Indonesia economic quarterly : continuity amidst volatility

55221 INDONESIA ECONOMIC QUARTERLY Continuity amidst volatility June 2010 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: Andrew Blackman (trade flows, balance of payments), Andrew Carter (government revenues and deflators), Andrew Ceber (national accounts and domestic demand), Fitria Fitrani (trade flows), Faya Hayati (prices, commodity prices and deflators), Ahya Ihsan (government expenditure), Telisa Falianty (monetary conditions), Neni Lestari (banking sector), Diva Singh (financial markets, monetary conditions, banking sector), Djauhari Sitorus (banking sector). Tim Bulman (executive summary, labor, government financing, and GDP deflators) and Andrew Ceber shared the editing and production. Enrique Blanco Armas, Ashley Taylor, Nathan Dal Bon and Peter Milne, 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 tbulman@worldbank.org. iii Table of contents Preface iii Executive Summary: Continuity amidst volatility viii A . ECONOMIC AND FISCAL UPDATE 1 1. Indonesia's economy continues to grow solidly 1 a. Private demand accelerated in the first part of 2010, offsetting a slowdown in government spending .......................................................................................................................................... 1 b. Imports are now growing faster than exports, narrowing the trade and current account surpluses ......................................................................................................................................... 3 c. Indonesia's economic growth is likely to continue to accelerate, and projections for 2010 have been raised ............................................................................................................................. 4 2. Indonesian financial markets fell in May on the back of Europe's debt crisis 7 a. Indonesian equities and bonds weakened in May due to large capital outflows that also put pressure on the rupiah .................................................................................................................... 7 b. Muted money supply growth and benign inflation led BI to hold the policy rate unchanged at 6.5 percent...................................................................................................................................... 10 c. Credit growth has continued to pick up, driven by consumer loans, but lending rates and net interest margins are still high....................................................................................................... 11 3. The balance of payments surplus increased in Q1, but is expected to narrow over the next two years 12 4. Inflation remained mild overall, but is likely to pick up 13 a. Core inflation has been limited, while food prices have been unusually volatile .................... 13 b. Weak core inflation suggests inflation in 2010 will be more subdued than previously forecast, while stronger economic growth, commodity prices and monetary expansion are expected to lift inflation in 2011 ................................................................................................... 15 5. Employment growth kept pace with the labor force in the first half of 2009, but the new jobs were all informal 16 6. Higher revenues and weaker spending are expected to narrow the budget deficit 16 a. The budget deficit for 2010 is expected to be lower than previously anticipated, and in 2011 the deficit is expected to be as low as 0.4 percent of GDP ........................................................ 16 b. Government revenues are expected to be slightly stronger than previously projected ......... 17 c. Disbursements on capital, subsidy and `other' spending have been weak in the first months of 2010, and this is likely to keep full-year spending below target ........................................... 18 7. Overall risks to Indonesia's economic outlook have increased with heightened instability in global financial markets 20 B . SOME RECENT DEVELOPMENTS IN INDONESIA'S ECONOMY 23 1. High lending rates and net interest margins in Indonesia: The sky's the limit? 23 a. Indonesia has the highest NIMs in the region, driven by high lending rates ........................... 23 b. Market Structure: Banks are oligopolistic and dominate the financial sector ......................... 23 c. Risk Premium: High and volatile historical inflation and bond yields raise risk ..................... 26 d. Efficiency: Banking competence may not be what's driving high NIMs................................... 27 e. Main findings and ways forward .................................................................................................. 27 2. How the GDP deflator has diverged from the CPI in the late 2000s, and what this means for projecting the government's revenues 29 a. Higher investment prices have driven a gap between the two key measures of prices in Indonesia ........................................................................................................................................ 29 b. GDP deflator is a more complete measure of prices relevant for government revenue forecasting and, with its acceleration in the past half-decade may provide a more accurate outlook for the budget balance .................................................................................................... 31 3. Commodity price movements are large and hard to forecast...and matter for Indonesia's growth, inflation and public finances 34 a. Commodity prices are volatile and hard to forecast .................................................................. 34 b. While commodity prices fluctuations mostly affect prices and the nominal economy in the short-term, there is some response in real activity 36  c. Commodity price volatility has a large impact on government revenues; on balance, higher prices reduce the budget deficit .................................................................................................. 