52200 INDONESIA ECONOMIC QUARTERLY Back on track? December 2009 Preface The Indonesian Economic Quarterly reports on and synthesizes the past three months' key developments in Indonesia's economy. It places them in a longer-term and global context, and assesses their implications for the outlook for Indonesia's economic and social welfare. Its coverage ranges from the macroeconomy to financial markets to indicators of human welfare and development. It is intended for a wide audience, including policy makers, business leaders, financial market participants, and the community of analysts and professionals engaged in Indonesia's evolving economy. This Indonesian Economic Quarterly was prepared and compiled by the Poverty Reduction and Economic Management group's macroeconomic analysis team at the World Bank's Jakarta office. Shubham Chaudhuri, Senior Economist, led the team and edited this Quarterly with Tim Bulman, Economist. Contributions came from Andrew Blackman and Fitria Fitrani (external sector, trade flows and balance of payments), Andrew Carter (government revenues and balance), Andrew Ceber (national accounts and domestic demand), Diva Singh, Neni Lestari and Telisa Falianty (financial markets, monetary sector and banking indicators), Ahya Ihsan (government expenditures and balance) Tim Bulman (prices and government financing) and Matt Wei-Poi (poverty and labor market analysis). Magda Adriani and Fitria Fitrani provided data support to the team. Edgar Janz and Vivi Alatas prepared the feature on developments in Indonesia's labor market, Shubham Chaudhuri described Indonesia as a middle income country, and Claudia Rokx prepared the material for the feature on health financing. Dhauhari Sitorus, Nathan Dal Bon and P. S. Srinivas provided editorial suggestions. The full team is under the leadership of World Bank Jakarta Office Lead Economist William E. Wallace. To be included on an email distribution list for this Quarterly series and related publications, please contact madriani@worldbank.org. For questions and comments relating to this publication, please contact tbulman@worldbank.org. For information about the World Bank and its activities in Indonesia, please visit www.worldbank.org/id i Table of contents Preface i Executive Summary: Back on track? iv A. ECONOMIC UPDATE 1 1. Indonesia's economy, less affected than most by the global downturn, has returned to near-pre- crisis growth rates 1 a. Growth was broadly based ............................................................................................................. 1 b. The economic recovery, with higher global commodity prices, has stabilized inflation at decade lows ..................................................................................................................................... 3 2. Indonesia's financial indicators remain volatile, rising by more than most 5 a. The balance of payments remained in surplus in Q3, with capital flowing into Indonesian financial assets ................................................................................................................................ 5 b. Equity and fixed income markets and the rupiah have continued the strengthening trend, at a slowing pace ................................................................................................................................. 6 c. The gains in financial markets and the exchange rate have been partly due to significant capital inflows .................................................................................................................................. 8 d. Despite the overall robustness of the banking sector, credit growth is showing only moderate recovery .......................................................................................................................... 9 3. The economic outlook is expected to be a little stronger than last quarter, with an ongoing, gradual recovery 10 4. The government's budget deficit is likely to be near target 15 a. Weaker-than-projected government revenue is offset by below-budget spending ................. 15 B. SOME RECENT DEVELOPMENTS IN INDONESIA'S ECONOMY 21 1. Indonesia's trade flows through the global crisis: from peak to trough and back again 21 2. The rupiah since late 2008: the scale of its movement and the driving factors 23 a. The rupiah has appreciated significantly since March, especially against the weakening US dollar ............................................................................................................................................... 23 b. Inflows of capital into liquid financial assets explain much of the appreciation... ................. 24 c. ...with the recovery in commodity prices fuelling strength as well .......................................... 26 C. INDONESIA 2014 AND BEYOND: A SELECTIVE LOOK 29 1. Seeing Indonesia as a middle-income country 29 2. Indonesia is entering a demographically critical decade 30 3. Creating better jobs for Indonesia's growing labor force 31 4. Financing healthcare for Indonesia's growing labor force and aging population 34 LIST OF FIGURES Figure 1: GDP growth returned to pre-crisis averages in Q3 ............................................................ 1 Figure 2: Growth across Indonesia's trading partners has rebounded ........................................... 1 Figure 3: Contributions to GDP expenditure growth ......................................................................... 2 Figure 4: Production sectors' contribution to growth ....................................................................... 2 Figure 5: Motor vehicle and motorcycle sales .................................................................................... 2 Figure 6: BI retail sales and consumer confidence ............................................................................ 2 Figure 7: Trade flows are recovering... ............................................................................................... 3 Figure 8: ...supported by global commodity prices, which are lifting Indonesia's export prices.. 3 Figure 9: The pick-up in inflation earlier in the second half of 2009 has not continued, allowing inflation to fall to decade lows ...................................................................................... 4 Figure 10: ...and consumers expect prices to be stable into the first half of 2010 ......................... 4 Figure 11: The IDX has risen more than most regional indices, before tracking sideways from late September ................................................................................................................ 6 Figure 12: ...and the rupiah's appreciation against the USD is the second strongest in the region .............................................................................................................................. 6 Figure 13: Local currency government bond yields, steadily falling across all tenors since March, have returned to early 2007 levels.................................................................... 7 Figure 14: Indonesian sovereign USD bonds have settled at levels slightly above their historical average, but have strengthened by more than most emerging market debt ............ 7 Figure 15: Indonesia has absorbed USD 6.5 billion in foreign capital since March, USD 2.6 billion of this in September and early October ............................................................ 8 Figure 16: Reserves have increased strongly since March while M2 growth has been slow, suggesting BI has been sterilizing its foreign exchange interventions .................... 8 Figure 17: Credit growth dropped sharply after September 2008 but has picked up since mid- 2009 ................................................................................................................................. 9 Figure 18: While other countries (apart from India) have seen credit slowdowns as well, Indonesia's stands out due to its rapid credit growth in the two years prior to October 2008 ................................................................................................................... 9 Figure 19: Despite various policy actions by the central bank, lending rates have only dropped 7 percent since January while deposit rates have fallen by 31 percent .................. 10 Figure 20: Indonesia is the only country where lending and deposit rates rose in the year to June 2009 ...................................................................................................................... 10 Figure 21: Indonesia's growth outlook improves ............................................................................. 11 Figure 22: ...along with the outlook for trading partners ................................................................ 11 Figure 23: Roll-over rates on Indonesia's external debt have also been high through 2009 ....... 14 Figure 24: ...have their greatest impact on 2010 growth ................................................................. 15 Figure 25, Figure 26: Spending on core programs has improved compared with recent years, but lower spending on `other' items and subsidies lowers overall spending ........ 16 Figure 27: VAT revenues have become more volatile than consumption spending recently ...... 20 Figure 28: VAT revenues from more industries producing more discretionary goods ................ 20 Figure 29: ...were particularly weak during the slowdowns around the turn of 2009 and 2006 ... 20 Figure 30: Trade values peaked in mid-2008, and troughed in February 2009 .............................. 21 Figure 31: From March, the rupiah has nominally appreciated much more against the USD than the USD has weakened against a broad basket of currencies ................................. 23 Figure 32: Indonesia's exchange rate has also appreciated significantly in real terms against a basket of currencies .................................................................................................... 23 Figure 33: The USD Index has moved in the opposite direction to global stock indices since the onset of financial market turmoil in September 2008................................................ 24 Figure 34: Indonesian local currency bond yields have fallen by one-third since March, but remain well above yields elsewhere ........................................................................... 24 Figure 35: There have been significant net capital inflows into Indonesia since March... ........... 25 Figure 36: ...increasing the stock of foreign capital held in Indonesia by USD 6.5 billion ­ over one-quarter ................................................................................................................... 25 Figure 37: Indonesia's foreign reserves have been correlated with the exchange rate since October 2008, suggesting BI has been partially limiting the exchange rate's volatility ......................................................................................................................... 26 Figure 38: Non-residents' holdings of Indonesian financial assets has fallen when country risk rises, and vice versa .................................................................................................... 26 Figure 39: Monetary and fiscal policy can limit the impact of capital inflows, but most options are costly....................................................................................................................... 26 Figure 40: Movements in commodity prices are correlated with movements in the rupiah, reflecting the importance of commodities in Indonesia's exports basket .............. 27 Figure 41: ...and the relationship is particularly strong against the real effective exchange rate27 Figure 42: Indonesia's demographic window of opportunity will close in the next decade ......... 30 Figure 43: Rising employment ........................................................................................................... 31 Figure 44: Stabilized unemployment ................................................................................................. 31 Figure 45: Slow formal sector employment growth ........................................................................ 32 Figure 46: Stagnant non-agricultural employment.......................................................................... 32 Figure 47: Highly informal workforce ................................................................................................ 32 Figure 48: Formal sector employees earn more ............................................................................... 32 Figure 49: Contract-less employees receive fewer non-wage benefits ........................................ 33 Figure 50: Redundancy costs in Indonesia are the highest in the region..................................... 33 Figure 51: Indonesia's health spending is relatively low ................................................................. 34 Figure 52: Only about a third of Indonesia's population enjoys health insurance coverage ....... 35 Figure 53: Demographics alone will increase Indonesia's health expenditures ........................... 36 LIST OF TABLES Table 1: The outlook remains for gradual recovery in growth .......................................................... v Table 2: The turnaround on the financial account expanded the balance of payments surplus, allowing reserves to rise................................................................................................ 5 Table 3: Indonesia's macroeconomic indicators............................................................................. 12 Table 4: The BoP surplus is expected to narrow through the forecast window, as the current account moves into deficit .......................................................................................... 13 Table 5: Indonesia's currently scheduled external financing needs over the coming 12 months total USD 24 bn ............................................................................................................. 14 Table 6: Projected financing sources give a BOP surplus of around USD 5 bn ............................ 14 Table 7: Alternative outcomes for key variables .............................................................................. 15 Table 8: Developments in revenue and spending ............................................................................ 17 Table 9: Small adjustments in the projected macroeconomic environment imply a slightly smaller budget deficit in 2009 and larger deficit in 2010 .......................................... 18 Table 10: Indonesia's 2010 financing needs remain considerable in 2010, although are likely to be supported by the government's likely 2009 financing surplus ........................... 19 Table 11: Indonesia's imports fell further, and recovered faster, than exports ............................. 22 Table 12: While trade flows fell across the board, exports to the emerging economies in Indonesia's region have recovered faster .................................................................. 22 Table 13: Movements in exchange rates and asset prices since September 2008 ....................... 27 Table 14: Regression analysis of the rupiah exchange rate and some of its key correlates ....... 28 Table 15: ...and of the correlates of the real effective exchange rate ............................................ 28 LIST OF BOXES Box 1: The economy's slowdown in late 2008 and 2009 has had a disproportionate impact on VAT revenues ............................................................................................................... 20 Executive Summary: Back on track? Indonesia's economy One year after the global financial crisis and economic downturn, Indonesia's economy seems back on track to appears to be broadly back on track. Economic activity has been picking up, inflation has faster growth and better remained moderate, financial markets have risen, and the newly reelected government, standards of living, but having established the strong fundamentals that supported Indonesia through the global risks remain crisis, appears to be now gearing up for new investments in Indonesia's physical infrastructure, human services and institutions of state. Indonesia seems well-positioned to get back on its pre-crisis growth trajectory, with the possibility of further acceleration and more inclusive growth. But this path is not inevitable and some questions remain. Significant risks remain in the global economy. The sustainability of the global recovery is still not entirely clear. And portfolio flows into emerging markets, which have surged in the last nine months, may as easily be reversed as policy makers elsewhere move to unwind the large monetary and fiscal stimulus efforts initiated over the last year. On the domestic front, political developments since October have begun to raise some questions about the timing and depth of future reforms. Indonesia's economy Many of the trends in Indonesia's real economy evident at the time of the September continued to gradually Quarterly continued into the third and fourth quarters of 2009. Movements in Indonesia's strengthen into Q4, real economy remained moderate. Indonesia has not experienced the sharp increases in continuing the trends growth in Q2 and Q3 2009 experienced by many of its neighbors, just as it was far less evident in September severely affected by the downturn around the turn of 2009. In Q3, Indonesia's growth continued to gradually accelerate, and the pick-up was broad based across both private and public demand and production sectors. Consumer indicators remained at the relatively high levels of mid year, while industrial activity sustained a measured recovery. Both export and import flows, which had fallen significantly with the crisis, continued to recover, supporting the ongoing current account surplus. Against expectations, inflation, which was gaining momentum in the third quarter, became subdued in October and November. 