Indonesia economic quarterly : maximizing opportunities, managing risks

58458 INDONESIA ECONOMIC QUARTERLY Maximizing opportunities, managing risks December 2010 i 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 the implications of these developments and other changes in policy 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 macroeconomic analysis team at the World Bank's Jakarta office, under the guidance of Lead Economist Shubham Chaudhuri and Senior Country Economist Enrique Blanco Armas: Magda Adriani (rice prices), Andrew Blackman (trade flows, balance of payments), Andrew Carter (government revenues), Andrew Ceber (national accounts), Faya Hayati (prices), Ahya Ihsan (government expenditure and fiscal disbursements), Diva Singh (financial markets, monetary conditions, banking sector, and capital flows). Additional contributions were received from Pandu Harimurti (Jamkesmas), Amri Ilmma (poverty), Jon Jellema (Bantuan Langsung Tunai), Paavo Monkkonen (housing), Jemima Sy (water and sanitation), Victoria A. Beard, Retno Sri Handini, and Anna I. Gueorguieva (Monitoring and Evaluation). Tia Chandra, Kiyoshi Taniguchi and Ashley Taylor shared the editing and production. Enrique Blanco Armas, Jonas Fallov, Hassan Noura, Hari Purnomo, Vijay Ramachandran and Theo Thomas provided detailed comments on earlier drafts. For more World Bank analys is of Indonesia's economy: For information about the World Bank and its activities in Indonesia, please visit www.worldbank.org/id In order 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 ataylor2@worldbank.org. iii Table of contents Preface iii Executive Summary: Maximizing opportunities, managing risks viii A . ECONOMIC AND FISCAL UPDATE 1 1. The global drivers of Indonesia's external balance have strengthened 1 2. The outlook for domestic growth remains robust for 2011 1 3. On the back of global developments, balance of payments inflows rose further 3 4. Domestic financial markets have been boosted by the capital inflows 4 5. Food price shocks again dominate recent movements in inflation 7 6. Weakness in fiscal expenditures continues and tax revenue growth has slowed 8 7. Near-term risks are predominantly external, but domestic policies will determine the medium- term growth trajectory 10 B. SOME RECENT DEVELOPMENTS IN INDONESIA'S ECONOMY 12 1. Managing capital inflows: Policy options for Indonesia 12 a. Capital inflows have been on the rise in Indonesia this year, bringing benefits but also risks that necessitate an appropriate policy response ....................................................................... 12 b. Rising portfolio inflows raise macroeconomic and prudential concerns and heighten the risk of disruptive outflows ................................................................................................................... 13 c. Medium-term policies should aim to attract more FDI and strengthen the financial system through macro-prudential regulations ........................................................................................ 14 d. Indonesia has various short-term policy options, of which gradual appreciation and the sterilized accumulation of reserves may be the two most appropriate .................................... 15 2. Quality of public spending and disbursement profile in Indonesia 16 a. Improving the quality of public spending is a key priority for the Government ...................... 16 b. Budget execution is skewed towards the end of the fiscal year ............................................... 16 c. International comparisons highlight Indonesia's budget execution challenges ..................... 17 d. Budget under-spending and a skewed disbursement profile can hinder the effectiveness and efficiency of public spending ................................................................................................ 18 e. Impediments to disbursement and recent policy reforms ......................................................... 19 f. Looking forward ............................................................................................................................ 20 C. INDONESIA 2014 AND BEYOND: A SELECTIVE LOOK 21 1. Assessing the performance of an Indonesian unconditional cash transfer: BLT 23 2. Does JAMKESMAS protect the population from health expenditure shocks? 27 3. Housing and services for low-income households in Indonesia 31 4. Incentivizing local governments to take responsibility for water and sanitation services 34 5. National Monitoring and Evaluation (M&E) in Indonesia 38 a. International shift towards performance-informed policy making, planning and budgeting . 38 b. M&E in Indonesia........................................................................................................................... 39 c. Moving towards performance-informed budgeting and developing a coordinated M&E system ............................................................................................................................................ 41 APPENDIX: SNAPSHOT OF THE INDONESIAN ECONOMY 42 LIST OF FIGURES Figure 1: Rising equity and bond flows to emerging markets .......................................................... 1 Figure 2: Global commodity prices have picked up........................................................................... 1 Figure 3: Growth weakened slightly in Q3... ...................................................................................... 2 Figure 4: ...with agriculture particularly weak .................................................................................... 2 Figure 5: Agricultural exports have picked up ................................................................................... 4 Figure 6: ...including Italy and Belgium .............................................................................................. 6 Figure 7: Indonesia's public debt has fallen and reserves are rising ............................................... 6 Figure 8: Sterilization of reserve accumulation continues ................................................................ 