37 d. Government policies can mitigate the impacts of commodity price variability ....................... 39 C . INDONESIA 2014 AND BEYOND: A SELECTIVE LOOK 41 1. Indonesia's climate change challenges 41 2. Improving maternal health in Indonesia through a stronger health system 44 3. Strengthening the accountability and reporting of the Specific Purpose Grants (DAK) 48 APPENDIX: SNAPSHOT OF THE INDONESIAN ECONOMY 52 LIST OF FIGURES Figure 1: Quarterly GDP growth remains at or above average rates ................................................ 1 Figure 2: Major trading partner growth continued to recover in Q1 ................................................. 1 Figure 3: Government consumption recorded its largest fall on record in Q1 ................................ 2 Figure 4: The recovery in investment takes its share of total spending in the economy to near- record highs.................................................................................................................... 2 Figure 5: `Non-tradable' output continues to expand ahead of the `tradables' sector.................... 3 Figure 6: Indonesia's manufacturing output growth is tracking sideways, contrasting with its neighbors' ....................................................................................................................... 3 Figure 7: The recovery in import values continues... ........................................................................ 4 Figure 8: ...while export values have stagnated ................................................................................ 4 Figure 9: The RMB increased by around 20 percent against the USD ............................................. 6 Figure 10: ... and has also appreciated relative to the rupiah ........................................................... 6 Figure 11: Transmission mechanisms of an appreciation of the Rupiah......................................... 6 Figure 12: The IDX and other equity indices fell in May as nervous investors switched to USD cash ................................................................................................................................. 7 Figure 13:...and rupiah sovereign bond yields rose slightly while others in the region did not, exposing Indonesia's vulnerability to external demand shocks ................................ 7 Figure 14: The rupiah weakened slightly in May after large foreign capital outflows wiped off over 60 percent of year to date net capital inflows... .................................................. 8 Figure 15: ...with sales of foreign holdings of SBIs representing 90 percent of the exodus ......... 8 Figure 16: Compared with late 2008, Indonesia's financial sector is more exposed to reversals that may arise from Europe's debt crisis .................................................................... 9 Figure 17: ...but foreign investments in SUNs have held their ground relatively well this year, so perhaps not all inflows are "hot money"...................................................................... 9 Figure 18: The government has filled over half of its 2010 bond issuance target, mostly from conventional, rupiah-denominated bonds ................................................................. 10 Figure 19: BI has curbed the impact of reserves fluctuations on base money through open market operations using SBI ....................................................................................... 11 Figure 20: Growth rates for M1 and M2 remain highly subdued compared to historic levels ...... 11 Figure 21: QoQ credit growth was still positive in Q1, with new loan approvals up over 100 percent since December... .......................................................................................... 12 Figure 22: ...and consumer loans leading, despite high average lending rates............................ 12 Figure 23: Price growth starts to recover, but remains below average.......................................... 13 Figure 24: Since troughing in mid-2009, Indonesia's consumer prices have grown by less than most of its trading partners', only partly due to regulated energy prices ............... 13 Figure 25: The wedge between the economic cost of fuel in Indonesia and the regulated price has been stable ............................................................................................................ 14 Figure 26: If fuel prices were deregulated `the impact on inflation would phase out in the short- term but there would be permanent budget savings ................................................ 14 Figure 27: Global food prices indicate Indonesia's food prices will decelerate over the next five months .......................................................................................................................... 15 Figure 28: Basing projected nominal GDP growth on the GDP deflator, rather than the slower- growing CPI, suggests revenues may be significantly stronger, and the budget deficit smaller, in 2010 and 2011 ................................................................................. 17 Figure 29: Cocoa export duty tariffs are based on developments in the international cocoa price19 Figure 30: A new tariff on the exports of cocoa... ............................................................................ 19 Figure 31: ... leads to a small increase in potential export duty revenues .................................... 19 Figure 32: Higher subsidy spending is the main contributor to higher deficit in the 2010 revised budget ........................................................................................................................... 20 Figure 33: Q1 budget outcomes are slightly below 2009 levels ...................................................... 20 Figure 34: A hypothetical European-centered economic downturn does not significantly impact Indonesia's 2010 outlook ............................................................................................. 21 Figure 35: Impact of commodity price shocks on the nominal economy and budget deficit ...... 