2009 will be the lowest inflation year in almost a decade. At play in recent months were good domestic supply conditions and the appreciating rupiah limiting the growth of tradable prices, allowing many retailers to reverse their Ramadan- and Idul Fitri-related price rises. Nonetheless inflation expectations remain above the lows of early in the year and inflation is likely to pick up in coming months. Financial markets have While Indonesia's real economy remains remarkably stable, particularly relative to its remained more volatile, neighbors', volatility in Indonesia's financial markets has continued. The rupiah continued with significant capital to appreciate into early October, as significant inflows of non-resident funds continued into inflows supporting liquid financial assets ­ government bonds, short-term money market notes, and equities. strengthening financial asset prices These markets all strengthened through to late September or early October. From mid October, the inflows appear to have slowed and the prices of these financial assets, and of Indonesian government USD bonds, generally tracked sideways through to early December, with the rupiah settling into a range of 9,400 to 9,500 ­ only slightly weaker than before the onset of the crisis and stronger on a real effective exchange rate basis. Unlike elsewhere in the region, the rise in financial assets prices does not appear to be leading to higher prices for non-financial assets, such as urban property. Other capital flows have generally returned to more `normal' patterns, although foreign direct investment inflows have remained weak and Indonesian residents shifted more funds into offshore bank accounts in Q3 than is typical for periods when financial markets are rising. Reserves continued to rise, reaching USD 65.8 billion by late November. The outlook remains for The outlook remains for the economy to continue its gradual recovery. Growth in 2010 is a gradual recovery in likely to be around 5.6 per cent, rising to 6.0 per cent in 2011. Ongoing solid consumption growth ­ and inflation, growth and a recovery in machinery & equipment investment should support the supporting a gradual economy. These projections assume that imports grow faster than exports given the improvement in poverty expected stronger performance of Indonesia's economy compared to others and expected increase in investment, although this projection may be conservative given the relative resilience of Indonesia's exports since late 2008. iv Inflation is projected to build again with the accelerating economy and projected gradual rise in commodity prices. But the rupiah's appreciation is expected to slow the rise in inflation in the first part of 2010. Energy pricing reform presents an upside risk to the headline inflation rate (less so core inflation) although, if these reforms are well managed and the rise in inflation expectations is capped, these reforms should only lead to a step- up in prices rather than contributing to a sustained increase in inflation. Together these developments should allow the poverty rate to continue to fall, by around 2˝ to 3 percentage points from early 2009 to early 2011, assuming that the government does not introduce new poverty reduction measures. Table 1: The outlook remains for gradual recovery in growth 2008 2009 2010 2011 Gross Domestic Product (annual % change) 6.1 4.5 5.6 6.0 Consumer price index (annual % change) 9.8 4.8 5.4 5.9 Poverty rate (% population) 15.4 14.2 13.5 11.4 Balance of payments (USD bn) -1.9 11.8 5.0 3.0 Budget balance (% GDP) -0.1 -2.3 -1.7 -- Major trading partner growth (annual % change) 2.4 -0.9 3.8 3.9 [Sources: MoF, BPS and other national statistical agencies via CEIC and World Bank The government's The government's 2009 budget deficit is likely to be slightly smaller than projected in the budget deficit is likely to revised budget, near 2.3 per cent of GDP, as below-budget spending (particularly on be slightly below subsidies and `other' items) offset weaker-than-projected revenues. Given the projections in 2009, and government's advanced financing and the strengthening of the exchange rate, this is likely may be slightly larger in 2010 to create a financing surplus, which will help support 2010's financing needs. Moreover, the government's improving disbursement performance together with recent developments in oil prices and the exchange rate suggest that the 2010 budget deficit may be slightly above the approved budget's 1.6 per cent projection. Risks to the outlook The risks to Indonesia's economic outlook remain significant, and slightly skewed to the remain significant; downside. The risks to the global economic environment have declined somewhat, although significant downside risks remain particularly as policy makers withdraw the various monetary and fiscal stimulus measures. Meanwhile domestically-sourced risks have risen, as recent domestic political developments have begun to raise questions about the timing and depth of future economic reforms. A. ECONOMIC UPDATE 1. Indonesia's economy, less affected than most by the global downturn, has returned to near-pre-crisis growth rates GDP growth returned to Many of the trends in Indonesia's real economy evident at the time of the September pre-crisis rates in Q3 Quarterly continued into the third and fourth quarters of 2009. Movements in Indonesia's real economy remained moderate, with growth and other indicators gradually returning to pre-crisis levels. GDP growth accelerated in Q3, returning to near pre-crisis averages. Year-on-year growth rose slightly, to 4.2 per cent from 4.0 per cent in the year to Q2. The economy expanded by around 1.5 per cent in the quarter (seasonally adjusted) ­ 6.0 per cent annualized­ compared with 1.2 per cent in Q2. (Figure 1). The acceleration in GDP is in line with improved international and domestic conditions. Improved consumer confidence and some softening in lending conditions have supported domestic consumption and investment, while consolidating commodity prices, recoveries in most of Indonesia's major trading partners, and much easier access to finance, have also supported investment, incomes and export demand. Figure 2: Growth across Indonesia's trading partners has Figure 1: GDP growth returned to pre-crisis averages in Q3 rebounded (per cent growth) (average GDP growth, weighted by Indonesia's export shares) Per cent Per cent Per cent Per cent 4 8 8 8 Year on year (RHS) Year on year (RHS) 6 6 3 6 4 4 QoQ seas. Average* 2 2 adjust (LHS) QoQ grow th 2 4 (LHS) 0 0 -2 -2 1 2 QoQ seas. adjust (LHS) -4 -4 0 0 -6 -6 Sep-02 Jun-04 Mar-06 Dec-07 Sep-09 Sep-02 Jun-04 Mar-06 Dec-07 Sep-09 * average quarter-on-quarter growth between Q1 2004 and Sources: National statistical agencies via CEIC and World Q2 2008. Sources: BPS, World Bank seasonal adjustment Bank a. Growth was broadly based Investment picked up, Contributions to growth were broadly based for the expenditure components of GDP while consumption (Figure 3). Investment has picked up, with both building and machinery and equipment remains robust investment accelerating. Like earlier quarters this year, growth was driven by consumption as well as the external sector. In a year on year basis the falls in imports continue to exceed those in exports, although both grew at a similar pace in Q3. Growth was also broadly based across production sectors (Figure 4), with non-tradable output continuing to grow somewhat faster than tradable output. Transport & communications contributed most to output growth, while wholesale & retail trade remained relatively weak. Solid domestic demand is Other consumer indicators suggest robust consumption: consumer confidence reached consistent with partial record highs in July, before retreating later in the quarter; and BI's retail sales index also indicators reached new highs (Figure 6). Motor vehicle and especially motor cycle sales have risen strongly from the start of the year, although are still well down on Q3 2008 (motorcycle sales 9 per cent lower and vehicle sales 27 per cent lower) (Figure 5). 1 Indonesia Economic Quarterly Back on track? Figure 3: Contributions to GDP expenditure growth Figure 4: Production sectors' contribution to growth (quarter-on-quarter percentage point contributions to (quarter-on-quarter percentage point contributions to aggregate GDP growth, seasonally adjusted) aggregate GDP growth, seasonally adjusted) Percentage points Percentage points 2.0 2.0 Percentage points Percentage points 2.0 2.0 Q2 Q3 GDP Q2 Q3 GDP 1.5 1.5 1.5 1.5 1.0 Domestic 1.0 Industry Services demand Discrepancy 1.0 1.0 0.5 Govt 0.5 cons 0.0 0.0 0.5 0.5 Priv Investment Net Agriculture cons exports -0.5 -0.5 0.0 0.0 Seasonally adjusted percentage point contributions may not sum to total GDP growth. Sources: BPS and World Bank Production indicators are Industrial sector indicators suggest manufacturing activity has risen since the start of the mixed year, but remains weaker than a year ago. Electricity consumed by industry and cement production were both slightly lower in Q3 2009 compared to a year earlier, although September movements must be read cautiously as all of the Idul Fitri holidays fell in that month this year. But both indicators have risen considerably since the start of 2009. The industrial production index reported moderate increases in activity since both Q2 and a year ago (around 2 per cent). Figure 5: Motor vehicle and motorcycle sales Figure 6: BI retail sales and consumer confidence (monthly purchases) (indices) '000 '000 Index Index 800 80 120 230 BI Consumer Motor cycles BI Retail Survey Index (LHS) 600 60 sales 100 190 400 40 80 150 200 Motor vehicles 20 (RHS) 0 0 60 110 Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sources: GAI and Astra via CEIC BI consumer confidence index is at 100 when the number of respondents with a positive outlook equals the number with a negative outlook. Source: BI via CEIC Net exports continued to Net exports continued to support economic growth in Q3 ­ as export volumes continued to contribute to growth as rebound more quickly than import volumes. Monthly trade flows continued to recover from merchandise trade flows their early 2009 lows in August through October, with both import and export values rising recover around two-thirds over this period. These gains have been supported by a recovery in demand as the world economy emerges from recession, and gains in global commodity prices support values, which have led Indonesia's export prices higher, (Figure 8) Recent monthly data have been volatile due to the holiday effect, and to three months of nickel exports being recorded in October. But even controlling for these effects, trade flows continued to recover into Q4, with exports rising 6 per cent in October, supported by electronics, mineral fuels and rubber exports. Import growth has remained more sluggish, THE WORLD BANK | BANK DUNIA December 2009 2 Indonesia Economic Quarterly Back on track? as capital goods imports, which were not as severely affected by the downturn, have picked up less (particularly for vehicles, electronics and machinery parts) and iron & steel imports remained soft. Services imports also continued to recover in Q3, growing by 2.5 per cent Q-o-Q -- primarily due to higher spending on freight with the increase in Indonesia's merchandise trade flows and recovery in global freight rates. However, service exports contracted slightly (by 0.8 per cent in the quarter), predominantly due to reduced business and government service exports. Tourist arrivals were up. ...narrowing the current Indonesia's current account surplus narrowed in Q3 relative to Q2. The stronger recovery account surplus in the nominal value of imports in Q3 relative to exports narrowed Indonesia's trade surplus. The wider income deficit added to this, as higher commodity prices led to increased outflows of income and profits from foreign investors in the oil & gas sector. Figure 8: ...supported by global commodity prices, which Figure 7: Trade flows are recovering... are lifting Indonesia's export prices (trade values and balance, billions of USD) (USD prices, indexed to 100 in July 2007) USD billion USD billion Index Index 6 15 190 190 Trade Balance (LHS) Exports (RHS) Energy 4 10 160 160 2 5 130 130 0 0 Exports 100 100 -2 -5 Non-energy -4 -10 70 70 Im ports (RHS) -6 -15 40 40 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 Sources: BPS and World Bank Sources: World Bank global commodity prices. Indonesian export prices calculated by World Bank from BPS trade data b. The economic recovery, with higher global commodity prices, has stabilized inflation at decade lows After gaining momentum From mid year to the Idul Fitri holidays, consumer prices accelerated from the very low in the third quarter, prices inflation rates of the first half of the year. But even at the peak during Ramadan, when were stable in October retailers raise prices with the higher demand for many consumer items, monthly inflation and November was no higher than in the equivalent period in earlier years. In October, after the Idul Fitri holiday week, when workers came back to work and demand returned to normal patterns, many of the Ramadan-related price rises, such as for many food items and for inter-city transport, were at least partly reversed, giving a low monthly inflation rate. Good fresh food supply, and some pass-through of the appreciating exchange rate, led average consumer prices to fall very slight between October and November. By November, headline year-on-year inflation had fallen to 2.4 percent, the lowest rate since early 2000. ...with falls in volatile While some fresh food (eggs & dairy products, beans & nuts, and fats & oils) and most prices adding to the transportation prices have been especially weak from September to November, inflation general weakness in for most other items has slowed too. Core inflation, which excludes the volatile and inflation administered (including regulated fuel) prices, remains about 2 percentage points above the headline rate, although it too has fallen to decade-lows, at 4.3 per cent in the year to November. The general disinflation has benefited poor households too, although they continue to experience price growth about 1 percentage point faster than the average Indonesian consumer. The cost of a poor household's consumption bundle rose by 3.2 per cent in the year to November. THE WORLD BANK | BANK DUNIA December 2009 3 Indonesia Economic Quarterly Back on track? The rupiah's appreciation The appreciation of the rupiah does appear to have muted price growth somewhat has muted price growth (against the USD, the rupiah appreciated 8.3 per cent in the six months to November). Econometric estimates suggest that the rupiah's appreciation is likely to have reduced inflation by 0.3 to 0.6 percentage points, with several tenths of a percentage point of further disinflation expected by early 2010. And this is evident in the prices of some of the more tradable items in the CPI. For example, in the six months to November, `equipment' (for transportation, education and the household), medicines, and women's and children's clothing prices have all increased by less than the overall CPI ­ but the difference in growth was small (0.4 to 1.1 percentage points weaker than the overall CPI over the 6 months) and inflation was weaker for many associated services. The appreciation's impact has been greater for upstream prices. The overall wholesale price index (WPI) fell by 3.5 per cent in the year to October, due partly to significantly lower rupiah prices for Indonesia's exports, which in turn appear to be feeding into industry prices, which were down by 8.2 per cent in the year to October. Economy-wide prices Growth of other prices has slowed too. The implicit GDP deflator, measuring prices across have also slowed, but the economy, grew by 4.6 per cent in the year to Q3, the slowest rate since early 2004. continue to increase Quarterly price growth slowed in Q3 relative to Q2, with export prices falling and faster than the CPI investment good prices increasing by 1.0 per cent from Q2 to Q3, the slowest quarterly rate since 2003. The national accounts implicit price deflators give a broader perspective on price movements across the economy than the consumer price index. The CPI reports the prices of the basket of goods and services consumed by the average urban household (weighted by expenditure), an important but incomplete picture of national prices, given that private consumption accounts for 60 per cent of GDP and half of Indonesia's households live outside urban areas. Figure 9: The pick-up in inflation earlier in the second half of Figure 10: ...and consumers expect prices to be stable into 2009 has not continued, allowing inflation to fall to decade the first half of 2010 lows (year-on-year inflation rates and index point level of inflation (year-on-year and month-on-month inflation rates) expectations) Per cent Per cent Per cent Index 5 15 24 199 Fresh food Poverty basket inflation 4 12 20 190 inflation RHS) (LHS) Expected inflation, Core 6 momths ahead 3 inflation 9 16 181 Inflation YoY (advanced 6 months, (RHS) (RHS) RHS) 2 6 12 172 Inflation MoM 1 3 8 163 (LHS) 0 0 4 154 Inflation (LHS) -1 -3 0 145 Jan 07 Jun 07 Nov 07 Apr 08 Sep 08 Feb 09 Jul 09 Dec 09 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Sources: BPS and World Bank estimates of poverty basket Sources: BPS and BI via CEIC inflation Inflation expectations are Consumers' inflation expectations have also stabilized since August above the Q1 trough rising faster than actual (almost 7 per cent higher). Consumers expect transportation & communications prices inflation particularly to rise in the coming 6 months, despite this being the weakest group of prices currently. Businesses continued to reduce their expectations of future inflation to historically low levels, with almost half the respondents to BI's survey expecting inflation below 7 per cent. THE WORLD BANK | BANK DUNIA December 2009 4 Indonesia Economic Quarterly Back on track? 