap to meet the country’s climate mitigation and adaptation B.1. Preface targets; (ii) determine the priority sectors requiring climate investments; and (iii) explore potential sources of Climate Dev. Urgency finance for priority sectors, including regulatory reforms that would encourage private sector financing. Incentivize the use of green bonds through diverse channels. This could include: (i) aggregation and Development in B.2. Climate & Indonesia securitization so that green bonds can reach the size that investors are demanding. For example, OJK could develop standardized contract templates and procedures to create consistency and simplicity in the bond issuance process; and (ii) reduce listing requirements for labeled bonds and support new and existing issuers Climate Dev. Urgency to bring these bonds to the market. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Develop further guidance and incentives to stimulate green loans. In 2019, Bank Indonesia issued a regulation on loan-to-valuation (LTV) ratios for green mortgages to support green building development (Iswara 2019). This regulation enables a five percent increase in the maximum LTV for green development (to 90 percent), thereby lowering the down payment paid by borrowers. In addition to the incentive frame-work Climate Dev. Urgency already introduced by Bank Indonesia, there are a range of other incentive mechanisms that authori-ties could B.4. Economic Foundations consider for encouraging the uptake or de-risking of these loan products—such as guarantees, subsidies, data Policy provision, and aggregation. (d) Trade policy & Side-Effects of B.5. The Impacts Climate Actions Adjustments to trade policies could be used to important standards that should be maintained, there support Indonesia’s decarbonization objectives. may be opportunities for streamlining these barriers. Indonesia has low average tariff rates on imports of There may also be scope for integrating environmental green goods and technologies (below rates for non- provisions in Indonesia’s trade agreements and for green goods), however, NTMs add costs to green Indonesia to more fully participate in policy initiatives Development Policy B.6. A Climate & goods that exceed tariff costs. While many represent on green trade. Framework 50 Indonesia Economic Prospects December 2023 Liberalize remaining tariffs on imports of green goods, including through multilateral participa-tion. While Contents Table of average tariffs are encouragingly low, there are a few remaining tariff peaks for green goods. Reducing import tariffs will reduce key goods’ prices and boost access to lower-cost and more energy-efficient technologies. This may be particularly important for industries that must comply with climate change mitigation policies. Climate Dev. Urgency Summary Executive Review and streamline NTMs on green goods. Some NTMs could be simplified such as import approv-als and compliance with SNI. Some NTMs could be considered for removal entirely, such as PSIs and port of entry restrictions. Over time, some NTMs could be phased out as a robust national single window and inte-grated Developments A.1. Recent Economic risk management system is developed. Climate Dev. Urgency Harmonize existing local standards with international ones and develop new standards that are aligned A.2. Policy with international standards and practices. Firms trading in green goods reported a lack of harmonization Stance with international standards as a key challenge. Misalignment imposes costs on exporters and increases the time required to bring green goods to market. Working toward a harmonization of prod-uct standards Climate Dev. Urgency across markets could encourage imports of green goods and boost Indonesian exports in new markets with A.3. Outlook comparable standards. and Risks Reduce the stringency of LCRs until demand can sustain local economies of scale. High LCRs prior to establishment of market demand large enough to support domestic manufacturing economies of scale may prevent industry development, increase prices, and prevent international technology transfer. Allowing the B.1. Preface market to first develop, such that domestic production can support the economies of scale required to keep Climate Dev. Urgency prices affordable, may be more effective. Look for opportunities to include enforceable environmental provisions in trade agreements and Development in B.2. Climate & Indonesia participate in plurilateral and multilateral trade policy initiatives on green goods. Environmental provisions and commitments are likely to become more detailed in terms of scope and ambition. Direct participation in multilateral and plurilateral environment-related trade policy initiatives would allow Indonesian exporters to Climate Dev. Urgency benefit from improved market access in destination markets, while also giving Indonesia a seat at the table to shape the content and course of discussions. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle Measures to improve enabling conditions could fuel subsidies. Longer-term actions could focus on focus on fiscal and financial measures in the short continued liberalization of tariffs on green goods term, including setting out a roadmap for carbon and gradual expansion of carbon pricing in line with pricing. Short-term measures will help to align tax the earlier developed roadmap. Other sequences of B.4. Economic Foundations incentives with climate goals and improve economic actions would be possible and will need to consider Policy efficiency. Reducing LCRs on renewable energy a range of factors including international economic technologies can help support uptake in the short- conditions and political feasibility. Through these and term while Indonesia’s domestic capacity continues other reforms, Indonesia can boost underlying drivers to build. Upfront planning for carbon pricing will of productivity and efficiency, helping to reduce the & Side-Effects of B.5. The