22 Figure 36: Lending rates have decreased by less than deposit rates after BI's policy rate cuts in 2008-2009...................................................................................................................... 23 Figure 37: ...keeping Indonesia's NIMs the widest in the region by a large margin ..................... 23 Figure 38: Deposits have dropped as a proportion to GDP over the past decade while loans have risen... .................................................................................................................. 24 Figure 39: ...owing to high credit growth in the years preceding 2009, but sluggish deposit growth ........................................................................................................................... 24 Figure 40: Banks are by and large the only source of financing in Indonesia's fledgling financial sector... ......................................................................................................................... 25 Figure 41: ...with corporate bonds, stock IPOs and right issues playing a minimal role so far in raising capital ............................................................................................................... 25 Figure 42: Private lending rates in Indonesia incorporate a premium for high and volatile historical inflation and yields ...................................................................................... 26 Figure 43: Average rates, inflation and sovereign yields in Indonesia are significantly higher than in other countries... ............................................................................................. 26 Figure 44: ...as are spreads between Indonesia's lending and deposit rates, and 5 year yields and inflation .................................................................................................................. 26 Figure 45: Historical inflation in Indonesia has been higher and more volatile than in other countries....................................................................................................................... 28 Figure 46: ...as have been Indonesia's sovereign bond yields ....................................................... 28 Figure 47: Economy-wide prices have out grown the consumer price index since the mid 2000s... .......................................................................................................................... 30 Figure 48: ...largely due to the acceleration in investment prices.................................................. 30 Figure 49: The gap between the GDP deflator and the CPI was driven by higher investment prices with higher construction costs... .................................................................... 31 Figure 50: ...which accelerated due to across-the-board increase input costs during the global commodity price boom ................................................................................................ 31 Figure 51: Using the GDP deflator improves the forecast of all tax revenues by, on average, nearly 2 percentage points in total, particularly when growth in the GDP deflator accelerated ahead of CPI inflation .............................................................................. 33 Figure 52: The choice of the prices measure for nominal growth has a significant impact on revenue projections ..................................................................................................... 33 Figure 53: ...more so than for its neighbors ..................................................................................... 34 Figure 54: Revisions of 2010 and 2011 forecasts for World Bank Energy Price Index ................. 35 Figure 55: Revisions of 2010 and 2011 forecasts for World Bank Non-Energy Price Index ......... 35 Figure 56: Energy price forecast scenarios ...................................................................................... 35 Figure 57: Non-energy price forecast scenarios .............................................................................. 35 Figure 58: The estimated impact of commodity shocks on the 2010 government estimates ...... 38 Figure 59: The estimated impact of commodity shocks on the 2011 government estimates ...... 38 Figure 60: Despite significant improvements, Indonesia's MMR rate remains high and the pace of improvement will need to accelerate in order to meet the 5th MDG target......... 45 Figure 61: Utilization of outpatient services by woman jumped following the introduction of ASKESKIN ..................................................................................................................... 46 Figure 62: Utilization of in-patient services by woman jumped following the introduction of ASKESKIN ..................................................................................................................... 46 Figure 63: Indonesia has a shortage and uneven distribution of maternal health specialists ..... 46 Figure 64: Midwifery coverage in Indonesia is highly variable ....................................................... 47 Figure 65: DAK regional allocation mechanisms ............................................................................. 50 Figure 66: The DAK reporting mechanism ........................................................................................ 51 LIST OF APPENDIX FIGURES Figure 1:GDP growth .......................................................................................................................... 52 Figure 2: Contributions to GDP (Expenditures)................................................................................ 52 Figure 3: Contributions to GDP (Production) ................................................................................... 52 Figure 4: Motor cycle and motor vehicle sales ................................................................................. 52 Figure 5: Consumer indicators .......................................................................................................... 