2. Indonesia's financial indicators remain volatile, rising by more than most a. The balance of payments remained in surplus in Q3, with capital flowing into Indonesian financial assets The BoP surplus The balance of payments (BoP) surplus increased to USD 3.5 bn in Q3 due to a expanded in Q3, due to a turnaround on the financial account to a surplus of USD 3.0 bn, somewhat offset by a turnaround on the narrowing in the current account surplus, to USD 1.7 bn. (Table 2) The additional financial account... allocation of 1.74 bn of special draw rights (USD 2.7 bn) to Indonesia by the IMF on August 21, contributed to this surplus, as did large foreign purchases of SBIs. This was somewhat offset by large transfers by Indonesian residents to foreign bank accounts. The surplus on the BoP ­ and in particular, the additional SDR allocation ­ saw Indonesia's foreign reserves rise to USD 65.8 billion at the end of November, surpassing the pre-crisis peak of July 2008. Upgraded ratings of Ratings upgrades of Indonesia's sovereign debt have supported inflows, although their Indonesian sovereign timing means the impact is likely to be greater in Q4. On 16 September Moody's debt have supported upgraded Indonesia's foreign and local-currency sovereign debt ratings to Ba2 from Ba3, inflows citing the nation's economic resilience during the global financial crisis. A month later, Standard & Poor's upgraded its outlook for the Indonesian economy to positive from stable, and reaffirmed its 'BB-' long-term foreign currency and 'BB+' long-term local currency sovereign credit ratings, citing cautious macro policies and the reform-minded leadership. Table 2: The turnaround on the financial account expanded the balance of payments surplus, allowing reserves to rise (billions of USD unless otherwise stated) 2008 2009 2005 2006 2007 2008 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Balance of Payments .4 14.5 12.7 -1.9 1.0 1.3 -.1 -4.2 4.0 1.1 3.5 Per cent of GDP 0.2 5.1 3.5 -0.5 0.8 1.0 -0.1 -3.8 3.5 0.8 2.4 Current Account .3 10.9 10.5 .1 2.7 -1.0 -1.0 -.6 2.7 2.9 1.7 Per cent of GDP 0.1 3.8 2.9 0.0 2.3 -0.8 -0.7 -0.6 2.4 2.2 1.2 Trade Balance 8.4 19.8 20.9 9.9 4.5 2.1 2.5 .9 4.3 5.4 4.6 Net Income & Current Transfers -8.1 -8.9 -10.4 -9.8 -1.7 -3.1 -3.4 -1.6 -1.6 -2.5 -2.9 Capital & Financial Accounts .3 3.0 3.6 -1.9 -.5 2.1 2.4 -5.8 1.9 -2.2 3.0 Per cent of GDP 0.1 1.1 1.0 -0.4 -0.4 1.6 1.6 -5.2 1.7 -1.7 2.0 Direct Investment 5.3 2.2 2.3 3.4 .6 .2 1.9 .7 .8 .2 -.1 Portfolio Investment 4.2 4.3 5.6 1.7 2.0 4.2 -.1 -4.4 1.9 2.0 3.4 Other Investment -9.4 -3.8 -4.8 -7.3 -3.2 -2.3 .4 -2.2 -.8 -4.5 -.4 Errors & Omissions -.2 .6 -1.4 -.2 -1.2 .2 -1.5 2.2 -.7 .4 -1.2 Foreign Reserves* 34.7 42.6 56.9 51.6 59.0 59.5 57.1 51.6 54.8 57.6 62.3 * Foreign reserves at end of September. Reserves rose to USD 65.8 billion at end November. Sources: BI, BPS via CEIC and World Bank Capital flows continue to While volatile by nature, flows in the financial accounts continued to return to more normal generally `normalize' patterns in Q3, following the turbulence around the turn of the year. Non-resident portfolio investors returned as significant purchasers in equity and bond markets after reducing their holdings in recent quarters. Corporations have re-entered offshore debt markets after a prolonged period of absence, consistent with the surge in funds globally to emerging market corporate bond issuers. Finally, trade credits have approached pre-crisis levels ­ consistent with increased trade activity and improved financial conditions. ...although foreign direct One important exception to this normalization was a further fall in foreign direct investment investment has weakened (FDI), as investors in oil & gas reduced their investments and withdrew more funds from further, particularly in the the sector, while non-oil & gas investment remained weak. Indonesians' investments oil & gas sector offshore fell to USD 0.5 billion in the quarter, about one-third of their usual level. THE WORLD BANK | BANK DUNIA December 2009 5 Indonesia Economic Quarterly Back on track? ...and residents are The other exception is Indonesian residents continuing to shift substantial amounts of shifting unusually large funds into bank deposits overseas. A total of USD 10 billion has been invested offshore in amounts into offshore the year to Q3, the most in any four quarters on record. The size of these transfers in Q3, bank accounts USD 3.5 billion, is unusual given the strengthening market conditions in this period, with past episodes of significant transfers offshore occurring when financial markets have been weakening rapidly. Some of these funds may have made their way back into Indonesia through `offshore' investments in financial markets. b. Equity and fixed income markets and the rupiah have continued the strengthening trend, at a slowing pace The IDX composite has While major Asian equity indices have all performed well in the last six months, the JCI's gained 92 per cent since 92 per cent gain since March is beaten only by the performance of the Bombay Stock March making it the top Exchange, which rose by 109 per cent over the same period (Figure 11). Like most regional performer after markets, the rate of growth has slowed since late September. After passing 2500 points the Bombay Stock Exchange in mid-October to trade at levels last seen in early March 2008, the JCI dipped slightly at the end of October with speculation that the recovery in global financial markets had been overplayed, and as some of the positive market sentiment surrounding domestic political developments eased. However, the sell-off was short-lived and equities inched back up through the second half of November. The Rupiah has Similarly, the rupiah has appreciated significantly against the USD and other major appreciated significantly currencies in the past six months, before stabilizing to a narrowrange around 9,450 from against the USD and early October to early December. Since March, the currency has gained 22 per cent other currencies over the against the USD, over 13 per cent against the euro and Singapore dollar, and 8 per cent past six months, although it is still somewhat below against the British pound. The movement in IDR/USD has been particularly marked and pre-September 2008 has therefore raised some concern among Indonesian authorities regarding the levels sustainability of the appreciation as well as its impact on competitiveness. While the magnitude of the Rupiah's rise versus the USD is not unusual given the high volatility (`beta') of Indonesian financial markets, the USD has weakened against most regional and major currencies indicating more than a rupiah story is at play (Figure 12). For example, since March the Korean won has gained 26 per cent against the USD, and the Australian dollar has appreciated by 47 per cent. The rupiah's appreciation has taken it towards levels it was trading at against the USD in August 2008, while the Indian rupee and Korean won are both still considerably weaker than they were pre-crisis. (Part B examines the recent rupiah appreciation and its drivers in more detail.) Figure 11: The IDX has risen more than most regional Figure 12: ...and the rupiah's appreciation against the USD is indices, before tracking sideways from late September the second strongest in the region (equity indices indexed to 100 on 2 January 2008) (currency pairs indexed to 100 on 2 January 2008) Index 2 Jan 08 = 100 Index 2 Jan 08 = 100 Index 2 Jan 08 = 100 Index 2 Jan 08 = 100 115 115 175 55 March 2009 March 2009 Thailand SET USD Appreciation AUD/USD 100 Singapore SGX 100 Jakarta JCI (RHS) EUR/USD 145 (RHS) 85 85 85 KRW/USD 70 70 115 IDR/USD 115 (LHS) (LHS) 55 55 Shanghai 85 145 Composite INR/USD SGD/USD 40 40 (LHS) JPY/USD Bombay BSE (LHS) (LHS) 25 25 55 175 Jan08 Apr08 Jul08 Oct08 Feb09 May09 Aug09 Dec09 Jan08 Apr08 Jul08 Oct08 Feb09 May09 Aug09 Dec09 Sources: FRB, CEIC and World Bank Sources: CEIC and World Bank THE WORLD BANK | BANK DUNIA December 2009 6 Indonesia Economic Quarterly Back on track? Indonesian rupiah and Indonesian local currency and USD denominated sovereign bonds continued the USD denominated strengthening trend that started in March into September, before flattening to a 50 basis sovereign bond yields point range from October to December, as monetary policy remained loose and inflation have fallen to 2007 levels numbers in October and November were below market analysts' expectations. Over the with loose monetary policy, low inflation and past three months, yields across the entirety of the curve have moved in parallel, and by strong demand early December the yield curve was down to early 2007 levels (Figure 13). Five year IDR government bond yields have fallen by 33 per cent since March, from nearly 14 per cent to about 9.35 per cent in late November. In spite of these declines, Indonesian local currency bond yields remain higher than those elsewhere in the region.( ) Indonesian EMBI USD bond spreads have also recovered to late 2007 levels (Figure 14), and remain below the global average emerging market spread to US Treasuries. Since countries' EMBI spreads are often taken as a proxy for measuring "country risk", Indonesia's narrowing spreads may have served to indicate lower country risk in recent months and thereby helped attract investors and capital into Indonesia's financial markets. Fuel subsidy reform and Going forward, the government's possible energy subsidy reform agenda in 2010 could lower government reduce bond yields. The current fuel pricing system, where prices are moved towards the financing needs in 2010 economic cost of fuel in large, ad hoc adjustments, generates uncertainty over the future should support bond path of inflation and may contribute to higher inflation expectations and hence Indonesia's prices structurally higher inflation rate. It also creates uncertainty over the government's financing needs and hence the number of bonds the government will sell each year, as higher economic costs of energy and irregular price adjustment make the cost of the government's energy subsidies higher and more volatile. These two effects lead investors to demand higher bond yields, especially for longer-term bonds, to protect against the higher inflation and greater potential volatility in bond prices. In addition, the smaller than expected fiscal deficit this year has lowered the government's financing needs for 2010. This will mean lower bond issuance needs next year and should therefore also help support bond prices. Figure 14: Indonesian sovereign USD bonds have settled at levels slightly above their historical average, but have Figure 13: Local currency government bond yields, steadily strengthened by more than most emerging market debt falling across all tenors since March, have returned to early (Indonesian EMBI spreads to US Treasuries and difference 2007 levels between Indonesian spreads and global emerging market (yields on 1 year to 15 year IDR sovereign bonds, percent) average, both in basis points) Percent Percent Basis points Basis points 14.5 14.5 1200 400 2 March 2009 13.5 13.5 1000 Indonesian EMBI 300 12.5 12.5 USD Bond Spreads 1 May 2009 (LHS) 800 200 11.5 11.5 Indonesian Spreads 1 September 2009 Less Global EMBI 10.5 10.5 600 100 Average (RHS) 9.5 26 March 2007 9.5 400 0 8.5 8.5 1 December 2009 200 100 7.5 7.5 6.5 6.5 0 200 1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y 11Y 12Y 13Y 14Y 15Y Jan05 Oct05 Aug06 May07 Mar08 Dec08 Oct09 Sources: CEIC and World Bank Sources: JP Morgan, Datastream and World Bank The strength in financial The strong recovery in financial asset prices in other economies in the region has lifted market prices has not nonfinancial asset prices too, particularly those for apartments and commercial property, passed into other asset while rents have been stable or fallen. The opposite appears to have been the case in prices Indonesia's urban property market. Growth in selling prices of apartments, offices, retail and industrial space in the Jabodebek (greater Jakarta) region all slowed to near zero by Q2 or Q3 of 2009, from growth rates around 15 percent in 2008 for offices and apartments. This slowdown may reflect market balances, with slight rises in vacancy rates and falls in selling rates through the first three quarters of 2009. Despite these THE WORLD BANK | BANK DUNIA December 2009 7 Indonesia Economic Quarterly Back on track? developments, rents have continued to grow relatively strongly (by 11.6 percent in the year to Q3 for apartments, although rental growth rates have slowed since late 2008 for all property types). c. The gains in financial markets and the exchange rate have been partly due to significant capital inflows Large inflows of offshore An important contributing factor to capital market and rupiah strength from March to funds have played an December has been large inflows of foreign capital into Indonesia. Non-residents have important role in invested approximately USD 6.5 billion (net) in Indonesian financial assets since March, strengthening financial with much of these funds entering in September and early October. This inflow of capital asset prices and the rupiah has increased overall foreign holdings of Indonesian equities, government bonds and short-term money market instruments by 28 per cent (Figure 15). Since non-residents' holdings represent a significant share of Indonesia's relatively shallow financial markets, such movements of foreign capital can have a sizeable impact on asset prices. Mostly carry trade driven, The reasons behind these inflows are not unique to Indonesia but rather linked to low these inflows provide interest rates in the United States and the weakening USD, which have led investors to more funds for put on large carry trades to take advantage of higher yielding assets in emerging markets. investment, but can also While such inflows are positive in so far as they give a kick start to the economy and be destabilizing if investors change market, they can be destabilizing if they are purely arbitrage driven and therefore leave sentiment suddenly and the country as quickly as they came in. Indonesia's open capital markets and high withdraw these funds interest rate differentials make it a particularly attractive haven for such inflows but also leave the country especially vulnerable to sudden reversals in investor sentiment. Figure 15: Indonesia has absorbed USD 6.5 billion in foreign capital since March, USD 2.6 billion of this in September and Figure 16: Reserves have increased strongly since March early October while M2 growth has been slow, suggesting BI has been (net inflows and total foreign capital stock of equities, sterilizing its foreign exchange interventions government bonds and money market instruments, billions of (M2 in trillions of IDR; international reserves in billions of IDR) USD) IDR billion IDR billion IDR trillion USD billion 240000 8000 2250 75 March 2009 Total Foreign Capital Stock 2000 65 190000 4000 (LHS) TotalReserves (RHS) 140000 0 1750 55 90000 Total Net Foreign Inflows 4000 1500 45 (RHS) M2 Broad Monetary Aggregates (LHS) 40000 8000 1250 35 10000 12000 1000 25 Oct08 Dec08 Feb09 Apr09 Jun09 Aug09 Oct09 Jan06 Jun06 Nov06 Apr07 Sep07 Feb08 Jul08 Dec08 May09 Oct09 Sources: BI, CEIC and World Bank Sources: BI, CEIC and World Bank The build-up of In order to neutralize the impact of capital inflows on the exchange rate and monetary international reserves base, central banks can intervene in the foreign exchange market by buying foreign and muted growth in the currency in exchange for local currency, then using open market operations to remove money supply since extra liquidity that was created in selling the rupiahs. BI appears to have done this to a March suggest that BI sought to offset the degree. International reserves rose by 23 per cent from early March (when the rupiah impact of capital inflows started a sustained appreciation against the USD) from USD 53.7 billion to USD on the exchange rate and 65.8 billion at the end of November (Figure 16). This USD 12.1 billion rise is equivalent to monetary base 6.3 per cent of the money base (M2) in March, and, without sterilization, the money base would be expected to accelerate by this rate in addition to its trend growth. Instead, growth in the money supply has been unusually slow during this period, rising at an annualized rate of 8.3 per cent between March and September, compared with average growth of 18.3 per cent in 2006 and 2007. THE WORLD BANK | BANK DUNIA December 2009 8 Indonesia Economic Quarterly Back on track? BI appears to have been reabsorbing some of the extra money supply it has created in intervening in the foreign exchange markets by issuing more short-term money market instruments. The stock of SBIs on issue more than quadrupled over this period, rising the equivalent of USD 3.5 billion. This occurred at the same time as BI was easing monetary policy ­ and would therefore usually be expected to be buying back SBIs in order to increase the money supply. This combination of building reserves and selling SBIs is costly for BI, as it earns low interest on its international reserves, while paying high yields of 6.5 percent on the SBIs it issues. All in all, while it is often difficult for central banks in emerging economies to fine tune short-run changes in the monetary base through open market operations, BI appears to have been fairly effective in limiting the impact of rapidly increasing reserves on the money supply. d. Despite the overall robustness of the banking sector, credit growth is showing only moderate recovery The banking sector Earnings of major banks and various aggregate indicators such as capital adequacy and remains in good health return on assets suggest the health of the overall banking sector remains robust. overall, according to In September, commercial banks' non-performing loan ratios fell to 3.8 percent, slightly financial ratios and above the 2008 average of 3.6 percent, but still well below the 2007 and 2006 averages of earnings reports 5.6 percent and 8.0 percent, respectively. ...but lending growth has Despite the overall buoyancy in the banking sector, credit growth remains slow, although it only shown a moderate has risen since Q2. (Figure 17) Lending has grown by 6 percent in 2009 to date, recovery in recent compared with 32 per cent in 2008. Further acceleration may be likely, given that new months loan approvals returned to their mid 2008 levels by Q3 2009. (Figure 17) While lending has stalled in many economies in the region this year (India notwithstanding), Indonesia's slowdown is conspicuous due to the fast pace of lending in the prior two years, which came to an abrupt halt in October 2008. (Figure 18). Figure 17: Credit growth dropped sharply after September Figure 18: While other countries (apart from India) have seen 2008 but has picked up since mid-2009 credit slowdowns as well, Indonesia's stands out due to its (quarterly new loan approvals in IDR trillion; credit growth in rapid credit growth in the two years prior to October 2008 percentage change quarter-on quarter) (commercial bank lending indexed to 100 in January 2006) 400 IDR trillion (quarterly) Percent QoQ 12 Index Jan 06 =100 Index Jan 06 = 100 275 275 255 255 350 10 India 235 235 300 8 215 215 Credit Growth Indonesia 250 (RHS) 6 195 195 200 4 175 175 Malaysia New Loan Approvals 155 155 150 2 Singapore (LHS) 135 USA 135 Thailand 100 0 115 115 Philippines 50 2 95 95 Mar07 Jun07 Sep07 Dec07 Mar08 Jun08 Sep08 Dec08 Mar09 Jun09 Sep09 Jan06 Dec06 Nov07 Oct08 Sep09 Sources: CEIC and World Bank Sources: FRB and BI via CEIC and World Bank Lending rates remain at Among the supply- and demand-side factors causing the slowing in lending, the high cost high levels despite BI's of borrowing has stood out. Lending rates have remained above 14 percent since October 300 bps policy rate cut 2008, despite BI's 300 basis point cut to its policy rate between December and August this and attempts to reduce year. Indonesia was the only country in the region to have higher lending and deposit the cost of funds by capping deposit rates rates in June 2009 compared to a year earlier, in spite of the central bank's policy rate cuts. (Figure 18) BI sought to reduce lending rates in August by asking the 14 largest commercial banks to sign a voluntary agreement to cap deposit rates. This agreement was intended to reduce interbank competition for funds. By October, the effect appears to have been limited, with THE WORLD BANK | BANK DUNIA December 2009 9 Indonesia Economic Quarterly Back on track? deposit rates falling 100 basis points from June, while lending rates dropped by only 35 basis points. Since rates peaked around the turn of the year, lending rates have only fallen 106 basis points, while deposit rates have decreased by over 330 basis points. International experience has been that this approach of capping and, in effect, regulating deposit and lending rates, has not been effective in addressing structural problems in the banking sector that limit investors' access to funds. Figure 19: Despite various policy actions by the central bank, Figure 20: Indonesia is the only country where lending and lending rates have only dropped 7 percent since January deposit rates rose in the year to June 2009 while deposit rates have fallen by 31 percent (rate differences between June 2008 and June 2009, (net interest margin, lending and deposit rates, per cent) percentage points) Percentage point Percentage point Percent Percent 6 6 6.00 16 Lending Rate Deposit Rate CB Policy Rate LendingDeposit LendingPolicy Rate Difference Difference Difference Spread Spread Lending Rates 4 4 5.80 (RHS) 14 2 2 5.60 12 Net Interest Margin 0 0 (LHS) 5.40 Deposit Rates 10 2 2 (RHS) 5.20 8 4 4 BI Policy Rate (RHS) 6 6 5.00 6 Indonesia Malaysia United Singapore Philipines United China India Thailand Sep07 Dec07 Mar08 Jun08 Sep08 Dec08 Mar09 Jun09 Sep09 Kingdom States Sources: CEIC and World Bank Sources: FRB and BI via CEIC and World Bank The rigidity of lending This stickiness in lending rates, while deposit rates have fallen, has meant that net interest rates has allowed net margins (NIMs) have remained at or above 5.5 percent since March, compared to other interest margins to countries in the region where NIMs range between 3-4 percent. While high net interest remain relatively high margins may make Indonesian banks some of the most profitable in the region, the compared to other countries in the region burgeoning spread between lending rates and deposit and savings rates increases the cost of investment and consumption smoothing, and so may limit economic growth. ...and BI aims to lower In light of this, in mid-November BI stated that it will encourage the banking sector to these by mid 2010 reduce net interest margins by June 2010. Before issuing a formal policy, the central bank plans to first conduct a detailed study on the cost structure of Indonesia's banking industry. It is also uncertain whether reducing net interest margins would actually lead to an increase in banks' lending. Due to the post-crisis tightening of credit standards and the downward pressure on lending rates this year, banks have been increasingly investing in government bonds and money market instruments, which provide relatively high and risk- free yields, as opposed to lending. Further pressure to narrow net interest margins and bring lending rates down could make banks even more averse to lending, and simply serve to increase their reliance on government bond investments and fee-based income. 