7 Figure 9: Credit growth has been driven by working capital loans .................................................. 7 Figure 10: Inflation has risen over the year but remains below historic averages.......................... 8 Figure 11: Core inflation has increased only steadily while volatile prices (mainly food) have driven headline inflation ................................................................................................ 8 Figure 12: The rise in net portfolio inflows has dominated the financial account since 2009... .. 13 Figure 13: ...with a majority of non-resident portfolio inflows going into domestic government securities (SUNs) .......................................................................................................... 13 Figure 14: The Rupiah saw a marked appreciation in nominal and real terms in 2009, but more gradual in 2010 ............................................................................................................. 14 Figure 15: Foreign ownership of domestic assets has increased, but so too have reserves ...... 14 Figure 16: Capital expenditures are heavily skewed........................................................................ 16 Figure 17: Spending frequently under-shoots Budget levels ......................................................... 16 Figure 18: Indonesia's skewed disbursement profile stands out amongst regional peers .......... 17 Figure 19: Aggregate poverty is falling ............................................................................................. 21 Figure 20: Provincial disparities in poverty remain ......................................................................... 22 Figure 21: GoI social assistance program coverage, 2008 and 2009 ............................................. 26 Figure 22: BLT incidence and coverage, 2005 and 2008 ................................................................. 26 Figure 23: Jamkesmas health insurance covers almost half the poor population........................ 27 Figure 24: Individuals with Jamkesmas coverage are more likely to use inpatient services ....... 28 Figure 25: Changes in housing conditions in urban areas, 1988 - 2007 ........................................ 31 Figure 26: Housing materials, infrastructure and land title by expenditure deciles, 2007 ........... 32 Figure 27: Rent-to-income and-expenditure ratios .......................................................................... 32 Figure 28: Declining total access to improved water supply .......................................................... 34 Figure 29: Urban usage of unimproved water supply has risen ..................................................... 34 Figure 30: Quality of access to water supply and household income are highly correlated ....... 35 Figure 31: Depreciation in urban water utilities (PDAMs) can exceed new investment................ 35 Figure 32: Access to improved sanitation ........................................................................................ 35 Figure 33: Good Governance in Kota Palembang Leads to Better Services ................................. 36 LIST OF APPENDIX FIGURES Figure 1: GDP growth moderates ...................................................................................................... 42 Figure 2: Contributions to GDP expenditures .................................................................................. 42 Figure 3: Contributions to GDP production ...................................................................................... 42 Figure 4: Motor cycle and motor vehicle sales ................................................................................. 42 Figure 5: Consumer indicators .......................................................................................................... 42 Figure 6: Industrial production indicators ........................................................................................ 42 Figure 7: Real trade flows................................................................................................................... 43 Figure 8: Balance of Payments .......................................................................................................... 43 Figure 9: Trade balance ...................................................................................................................... 43 Figure 10: International reserves and capital inflows ...................................................................... 43 Figure 11: Term of trade and monthly export and import chained Fisher-Price indices .............. 43 Figure 12: Inflation and monetary policy .......................................................................................... 43 Figure 13: Monthly breakdown of CPI ............................................................................................... 44 Figure 14: Inflation amongst neighboring countries........................................................................ 44 Figure 15: Domestic and international rice price comparison ........................................................ 44 Figure 16: Poverty, employment, and unemployment rate .............................................................. 44 Figure 17: Regional equity indices .................................................................................................... 44 Figure 18: Broad Dollar Index and Rupiah spot ............................................................................... 44 Figure 19: 5 Year local currency bond yields ................................................................................... 45 Figure 20: Sovereign USD Bond EMBI Spreads ............................................................................... 45 Figure 21: International commercial bank lending ........................................................................... 45  Figure 22: Banking sector financial indicators ................................................................................. 