Indonesia Economic Quarterly Building Momentum

1. Indonesia Economic Quarterly Building Momentum Shubham Chaudhuri Lead Economist World Bank 8 April 2010 Jakarta Indonesia

2. Outline • Indonesia’s economic momentum built through 2009 • Policy has generally supported this momentum, and near-term risks may be smaller than they first appeared • Strong capital inflow • China-ASEAN FTA • Fiscal stimulus • Impact of windfall revenue on the Budget • The improving near-term economic outlook allows focus to shift to building the current momentum into the medium term • The Government’s medium development plan (RPJMN) • Infrastructure • Social protection

3. Building momentumIndonesia’s growth built through 2009 • Indonesia’s economy accelerated each quarter of 2009, ending the year outpacing the past decade’s average • Economy expanded by 4.5% in 2009 • Growth has been broad based across all components of GDP • Indonesia’s trading partners have also recovered, supporting trade volumes Sources: BPS via CEIC, World Bank

4. Building momentum …and other domestic indicators are strong • Other economic indicators have stabilized at high levels • Consumer indicators are around record highs • Industrial indicators are strong Sources: CEIC, World Bank

5. Building momentumInflation has fallen to decade lows • Headline inflation has picked up from its low point • Core inflation has continued to fall, to decade lows of 3.6% year to March • Inflation picked up at the start of the year, largely because the seasonal increases in food prices were larger than normal, and this affected poorer households especially • As the harvest comes in andglobal growing conditionsimprove, these increases shouldunwind • But inflation remains higher thanin most of Indonesia’s neighbors • And Indonesia has delayedpassing on to consumers lastyear’s recovery in globalenergy prices Source: BPS

6. Building momentumFinancial markets have bounced back • Yields on Indonesian debt have returned to pre-crisis • Spreads have narrowed further than other emerging markets • In January, yields on five year IDR sovereigns hit their lowest level since these bonds were first issued in 2003 • Agencies have raised their sovereign debt rating for Indonesia Sources: BPS via CEIC, World Bank

7. Building momentum2009 budget deficit was smaller than expected • Revenue surged at the end of 2009, while expenditure was only a little weaker than expected cutting the budget deficit to 1.6 per cent of GDP • The government spent about 95 per cent of the revised Budget • Programmatic spending was up on previous years; subsidies and interest costs down • The fiscal stimulus is estimated to have added as 1 percentage point to GDP growth Government tax revenues Share of line ministries’ budget spent Sources: BPS via CEIC, World Bank

8. The OutlookFaster growth, moderate inflation • Outlook remains for gradual pick-up in growth • Major trading partner growth is expected to pick up and drive exports • Domestic demand, particularly investment, and more export processing activity, are expected to drive further import growth • Inflation should slowly pick up into 2011 on solid domestic demand and a more stable exchange rate Sources: BPS, CEIC, World Bank. World Bank projections

9. There are both risks to the outlook and near-terms issues to consider • Some risks for the outlook: • Withdrawal of global fiscal and monetary stimulus • Weak demand from OECD economies, as consumer and public debt levels are addressed • Ongoing economic reforms in the region so growth is more reliant on domestic demand • On top of these external risks to Indonesia’s economic outlook arenear-term issues challenging policy makers: • Strong capital inflows into Indonesia • Ongoing exposure of Indonesia’s budget to commodity price shocks • Fears that the ASEAN-China FTA will have a significant impact on domestic producers

10. The Outlook…and these risks impact the outlook for Indonesia • There are both upside potential (from policy breakthroughs and stronger improvements in the global economy) and downside risks to the outlook Scenarios Annual GDP growth Sourcse: BPS, World Bank projections

11. The OutlookRisks remain to the global outlook • The medium term global challenge is to unwind the various stimuli used to fight the downturn: • Reducing the fiscal stimulus and developed country debt burdens is made more difficult by aging populations and political will • And unwinding monetary stimulus is difficult due to uncertainty around lags (too soon and recovery suffers, too late and inflation takes off) and the shift from goods inflation to asset price volatility • This implies that financial markets may remain volatile for some time (exchange rates, commodity prices, interest rates and so forth) • Indonesia is particularly vulnerable to this volatility • Still the volatility, and impact on the economy, is likely to be smaller than late 2008 • And the longer term challenges • Addressing global imbalances – improving but are still large implying weaker world growth as OECD consumers save more and consume less • And a difficult structural adjustment to higher world capital and energy prices – compounded by higher carbon prices?

12. The proposed revised BudgetVolatile oil prices again expanding the deficit • The proposed revised 2010 Budget projects a wider deficit of 2.1% of GDP • Mostly due to higher oil price projections, repeating past years’ experience • Total expenditure is expected to increase by around 3 per cent in 2010 • Mostly due to higher energy subsidies and transfers to subnationalgovernments • Delayed reform of regulated energy prices and higher outlook for global oil prices are expected to increase subsidy costs by 30% Energy subsidies, as % of GDP Sources: MoF and BPS. World Bank 2010 projections