3. The economic outlook is expected to be a little stronger than last quarter, with an ongoing, gradual recovery Indonesia's growth The outlook for Indonesia's economy has improved over the last three months (Figure 21). outlook has risen slightly The economy is expected to grow by 4.5 per cent in 2009, higher than the previous in the past three months forecast of 4.3 per cent, due to the stronger-than-expected outcomes across Indonesia's trading partners mid-year, consolidation of higher commodity prices, and somewhat stronger-than-expected Q3 Indonesian GDP outcome. In 2010 growth is expected to rise to 5.6 per cent, higher than the 5.4 per cent expected previously. Growth is expected to return toward trend of around 6 per cent from 2011. The improved outlook follows the slightly stronger than expected Q3 GDP and improved external environment and outlook. THE WORLD BANK | BANK DUNIA December 2009 10 Indonesia Economic Quarterly Back on track? Investment growth is The major drivers of Indonesia's growth in 2010 are expected to continue to come from expected to rebound domestic demand, with support from a recovery in the external sector (Table 3). Private while government consumption expenditure is expected to accelerate, growing by around 5.1 per cent in spending will remain 2010 with the continued impact of the fiscal stimulus, moderate price growth and strong improving incomes. Investment growth is also expected to accelerate in 2010, as increasing commodity prices and external demand, and easier access to finance, support investors' plans. Government consumption is expected to continue growing with greater spending on core government programs and improved disbursement rates. Figure 22: ...along with the outlook for trading partners Figure 21: Indonesia's growth outlook improves (average annual GDP growth of Indonesia's export (annual average GDP growth, per cent) destinations) Per cent Per cent Per cent Per cent 8 8 8 8 September update Current forecasts Forecasts September update Forecasts 6 6 6 6 Current forecasts 4 4 4 4 2 2 2 2 0 0 0 0 -2 -2 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Sources: BPS and World Bank forecasts Sources: CEIC, Consensus Forecasts Inc and World Bank Inflation is expected to After being a little stronger than expected in August and September and then weaker than accelerate gradually, as expected in October and November, the outlook for CPI inflation in 2009 has changed the stronger rupiah little, with an annual rate of 4.8 per cent. The pickup in GDP growth and commodity prices offsets the firmer outlook that has occurred since Q2 and that is projected to continue over the forecast horizon for growth and commodity prices should feed into a gradual acceleration in prices, with annual inflation rates rising to 5.5 to 6 per cent range in 2010 and 2011. The additional appreciation of the rupiah in the past few months has lowered the outlook ­ latest estimates suggest that a 10 per cent appreciation of the rupiah against the USD lowers prices by 0.6 to 0.9 per cent over about 6 months, suggesting that the appreciation up to October will limit price growth into the second quarter of 2010. The inflation rate experienced by poor households, and the core inflation rate (excluding volatile and administered prices), are projected to slowly converge with the headline rate while following a similar path, rising towards 6 per cent in 2010 and remaining at that rate into 2011. The exchange rate's appreciation is projected to have a larger impact on core inflation, and a smaller impact on poor households' inflation rate (as a relatively larger share of poor households' consumption basket is spent on items with prices that are domestically determined). Specific policy initiatives to better target energy and other subsidies and to allow regulated prices to move more in line with economic costs have yet to be announced, beyond some limited adjustment to bring some electricity tariffs closer to the cost of supply and in some LPG prices; both of these initiatives have little impact on the overall CPI. Such reforms do present a risk to the inflation projections, as prices undergo a one-off upward step. Poverty is likely to These projections suggest the official poverty rate is likely to continue to fall, from 14.2 per continue to fall, modestly February 2009 to around 13.5 per cent in early 2010 and 11.4 per cent in early 2011. Like the larger macroeconomic environment, these projections have changed little in the last three months, although household-level data from the latest household survey has reduced the projected rate of poverty reduction for technical reasons. Poverty reduction is likely to be supported by the planned expansion of the PKH and PNPM Mandirii programs, THE WORLD BANK | BANK DUNIA December 2009 11 Indonesia Economic Quarterly Back on track? with other targeted poverty reduction policies currently under development; in the longer- term the government's 100 day plan also features various other policy measures that may accelerate poverty reduction indirectly. Table 3: Indonesia's macroeconomic indicators (percentage change, unless otherwise indicated) d Annual Year to December quarter Revisions to Annual 2008 2009 2010 2011 2008 2009 2010 2011 2009 2010 2011 1. Main economic indicators Total Consumption expenditure 5.9 6.0 5.6 5.4 6.4 5.1 5.1 5.4 0.8 0.7 0.4 Private consumption expenditure 5.3 5.0 5.1 5.3 4.8 4.7 4.9 5.3 0.5 0.4 0.3 Government consumption 10.4 12.7 8.8 5.8 16.4 7.7 8.9 6.1 1.9 2.6 1.1 Gross fixed capital formation 11.7 3.7 9.0 7.4 9.1 4.7 8.5 6.9 1.0 0.8 0.6 Exports of goods and services 9.5 -11.4 8.8 10.8 1.8 -3.0 6.7 12.6 0.7 -0.8 -0.5 Imports of goods and services 10.0 -19.5 12.6 12.1 -3.5 -8.7 9.3 13.6 -1.0 -0.6 0.4 Official poverty rate (%) 15.4 14.2 13.5 11.4 n/a n/a n/a n/a n/a -0.1 -0.1 Gross Domestic Product 6.1 4.5 5.6 6.0 5.2 5.4 5.6 6.1 0.2 0.2 0.1 2. External indicators Trade balance (USD bn) 9.9 17.7 10.0 10.9 n/a n/a n/a n/a 0.8 -1.9 -0.3 Balance of payments (USD bn) -1.9 11.8 5.0 3.0 n/a n/a n/a n/a -0.2 -3.0 0.8 Financial account balance (USD bn) -2.2 4.5 4.1 2.7 n/a n/a n/a n/a 1.0 -1.4 -0.4 3. Other economic measures Consumer price index 9.8 4.8 5.4 5.9 11.5 2.7 6.0 6.3 0.1 -0.3 -0.6 Poverty basket Index 11.6 5.8 5.4 5.9 13.5 2.9 6.4 6.2 0.1 -0.3 -0.4 GDP Deflator 18.2 7.3 9.2 10.9 17.1 6.0 7.4 13.0 -1.7 -2.1 0.9 Nominal GDP 25.4 12.1 15.3 17.6 23.1 11.8 13.3 19.8 -1.6 -1.9 1.1 4. Economic assumptions Exchange rate (IDR/USD) 9757 10362 9500 9500 11365 9500 9500 9500 -153 -500 -500 Interest rate (SBI, 1 month) 8.7 7.1 6.5 6.5 9.4 6.5 6.5 6.5 -0.2 -0.5 -0.5 Indonesian crude price (USD/bl) 97.0 60.9 79.0 83.6 52.8 72.5 81.3 84.5 0.7 4.9 8.0 Major trading partner growth 2.4 -0.9 3.8 3.9 -1.3 3.0 3.2 4.2 0.9 0.5 0.5 Notes: Projected trade flows relate to the national accounts, which may overstate the true movement in trade volumes and understate the movement in prices. The national accounts reported that the Rupiah value of exports fell by 15 per cent in the year to mid-2009--consistent with the balance of payments data--while the volume of exports fell by almost 16 per cent, imply that Indonesia's export prices, in rupiah terms, rose by 1.3 per cent, notwithstanding the collapse in commodity prices over this period and 12 per cent depreciation of the rupiah. The outlook remains for a The outlook for trade flows in 2009 remains for imports to fall by more than exports, due to strong rebound in trade larger contractions in imports earlier in the year; the recovery in Q3 was in line with earlier flows in 2010 and 2011, expectations. The gradual recovery in the world economy and higher commodity prices following contractions in are expected to support firm growth in Indonesia's exports volumes and prices over the 2009... forecast horizon (Table 3, ), with volumes reaching pre-crisis levels by early 2011. Values should rise even faster ­ and accelerate into 2011 ­ supported by rising commodity prices. Imports are expected to recover faster than exports, as the domestic economy grows more quickly than Indonesia's export destinations and the growth in production of export items demands more imported inputs. ...with stronger growth in The 2009 trade surplus is expected to remain near USD 17.7 billion, before narrowing in imports narrowing the 2010 to around USD 10 bn with the projected faster recovery in imports than exports. The trade surplus surplus is expected to be stable in 2011, as nominal exports and imports both register annual growth of around 19 per cent. THE WORLD BANK | BANK DUNIA December 2009 12 Indonesia Economic Quarterly Back on track? The balance of payments The balance of payments (BoP) is expected to register a slightly smaller surplus in Q4 is likely to be in surplus 2009, as the trade balance narrows, the government issues only a small amount of new in 2009... debt to meet its financing needs, Indonesian residents reduce the transfer of deposits offshore, and as portfolio inflows slow. As a result, the BOP is expected to register a surplus of around USD 12 bn in 2009. ...before narrowing in Consistent with the September IEQ, the BoP surplus is expected to narrow through 2010 2010 and 2011, as the and 2011, as the current account approaches balance. Ongoing surplus should support recovery in commodity continued accumulation of reserves. (Table 3) The current account is expected to move prices and imports bring towards balance through the forecast horizon, as the trade balance continues to narrow the current account to balance. and the income deficit continues to widen due to higher expected repatriation of profits to foreign equity holders, as oil & gas production increases and global energy prices recover. Remittances from Indonesians working abroad are expected to be stable. Net direct investment is expected to improve as domestic growth picks up and the global economic recovery consolidates. Offsetting this is the projection of slightly smaller surplus on portfolio investment, as domestic residents place more funds in foreign equity and debt markets. On the other hand, portfolio investment inflows in both short and long-term asset classes remain robust, assuming foreign investors continue their current search for yields. The recent upgrades in Indonesia's general credit rating and foreign and local-currency sovereign debt ratings by Standard & Poor's and Moody's should support these inflows. Table 4: The BoP surplus is expected to narrow through the Over the 12 months to Q3-2010, Indonesia's scheduled forecast window, as the current account moves into deficit external financing obligations total USD 24 bn, based on (billions of USD) BI reporting of the current stock of outstanding debt 2007 2008 2009 2010 2011 (Table 5). Over the same period, projections of trade and investment-related capital flows, plus net purchases of Balance of Payments 12.7 -1.9 11.8 5.0 3.1 liquid financial assets (based on conservative Current Account 10.5 0.1 8.5 0.6 0.0 assumptions), generate a projection of net inflows of around USD 29 bn. Combined, this gives a BoP surplus of Trade Balance 20.9 9.9 17.7 10.1 10.9 Income Balance -15.5 -15.2 -14.0 -15.1 -16.7 around USD 5 bn, consistent with the projections Transfers Balance 5.1 5.4 4.8 5.6 5.8 presented in Table 4. Capital & Financial Accounts 3.6 -1.9 4.7 4.4 3.1 The assumptions underlying this projection are relatively Capital Account 0.5 0.3 0.2 0.3 0.3 conservative given recent trends. The 95 per cent roll- over rate on SBIs is lower than the realized rate through Financial Account 3.0 -2.2 4.5 4.1 2.7 Direct Investment 2.3 3.4 1.9 2.8 3.1 2009, and allows for BI to reduce the stock of SBIs on Portfolio Investment 5.6 1.7 7.1 6.5 5.0 issue. The 90 per cent roll-over rate on private short-term Other Investment -4.8 -7.3 -4.5 -5.2 -5.4 debt reflects still-recovering global credit conditions, plus the scaling back of some projects following the global Foreign Reserves (a) 56.9 51.6 64.5 downturn and lower commodity prices. These roll-over (a) 2009 foreign reserves value at end of November. Sources: BI and World Bank projections. rates compare to the implied roll-over rates on total external debt, with more debt being issued than has fallen due through 2009 (Figure 23). The volatility in In late 2008, following capital outflows in September through November, policy makers Indonesia's financial and observers were concerned about the risk of larger capital outflows destabilizing markets and external Indonesia's macroeconomy. By late 2009, that concern has reversed, of the destabilizing capital flows remains a impact of financial market volatility flowing from large inflows into liquid, high yielding policy challenge financial assets. As two other major emerging markets (Brazil and Taiwan POC) introduced measures designed to slow the inflow of short-term capital, in mid-November BI announced it was "seriously considering" the implementation of capital controls on foreign ownership of one-month SBIs. However, by early December there has been no indication BI will apply such measures, with officials stating that: BI remained comfortable with the current policy; the inflows and outflows of foreign funds remained manageable; and these foreign flows did not cause any sharp fluctuations in the exchange rate. The vice-president stated that the government was not in favor of imposing capital controls on foreign investment flows. However, this public debate suggests that some policy change is more likely than has been the case for some time. THE WORLD BANK | BANK DUNIA December 2009 13 Indonesia Economic Quarterly Back on track? Table 5: Indonesia's currently scheduled external financing Table 6: Projected financing sources give a BOP surplus of needs over the coming 12 months total USD 24 bn around USD 5 bn (billions of USD) (billions of USD) EXTERNAL FINANCING NEEDS 24.0 PROJECTED EXTERNAL FINANCING SOURCES 28.7 Current account balance -.3 Maturing short-term FCU private debt 8.7 Trade balance 8.8 Am ortization of m edium and long-term FCU debt 9.4 Net income and transfers balance -9.2 Public 6.8 Net FDI Inflow s 2.7 Private (a) 2.6 Official Foreign Financing -.1 Short-term IDR liabilities to non-residents 5.3 Draw ings 6.2 Am ortization of m edium and long-term IDR debt Repayments -6.3 to non-residents .5 New Debt Issuances 23.9 Notes and source: (a) Excludes standstill debt of Short-Term Debt Instruments 12.5 USD 6.5 bn. BI and World Bank. Public (SBIs) (a) 4.2 Private (notes) 8.4 IDR debt (b) .8 Figure 23: Roll-over rates on Indonesia's external debt have FCU debt 7.5 also been high through 2009 (monthly principal repayments and issuances) o/w loans 10.6 o/w trade credits (c) -4.3 USD billion USD billion 8 8 Medium and Long-Term Bonds 11.4 Issuance Public (SUN) 4.9 6 6 Foreign investment in IDR bonds (d) 1.4 Net Issuance FCU bonds 3.5 4 4 Private (bonds) 6.5 Non-residents' net purchases of debt and 2 2 equity on secondary m arkets (e) 6.1 Public (SUN and SBIs) 3.0 0 0 Private (debt and equity) 3.1 Net investm ent offshore by residents ( f ) -3.6 -2 -2 o/w outflow s on currency and deposits (f,g) -.1 -4 Repaym ent -4 (a) assuming 95 per cent roll-over rate; (b) assuming 90 per Jan Feb Mar Apr May Jun Jul Aug Sep cent roll-over rate; (c) expected to rise with increasing trade flows; (d) assuming 18 per cent foreign ownership of new SUN (government IDR bonds); (e) reflecting increasing net Sources: BI and World Bank purchases of domestic assets by foreigners; (f) negative reflects outflow; and (g) reflecting residents shifting assets back from foreign bank accounts. World Bank projections. While the external risks to There remains considerable uncertainty to the outlook. On the one hand, the risks to the the outlook have declined global economy, while still considerable, appear to have been reduced. Recent outcomes somewhat, risks from have surprised on the upside, some international imbalances are stabilizing, and many domestic developments economists have raised their forecasts, although the large recent capital flows and have risen exchange rate movements create new risks, and the uncertainty surrounding the outlook for the global economy will increase when fiscal and monetary stimulus are withdrawn in the major economies. On the other hand, the risks to the domestic outlook have increased. The increase in rolling blackouts in the Jakarta region and elsewhere in the country is likely to slow growth. The Jakarta region produces about 15 per cent of national output, so a small impact on activity in Jakarta can impact the national data. But these impacts are likely to be short-term, as the immediate cause of the increased blackouts around Jakarta is likely to be repaired before the end of Q4, while the national fast-track nationwide generation construction program appears to be near schedule. In addition, political developments since October have begun to raise some questions about the timing and depth of future reforms, with potential downside risks to growth. Scenario analysis indicates a possible range of Indonesian GDP outcomes if these up- or down-side risks are realized. (Table 7 and Figure 24) The `high growth scenario' provides for a faster recovery in the global economy, supporting accelerating export prices. This scenario also provides for stronger domestic conditions, with improved investor and THE WORLD BANK | BANK DUNIA December 2009 14 Indonesia Economic Quarterly Back on track? consumer confidence accelerating credit, and capital inflows appreciating the rupiah. Under this scenario, GDP growth is 1Ľ percentage points above the reference scenario presented above (Table 3). The `low growth' scenario' assumes the impact of the recent rebound in trading partner growth and commodity prices is temporary, and that a weaker domestic investment climate weakens credit growth. This scenario subtracts up to 1 percentage points from GDP growth from 2009 to 2011 relative to the reference scenario. Table 7: Alternative outcomes for key variables Figure 24: ...have their greatest impact on 2010 growth (annual percentage growth; exchange rate level) (annual percentage change) Export Rupiah Per cent Per cent MTP* Credit prices (USD/IDR) 7 7 2009 Reference 0.9 15 1.2 10362 High Low Reference Low 1.0 14 0.9 10487 6 6 High 0.7 16 1.5 10362 2010 Reference 3.8 14 1.5 9500 5 5 Low 2.2 10 1.0 