45 LIST OF TABLES Table 1: Robust growth to continue through 2011 .......................................................................... viii Table 2: Aggregate GDP projections for 2010 and 2011 are broadly unchanged ............................ 3 Table 3: Record balance of payments inflows expected for 2010..................................................... 4 Table 4: Indonesia's CDS spreads are well below several investment-grade sovereigns... .......... 5 Table 5: The approved 2011 Budget projects a higher deficit than currently projected for 2010 10 Table 6: Ministry of Health budget allocation and target performance .......................................... 18 Table 7: Summary of BPK audit findings on the road sector .......................................................... 19 Table 8: BLT recipients found jobs at a greater rate ........................................................................ 25 Table 9: BLT households also avoided reductions in school participation and increases in child labor .............................................................................................................................. 25 Table 10: BLT Deduction Frequencies, Amounts, Actors, and Uses.............................................. 26 Table 11: M & E Systems .................................................................................................................... 39 Table 12: National Level Indicators used by Central Governments................................................ 39 Table 13: Agencies and M&E Mandates in Indonesia ...................................................................... 40 Table 14: Budget outcomes and estimates ....................................................................................... 46 Table 15: Balance of Payments .......................................................................................................... 46 LIST OF BOXES Box 1: Moody's puts Indonesian government bonds on review for ratings upgrade ..................... 5 Box 2: Allocation and spending for the Ministry of Health .............................................................. 18 Box 3: Enhancing internal control and supervision can improve quality of spending ................. 19 Box 4: A brief introduction to the Jamkesmas program .................................................................. 28  ABBREVIATIONS AND ACRONYMS APBD Anggaran Pendapatan dan Belanja Daerah MenPAN Kementerian Pemberdayagunaan (Sub-national budget) Aparatur Negara (State Ministry of Administrative Reforms) APBN Anggaran Pendapatan dan Belanja Negara MoF Ministry of Finance (State Budget) Askes Asuransi Kesehatan mom month-on-month BAPEPAM Capital Market and Financial Institution MSME Micro, Small, and Medium Enterprises Supervisory Agency BAPPENAS Badan Perencanaan Pembangunan MTEF Medium-Term Expenditure Framework Nasional (National Development Planning Agency) BI Bank Indonesia OECD Organization for Economic Co-operation and Development BKPM Badan Koordinasi Penanaman Modal PAD Pendapatan Asli Daerah (own Source (Indonesia Investment Coordinating Board) Revenue of sub-national government) BLI Base-line Indicator PBB Performance Based Budgeting BoP Balance of Payments PFM Public Financial Management BLT Bantuan Langsung Tunai (cash transfer) PPP Purchasing Power Parity BPN National Land Agency PLN Perusahaan Listrik Negara (State Electricity Company) CDS Credit default swap PMK Peraturan Menteri Keuangan (Minister of Finance Regulation) CPI Consumer price index PNS Pegawai Negeri Sipil (Civil Servants) DIPA Daftar Isian Pelaksana Anggaran (Program qoq quarter-on-quarter Budget Authorization Document) EMBI Emerging Market Bond Index RPJM Rencana Pembangunan Jangka Menegah (Medium-Term Development Plan) EME Emerging Market Economies RPJMN Rencana Pembangunan Jangka Menengah National (National Medium Term Development Plan) FDI Foreign Direct Investment SBI Sertifikat Bank Indonesia (Bank of Indonesia Certificate) FY Fiscal Year SME Small Medium Enterprise GDP Gross Domestic Product SOE State-owned Enterprise GoI Government of Indonesia SUNs Surat Utang Negara (government securities) IDR Indonesian Rupiah UKP4 Unit Kerja Presiden Bidang Pengawasan dan Pengendalian Pembangunan (The Presidential Working Unit for Supervision and Management of Development) Keppres Keputusan President (Presidential Decree) USD US dollar JAMKESMAS Jaminan Kesehatan Masyarakat (Health WB World Bank Insurance Reform Scheme) M&E Monitoring and Evaluation yoy year-on-year Executive Summary: Maximizing opportunities, managing risks Global drivers of Key global drivers of Indonesia's external balance, namely capital inflows and commodity Indonesia's external prices, have strengthened. The challenge for Indonesia is to maximize the opportunities balance, including capital that this brings, in terms of enhancing future growth and making investments that can inflows, have improve the welfare of the entire population, while managing the associated risks. strengthened Strong capital inflows, particularly portfolio, have been seen across emerging markets, including Indonesia. These inflows are driven by yield differentials and the stronger growth prospects, and improved creditworthiness, of emerging economies relative to heavily- indebted, higher-income economies. Further quantitative easing in the US has provided an additional, cyclical boost to this trend. Commodity prices have Global commodity prices also picked up in recent months. In November, the US dollar made further gains price of non-energy commodities rose by 3.4 percent over the month with food and raw material prices up by 4.9 percent and 7.6 percent, respectively. The underlying drivers were strong growth in demand from emerging economies, particularly China, and also supply disruptions in the agriculture sector. Domestically, growth Annual GDP growth weakened in Q3 2010 for the first time since Q2 2009. However, at softened in Q3... 