13. The proposed revised BudgetVolatile oil prices again expanding the deficit • Tax revenues are expected to increase significantly as incomes recover • With a stronger exchange rate and given past patterns, revenues may be event stronger than projected • There are upside risks to the government’s projections; stronger assumptions about the economy and for revenues reduce the deficit towards 1% of GDP • The wider deficit can be easily financed from the 2009 financing surplus • And the government is well-advanced on its commercial debt sales, selling debt at sharply lower interest rates and for longer terms Sources: BPS via CEIC, World Bank

14. The proposed revised Budget Volatile revenues hinder effective budgeting • A large spike in revenues with, eg, higher oil prices means more funds need to be allocated to the education budget under the ’20% rule’ • Some of the problems with these ‘windfalls’ to the education budget have been addressed: • The Government’s early revision to the state budget reduce the risk of a large windfall arising late this fiscal year • The revised budget establishes an education endowment fund to help ensure that ‘windfalls’ are managed and spent well • Strengthening budget contingency planning in MoNE and MoRA could also help to better manage the problem • Windfalls for the education budget are part of a broader problem, namely, volatility in the budget caused by energy subsidies and fluctuations in resource revenues

15. Some policy challengesFinancial markets continue to rebound, bringing large capital inflows • USD 6.6 billion of foreign capital has flowed into Indonesian financial assets since June 2009 • In this time the Rupiah appreciated 9% • And the central bank has allowed its foreign exchange reserves to grow, while ‘sterilizing’ these increases • The cost of this sterilization is estimated to be low…so far Sources: BPS via CEIC, World Bank

16. Some policy challengesLimited impact from the ACFTA • Cuts in tariffs on goods imported from China start in 2005 and another round occurred on 1 January 2010. • The cuts in January were relatively small and follow gradual reduction; higher tariffs remain on some ‘sensitive’ goods • Few traders are using the lower rates available under the agreement • …suggesting this round of tariff reductions is likely to have a small impact • The agreement offers large potential benefits to Indonesia • Since tariff reductions began in 2005, Indonesia’s exports to China have increased by almost 70% • The agreement also promiseslower prices forIndonesianconsumers andproducers, andbetter access toChina's markets Sources: MoF

17. Realizing the development agenda • The improving economic environment allows Indonesia to shift focus to the medium term development issues • Indonesia is poised for government-catalyzed and private sector- driven investment and growth with the right policy improvements for the investment climate and complementary public investments • The Government focuses on these issues in its new medium term development agenda (RPJMN) • The improved economic environment allows Indonesia to spend more on its development priorities • Indonesia’s fiscal and debt position is strong… • …and there are resources to be had ifenergy subsidies are redirected towards targeted social spending and infrastructure investments

18. Realizing the development agendaAccelerating investment climate reforms and attacking coordination problems • More aggressive stance toward facilitating domestic and foreign investment: • Foreign direct investment levels are relatively low; these investments are far less footloose than short-term inflows into capital markets • Lower entry barriers, including the time and cost to start a business, the Negative List • Lower operating costs with a focus on actionable steps to improve logistics, • Improve trade facilitation through the National SingleWindow • and control the proliferationof non-tariff barriers thatraisecosts and reducecompetitiveness • Solution for Coordination:Regulatory Reform Commission Foreign direct investment as % of GDP, 2004-2008 Sources: UNCTAD, World Bank

19. Realizing the development agenda…supporting investment growth • As China rebalances from investment to consumption-led growth, Indonesia will want to spur investment and net exports Contributions to annual average growth, 2003-2008 Source: World Bank

20. Realizing the development agendaPolicies need to support economy-wide growth • Sectors with the greatest reforms grew faster last decade • Service sectors, many deregulated at the start of the decade, have been growing much faster than the rest of the economy • Telecoms, retailing and domestic airlines all experienced rapid growth • But partly the reflects that other sectors, especially mining and manufacturing have not been doing as well (average annual growth) Source: BPS via CEIC

21. Putting in place a Social Protection System consistent with Middle Income Status • Opportunities and Challenges • Indonesia has the resources and institutional capacity to develop effective social protection systems • as demographic and epidemiological challenges mount • Key elements • Build proven and successful social assistance and poverty alleviation programs(PNPM, BOS, BLT,…) into a comprehensive social assistance program • Lay the groundwork for a future National Health Insurance System that is clear, feasible and affordable • And put in place a grand bargain between employers and workers on severance pay that provides worker’s security without discouraging job creation

22. But all of this will require a bigger push on Institutional and Civil Service Reforms • Replicate models of institutional reform underway (at the Ministry of Finance – especially Tax and Treasury) in other institutions with significant contact with the public—Customs, BPOM, Manpower, Trade and Industry… • Complement ongoing bureaucracy reforms at the institution level with a modernized regulatory framework and central institutional set-up for civil service policy making, regulation and management • Improve compensation, recruiting and promotion but link it to accountability • Allowing fit for function institutions (not one size fits all)

23. Indonesia Economic Quarterly Building Momentum Shubham Chaudhuri Lead Economist World Bank 8 April 2010 Jakarta Indonesia

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25. These development items are consistent with the Government’s development plan • The Government’s 11 priorities; • i) Bureaucracy and governance reform, • ii) Education, • iii) Health, • iv) Poverty reduction, • v) Food security, vi) Infrastructure, • vii) Investment and business climate, • viii) Energy, • ix) Environment and disaster management, • x) Least developed, frontier, outer, and post conflict areas, xi) culture, creativity, and technological innovation.