11000 High 5.5 19 9.4 8500 4 4 2011 Reference 3.9 23 7.5 9500 Low 2.2 15 4.1 10000 3 3 High 5.7 31 14.8 9000 2001 2003 2005 2007 2009 2011 * weighted average of major export destinations. Sources: Sources: BPS via CEIC and World Bank CEIC, Consensus Forecasts Inc. and World Bank. 4. The government's budget deficit is likely to be near target a. Weaker-than-projected government revenue is offset by below-budget spending Government revenues are Government revenues have continued to slow. Total central government revenues to the weaker in line with end of November 2009 were 18 per cent below the equivalent period in 2008 ­ in the year nominal GDP, tax cuts to July they had were down by 15 per cent. The further 3 percentage points of weakness and lower commodity reflect the ongoing impact of slower economic activity around the turn of 2009, the impact prices and profits of the government's scheduled and stimulus tax cuts, and lower commodity prices and corporate profits. Together, these factors led to a fall in government revenues that has been sharper than the slowdown in nominal GDP growth. Over 2009 as a whole, government revenues are likely to be 17 per cent weaker than in 2008. This is weaker than the projection made in September, reflecting weaker nominal GDP growth as prices have been weaker than expected, offsetting the impact of slightly stronger-than-expected growth in real GDP. Spending in core The government spent 67 per cent of its personnel, materials, and capital budget by the government programs end of October, compared with 60 per cent in the first ten months of 2008, despite the continued to be stronger increased budget allocation to these three spending types. This improvement follows than recent years, while measures to accelerate disbursement of the overall budget and the stimulus package. For subsidy spending in particular will be lower example, procurement can begin before the start of fiscal year, and unspent funds from 2008 were carried into 2009 to support the parliamentary and presidential elections, cash transfers program (BLT), PNPM programs, and some infrastructure projects. In addition, the thirteen month salary payment to government employees in June also contributed to improved government spending rates. However, the rate of realized expenditure overall has been lower relative to the first 10 months of 2008, as lower spending on `other' expenditures (which are mostly ad hoc items) and subsidies more than offset the improved spending rates on core government programs. In total, the central government has only spent 68 per cent of its revised budget THE WORLD BANK | BANK DUNIA December 2009 15 Indonesia Economic Quarterly Back on track? (APBN-P) by the end of October, 6 per cent less than in the same period of 2008. Lower international energy prices, tariff adjustments and the government's ongoing kerosene-to- LPG conversion program, and lower contingency budget spending (e.g., funds allocated to in case the economy diverges from projections) due to relatively supportive macroeconomic condition explain this weakness. Less than half of the Less than half (42 per cent) of the government's IDR 11.5 trillion of stimulus spending had stimulus spending had been disbursed by the end of October, although the rate of spending has accelerated disbursed by the end of (25 per cent had been spent at the start of the month). Bappenas has been monitoring October, although disbursement closely. The Ministry of Public Work has spent half its allocation of 57 per spending had accelerated cent of the stimulus spending, while other ministries receiving significant shares of the package (transportation, energy, and public housing) have only spent 35 per cent. The government reported that the programs funded by the stimulus spending have employed 754,000 people or 75 per cent of the 1 million people targeted. Figure 25, Figure 26: Spending on core programs has improved compared with recent years, but lower spending on `other' items and subsidies lowers overall spending (budget realization as per cent of revised budget (APBN-P) by end (actual stimulus spending of selected line ministries by end October) October*) 100% 100% IDR trillion IDR trillion 2007 2008 2009 7 7 Budget Allocation Disbursement 80% 80% 6 6 5 5 60% 60% 4 4 50% 40% 40% 3 3 2 2 20% 20% 1 37% 1 44% 24% 0% 0% 0 0 Social ExpOthers Total CG Transf. Person.Materials Capital Int. Subsidies Total Public Works Transportation Energy & Public Housing payments Nat.Resources *These four line ministries represent 87 per cent of total stimulus spending. Sources: Ministry of Finance and World Bank staff estimates. Spending in 2009 is likely Spending to date and the projected economic environment for the rest of the year suggest to be slightly below that overall spending in 2009 is likely to be below the revised budget, largely because of budget, offsetting weaker weakness in subsidies and `other' spending. (Table 8) This weakness is 4 per cent greater revenues to give a budget than had been projected in September, and partially offsets the weaker revenue deficit slightly less than planned projections. Together, these projections suggest a budget deficit near 2.3 per cent of GDP, 0.1 percentage points higher than previously estimated, and close to the government's revised estimate of 2.4 per cent. Revenue growth in 2010 In 2010, total revenue is expected to bounce back, growing by 15.9 per cent, broadly in is expected to recover line with the expected recovery in nominal GDP. Tax revenues, which typically map more with stronger nominal closely with nominal GDP, are expected to grow by 16.2 per cent. Oil & gas income tax GDP and no further revenues are expected to remain relatively subdued, despite a higher oil price planned tax cuts assumption, due to expectations of little production growth and higher cost recovery charges. Non-oil income tax, which continued to grow in 2009, is expected to show particular strength as corporate profits and personal incomes improve. VAT revenues are expected to bounce back after this year's unusual weakness (Box 1), growing by around 16 per cent following a recovery in consumption of taxable incomes. The higher oil price assumption is expected to have a larger impact on non-tax oil & gas revenues. (Table 9) THE WORLD BANK | BANK DUNIA December 2009 16 Indonesia Economic Quarterly Back on track? Table 8: Developments in revenue and spending (central government revenue and spending) 2006 2007 2008 To Nov 2009* Explanation Annual percent change and YoY percentage percentage point contributions point contrib's Cuts in tax rates, low er profits and formal w ages w ith low er commodity Tax revenue 17.9 20.4 33.4 -8.0 prices and slow er activity grow th Non-oil and gas 7.3 7.1 11.0 -4.3 Low er profits w ith low er commodity prices & demand; cuts in tax rates Oil & Gas 2.3 0.5 6.4 1.5 Around a 50% fall in the international oil price; slightly low er production VAT 6.3 7.8 11.1 -2.8 Less discretionary spending, partic. for goods subject to luxury tax rates Land and building tax 1.3 0.7 0.4 -0.1 Slow er investment Duties on land and -0.1 0.7 -0.1 0.1 Reduced economic activity building transfer Excise 1.3 1.7 1.3 0.6 Slow ing in consumption, offsetting the increase in cigarette excise rate Other taxes 0.1 0.1 0.1 0.0 Slow ing of economic activity Import duties -0.8 1.1 1.2 -0.8 Reduced import values w ith low er commodity prices and destocking Export duties 0.2 0.8 1.9 -2.2 Low er commodity prices and w eak export volumes Non-tax revenue 54.5 -5.2 49.1 -39.3 Significant falls in oil prices Oil 35.6 -13.9 35.0 -46.5 Around a 50 per cent fall in international oil prices Gas 1.4 -0.8 5.3 9.0 Gas production remains steady Mining 2.4 -0.4 1.4 -0.1 Low er prices and some w eakening in volume demand reducing profits Forestry -0.6 -0.1 0.2 0.0 Slow ing demand for w oods and related products Fishery 0.0 0.0 0.0 0.0 A small item w here contributions to grow th remain low SOE transfer 6.9 0.1 2.7 -3.8 Reduced domestic demand reducing activity Other 8.8 9.9 4.6 2.0 Low er fee collection through the slow ing of domestic activity Central gov't 21.8 14.7 37.3 -11.2 Grow th in programmatic spending offset by a sharp decline in subsidies expenditure Salaries 5.3 3.9 4.4 2.3 Grow th in line w ith previous years' and streamlined 13th month salary Goods and services 5.0 1.7 0.5 2.9 Increase in government consumption and early procurement Capital 6.1 2.1 1.6 0.8 Planned government investment being spent earlier in the year Social assistance 4.4 2.1 1.4 2.3 Grow th in social expenditure and the BLT program Others 1.0 -5.0 2.9 0.3 Election spending and increased 'planned expenditure' In line w ith projections, w ith appreciation in IDR offsetting higher interest Interest payments 3.8 0.2 1.7 3.6 costs on new debt Refined fuel prices have halved and the government continues to Subsidies -3.7 9.7 24.8 -23.4 encourage less consumption of higher cost-energy Notes and sources: * 2009 contributions relate to the first 11 months of 2009 relative to the same period in 2008. Central government expenditure data are to October 2009 only and so relate to the first 10 months. MoF, World Bank The 2010 deficit target The government approved the 2010 budget on September 30. The budget deficit has remains 1.6 per cent of remained at the proposed 1.6 per cent of GDP, a significant consolidation from 2009's GDP, a significant 2.3 to 2.4 per cent deficit. The composition of spending is broadly unchanged from the consolidation from 2009 government's proposal, with total budgeted spending of IDR 1,046 trillion, 5 per cent more than budgeted for 2009. The energy subsidy is budgeted slightly above the proposed budget as the oil price assumption was raised to USD 65 per barrel. Personnel expenditure represents 15 per cent of planned spending, the same share as subsidies, while capital expenditure only receives 8 per cent of total budget. The assumptions and projections presented in section 3 above imply a slightly larger budget deficit, at around 1.7 per cent of GDP for 2010. This partly follows slightly weaker revenues, largely due to the base effects of projected nominal GDP growth in 2009 being below the government's projection. Projected higher oil prices and ongoing improvements in the government's spending performance will potentially lead to higher overall spending than budgeted in 2010. But the current economic environment makes forecasting the magnitude and timing of the recovery in revenues unusually difficult, and a large amount of uncertainty surrounds the deficit projection. THE WORLD BANK | BANK DUNIA December 2009 17 Indonesia Economic Quarterly Back on track? Table 9: Small adjustments in the projected macroeconomic environment imply a slightly smaller budget deficit in 2009 and larger deficit in 2010 (central government revenue and spending, trillions of IDR) 2007 2008 2009 2009 (f) 2010 2010 (p) WB WB Actual Actual Revised Budget estimate estimate A. State Revenues and Grants 707.8 981.6 871.0 814.5 949.7 943.6 1. Tax Revenues 491.0 658.7 652.0 619.8 742.7 720.3 a. Domestic tax 470.1 622.4 631.9 601.4 715.5 699.7 i. Income tax 238.4 327.5 340.2 308.7 351.0 360.6 - Oil & gas 44.0 77.0 49.0 48.1 47.0 52.1 - Non oil & gas 194.4 250.5 291.2 260.6 303.9 308.5 ii. Other domestic tax 231.6 294.9 291.7 292.7 364.6 339.1 b. International trade tax 20.9 36.3 20.0 18.4 27.2 20.7 i. Import duties 16.7 22.8 18.6 17.8 19.6 19.4 ii.Export tax 4.2 13.6 1.4 0.6 7.6 1.2 2. Non tax receipts 215.1 320.6 218.0 193.7 205.4 221.8 o/w natural resources 132.9 224.5 138.7 110.8 132.0 137.1 i. Oil and Gas 124.8 211.6 127.7 100.2 120.5 125.3 ii. Non Oil & Gas 8.1 12.8 10.9 10.6 11.5 11.8 B. Expenditures 757.7 985.7 1,000.8 942.9 1,047.7 1,054.3 1. Central government 504.6 693.4 691.5 641.0 725.2 738.0 - Personnel 90.4 112.8 133.7 128.4 158.1 151.8 - Material expenditure 54.5 56.0 85.5 77.9 103.0 93.9 - Capital expenditure 64.3 72.8 73.4 71.9 83.2 81.5 - Interest payments 79.8 88.4 109.6 108.6 115.6 113.7 - Subsidies 150.2 275.3 158.1 142.8 157.8 191.1 - Grants expenditure 0.0 0.0 0.0 0.0 7.2 7.2 - Social expenditure 49.8 57.7 77.9 76.2 69.6 68.0 - Other expenditures 15.6 30.3 53.3 35.2 30.7 30.7 2. Transfers to the regions 253.0 292.4 309.3 301.9 322.4 316.3 C. Primary Balance 30.0 84.3 (21.3) (19.9) 16.0 2.9 D. SURPLUS / DEFICIT (49.8) (4.1) (129.8) (128.5) (98.0) (110.7) Deficit (per cent of GDP) (1.3) (0.1) (2.4) (2.3) (1.6) (1.7) Economic assumptions/outcomes Gross domestic product 3,957.4 4,954.0 5,425.4 5,555.7 5,981.4 6,403.7 Economic Growth (%) 6.3 6.1 6.0 4.1 5.5 5.4 Inflation (%) 6.6 11.1 4.5 4.8 5.5 5.4 Exchange Rate (Rp/US$) 9,419 9,691 10,500 10,362 10,000 9,500 Crude-Oil Price (US$/Barrel) 78.0 97.0 61.0 60.9 65.0 79.0 Oil Production (barrel per day) 0.91 0.93 1.0 1.0 1.0 1.0 % of civil service wages increase 15.0 20.0 15.0 15.0 5.0 5.0 Interest rate of SBI (average %) 8.0 9.3 7.5 7.1 6.5 7.0 * 2009 contributions relate to the first 11 months of the year. Central government expenditure data are to October 2009 only. Sources: Ministry of Finance, World Bank The government appears Like 2008, the slightly less-than-projected deficit and the government's front-loaded likely to have a financing financing strategy appear set to generate another financing surplus in 2009. (Table 10) surplus in 2009 The rupiah's appreciation has further reduced financing requirements. Even so, the government's financing needs in 2009, were still large, at around USD 22.5 bn, and in 2010 are likely to remain considerable, near USD 20 bn depending on the rate of nominal economic growth, the deficit and exchange rate movements. The budget passed at the end of September contained plans to fill about two-third of these needs from market sources, including through sales of sukuk (Islamic) bonds aimed at developing local Islamic finance markets. The government anticipates filling much of its remaining needs from official sources, while continuing to borrow less from official sources than it is repaying each year. These plans may change, as the budget financing plan made small use of the government's own funding sources, which may be larger than estimated at the THE WORLD BANK | BANK DUNIA December 2009 18 Indonesia Economic Quarterly Back on track? time of preparing the budget given the estimated 2009 financing surplus. Further, the improvement in global financial market conditions means the government has not yet had need to call on the Public Expenditure Support Facility, and so the full resources of the facility will remain in place to support the government's financing should market conditions deteriorate again in 2010. Table 10: Indonesia's 2010 financing needs remain considerable in 2010, although are likely to be supported by the government's likely 2009 financing surplus (trillions of IDR unless otherwise indicated) 2009 2010 2005 2006 2007 2008 APBN-P WB APBN WB Net financing needs: A Primary deficit -50.8 -49.9 -30.0 -84.3 20.3 19.9 -17.6 -2.9 B Total interest payments 65.2 79.1 79.8 97.0 109.6 108.6 115.6 113.6 of which:[1] Total commercial bonds: 45.9 58.0 55.9 66.3 70.7 70.2 77.4 77.4 Variable interest rate 18.2 22.8 14.4 15.3 10.9 8.9 USD-denominated 1.9 3.6 4.9 8.9 12.0 11.0 Official external loans -37.1 -52.7 -57.9 -63.4 38.9 38.4 38.2 36.2 A+B Overall deficit: 14.4 29.1 49.8 12.7 129.8 128.5 98.0 110.7 Amortizations: C Commercial bonds [2] 19.7 23.6 34.4 40.6 37.2 37.2 37.1 37.1 D Official external loans 12.3 13.6 19.6 25.4 69.0 68.1 58.8 55.9 C+D Total am ortization: 32.0 37.2 54.0 66.0 106.2 105.3 96.0 93.0 Gross financing needs: A+B+C+D Total gross financing needs: 46.4 66.3 103.9 78.7 236.0 233.8 194.0 203.8 (in billions of USD) 4.8 7.3 11.3 8.1 22.5 22.6 19.4 21.4 Financing sources: [3] Official borrow ing 28.1 26.1 34.1 50.2 69.3 68.4 57.6 Total commercial bonds: 22.6 36.0 57.2 85.9 142.4 144.1 141.6 IDR denominated 97.2 USD denominated 46.9 Domestic banking -2.6 18.9 8.4 16.2 56.6 56.6 7.1 Other 6.6 3.1 2.7 2.9 3.1 3.1 1.2 Total gross financing sources: 54.6 84.1 102.4 155.2 271.3 272.2 207.5 (in billions of USD) 5.6 9.2 11.2 15.9 25.8 26.3 20.7 M emo items: Variable interest rate (SBI-90 day rate) 9.16% 11.74% 8.04% 9.47% 7.50% 7.10% 6.50% 6.50% Share of bonds at variable interest rate 31.9% 33.1% 28.6% 23.9% 21.6% IDR/USD exchange rate 9,751 9,141 9,164 9,757 10,500 10,366 10,000 9,500 Share USD bonds (prevailing exchange rate) 3.7% 6.9% 8.0% 11.8% 15.6% [1] Interest payments by component may not sum to totals due to different data sources, timing and rounding issues. [2] No USD bonds are due over this period. [3] 2009 financing source projections in italics are taken from the APBN-P. Sources: CEIC, Ministry of Finance, World Bank projections THE WORLD BANK | BANK DUNIA December 2009 19 Indonesia Economic Quarterly Back on track? Box 1: The economy's slowdown in late 2008 and 2009 has had a disproportionate impact on VAT revenues After non-oil income tax, VAT is the second largest source of Figure 27: VAT revenues have become more volatile than central government revenue, accounting for almost one-fifth of consumption spending recently government revenues in recent years. In 2009, VAT revenues (trillions of IDR) are likely to have fallen around 3.6 per cent from 2008, the largest fall in 40 years. The slowdown in real spending and IDR trillion IDR trillion 60 stabilization in prices, particularly in contrast with the very rapid 60 nominal growth of 2008 appears to have had a disproportionate impact on VAT revenues. For example, the relationship 50 50 between notional consumption subject to VAT and VAT receipts has weakened, with VAT stronger than consumption in 2008 VAT revenue and weaker in 2009. (Figure 27) (Privation consumption subject 40 40 to VAT is assumed to be all of non-food private consumption, and 20 per cent of food consumption, as most fresh foods are 30 30 not subject to VAT; the actual number is likely to be smaller 10% of cons. that is subject to VAT given that much retail activity is informal). 