5.8 percent year-on-year, Indonesian growth remains relatively strong compared with other countries in the region. Domestic factors played the main role in explaining the weaker Q3 growth. These included weather-related disruptions to agriculture and mining and quarrying, for example. Quarterly growth for retail trade, services, and manufacturing performance was also affected by the Ramadan period. On the expenditure side, a slight weakening in the contribution of private consumption to growth was offset by substantial gains for government consumption and investment, as well as net exports. ... but the growth forecast Due to the softer third quarter figures, the World Bank's 2010 growth forecast has been for 2011 remains at 6.2 revised downward by 0.1 percentage point to 5.9 percent (Table 1). Looking forward, the percent recent strength of investment is expected to continue. Higher frequency indicators of consumption are also supportive. In terms of external demand, the forecast for real export growth for 2011 has been downgraded slightly due to base effects from the strong performance of 2010 and the downward revision to the forecast for major trading partner growth. The adverse economic impacts of the natural disasters that have hit Indonesia in recent months, such as the Mt. Merapi eruptions, are expected to be localized. Overall, the growth forecast for 2011 remains unchanged from the September IEQ at 6.2 percent. Table 1: Robust growth to continue through 2011 2009 2010 2011 Gross domestic product (Annual percent change) 4.5 5.9 6.2 Consumer price index* (Annual percent change) 2.6 6.2 6.0 Budget balance** (Percent of GDP) -1.6 -1.5 -1.8 Major trading partner growth (Annual per cent change) -0.8 6.6 4.0 Note: * Q4 on Q4 inflation rate. ** Ministry of Finance projection, 2011 figure is approved Budget. Sources: Ministry of Finance, BPS and other national statistical agencies via CEIC, Consensus Forecasts Inc., and World Bank Movements in volatile Rising food prices moved headline CPI inflation up to 6.3 percent year-on-year in food prices continue to November, from 5.7 percent in October. Grain prices (including rice) rose by 25 percent affect headline inflation year-on-year, the highest rate since 2006. As the poor consume a greater share of such food items in their consumption bundles, the gap between the headline inflation rate and the World Bank's poverty basket inflation rate widened further. Core inflation remains subdued (at 4.3 percent year-on-year in November). Even though it is gradually increasing, it still remains well below levels seen in 2008. Reflecting the contribution of volatile items to recent inflation developments, Bank Indonesia maintained its policy rate at 6.5 percent in December. Reflecting global Balance of payment inflows have been boosted by the performance of both the financial developments, balance of account and the trade balance. In the first three quarters of 2010, Indonesia's financial payment inflows have and capital account net inflows moved well above pre-crisis average levels. Net portfolio risen inflows accounted for the vast majority of this trend, particularly into government securities. Foreign direct investment inflows are also on an upward trend, but remain lower than elsewhere in the region. Although net non-resident portfolio outflows were observed in November, this was mainly due to a fall in foreign holdings of Bank Indonesia certificates (SBIs), following the suspension of 3-month SBI auctions. In early December further non-resident inflows into government securities and local equities were seen. Parliament has approved The programs and priorities in the 2011 Budget approved by Parliament are generally in the Budget for 2011 line with the proposed Budget. Much-needed capital expenditures will receive a substantial increase in allocated funds. The overall deficit was increased slightly to 1.8 percent of GDP, compared with 1.7 percent in the proposed Budget. Government revenue growth in the year-to-date has slowed since the September IEQ. In addition, as in recent years, weak disbursement was seen through the first eleven months of 2010. Although some reforms to improve budget execution have been introduced, some long-standing issues constraining timely budget disbursement still persist. Reflecting these two trends in performance over 2010 to date, the World Bank projection for the overall deficit in 2010 is 1.1 percent of GDP. This compares with the earlier Government Semester I Report projection of a deficit of 1.5 percent of GDP. The near-term risks are Rising capital inflows over 2010 have led to policy challenges for many emerging market mainly external, economies, including Indonesia. In the short-term, Indonesia still remains vulnerable to particularly relating to adverse shocks to investor sentiment. Further measures to shift inflows towards longer- capital inflows term flows can help to mitigate this risk, particularly policies to enhance incentives for foreign direct investment. Looking to the medium-term outlook, the main domestic risk is whether the policies required to boost growth to 7 percent are adopted and implemented. This risk provides both upside and downside potential around the baseline outlook. Coordinated action will be required to address Indonesia's infrastructure needs, to address the investment climate-related constraints on growth, to enhance the creation of quality employment, and to ensure that the benefits of growth continue to be shared across the population. Policies aimed at Different aspects of poverty and service delivery are the focus of the medium-term policy addressing vulnerability discussion in this IEQ. Social protection programs can help limit the vulnerability of to poverty and improving households to poverty. For example, the Government of Indonesia employed a nationwide access to basic services temporary cash transfer program for poor households, Bantuan Langsung Tunai (BLT), in across the population can help to promote further 2005 and 2008 to limit the impact on household welfare of upward adjustments in fuel inclusive growth going prices as subsidies were cut. Providing financial protection from necessary health forward expenditures is also one of the health development goals in Indonesia. In this area, the tax-financed Jamkesmas health insurance for the poor program plays a key role, accounting for