Impacts Climate Actions help inform the private sector’s medium- and long- short-term costs of emissions cuts and adaptation, term investment decisions. Medium-term actions, while strengthening long-run growth prospects as meanwhile, could include harmonization of trade Indonesia and the world moves towards a low-carbon standards for green goods, and electricity tariff future. reform, along with continued retargeting of remaining Development Policy B.6. A Climate & Framework 51 Indonesia Economic Prospects December 2023 Re ference s Contents Table of Summary Executive PART A Developments A.1. Recent Economic Basri, M. C. and Patunru, A. A. 2012. How to keep trade policy open: the case of Indonesia. Bulletin of Indonesian Economic Studies, Taylor & Francis Journals, vol. 48(2), pages 191-208, August. Constantinescu, C., Mattoo, A., Ruta, G. 2015. The Global Trade Slowdown: Cyclical or Structural? Washington, DC: IMF. Helton, J. 2021. Alaska: The Jones Act’s Original Victim. Grassroot Institute of Hawaii in association with Alaska Policy A.2. Policy Stance Forum. Kashian, R., Pagel, J., Brannon, I. 2017. The Jones Act in Perspective: A survey of the costs and effects of 1920 Merchant Marine Act. Grassroot Institute of Hawaii. A.3. Outlook and Risks Soesastro, H. and Basri, M. Ch. 2005. The Political Economy of Trade Policy in Indonesia. Trade Working Papers 22033, East Asian Bureau of Economic Research. Wihardja, M. and Cunningham, W. 2021. Pathways to Middle-Class Jobs in Indonesia. Washington, DC: World Bank. B.1. Preface World Bank. 2022. Indonesia Economic Prospects, June 2022: Financial Deepening for Stronger Growth and Sustainable Recovery. Washington, DC: World Bank. World Bank. 2023a. Global Economic Prospects, June 2023. Washington, DC: World Bank. Development in B.2. Climate & World Bank. 2023b. World Bank Commodity Market Outlook, October 2023. Washington, DC: World Bank. Indonesia World Bank. 2023c. Indonesia Affordability Divide. Forthcoming. World Bank. 2023d. Measuring Logistics Costs in Indonesia. Forthcoming. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle World Bank. 2023e. Services for Development: East Asia and Pacific Economic Update, October 2023. Washington, DC: World Bank. PART B Asian Development Bank. 2019. Policies to Support Investment Requirements in Indonesia’s Food and Agriculture B.4. Economic Foundations Development during 2020–2045, October 2019. Manila: IFPRI, Bappenas, ADB. Policy Bappenas. 2021. A Green Economy for a Net-zero Future: How Indonesia can build back better after COVID-19 with the Low Carbon Development Initiative (LCDI). Republic of Indonesia: Ministry of National Development Planning. & Side-Effects of Coalition for Urban Transition. 2021. Seizing Indonesia’s Urban Opportunity: Compact, Connected, Clean and Resilient B.5. The Impacts Climate Actions Cities as Drivers of Sustainable Development. Washington, DC: Coalition for Urban Transition c/o World Resources Institute. Climate Bonds Initiative. 2019. Unlocking green bonds in Indonesia: A guide for issuers, regulators and investors, December 2019. United Kingdom: Climate Bonds Initiative. Development Policy B.6. A Climate & Emam, A. R., Kumar, P., Mishra, B. K., Masago, Y. 2016. Impact Assessment of Climate and Land-Use Changes on Framework Flooding Behavior in the Upper Ciliwung River, Jakarta, Indonesia. Water 2016, 8(12), 559; https://doi.org/10.3390/ w8120559. 52 Indonesia Economic Prospects December 2023 Goldberg, L., Lagomasino, D., Thomas, N., & Fatoyinbo, T. 2020. Global declines in human-driven mangrove loss. Global Change Biology, 26(10), 5844–5855. https://doi.org/10.1111/gcb.15275. Contents Table of Ministry of Environment and Forestry (MoEF). 2022. “State of Indonesia’s Forests.” Jakarta: Ministry of Environment and Forestry. Summary Executive Ministry of Finance. 2021. Penandaan Anggaran dan Pendanaan Publik Perubahan Iklim Nasional dan Daerah untuk Mencapai Target NDC. Republic of Indonesia: Ministry of Finance. Orbitas. 2021. Agriculture in the Age of Climate Transitions: Stranded Assets. Less Land. New Costs. New Opportunities. Developments A.1. Recent Economic Republic of Indonesia. 2022. Long-Term Strategy for Low Carbon and Climate Resilience Development 2050 (LTS-CCR 2050). OJK. 2022. Indonesia Sustainable Finance Roadmap Phase I (2015-19) and II (2021–2025). Sustainable Finance Initiative in Indonesia. Republic of Indonesia: The Financial Services Authority. A.2. Policy Stance Setyawan, D. 2020. Energy efficiency in Indonesia’s manufacturing industry: a perspective from Log Mean Divisia Index decomposition analysis. Sustainable Environment Research 30, Article number: 12 (2020). https://doi.org/10.1186/ s42834-020-00053-9. A.3. Outlook Tsujino, R., Yumoto, T., Kitamura, S., Djamaluddin, I., Darnaedi, D. 2016. History of forest loss and degradation in and Risks Indonesia. https://doi.org/10.1016/j.landusepol.2016.05.034. World Bank and Asian Development Bank. 2021. Climate Risk Profile: Indonesia. World Bank Group and Asian Development Bank. B.1. Preface World Bank. 2021a. Planning for an Uncertain Future: Strengthening the Resilience of Indonesian Water Utilities. Washington, DC: World Bank. World Bank. 2021b. The Changing Wealth of Nations 2021: Managing Assets for the Future. Washington, DC: World Development in Bank. B.2. Climate & Indonesia World Bank. 2022. Indonesia Economic Prospects, June 2022: Financial Deepening for Stronger Growth and Sustainable Recovery. Washington, DC: World Bank. World Bank. 2023f. Indonesia’s Energy Subsidy Reforms. Forthcoming. Resilience & Growth of Decarbonization, B.3. A Virtous Cycle World Bank. 2023g. Indonesia Country Climate and Development Report, May 2023. Washington, DC: World Bank. B.4. Economic Foundations Policy & Side-Effects of B.5. The Impacts Climate Actions Development Policy B.6. A Climate & Framework 53 Supported by funding from the Australian Government through the Australia-World Bank Indonesia Partnership (ABIP) program