20 20 Stable prices and a weaker economy, especially in manufacturing, trade, hotels & restaurants and mining, seem to 10 10 explain this fall in VAT. In times of an economic slowdown, consumers typically shift consumption away from discretionary items, which are generally taxable, towards personal savings or 0 0 essential items such as basic food which are generally not Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 subject to VAT, meaning that VAT collections can slow at a rate Sources: Ministry of Finance, BPS and World Bank greater than the overall economy; the opposite is true in boom years. Nominal private consumption that is subject to VAT is expected to grow in 2009 by around 9 per cent, compared with 20 per cent in 2008, as the drop in inflation offsets a moderate acceleration in the real value of spending. The corresponding VAT category is likely to have shrunk 5.6 per cent in 2009, after increasing by over one-third in 2008. The industries, and sources of VAT revenue, most affected by slowdowns in the economy also appears to be those more dependent on discretionary spending. (Figure 28, Figure 29) VAT from manufactured goods, and trade, hotels & restaurants has been particularly weak both in the final quarter of 2008 and early 2009, and in late 2005 and early 2006, when a large one-off increase in regulated fuel prices impacted disposable incomes and slowed real spending. VAT on imports and on domestic and imported luxury goods also led the weakness during these periods, and particularly strong during the peak of the recent cycle in the first part of 2008. (Q3 2009 VAT receipts are distorted by Pertamina's payments being reclassified from `oil & gas mining' to `manufacturing'.) Over the coming years VAT revenues should bounce back slightly faster than the recovery in nominal GDP and private consumption, close the gap between VAT payments and the tax base in Figure 27. Figure 28: VAT revenues from more industries producing Figure 29: ...were particularly weak during the slowdowns more discretionary goods around the turn of 2009 and 2006 (year-on-year percentage growth) (year-on-year percentage growth) Per cent Per cent Per cent Per cent 40 40 40 40 30 30 30 30 20 20 20 20 10 10 10 10 0 0 0 0 -10 -10 -10 -10 -20 -20 -20 -20 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Manufacturing Trade, hotel & restaurant Mining: Oil & gas Finance & business services Transport & communication Other* Domestic VAT Import VAT Domestic LST Import LST Other VAT * `Other' industries include agriculture, livestock and fishery, non- Sources: Ministry of Finance, World Bank oil & gas mining:, quarrying, electricity, gas & water supply, construction, services and `other'. Sources: Ministry of Finance, World Bank THE WORLD BANK | BANK DUNIA December 2009 20 B. SOME RECENT DEVELOPMENTS IN INDONESIA'S ECONOMY 1. Indonesia's trade flows through the global crisis: from peak to trough and back again Indonesia's trade flows From July 2008 to February 2009, the value of Indonesia's merchandise exports fell by halved during the global 43 per cent, while merchandise imports fell by 56 per cent. ( , Table 11) This economic crisis, mostly slump, with the jump in volatility in financial markets and capital outflows, represented the due to the slump in greatest impact of the global economic downturn on the Indonesian economy. Indonesia's commodity prices trade flows with all major trading partners fell during the period, with particularly significant falls in exports to Japan, Singapore and China. Import values also fell across all trading partners, as firms drew down inventories and the decline in exports reduced demand for imported inputs. The collapse in oil and bulk commodity prices during this period explains most of the decline, while trade volumes remained relatively stable through late 2008 and early 2009. (Table 11) Compositional shifts contributed, too. Overall Indonesia's tradeables sector was not immune to the downturn in global demand ­ but lower commodity prices may have been sufficient to support higher demand for some goods in some markets, partially offsetting some of the negative impact of the global recession on Indonesia's trade flows. Figure 30: Trade values peaked in mid-2008, and troughed in For exports, while retrenched demand saw large falls in February 2009 mining and manufacturing volumes ­ particularly to Japan, (USD billions, non-seasonally adjusted) Singapore and the US ­ oil & gas export volumes appear to have increased to Korea, and the volume of agricultural 14 14 exports to China also rose (particularly in vegetable oils July 08 Feb 09 and palm oils). The contraction in export values to Japan was most severe, accounting for around a third of the total 12 12 fall in export values ­ near Japan's export weight. This was predominantly due to lower prices for oil & gas 10 10 exports, and lower prices and volumes of nickel exports. Contractions in export values to Singapore, China and the US also made significant subtractions. The fall in exports 8 8 to the US and Singapore were due to lower volumes of textiles, clothing and footwear and chemicals, as well as lower prices and volumes in oil & gas and rubber exports, 6 6 while the lower export values to China were driven by lower prices on rubber and oil products. 4 4 Similarly for imports, while investment-related capital and Oct-07 Apr-08 Oct-08 Apr-09 Oct-09 transportation volumes fell ­ particularly from Japan, Source: BPS China and Korea ­ price falls suggest that import volumes for lubricants from China and chemicals, transport and machinery from the US increased. 21 Indonesia Economic Quarterly Back on track? Table 11: Indonesia's imports fell further, and recovered faster, than exports (per cent unless otherwise stated) July 2008 to February 2009 February 2009 to July 2009 Percentage Percentage Percentage Percentage point point Proportion point point Proportion Values contribution contribution of total Values contribution contribution of total Growth due to prices due to volumes growth Growth due to prices due to volumes growth Total Exports -43 -40 -3 100 36 -6 42 100 Oil & Gas -64 -82 17 34 45 45 0 18 Non-Oil & Gas -37 -25 -12 66 34 -13 47 82 Agriculture -34 -47 13 12 23 2 21 12 Mining & Minerals -55 -17 -39 28 100 2 98 47 Forestry -31 -27 -5 4 5 -3 8 1 Manufactured -27 -17 -10 22 18 -27 44 22 Total Imports -56 -62 6 100 50 -7 58 100 Consumer Goods -41 -34 -7 3 53 -9 62 10 Intermediate -57 -60 3 35 47 -29 76 15 Fuels and Lubricants -73 -97 24 44 89 42 47 7 Transportation Goods -50 25 -75 4 77 21 57 18 Capital Goods -34 -3 -31 14 25 -16 41 50 Sources: BPS and World Bank Categories that had been By July, the value of Indonesia's exports and imports had grown by around 36 and 46 per hardest hit in the cent, respectively. These gains were seen across all trade categories, but predominantly downturn recovered in oil & gas and mining commodities. Implied price movements suggest that much of the fastest gain was in volumes, with a recovery in demand, in line with increasing investment and inventory restocking, both globally and in Indonesia, contributing significantly to the gain in trade values. It also suggests that only part of the recovery in global commodity prices has passed into Indonesia's exports and imports prices, with trade prices remaining subdued as further declines in electronics, machinery and capital goods prices more than offset gains in oil and bulk commodity prices. (Table 11) With these price and volume developments, the recovery in export values has been driven by increasing mining & mineral and oil & gas exports to Japan, China and Korea. By August 2009, export values to China and Korea had returned to near pre crisis levels, in contrast to exports to Japan which remain about 40 per cent below their July 2008 level. Table 12: While trade flows fell across the board, exports to the emerging economies in Indonesia's region have recovered faster (USD millions and per cent) Exports Imports July 2008 Contribution Feb 2009 Contribution Aug 2009 July 2008 Contribution Feb 2009 Contribution Aug 2009 Level to Fall Level to Rise Level Level to Fall Level to Rise Level Japan 2,787 31 1,140 16 1,700 1,388 10 668 5 859 China 1,077 10 517 15 1,013 1,408 9 762 19 1,468 US 1,246 8 811 5 990 821 4 564 2 632 Singapore 1,376 11 781 -1 744 2,240 19 933 28 2,000 Korea 643 3 502 5 688 801 7 295 4 457 India 529 3 375 10 702 248 2 139 2 212 Malaysia 497 3 342 9 655 951 9 331 3 453 Australia 527 6 203 2 260 367 3 191 4 333 Other 3,845 26 2,464 39 3,793 4,645 37 2,057 33 3,293 Total 12,528 100 7,134 100 10,544 12,870 100 5,939 100 9,707 Sources: BPS and World Bank THE WORLD BANK | BANK DUNIA December 2009 22 Indonesia Economic Quarterly Back on track? 2. The rupiah since late 2008: the scale of its movement and the driving factors a. The rupiah has appreciated significantly since March, especially against the weakening US dollar Since March the rupiah Since March 2009, the Indonesian rupiah has appreciated by 22 percent against the US has appreciated Dollar (USD). (Table 13, Figure 31) The rupiah has also gained strength against other significantly against the currencies (Table 13), with the real effective exchange rate (REER, a trade-weighted USD, to a lesser extent index of key rupiah bilateral exchange rates taking into account inflation) rising by over 16 against other currencies percent during this period. (Figure 32) But the degree and pace of appreciation versus the USD has been particularly marked, raising concerns about its sustainability as well as impact on the real economy and competitiveness. Inflows of foreign capital into Indonesian financial markets and the recovery in commodity prices appear to account for much of the rupiah's appreciation. In sum, a 1 percent increase in non-residents' investment in Indonesian financial assets is associated with a 0.62 per cent appreciation against the USD, holding commodity prices constant; and a 1 percent increase in non-oil export weighted commodity prices is associated with a 0.49 per cent appreciation, holding capital inflows constant. These factors together account for 73 per cent of the variation in the spot exchange rate between October 2008 and November 2009, and for almost 90 percent of the REER's movements over this period. (Table 14, Table 15) The relationship between these factors and the rise of the rupiah is developed below. Figure 31: From March, the rupiah has nominally Figure 32: Indonesia's exchange rate has also appreciated appreciated much more against the USD than the USD has significantly in real terms against a basket of currencies weakened against a broad basket of currencies (real effective exchange rate based on JP Morgan trade (USD broad index, indexed to 100 on 21 January 1997) weighted index; IDR per USD level) Index IDR per USD Index IDR per USD 120 8500 190 8000 115 IDR/USD 9000 8750 (RHS) 110 9500 160 9500 105 10000 Dollar Index 100 10500 10250 (LHS) IDR Real Effective Exchange Rate (LHS) 95 11000 IDR/USD Spot IDR Appreciation 130 11000 (RHS) 90 11500 Appreciation 11750 85 12000 80 12500 100 12500 Jan08 Apr08 Jul08 Oct08 Feb09 May09 Aug09 Dec09 Jan07 Apr07 Jul07 Oct07 Jan08 Apr08 Jul08 Oct08 Jan09 Apr09 Jul09 Oct09 Sources: Federal Reserve Board and BI via CEIC Sources: JP Morgan and BI via CEIC The FRB's broad USD The rupiah has not been the only currency to appreciate against the USD in recent index has weakened by months. The Federal Reserve Board's Broad Dollar Index (which includes 26 currencies 11.5 percent since March, representing America's major trading partners) has weakened by 11.5 percent since while equities and March, when global equity markets and asset prices in emerging market countries in emerging market assets and key commodity particular started to rise (Table 13). prices have rebounded strongly Moreover, the USD has exhibited a strong inverse relationship with the price of risky assets since the onset of the crisis last October. At the height of the crisis, when equities and asset prices crashed in late 2008 and then again in February-March 2009, the Dollar Index strengthened to its highest levels since 2005 as investors switched from risky assets to USD cash. But ever since asset markets began their recovery in the second quarter of 2009 and investors' risk appetite returned, the USD has depreciated substantially. THE WORLD BANK | BANK DUNIA December 2009 23 Indonesia Economic Quarterly Back on track? Since March, major Asian equity indices have gained over 80 percent on average. ( , Table 13) Furthermore, loose monetary policy has enabled bonds to perform well in emerging and developed economies: in Indonesia, 5 year local currency sovereign yields have dropped by 33 percent since March, while in developed nations such as the United States, central banks' quantitative easing programs have buttressed bond prices. ( ) In addition, gold, which is seen by investors as an inflation hedge as well as alternative currency, and which has historically had an inverse correlation with the USD, has risen by 20 percent since March to historical peaks in nominal terms. Figure 33: The USD Index has moved in the opposite Figure 34: Indonesian local currency bond yields have fallen direction to global stock indices since the onset of financial by one-third since March, but remain well above yields market turmoil in September 2008 elsewhere (equity market indices, indexed to 100 on 2 January 2008) (5 year local currency sovereign bond yields in per cent) Equity Indices 2 Jan 08 = 100 Dollar Index Percent Percent 115 120 24 24 Thailand SET March 2009 Dollar Index 115 21 21 100 Singapore SGX (RHS) Jakarta JCI 110 18 18 85 Indonesia 105 15 15 70 100 12 12 Philippines 95 9 9 55 Shanghai 90 6 Thailand 6 Composite Malaysia 40 Bombay BSE 85 3 3 United States 25 80 0 0 Jan08 Apr08 Jul08 Oct08 Feb09 May09 Aug09 Dec09 Jan08 Apr08 Jul08 Oct08 Feb09 May09 Aug09 Dec09 Sources: CEIC and World Bank Source: CEIC The IDR/USD exchange The IDR/USD exchange rate has moved closely with the Dollar Index since late 2008 (ie, rate became highly the rupiah has gained strength as the Dollar Index has weakened, and vice-versa), with correlated with the USD movements in the Index tending to be associated with greater than proportionate index from September movements in the IDR/USD exchange rate, especially since the onset of the crisis. The 2008, with movements in the USD index coinciding correlation between movements in IDR/USD and the Dollar Index is 68 per cent from with larger than January 2007 to November 2009, but strengthens to 92 per cent if we isolate the period proportionate movements from September 2008 to the present. In addition, regression analysis for January 2007- in the IDR/USD rate November 2009 indicates that a 1 percent increase in the Dollar Index is associated with a 1.22 percent depreciation of IDR/USD. Narrowing the timeframe to September 2008- November 2009 strengthens this association to a 2.1 percent depreciation of the rupiah for every 1 percent gain of the Dollar Index. Both results are statistically significant at a high level and appear robust. (Table 14) b. Inflows of capital into liquid financial assets explain much of the appreciation... USD weakness, The combination of low interest rates in the United States, the weakening USD, and historically low interest strengthening asset prices in emerging markets has led to a huge inflow of capital into rates in the US and emerging economies with open capital accounts in the past six months. Investors have strengthening emerging put on carry trades, borrowing in USD to buy higher yielding assets in emerging markets markets have led to large capital inflows into -- at effectively negative interest rates. This has added pressure on emerging market emerging economies asset prices and currencies, leading some commentators to suggest that asset prices have risen by more than is justified by improving economic fundamentals. Indonesia has attracted Indonesia, with its highly attractive interest rate differentials and open capital markets, has capital inflows of USD 6.5 drawn significant inflows of non-residents' capital. ( ) Since March 2009, the billion since March, which country has absorbed USD 6.5 billion in net foreign inflows, 40 per cent of this in correlate closely with the September and October. ( ) rupiah's appreciation Without full sterilization by the central bank (building its foreign exchange reserves and offsetting the impact on the domestic economy), such inflows inherently cause a short-run THE WORLD BANK | BANK DUNIA December 2009 24 Indonesia Economic Quarterly Back on track? appreciation of the exchange rate. The correlation between the IDR/USD rate and the total stock of non-residents' holdings is 70 per cent between October 2008 and November 2009 (ie, the rupiah appreciates when the foreign capital stock increases), with a 1 per cent increase in the stock of foreign capital associated with a 0.53 percent appreciation of IDR/USD. (Table 14, ) Since the total stock of foreign capital in Indonesia has increased by about 28 percent since March (with September and October accounting for 9 percentage points of the increase), capital inflows have contributed significantly to the rupiah's appreciation over this period. Figure 35: There have been significant net capital inflows Figure 36: ...increasing the stock of foreign capital held in into Indonesia since March... Indonesia by USD 6.5 billion ­ over one-quarter (net flows in IDR billion; USD Index and IDR/USD indexed (non-residents' holdings of equities, government IDR bonds to 100 in October 2008) and short-term money market instruments) IDR billion Index Oct08=100 IDR billion IDR per USD 30000 120 250000 8500 115 20000 IDR/USD 9500 110 (RHS) 10000 200000 105 Total Foreign Capital Stock IDR/USD spot 10500 0 100 (LHS) (RHS) Net Foriegn Dollar Index Flows (LHS) 95 10000 (RHS) 150000 IDR Appreciation 90 11500 20000 IDR Appreciation 85 30000 80 100000 12500 Oct08 Dec08 Mar09 May09 Jul09 Sep09 06Oct08 06Jan09 06Apr09 06Jul09 06Oct09 Sources: Federal Reserve Board, CEIC, BI and World Bank Sources: : Federal Reserve Board, CEIC, BI and World Bank Non-residents' Among the factors driving inflows, the stock of foreign capital shows an 80 per cent investment in Indonesian inverse correlation with both the Dollar Index and interest rate differentials between financial assets is Indonesia and the US. Regression analysis indicates that a 1 per cent increase in the inversely correlated with Dollar Index is associated with a -1.34 per cent decrease in the foreign capital stock, USD strength, interest rate differentials, and holding interest rates constant. Similarly, a 1 per cent increase in interest rate differentials Indonesian EMBI spreads (between 3-month Indonesian SBIs and 3-month US T-Bills) is associated with a 0.62 per ...when risk increases, cent reduction in the foreign capital stock, holding the Dollar Index constant. (Table 14) foreigners cut their Indonesian holdings While it may seem counterintuitive that an increase in interest rate differentials is associated with a decline rather than an increase in foreign capital stock, this may reflect baseline differences between Indonesian and US rates being so high that any further increase in differentials is usually due to a negative shock or rise in perceived Indonesian risk and therefore coincides with a decrease in non-residents holdings. The total stock of foreign capital in Indonesia has a 95 per cent negative correlation with Indonesian EMBI spreads, which are often used as a proxy for country risk ( ): a 1 per cent increase in EMBI spreads is associated with a 0.23 per cent decline in the stock of foreign capital. So when spreads and country risk increase, money flows out. (These spreads are also highly positively correlated with the Dollar Index and interest rate differentials.) Indonesia remains While the speed and volume of capital inflows into liquid Indonesian financial assets has particularly vulnerable to not been dissimilar to other emerging market countries in Asia and Latin America, the hot money inflows as the archipelago remains particularly vulnerable to this `hot money'. First, the country has flows tend to be volatile completely open capital markets, more so than its neighbors, and has thus far remained and can leave rapidly, disrupting financial committed to not imposing capital controls. Second, the legacy of the 1997-98 crisis markets and the economy makes investors in Indonesia particularly liable to shift large amounts of funds for reasons that may be tenuously related to fundamentals (as indicated by the highly negative correlation between EMBI spreads, indicating perceived country risk, and the stock of non-residents' holdings). To the extent that money flows out of the country as quickly as it flows in, and trading volumes on Indonesia's financial markets remain relatively thin, hot money flows can significantly add to market volatility, with wider impacts on investor confidence, the exchange rate, and the real economy. Intervention by policy makers