two-thirds of Indonesians with formal health insurance coverage. On access to basic infrastructure services, the Government's National Medium-Term Development Plan, RPJMN (2010-2014), sets out an ambitious agenda for water and sanitation. National government budgets for the sector are to rise markedly and annual special allocation grants will become available to support local government investments in community-based water and sanitation systems. These are signs that positive steps are being taken to curb the recent downward trend in service levels. Housing conditions in Indonesia are also modestly improving. With ongoing urbanization, government attention on urban housing becomes increasingly important so as to ensure infrastructure provision, protect property rights and mitigate externalities such as congestion and pollution. Finally, monitoring and evaluation (M&E) information can be used to inform assessments of a government's progress in addressing poverty through the delivery and receipt of public goods. Indonesia is shifting towards a performance-informed budgeting system, an important input to which is M&E information. Future steps in developing coordinated M&E systems will likely include greater information sharing, improving systems and building consensus on indicators, formats and coordination across agencies. ix A. ECONOMIC AND FISCAL UPDATE 1. The global drivers of Indonesia's external balance have strengthened Global portfolio capital Strong growth in capital inflows has been seen across emerging markets over 2010 flows to emerging (Figure 1). Global flows to emerging markets, covering equity and bond issuance and markets have surged in bank lending, reached USD 403 billion in the first ten months of the year, albeit weakening recent quarters in October. This compares with a total of USD 353 billion in 2009 as a whole. Inflows have been driven by yield differentials and the stronger growth prospects, and improved credit worthiness, of emerging economies relative to heavily-indebted higher-income economies. Further quantitative easing in the US has provided an additional cyclical boost to this trend. Policymakers throughout emerging economies are grappling with the appropriate policy response to mitigate macro and prudential concerns relating to these inflows (Part B provides a more detailed discussion of these issues). Commodity prices have Global commodity prices have also picked up in recent months (Figure 2). In November, made further gains non-energy commodity prices rose by 3.4 percent on the month in US dollar terms, while food prices were up 4.9 percent and raw materials up 7.6 percent. The underlying drivers are the strong growth in demand from emerging economies, particularly China, and also certain supply disruptions, particularly in the agriculture sector. Looking forward, the World Bank US dollar global commodity forecasts have been upgraded for 2010 and 2011 (with the level of the forecast for the non-energy and energy indices in 2011 upgraded by 9.8 percent and 6.7 percent respectively). Figure 1: Rising equity and bond flows to emerging markets Figure 2: Global commodity prices have picked up (capital flows to emerging markets, USD billion) (USD global commodity price index, index Jan 2009=100) 500 500 180 180 Banks Equity Bonds 400 400 160 160 Energy Non-energy 300 300 140 140 200 200 120 120 Agriculture 100 100 100 100 0 0 80 80 2008 2009 2010 Jan-Oct Jan-09 Jul-09 Jan-10 Jul-10 Source: World Bank DECPG Source: World Bank After a strong rebound, Following their strong rebound, growth in many of Indonesia's major trading partners the growth of Indonesia's (MTP) has moderated. The weighted MTP growth reached 7-8 percent in the first half of major trading partners 2010 but fell to 6 percent in Q3. This normalization of growth rates among MTPs is has moderated expected to continue. 2. The outlook for domestic growth remains robust for 2011 Growth in Q3 was slightly GDP growth on a year-on-year basis weakened in Q3 for the first time since Q2 2009 lower than expected (Figure 3). The performance was slightly lower than expected at 5.8 percent year-on-year (yoy), or 1.2 percent quarter-on-quarter (qoq) seasonally adjusted. Growth was, however, relatively strong compared with other countries in the region. For example, Malaysia and Thailand saw quarterly contractions on a seasonally adjusted basis. While in other regional economies the performance was mainly driven by the manufacturing sector, for Indonesia, domestic temporary factors also played a role. Due to weather-related disruptions, agricultural production was particularly weak in Q3, down 0.1 percent qoq seasonally adjusted. Construction, mining and quarrying activity  Indonesia Economic Quarterly Maximizing opportunities, managing risks was also dampened due to similar factors. However, in terms of contributions to quarterly growth there were also falls for retail trade, services and manufacturing (likely due to Ramadan-related factors). Communication and transport growth held up well (Figure 4). Figure 3: Growth weakened slightly in Q3... Figure 4: ...with agriculture particularly weak (percentage change in real GDP) (contribution to quarter-on-quarter seasonally adjusted growth, percent) Agriculture Mining and construction Percent Percent Manufacturing Com & trans 4 8 Retail trade Other (incl services) Year on year GDP* (RHS) Percent Percent 3 6 2 2 QoQ seas. adjust 2 (LHS) 4 1 1 Average (LHS)* 1 2 0 0 0 0 -1 -1 Sep-03 Jun-05 Mar-07 Dec-08 Sep-10 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep-10 Note: * Average QoQ growth between Q1 2000 and Q2 2010 Note: Contributions may not sum to overall GDP growth due Source: BPS, World Bank seasonal adjustment to seasonal adjustment of each individual series Sources: BPS and World Bank staff calculations Investment growth made On the expenditure side, on a quarterly-growth basis, a slight weakening in the a strong contribution on contribution of private consumption was offset by substantial gains for government the expenditure side consumption and investment. The rise in investment spending was driven by machinery equipment investment, perhaps due to the strength of the exchange rate lowering investment prices but also expectations of sustained demand for production going forward. Net exports also contributed strongly, although this was offset by the large statistical discrepancy. Growth of 6.2 percent is The softer Q3 growth contributed to a small downward revision in the World Bank's forecast for 2011, up on forecast for 2010 to 5.9 percent from 6.0 percent in the September IEQ (Table 2). Looking an expected 5.9 percent forward, monthly indicators of consumption and investment remain supportive. For for 2010 instance, consumer confidence has rebounded following its downturn during the previous mid-year food price spikes. Motor vehicle sales picked up in October following the drop during Ramadan. Growth in real exports has been downgraded slightly for 2011, due to base effects from the strong performance of 2010 and the forecast revision to major trading partner growth. The downward revision for government consumption growth reflects ongoing weakness in disbursement. The real economy impact of the natural disasters which have hit Indonesia in recent months, such as the Mt. Merapi eruptions, is expected to be localized with limited impact on national GDP. The growth forecast for 2011 is unchanged at 6.2 percent. However, moving growth upwards to the RPJM-N (National Medium-Term Development Plan) targets of around 7 percent for 2013 and 2014 will require concerted policy actions over the coming year in areas such as infrastructure and investment climate. THE WORLD BANK | BANK DUNIA December 2010 2  Indonesia Economic Quarterly Maximizing opportunities, managing risks Table 2: Aggregate GDP projections for 2010 and 2011 are broadly unchanged (percentage change, unless otherwise indicated) Annual Year to December quarter Revision to Annual 2009 2010 2011 2009 2010 2011 2010 2011 1. Main econom ic indicators Total Consumption expenditure 6.2 4.4 5.5 5.9 7.0 3.6 -0.8 0.1 Private consumption expenditure 4.9 5.0 5.1 4.0 5.7 4.3 -0.3 -0.2 Government consumption 15.7 1.2 8.6 17.0 13.4 0.4 -4.3 2.2 Gross fixed capital formation 3.3 8.6 10.0 4.2 9.7 9.6 0.3 0.8 Exports of goods and services -9.7 12.5 10.3 3.7 5.8 11.6 1.0 -0.7 Imports of goods and services -15.0 13.4 10.3 1.6 3.9 13.5 -1.6 -1.3 Gross Dom estic Product 4.5 5.9 6.2 5.4 5.8 6.5 -0.1 0.0 Agriculture 4.1 2.3 3.5 4.6 1.0 4.3 -1.2 0.4 Industry 3.5 4.3 5.0 5.1 4.3 5.0 0.0 -0.3 Services 5.7 8.4 8.0 5.9 8.4 8.4 0.2 0.1 2. External indicators Balance of payments (USD bn) 12.5 23.5 11.2 n/a n/a n/a 4.5 2.4 Current account balance (USD bn) 10.5 6.9 -1.9 n/a n/a n/a 5.1 -0.7 Trade balance (USD bn) 21.0 20.6 10.9 n/a n/a n/a 6.7 0.4 Financial account balance (USD bn) 3.6 18.3 12.8 n/a n/a n/a 1.9 3.1 3. Other econom ic m easures Consumer price index 4.8 5.1 6.3 2.6 6.2 6.0 0.0 -0.1 Poverty basket Index 5.8 8.4 8.5 2.9 11.1 6.8 0.6 1.1 GDP Deflator 8.5 7.4 10.0 6.6 8.0 9.9 -1.3 -2.2 Nominal GDP 13.4 13.7 16.9 12 14.2 17.1 -1.6 -2.3 4. Econom ic assum ptions Exchange rate (IDR/USD) 10356 9080 9000 9475 9000 9000 -11.1 0.0 Interest rate (SBI, 1 month) 7.3 6.4 6.5 6.5 6.5 6.5 0.0 0.0 Indonesian crude price (USD/bl) 61.6 76.6 75.3 75.1 75.3 75.3 -0.8 -1.7 Major trading partner grow th -0.8 6.6 4.0 3.4 5.6 4.9 0.1 -0.3 Note: Projected trade flows relate to the national accounts, which may overstate the true movement in trade volumes and understate the movement in prices due to differences in price series. Source: MoF, BPS, BI, CEIC and World Bank projections 3. On the back of global developments, balance of payments inflows rose further Both the trade balance The overall balance of payments surplus for the first three quarters of 2010 of USD 19 and financial accounts billion exceeded the highest annual inflow previously recorded (USD 14.5 billion in 2006). contributed to rising Reserves have risen to USD 93 billion at the end of November. Both the financial and balance of payments current balances posted strong performance in Q3. inflows On the current account, the trade balance surplus has rebounded strongly from the temporary small deficit of July. In October the balance reached USD 2.1 billion, after a USD 2.6 billion surplus in September. Agricultural exports have picked up strongly, contrasting with the weak performance of agricultural GDP (Figure 5). This reflects the larger share of food crops in agricultural GDP (just under 80 percent for the first three quarters of 2010). Non-food crops, such as vegetable oils, account for most of agricultural exports (67 percent over the same period) and have benefited from rising global commodity prices. Manufacturing export growth faltered in September (although this might reflect Ramadan-related effects). On the import side, capital and intermediate goods continue to be the main drivers of growth, in line with buoyant investment. THE WORLD BANK | BANK DUNIA December 2010 3  Indonesia Economic Quarterly Maximizing opportunities, managing risks Financial account inflows The strength of Indonesia's financial account over 2010 should be viewed in the context of were boosted by strong global flows towards emerging markets discussed above. Pull factors are also at play. portfolio flows, and rising These factors include Indonesia's strong economic growth, macro policy management FDI and rising domestic demand. As a result, financial account inflows moved higher in Q3, and the numbers for Q1 and Q2 were also revised upwards. Portfolio flows accounted for the largest share of net financial inflows, and within them purchases of longer-term government securities (USD 5.9 billion of a total USD 12.4 billion of net portfolio inflows in the first three quarters of 2010). However, FDI also appears to be on an upward trend (although it is difficult to strip out from the balance of payments data the contribution of new investment from that of reinvested earnings). Figure 5: Agricultural exports have picked up Table 3: Record balance of payments inflows expected for 2010 (USD billion, 3 month moving average) (USD billion) 2007 2008 2009 2010 2011 Balance of Payments 12.7 -1.9 12.5 23.5 11.2 Current