can limit the impact of these flows, but most policy options are costly. ( ) THE WORLD BANK | BANK DUNIA December 2009 25 Indonesia Economic Quarterly Back on track? Figure 38: Non-residents' holdings of Indonesian financial Figure 37: Indonesia's foreign reserves have been correlated assets has fallen when country risk rises, and vice versa with the exchange rate since October 2008, suggesting BI (foreigner's stock of Indonesian financial assets in billions of has been partially limiting the exchange rate's volatility IDR; Dollar Index, EMBI spread and interest rate differential (reserves in millions of USD, IDR/USD exchange rate level) indexed to 100 on 6 October 2008) IDR billion Index 6 Oct 08=100 200 USD million IDR per USD 250000 70000 7500 60000 8500 200000 140 50000 9500 IDR/USD Spot Dollar Index (RHS) (RHS) 40000 10500 IndonesiaUS Interest 150000 80 Rate Differential (RHS) IDR Appreciation Total Foreign Capital Stock 30000 11500 (LHS) International Reserves Indonesia EMBI spread (LHS) (RHS) 20000 12500 100000 20 Jan05 Oct05 Aug06 May07 Mar08 Dec08 Oct09 06Oct08 06Jan09 06Apr09 06Jul09 06Oct09 Sources: BI via CEIC and World Bank Sources: Federal Reserve Board, CEIC, BI and World Bank Figure 39: Monetary and fiscal policy can limit the impact of capital inflows, but most options are costly i A : Allow inflow of money (shifts LM right ) Can be inflationary BP ' LM B : Sterilize inflow by building reserves, OMO (stay at B ) Can prolong inflows by keeping interest rates high BP=0 D C : Allow appreciation (shifts IS and BP left ) Exports lose competitiveness C, E D : Impose capital controls (moves BP upward, steeper B slope ) Lose efficiency; have to finance investment A through higher cost domestic funds rather than borrowing from abroad at lower cost E : Fiscal contraction (shifts IS left ) Can be IS' IS LM' recessionary; politically difficult Y The IS-LM model is a Keynesian framework that focuses on the interaction between the real and monetary elements of the economy. The IS (investment-savings) curve represents the relationship between output and interest rates that gives equilibrium in the goods market, while the LM (liquidity preferences and money supply) curve represents the relationship between income and interest rates that gives equilibrium in the money market. c. ...with the recovery in commodity prices fuelling strength as well Since commodities make Commodity prices are a second important channel through which USD weakness impacts up much of Indonesia's the IDR/USD exchange rate. The USD Index bears a strong inverse correlation with exports, the rupiah tends commodity prices: a 1 per cent increase in the Index is associated with a 4.2 per cent to strengthen with decrease in Indonesia's non-oil export-weighted commodity price index. (Table 14) commodity prices Commodities account for more than half of Indonesia's total exports. Empirical studies by Rogoff and Chen (2003) have found a significant correlation between real exchange rates and the world price of the commodity exports of Australia, Canada and New Zealand-- three countries where primary commodities constitute a major component of exports. A similar relationship seems to exist in Indonesia between USD export-weighted commodity price indices (EWCPI) and both the spot and real effective exchange rates. ( , ) The spot exchange rate exhibits an inverse correlation of 69 per cent with the oil- and non-oil EWCPIs (ie, the rupiah appreciates when commodity prices rise). A 1 per cent increase in the non-oil EWCPI is associated with a 0.26 per cent appreciation THE WORLD BANK | BANK DUNIA December 2009 26 Indonesia Economic Quarterly Back on track? of IDR/USD (the appreciation is 0.25 per cent for oil EWCPI). The correlation and regression results are even stronger for the REER. The non-oil EWCPI shows an 88 per cent correlation with the real exchange rate, and a 1 per cent increase in the index is associated with a 0.46 per cent appreciation (the relationship is similar for oil EWCPI). (Table 14, Table 15) These results suggest that the recent weakness of the Dollar Index has filtered into higher commodity prices, and given the positive correlation between the rupiah and commodity prices, this has been another channel through which IDR/USD has appreciated. Table 13: Movements in exchange rates and asset prices since September 2008 Level Sep 2 2008 March 2009 High Level Nov 9 2009 % Change since March % Change since Sep 08 IDR Crosses IDR/USD 9192 12065 9420 -22 2.5 IDR/EUR 13407 16130 14040 -13 5 IDR/GBP 16463 17119 15705 -8 -5 IDR/SGD 6437 7837 6778 -13.5 5 IDR/AUD 7808 8187 8712 6.4 11.5 USD Crosses INR/USD 44.4 51.8 46.36 -10.5 4 SGD/USD 1.4308 1.5565 1.3862 -11 -3 KRW/USD 1134.45 1570.1 1154.6 -26 2 JPY/USD 108.85 97.17 89.92 -7.5 -17 USD/AUD 0.8360 0.6301 0.9293 47 11 USD/EUR 1.4522 1.2580 1.4999 19 3 Dollar Index 99.83 115 101.9 -11.4 2 Stock Indices Jakarta 2159 1256 2406 92 11 Bombay 7861 4160 8703 109 11 Shanghai 2305 2071 3175 53 38 Singapore 2759 1456 2693 85 -2 Thailand 659 413 713 73 8 5yr IDR Govt Bond Yield 12 14 9.35 -33 -22 Gold Price ($/troy oz) 798 890 1062 20 33 Source: CEIC and World Bank Figure 40: Movements in commodity prices are correlated Figure 41: ...and the relationship is particularly strong with movements in the rupiah, reflecting the importance of against the real effective exchange rate commodities in Indonesia's exports basket (USD broad dollar indexed to 100 on 21 January 1997; gold (Indonesian commodity export prices indexed to 100 in 2000) price in USD per troy oz) Index 3 Jan 2000 =100 Index 3 Jan 2000 =100 Index Jan04=100 Index Jan04=100 500 8500 350 200 Oil Export Weighted Commodity Price Index (LHS) Oil ExportWeighted Commodity Price Index 300 180 400 9500 (LHS) NonOil Export Weighted IDR/USD spot (RHS) NonOil Export Weighted Commodity Price Index 250 160 (LHS) Commodity Price Index (LHS) IDR Real Effective 300 10500 Exchange Rate (RHS) 200 140 IDR Appreciation 200 11500 150 120 100 12500 100 100 2Jan07 2May07 2Sep07 2Jan08 2May08 2Sep08 2Jan09 2May09 2Sep09 Jan07 May07 Sep07 Jan08 May08 Sep08 Jan09 May09 Sep09 Sources: BI via CEIC and World Bank Sources: Federal Reserve Board, CEIC, BI and World Bank THE WORLD BANK | BANK DUNIA December 2009 27 Indonesia Economic Quarterly Back on track? The Australian dollar, Many of the characteristics that appear to have supported the rupiah are shared buy the with similar Australian dollar (AUD), despite the two economies' substantial differences in income and characteristics to the institutional development. Both economies have open capital accounts, domestic interest rupiah, has strengthened rates significantly higher than global rates, and a large share of commodities in their by even more since March export baskets. Both have appreciated considerably against the USD and other currencies this year: the AUD has appreciated by 47 per cent against the USD since March, twice as much as the rupiah. (Table 13) Table 14: Regression analysis of the rupiah exchange rate and some of its key correlates (regressions on daily data) Dependent Variable: Log IDR/USD spot Independent Variab le Time Period Coefficient R Square T-Statistic (1) Log FRB Dollar Index Jan 07 - Nov 09 1.229 0.47 24.1 (2) Log FRB Dollar Index Sep 08 - Nov 09 2.108 0.85 38.9 (3) Log Foreign Capital Stock Oct 08 - Nov 09 -0.535 0.49 -16.0 (4) Log Non-Oil Export Weighted CPI Jan 07 - Oct 09 -0.261 0.47 -24.5 (5) Log Oil Export Weighted CPI Jan 07 - Oct 09 -0.246 0.48 -24.7 (6) Log Indo EMBI Spread Oct 08 - Nov 09 0.148 0.66 21.9 (7) Log Interest Rate Differential Oct 08 - Nov 09 0.833 0.70 24.4 (8) Log Foreign Capital Stock Oct 08 - Nov 09 -0.621 0.73 -21.1 Log Non-Oil Export Weighted CPI Oct 08 - Nov 09 -0.486 0.73 -17.1 Dependent Variable: Log Foreign Capital Stock (1) Log FRB Dollar Index Oct 08 - Nov 09 -2.506 0.65 -21.5 (2) Log Indo EMBI Spread Oct 08 - Nov 09 -0.228 0.91 -50.4 (3) Log FRB Dollar Index Oct 08 - Nov 09 -0.619 0.73 -8.9 Log Interest Rate Differential Oct 08 - Nov 09 -1.335 0.73 -8.1 Dependent Variable: Log Indo EMBI Spread (1) Log FRB Dollar Index Oct 08 - Nov 09 11.547 0.78 30.1 Dependent Variable: Log FRB Dollar Index (1) Log Non-Oil Export Weighted CPI Jan 07 - Oct 09 -0.183 0.76 -45.7 Dependent Variable: Log Non-Oil Export Weighted Commodity Price Index (1) Log FRB Dollar Index Jan 07 - Oct 09 -4.171 0.76 -45.7 Source: World Bank Table 15: ...and of the correlates of the real effective exchange rate (regressions on monthly data) Dependent Variable: Log REER Independent Variab le Time Period Coefficient R Square T-Statistic (1) Log Non-Oil Export Weighted CPI Jan 04 - Oct 09 0.458 0.77 15.2 (2) Log Oil Export Weighted CPI Jan 04 - Oct 09 0.446 0.73 13.6 (3) Log Net Foreign Assets Jan 04 - Aug 09 0.418 0.82 17.3 (4) Log Non-Oil Export Weighted CPI Jan 04 - Aug 09 0.227 0.89 6.2 Log Net Foreign Assets Jan 04 - Aug 09 0.251 0.89 7.6 Source: World Bank THE WORLD BANK | BANK DUNIA December 2009 28 C. INDONESIA 2014 AND BEYOND: A SELECTIVE LOOK 1. Seeing Indonesia as a middle-income country A decade after a twin As the first decade of the 21st century draws to a close, Indonesia has emerged as a crisis, Indonesia is now middle-income economy, economically strong, politically stable, and with increasing an emerging confident confidence and global standing. This was unexpected a decade ago, when Indonesia middle-income country ... experienced a severe economic crisis that resulted in the economic dislocation of millions of households, a sharp rise in poverty, a 13 percent decline in GDP, and near bankruptcy of the financial sector. The economic crisis triggered a dismantling of the previous political order, leading to a period of political turmoil characterized by several changes in government and the heightening of separatist tensions. ... with fundamental Over the past decade, Indonesia's fiscal and political systems have been transformed. structural changes ahead Perhaps less mentioned, but ultimately just as important, Indonesia is also in the midst of a fundamental demographic and geographic shift. Indonesia is now an urban country with more than 50 percent of the population living in urban areas. Within the next five years, Indonesia will have a population of 250 million people, almost 60 percent of whom will live in cities. At the same time, with declining fertility rates and with the fraction of elderly yet to rise sharply, Indonesia will continue to enjoy a "demographic dividend" in the next decade as the working age population increases relative to the rest of the population. ...and the potential to rise Because of Indonesia's achievements in the past decade, it is now possible to imagine a further into the ranks of new Indonesia emerging in the decade ahead: an Indonesia in which every child receives dynamic, inclusive a quality primary education and goes on to complete secondary education; an Indonesia middle-income where highways connecting Surabaya with Jakarta and Medan provide market access economies and an economic lifeline to the towns and villages along the way; an Indonesia that is globally competitive not just in the commodity-based sectors where it has a natural resource advantage but also in selected manufacturing and service industries; and an Indonesia where all Indonesians enjoy affordable access to quality health services. If Indonesia is able to build on the robust foundation of macroeconomic and political stability it has established thus far and accelerate growth while ensuring that growth is shared and is sustainable, it has the potential to become a dynamic, competitive and inclusive middle- income country in the decade ahead. Much remains to be done, However, to realize the vision and potential of a rising Indonesia, much remains to be however, to realize this done. Growth has restarted and has been robust, but infrastructure continues to be poor potential ... and the investment climate remains weak. Higher levels of growth have not translated, to the extent hoped for, into greater poverty reduction, and a large percentage of the population remains vulnerable to poverty. On the employment front, there are positive signs of a turnaround in the last five years, but Indonesia still lags behind its more prosperous neighbors in creating higher value-added non-agricultural jobs. Because of geographic and income-related disparities and the poor quality of health, water and sanitation and education service delivery at the local level, Indonesia's performance in terms of human development outcomes has been quite uneven over the last decade despite significant increases in public expenditures. There is considerable evidence as well that Indonesia's environmental quality is deteriorating and its natural resources being unsustainably depleted. ...and the task will not be Against the background of a strong fiscal position, the next five years provide an easy and it will take time opportunity for Indonesia to address these structural weaknesses. But the task will not be easy and it will take time. Democratization and decentralization have fundamentally changed accountability structures and decision-making processes within government. These changes have highlighted systemic weaknesses in the processes and capacity for formulating and implementing policy and have made the process of implementing reforms a more challenging and time-consuming task. Government effectiveness has been limited by insufficient capacity and accountability of civil servants and by coordination problems within government. Because highly competitive elections have led to coalitional politics at the national level and in many regions, and greater voice in the political arena has been afforded to a wide range of non-state actors, the task of reaching consensus on critical policies and reforms has become that much more challenging. Decentralization has changed accountability structures or weakened them, as the division of roles and 29 Indonesia Economic Quarterly Back on track? responsibilities between the various levels of government remains unclear in many spheres of government activity. At the same time, the tasks Indonesia faces, as an emerging middle-income economy, have become more difficult, in part because of its own past successes and in part because the global economic environment is rapidly changing. An opportune moment to But this is a particularly opportune moment for Indonesia to tackle this task. Having take on the task, at the weathered the global downturn well, Indonesia is now much better positioned than most threshold of a new middle-income economies to think more proactively about development policy and decade, with a new spending priorities for the next five years and beyond. The newly reelected government government and a new five-year plan will have the opportunity to implement an ambitious development program. In particular, the National Medium-Term Development Plan (RPJM) for 2010-2014, which is currently being finalized and will be submitted for parliamentary approval early in 2010, provides the government a crucial opportunity to shape Indonesia's development prospects for the next five years and lay the foundations for the remainder of the coming decade. The government will face important policy and public expenditure choices. The institutional and policy reforms Indonesia prioritizes, the amount of resources it chooses to spend on development, where it chooses to spend these resources and how effectively it implements its development programs will substantially influence Indonesia's longer-term economic and social prospects. A selective look at To contribute to and inform the public discussion about these important choices, this Indonesia's development edition and this part of the Indonesia Economic Quarterly begins a selective look at priorities and challenges Indonesia's development prospects, priorities and challenges in the next five years and beyond. It does so by drawing on recently completed, forthcoming and ongoing analytic work undertaken by the World Bank to present salient facts and analyses on selected topics relevant for thinking about Indonesia's medium-term development priorities and challenges. In this edition, the focus is on the demographic trends Indonesia will confront in the coming decade and the challenges and opportunities that these present in terms of creating jobs and financing healthcare. 2. Indonesia is entering a demographically critical decade Indonesia has enjoyed a For the last forty years Indonesia has enjoyed a kind of demographic dividend as declines demographic dividend in in fertility have reduced the fraction of children (ages 0 to 14) in the population without a the last forty years... corresponding increase in the fraction of elderly (ages 65 and over). And as a result, the dependency ratio--the ratio of children and elderly (i.e., dependents) to the working-age population--has steadily declined from over 0.8 in 1970 to about 0.5 in 2009 (Figure 42). Figure 42: Indonesia's demographic window of opportunity will close in the next decade 80.0 0.90 Dependency ratio (young and 70.0 0.80 elderly to working age) 60.0 0.70 Dependency % of population Working age ratio (RHS) 0.60 50.0 (15 to 64) (LHS) 0.50 40.0 Children 0.40 30.0 (0 to 14) 0.30 20.0 (LHS) Elderly 0.20 10.0 (65 and over) (LHS) 0.10 0.0 0.00 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 Sources: Demographic projections from BPS and UN Statistics. THE WORLD BANK | BANK DUNIA December 2009 30 Indonesia Economic Quarterly Back on track? ...but this demographic But this demographic window of opportunity will close in the next decade. Sometime window of opportunity between 2020 and 2025 Indonesia's dependency ratio will begin to rise again. And it will will close in the next do so because the fraction of elderly in the population will begin to rise sharply, offsetting decade both the decline in the share of children as well as the increases in the working-age population. In the coming decade the number of Indonesians over the age of 65 is expected to increase by about 4 million, roughly the number by which it increased in the last decade. However, between 2020 and 2030, the number of elderly will rise by 8 million, and by 2030 the fraction of elderly in Indonesia's population is projected to be around 10%. From a demographic perspective, therefore, the next decade will be critical for Indonesia. 