Account 10.5 0.1 10.7 6.9 -1.9 Trade Balance 20.9 9.9 21.0 20.6 10.9 Income Balance -15.5 -15.2 -15.1 -18.6 -18.1 Transfers Balance 5.1 5.4 4.9 4.9 5.4 Capital & Financial Accounts 3.6 -1.8 3.5 18.4 13.1 Capital Account 0.5 0.3 0.1 0.1 0.3 Financial Account 3.0 -2.1 3.5 18.3 12.8 Direct Investment 2.3 3.4 1.9 7.9 5.4 Portfolio Investment 5.6 1.8 10.3 15.9 14.3 Other Investment -4.8 -7.3 -8.8 -5.5 -6.8 Foreign Reserves (a) 56.9 51.6 66.1 92.8 (a) 2010 value reflects value at end of November Source: BPS and World Bank staff calculations Sources: BI and World Bank staff projections The overall balance of Forecasting Indonesia's balance of payments in the current global environment is a payment forecasts have difficult task. Projections are sensitive to the global outlook for commodity prices and been upgraded for 2010 investment sentiment towards emerging markets. However, continuing net capital inflows and 2011 during the second half of 2010 are expected to support an annual balance of payments surplus in excess of the historic high of USD 14.5 billion in 2006 (Table 3). On the current account, the trend of higher import growth relative to that of exports, reflecting the relative strength of domestic demand, is expected to lead a gradual move of the current account from surplus to deficit. Higher bond amortizations will also contribute to the contraction in the overall inflows in 2011. The regular fluctuations in public debt issuances and loans drawings and repayments will continue to create volatility in the quarterly balance of payments. In addition to forecasting difficulties due to international factors, statistical features also complicate the picture. In particular, since Q1 2009 there has been a widening divergence between the national accounts trade data, which is the basis of the World Bank trade forecasts, and the balance of payments trade data. The difference is largely related to the valuation of imports of goods; goods imports under the balance of payments were USD 9.1 billion higher over Q1 to Q3 2010 than under the national accounts. 4. Domestic financial markets have been boosted by the capital inflows The surge in capital The surge in capital inflows over 2010 has prompted a wide-ranging policy debate within inflows has prompted a emerging economies. The appropriate response depends on the nature of the flows, range of policy proposals country circumstances and the extent of various macroeconomic and prudential concerns to address concerns over and vulnerabilities to a reversal of flows. These issues are discussed in more detail in vulnerability to outflows and the impact of further Part B. THE WORLD BANK | BANK DUNIA December 2010 4  Indonesia Economic Quarterly Maximizing opportunities, managing risks exchange rate Over the course of 2010, Bank Indonesia (BI) has been pursuing a range of prudential appreciation 1 regulatory policy measures to shift flows towards less volatile short-term funds. In June a 1-month minimum holding period for BI certificates (SBIs) was announced, applying to both resident and non-resident investors. The 1-month and more recently 3-month auctions of these certificates, which tend to be held by shorter-term investors, have also been suspended. In December BI's monetary policy decision indicated that it is preparing further measures to "mitigate the negative impact of capital inflows as well as to strengthen banking system resilience". These relate in part to the regulation on foreign currency statutory reserves and vostro accounts (rupiah demand deposit accounts held by non-residents in domestic banks). The trend in portfolio capital inflows was however reversed in November, although initial data for December suggest a continuation of inflows. Non-resident investor portfolio outflows of around IDR 18 trillion were seen in November, about 80 percent of which were due to a decline in holdings of Bank Indonesia certificates (SBIs). This followed the suspension in mid November of 3-month SBI sales. In addition these outflows were seen during increased international financial market concern over the Irish debt crisis. Data for December-to-date indicate a return to net portfolio inflows and a rise in non-resident holdings of government securities. Domestic bond and Looking over the course of 2010, equities and bond prices continue to reach record highs. equity prices have The Jakarta composite equity index has gained 40 percent since the start of 2010, benefited from the capital compared with a 5.6 percent rise in the local currency MSCI World index, and is up 190 inflows... percent on the lows of March 2009. Local currency sovereign yields are at their lowest levels ever. One-, five- and ten-year yields are down approximately 180 to 230 basis points over the year-to-date. The spread of Indonesian USD sovereign bonds over US treasuries has returned to pre-crisis 2007 lows, under 200 basis points, and over 100 basis points below the global Emerging Market Bond Index spread. In addition to improvements in market indicators of creditworthiness, Moody's rating agency announced that it was putting Indonesia's sovereign rating on upgrade watch (Box 1). Box 1: Moody's puts Indonesian government bonds on review for ratings upgrade On December 1, 2010 Moody's put Table 4: Indonesia's CDS spreads are well below Indonesia's foreign and local several investment-grade sovereigns... currency government bonds on review for a possible ratings Ratings upgrade, which would move them CDS spreads from Ba2 to investment grade. (Nov 30 2010) Moody's S&P Previously in June this year, Moody's had shifted the outlook for Indonesia 147 Ba2 BB Indonesia's sovereign rating from stable to positive. Indeed, market Thailand 105 Baa1 BBB+ indicators currently put Indonesia's Malaysia 85 A3 A- creditworthiness at comparable, or higher, levels than other investment Korea 110 A1 A grade sovereigns (Table 4). Greece 973 Ba1 BB+ The main reasons cited for Moody's Portugal 532 A1 A- December decision included Indonesia's resilience to the global Ireland 608 Aa2 A financial crisis and continued strong macroeconomic fundamentals, the Spain 343 