3. Creating better jobs for Indonesia's growing labor force Indonesia's window of Indonesia's working-age population will grow in size by about 20 million over the next demographic opportunity decade, or about 2 million per year. To make the most of its remaining demographic also creates a challenge window of opportunity Indonesia will need to generate a large flow of new, good quality to create many new, jobs. better quality jobs The World Bank's forthcoming Indonesia Jobs Report, scheduled for release in early 2010, reviews the main trends in Indonesia's labor markets over the last two decades, will provide further ideas for how labor policies and programs can encourage job creation and better prepare disadvantaged workers to succeed in the labor market. The following paragraphs summarize some of the basic trends and developments in the Indonesian labor market described in the Report. Accelerating poverty Labor is one of the few assets of the poor. If provided with a good job, they have a chance reduction depends on the to earn their way out of poverty. Indonesia experienced jobless growth from 1999 until creation of more jobs 2003, which slowed down the rate of poverty reduction. The uneven performance of the labor market in Indonesia continues to raise concerns whether Indonesia is at risk of falling into a situation of jobless growth again. To ensure that the benefits of growth are be shared more broadly, economic growth must translate into more jobs. Employment trends are The employment rate, after falling for six years, is turning around and has been on an improving but job upward trend since 2006. More recently, the rate increased from 61.5 percent in August creation is remains 2008 to 62.1 percent in August 2009. Employment gains have strongest among female moderate workers, as well as rural and young workers. The core unemployment rate has stabilized during recent years and actually decreased from 8.39 percent in August 2008 to 7.87 percent in August 2009. Although an encouraging sign, stable unemployment rates can mask problems in the labor market if workers are being pushed into jobs that are less secure or provide poorer conditions. It is necessary, therefore, to also examine some indicators of the quality of employment. Figure 43: Rising employment Figure 44: Stabilized unemployment (per cent of working age population) (per cent of working age population) % 65 8 % 1990-1997 1997-1999 1999-2003 2003-2008 1990-1997 1997-1999 1999-2003 2003-2008 64 7 63 6 Susenas unemployment 5 62 Core unemployment 4 61 3 60 2 59 1 58 0 1990 1992 1994 1997 1999 2001 2003 2005 2006 2008 1990 1992 1994 1997 1999 2001 2003 2005 2006 2008 Sources: Sakernas and World Bank Sources: Sakernas and World Bank The creation of `better' Two main indicators for the quality of employment are the share of active workers jobs has leveled off employed in the non-agricultural and in the formal sectors. Formal sector jobs are considered `better' because regular salaries provide employees with more income security and they are entitled to additional benefits legislated by the Manpower Law (No. 13/2003). Similarly, non-agricultural jobs are more productive and offer higher wage premiums for THE WORLD BANK | BANK DUNIA December 2009 31 Indonesia Economic Quarterly Back on track? workers. Despite Indonesia's economic recovery during 1999-2003, formal sectoral employment fell and workers were pushed into agricultural jobs. The quality of employment, however, has been gradually improving since 2003. Recent formal and non- agricultural job creation has stagnated, increasing by 0.22 and 0.63 percentage points, respectively, from August 2008 to August 2009. Figure 45: Slow formal sector employment growth Figure 46: Stagnant non-agricultural employment (per cent of working age population) (per cent of working age population) 60 % 50 % 1990-1997 1997-1999 1999-2003 2003-2008 1990-1997 1997-1999 1999-2003 2003-2008 55 45 50 40 Formal old definition 45 35 Formal new definition 40 30 1990 1992 1994 1997 1999 2001 2003 2005 2006 2008 1990 1992 1994 1997 1999 2001 2003 2005 2006 2008 Sources: Sakernas and World Bank Sources: Sakernas and World Bank The majority of the Employment trends in Indonesia's labor market have been positive, albeit gradual, since workforce have inferior 2003. Nevertheless, the workforce remains highly informal. In 2007, 24.1 percent of the jobs in the informal active workforce was informally employed in service and industrial jobs, while another sector 37.2 percent worked informally in agriculture. Some workers prefer the informal sector. Approximately one-quarter of informal workers earn more in this sector than they could expect to earn in a formal jobs. Most, however, would be better off in the formal sector. On average, workers in the informal sector earn 30 percent less than employees in the formal sector or employers. They do not benefit from non-wage benefits that formal sector workers expect, such as medical benefits or transportation and access to credit. Informal workers also report facing greater work stress than workers in the formal sector. Without accelerated job creation in the formal sector, most of these workers will remain in inferior informal jobs. Since informal workers tend to be poorer, stagnant formal employment growth will also slow-down the pace of poverty reduction in Indonesia. Figure 47: Highly informal workforce Figure 48: Formal sector employees earn more (shares of the labor force) (mean log monthly wages) 8.1 8 7.9 Informal Informal non- 7.8 agricultural agricultural 27% 7.7 27% 7.6 Employers 7.5 2% Permament 7.4 contract employees 7.3 Employees with 3% no contract 7.2 Fixed-term 38% contract 7.1 employees Permanent Fixed Term Employees with Informal workersInformal workers 3% Employees & Contract no Contract (non-agricultural) (agricultural) Employers Employees Source: Sakernas 2007 and World Bank Source: IFLS 2007 But even in the formal Jobs in the formal sector, however, are not necessarily better than those in the informal sector, most employees sector. 81 percent of employees in the formal sector work without a contract in place. On are only slightly better off average, they earn approximately the same as agricultural or non-agricultural workers in than informal workers the informal sectors. They are less likely to receive any of the non-wage benefits typically associated with formal sector employment, including severance pay, pension, credit and transportation benefits. For example, two-thirds of employees with permanent contracts and over one-half of workers with temporary contracts report receiving medical benefits. THE WORLD BANK | BANK DUNIA December 2009 32 Indonesia Economic Quarterly Back on track? Only one-quarter of contract-less workers, in contrast, receive these benefits. When disputes arise with employers, non-contractual employees are also disadvantaged. Without job documentation to use as evidence they face barriers in accessing industrial relations courts. Figure 49: Contract-less employees receive fewer non- Figure 50: Redundancy costs in Indonesia are the highest in wage benefits the region (share of workers receiving benefit) (severance costs in weeks of average earnings) 120 70% Permanent contract/Employer 60% 100 Fixed-term contract 50% 80 No contract 40% 60 30% 40 20% 20 10% 0 0% East Asia China Indonesia Malaysia Philippines Thailand Vietnam Severance Pension Medical Credit Transport Meal & Pacif ic Source: IFLS 2007 Sources: `Doing Business' 2010 Debates continue on The Manpower Law contributed to improvements in the creation of `better' jobs by whether the pace of job establishing a system to moderate minimum wages that, between 1999 and 2003, were creation could be rising rapidly. At the same time, the law significantly tightened hiring and firing regulations accelerated. by restricting the use of temporary contracts and increasing severance rates. Since then, redundancy costs in Indonesia have continued to be the highest in the region. This has sparked an on-going controversy around the extent to which these regulations deter employers from hiring staff, and whether rigidities in the labor market are slowing the pace of job creation in the formal and non-agricultural sectors. In a highly segmented In the current debate surrounding labor reform, workers groups have focused on workforce, policies must improving workers' welfare through the enforcement of hiring and firing regulations. take the interests of the Workers with permanent or temporary contracts are concerned about improving worker voiceless majority into protection. Informal workers, however, would benefit from policies that spur job creation in account the formal and non-agricultural sectors, which would provide more opportunities for them to move into jobs with greater income security and benefits. Similarly, contract-less employees in the formal sector would benefit from policies that would encourage employers to employ more workers with permanent contracts. These workers, who represent the majority of the workforce, have little voice in shaping labor market policies that are negotiated in tripartite forums ...with the aim to expand Job creation helps to share the benefits of growth more broadly, providing opportunities opportunities for work in for the poor to earn their way out of poverty. In a segmented labor force like Indonesia's, `better' jobs however, job creation must focus on the creation of `better' jobs in the preferred formal and non-agricultural sectors. The challenge faced by the new government, therefore, is to identify and support policies that encourage job creation to benefit the majority of workers seeking to find better jobs, while still ensuring adequate protection for formal sector workers. The World Bank's forthcoming Indonesia Jobs Report, expected for release in early 2010, will provide further ideas how labor policies and programs can encourage job creation and better prepare disadvantaged workers to succeed in the labor market. THE WORLD BANK | BANK DUNIA December 2009 33 Indonesia Economic Quarterly Back on track? 4. Financing healthcare for Indonesia's growing labor force and aging population A commitment to With the passage of Law 40/2004 on the National Social Security System (SJSN) in 2004, universal health coverage Indonesia became one of only a handful of developing economies committed to providing but with many important universal health insurance coverage for its entire population through a mandatory public details to be worked out health insurance scheme. The SJSN law calls for universal coverage by 2020. The details and the time-line for implementation of any move towards universal coverage have yet to be fully fleshed out. But it is clear, especially given the demographic trends highlighted above, that a move towards universal coverage is likely to result in substantial increases in the cost for health spending over the coming decade. And policy choices regarding how the reform will be financed, which groups should be subsidized by the government, what specific health benefits should be covered, what changes are needed in the service delivery system and how to pay those who provide the care, and a host of other regulatory and administrative issues will determine the financial sustainability of any initiative as well as the quality and extent of coverage and ultimately, the improvements in health outcomes enjoyed by Indonesia's population. A recently released World Bank report-- Health Financing in Indonesia: A Reform Road Map--provides evidence and analyses meant to inform and assist the government as it develops and implements the move towards universal health insurance. This section provides a selective summary of the main messages of this report. Over the last four Health outcomes have improved significantly since 1980 when life expectancy was only decades, Indonesia has 52 years compared to almost 70 today, and some 100 infants out of every 1000 died made major before their first birthday, compared to less than 30 today. The total fertility rate has improvements in health declined from 4.7 children per woman to slightly above 2. Despite these impressive outcomes... improvements, Indonesia's achievements have been less impressive than some of its neighbors, and for certain health outcomes, such as maternal mortality, the country does not perform as well as other comparable income and health spending level countries. Figure 51: Indonesia's health spending is relatively low Health spending as % of GDP in 2006 7.0 Public Private 6.0 5.0 4.0 3.0 2.0 1.0 0.0 India China Thailand Korea Indonesia Philippines Malaysia Viet Nam ...and Indonesia's health Indonesia's health delivery system expanded significantly over the past 40 years. Virtually delivery capacity has all Indonesian's have access to basic care through a network of 8000 Puskesmas and expanded significantly 22,200 Puskesmas Pembantu, and some 5,800 mobile health clinics. On the other hand, while Indonesia has far fewer hospital beds per capita compared to other comparable income countries, these beds are poorly utilized with occupancy rates on the order of 60 percent. In terms of human resources for health, while nurse mid-wives are readily available throughout the country, Indonesia's health workforce overall is small relative to other similar income countries and concerns over quality and efficiency persist. Its physician workforce is very small relative to comparators, and there are severe shortages of specialists, which are particularly problematic given the proposed expansions in health insurance coverage and the oncoming non-communicable disease burden. THE WORLD BANK | BANK DUNIA December 2009 34 Indonesia Economic Quarterly Back on track? From a cross-country From a cross-country perspective, Indonesia's health spending is relatively low, but the perspective, Indonesia's country gets reasonable `value for money' in terms of some health outcomes as well as health spending is relatively good financial protection. Indonesia spends only slightly more than 2 percent of relatively low its GDP on health, about half the level of other comparable income countries. Half of all health spending is public. About one-third of health spending comes directly from of out of pocket payments by households. Health is a relatively small share of the government's budget, some 5 percent, although the share has been increasing since the implementation of the Askeskin program in 2004. Despite low spending health outcomes and financial protection are relatively good, although these latter results may be due to Indonesia's relatively high education levels and extended family social structure. Public health Private health expenditure has, historically, played a more important role than public expenditures are playing health spending in terms of overall health financing in Indonesia. However, this trend an increasing important started to change beginning in 2004 as the government introduced major health insurance role... programs targeted at the poor. It is expected that public health expenditure will have an increasingly important role to play in subsequent years as the government extends universal coverage to the entire Indonesian population. The establishment of Jamkesmas/Askeskin in 2004 has had an impact on both total health spending and the public share of spending. Out-of-pocket payments still comprise a sizeable share of health spending however, and the challenge for the government is to channel these expenditures into risk-pooling mechanisms in order to effectively provide protection against catastrophic health spending. ...and all of the major Private Voluntary Health Insurance (PVHI) is not well developed in Indonesia. Each of the health insurance three major existing health financing programs is publicly owned and coverage levels, until programs are publicly recently have been low: owned Civil servants and their dependents are covered under the ASKES program, which is administered by a for-profit state enterprise, P.T Askes. Jamkesmas was originally designed to cover the poor but was expanded to also cover the near poor. It was originally administered by ASKES but in 2008 the Ministry of Health (MoH) took over most of the major administrative functions, including provider payment. Jamsostek is similar to a classic social insurance program for private sector employees in firms with 10 or more employees and is also administered by a for-profit state enterprise. Employers have the option to opt out, either by self-insuring or by purchasing private insurance for their employees. Both P.T. Askes and Jamsostek also sell private commercial policies. Figure 52: Only about a third of Indonesia's population enjoys health insurance coverage 30.0 % of population under different health insurance program s 25.0 20.0 15.0 10.0 5.0 - 2003 2004 2005 2006 2007 ASKES Poor-targeted Jam sostek Self-insured JPKM Sources: World Bank staff estimates from SUSENAS surveys. THE WORLD BANK | BANK DUNIA December 2009 35 Indonesia Economic Quarterly Back on track? There are two possible Given Indonesia's existing health financing programs, the current policy debate, and the approaches to providing 2004 Social Security Law, two main approaches to universal coverage seem viable. Both universal coverage options would result in universal coverage, and both would have sufficiently large numbers of enrollees for effective risk pooling. Irrespective of the approach chosen, however, crucial decisions regarding the benefit package, cost-sharing, payment/contracting arrangements and modalities to address supply-side constraints need to be made. The three approaches are: A national health service fully financed by the government, similar to the national systems in Sri Lanka and Malaysia. This "Jamkesmas for all" would involve expanding the general revenue financed Jamkesmas program for the poor and near poor to cover the entire population. A single national mandatory health insurance system where the government subsidizes the poor and other disadvantaged groups, similar to the systems in Thailand and Turkey. This would approximate the `new' national Social Health Insurance (SHI) model (now called Mandatory Health Insurance (MHI)), where the MHI system is funded through both wage-based contributions for public and private sector workers (and retirees) and government general revenue contributions for the poor and other disadvantaged groups. Whichever approach is Clearly, whichever option is chosen, the movement to universal coverage will have a adopted, movement to sizeable impact on Indonesia's health spending. Micro-analyses of current program costs universal coverage will and utilization patterns after the introduction of Askeskin/Jamkesmas allow crude have a sizeable impact on projections of future costs. For example, crude estimates of future Jamkesmas costs health spending range from 20 percent of current Jamkesmas spending to sixfold increases, depending on the coverage expansion scenario and health inflation assumptions chosen. Demographics alone are likely to substantially raise health expenditures over the next decade as the fraction of elderly in the population increases and the number of outpatient visits as well as inpatient bed-days Figure 53: Demographics alone will increase Indonesia's health expenditures 80 0 00 0 0 8 0 00 0 00 O u t p a t ie n t v i s it s I n p a t ie n t b e d - d a y s 60 0 00 0 0 6 0 00 0 00 20 2 5 40 0 00 0 0 4 0 00 0 00 20 1 5 2 02 5 20 0 7 2 01 5 20 0 00 0 0 2 0 00 0 00 2 00 7 0 0 -4 -9 4 9 9 4 9 -9 4 4 9 4 + 4 9 4 9 4 9 4 4 -4 9 4 9 4 9 9 4 4 9 + -1 -1 -2 -2 3 -3 -4 -5 -6 -7 -1 -1 -3 -4 -4 -5 -7 -4 -5 -6 5 -2 -2 -3 -5 -6 -6 5 0 5 0 5 - 7 7 0 5 0 5 0 5 0 5 0 5 0 5 0 0 5 0 0 5 0 5 0 5 0 5 0 5 2 2 3 6 1 4 5 1 1 3 4 4 5 5 6 7 1 2 2 3 3 4 5 6 6 7 A g e c a te g o r y A g e c a t e g o ry Sources: Health Financing in Indonesia (World Bank, 2009) Successful implementation of the move towards universal coverage will require carefully sequenced implementation of targeted, effective, and fiscally sound policies. The Social Security Council and the Ministry of Health have taken important first steps, but more is needed. The drafting of the 2010-2014 Medium-term Development Plan (RPJM), the Ministry of Health's own internal planning efforts in developing the next Renstra, and the potentially large and possibly unaffordable expenditure implications of expanding health insurance to some 76 million poor and near poor, make this an ideal time to refocus efforts on the comprehensive set of policies needed to effectively implement universal health coverage in the next decade. THE WORLD BANK | BANK DUNIA December 2009 36