Aa1 AA steady improvement in the Brazil 119 Baa3 BBB- government's debt position, and the increase in foreign currency Belgium 183 Aa1 AA+ reserves that could provide a Italy 244 Aa2 A+ cushion against balance of payments shocks. Sources: Thomson Financial Datastream, Moody's and S&P Note: 5-year US dollar sovereign CDS spreads 1 For more details on Bank Indonesia's policy responses see Nanang Hendarsah (2010), `Challenges and Policy Options in Managing Portfolio Investment Flows: Bank Indonesia's Recent Experiences', Directorate of Economic Research and Policy, Bank Indonesia, November. THE WORLD BANK | BANK DUNIA December 2010 5  Indonesia Economic Quarterly Maximizing opportunities, managing risks As with other Asian credits, Indonesia was relatively unaffected by the recent Irish debt crisis in the Eurozone (Figure 6). Indeed, Indonesia's falling public debt levels and solid fiscal balances stand out in comparison to many OECD countries, especially those in Europe which have faced major public debt crises this year. From over 100 percent in 1999, Indonesia's public debt to GDP ratio dropped by an average 7 percentage points each year to reach 28 percent in 2009 (Figure 7). Reserves have also been moving upwards, as discussed above. Figure 6: ...including Italy and Belgium Figure 7: Indonesia's public debt has fallen (sovereign 5-year US dollar CDS spreads in basis and reserves are rising points) (public debt-to-GDP, percent; reserves, USD billion ) Basis points Basis points Percent USD billion 1400 1400 120 120 1200 1200 Indonesia Greece 100 100 Public Debt to GDP 1000 1000 (LHS) 80 80 Foreign 800 800 Reserves (RHS) 60 60 600 600 Ireland 40 40 400 400 200 200 20 20 Italy Belgium 0 0 0 0 Mar-08 Nov-08 Jul-09 Mar-10 Nov-10 1998 2000 2002 2004 2006 2008 2010 Source: Thomson Financial Datastream Sources: BI, CEIC and World Bank (WB) Note: 2010 reserves are until end-November and public debt-to-GDP is WB estimate ... but intervention has The Rupiah exchange rate has remained stable in recent months (and has appreciated by limited the movement of 4 percent in the year-to-date). Daily volatility has been low. The nominal effective the exchange rate exchange rate (i.e. Indonesia's bilateral exchange rate with different countries weighted by their importance in Indonesia's trade) actually depreciated by 2.9 percent from August to November (up 2.7 percent on December 2009). The real effective exchange rate, i.e. also incorporating differences in relative prices across countries, has also depreciated from August to November (down 2.5 percent) but is up 5 percent since December 2010. Intervention by BI in the foreign exchange market has seen reserves rise from USD 81 billion at end-August to USD 93 billion at end-November (although the rate of accumulation dropped in November). However, due to the sterilization of reserve accumulation, monetary growth rates have not picked up markedly (Figure 8). The pattern of sterilization by open market operations in recent months has relied increasingly on term deposit facilities and the overnight BI Deposits Facility (FASBI) rather than SBI issuance. The stock of outstanding SBIs has declined, as BI adapts its operations to shift funds away from short-term SBI paper (which is the more volatile of portfolio inflows). Credit conditions On the quantity side, credit growth has been driven by working capital loans. Overall credit continue to appear growth rose to 21 percent yoy in September, as growth in loans for working capital supportive of future continue to rebound (Figure 9). Consumer loans, which account for one-third of total investment and growth loans, grew at 25 percent yoy. Loan approvals (albeit reported with a lag) are also up. In terms of the cost of credit, nominal lending rates have tracked down over the year (down 100 basis points to 13.4 percent in September). This follows the decline in sovereign yields highlighted above. Measured on an ex-post basis, real loan rates are approximately 7 percent with deposit rates almost zero. Banking sector balance sheet indicators, such as capital adequacy ratios, non-performing loans and loan-to deposit ratios, remain relatively robust, and are broadly unchanged since the previous IEQ. In related news, Indonesia's Parliament has given preliminary THE WORLD BANK | BANK DUNIA December 2010 6  Indonesia Economic Quarterly Maximizing opportunities, managing risks approval for the creation of a new financial regulator, which will be responsible for monitoring banks, brokers and fund management companies and will take over regulatory functions currently residing with Bank Indonesia and Bapepam (the Capital Market and Financial Institution Supervisory Agency). Figure 8: Sterilization of reserve accumulation continues Figure 9: Credit growth has been driven by working capital (base money and open market operations, OMOs, outstanding loans IDR trillion; reserves, USD billion) (M1 and M2 growth in year-on-year percentage change) IDR trillion USD billion Percent YOY Percent 500 100 50 18 Total Reserves (RHS) Investment Loan Lending Rate M0 Base Money Growth (LHS) (RHS) (LHS) 40 15 400 80 30 12 300 60 20 9 Consumer Loan 200 40 Growth (LHS) Total stock of OMOs to 10 6 reduce net domestic assets Total Loan (LHS) Growth (LHS) 100 20 0 3 Working Capital Loan Growth (LHS) -10 0 0 0 Jan-07 Mar-08 Jun-09 Sep-10 Jan-08 Dec-08 Nov-09 Oct-10 Source: BI, CEIC and World Bank Source: BI, CEIC and World Bank 5. Food price shocks again dominate recent movements in inflation Movements in volatile Weather-related disruptions to food prices lifted headline CPI inflation to 6.3 percent yoy food prices continue to in November, up from 5.7 percent in October (Figure 10). In particular, grain prices (which drive headline inflation include rice) were up 25 percent yoy, the highest rate since the food crisis in 2006. These price increases hit the poor disproportionately given the weight of such food items in their consumption bundles. The wedge between the World Bank's poverty basket inflation, which puts greater weight on such food items, and overall CPI inflation has increased above 5 percentage points