52 Figure 6: Industrial activity indicators............................................................................................... 52 Figure 7: Real trade flows................................................................................................................... 53 Figure 8:Balance of Payments ........................................................................................................... 53 Figure 9: Trade balance ...................................................................................................................... 53 Figure 10: International reserves ....................................................................................................... 53 Figure 11: Terms of trade and implicit export and imports prices, quarterly ................................ 53 Figure 12: Inflation .............................................................................................................................. 53 Figure 13: Inflation, food prices and poverty basket inflation ........................................................ 54 Figure 14: Breakdown of monthly CPI inflation rates ...................................................................... 54 Figure 15: Inflation in neighboring economies ................................................................................. 54 Figure 16: Poverty, formal sector employment and unemployment rates ..................................... 54 Figure 17: Regional equity indices .................................................................................................... 54 Figure 18: Broad dollar index and rupiah spot ................................................................................. 54 Figure 19: 5-year local currency bond yields ................................................................................... 55 Figure 20: Sovereign USD bond EMBI spreads ................................................................................ 55 Figure 21: International commercial bank lending ........................................................................... 55 Figure 22: Banking sector financial indicators ................................................................................. 55 LIST OF TABLES Table 1: The outlook remains for gradual recovery in growth ......................................................... ix Table 2: Domestic demand is projected to continue to support a gradual acceleration in Indonesia's economy ..................................................................................................... 5 Table 3: Factors affecting Net Interest Margins ............................................................................... 28 Table 4: Growth in real GDP inflated by the GDP deflator relates more closely with growth in government revenues, particularly tax revenues, than when it is inflated by the CPI ................................................................................................................................. 31 Table 5: Across tax revenue items, using the GDP deflator does most to improve forecasts of revenues most closely related with commodity prices............................................. 32 Table 6: Ten reasons why commodities matter for Indonesia's economy..................................... 34 Table 7: Commodity price shock Impacts on key economic and poverty indicators ................... 36 Table 8: Changes to budget estimates .............................................................................................. 39 Table 9: Commodity price shock Impacts on key economic indicators, poverty and Government revenues and expenditure ........................................................................................... 40 Table 10: The DAK allocation has grown more than ten-fold in the past 6 years.......................... 49 Table 11: Balance of payments .......................................................................................................... 55 Table 12: In 2010 the deficit is projected to reduce to 1.0 percent of GDP, compared to the government's projection of 2.1 percent of GDP, while in 2011 the deficit may be as small as 0.4 percentage points of GDP ...................................................................... 56 LIST OF BOXES Box 1: How a stronger Chinese Renminbi would impact Indonesia's economy ............................. 5 Box 2: A new tax on cocoa exports ................................................................................................... 19 Box 3: Climate change issues: land use change and forestry ....................................................... 42 Executive Summary: Continuity amidst volatility Indonesia continues to Through an uncertain environment, Indonesia's economy continued to consolidate its consolidate its robust recovery from the global economic and financial crisis. As expected, growth moderated in economic performance, the first quarter of 2010, but remained above pre-crisis averages, and appears to have but risks remain large accelerated in the second. Price growth remained relatively modest for the most part, and tilted to the downside supporting consumers' spending power. International financial flows remained large but volatile, continuing to challenge policy makers. Further large flows in March and April into liquid Indonesian financial assets reversed during the volatility in global financial markets in May. But the authorities appear to have managed this well and the impact on local financial markets was comparatively small. The economy is expected to gradually accelerate through 2011, largely due to domestic demand. The renewed volatility in global financial conditions and uncertain developed economy outlook has increased the near- term downside risks to forecasts, while domestic political developments appear to be increasing the longer-term risk that the government falls short of its ambitious reform agenda required to lift growth above 7 percent by mid-decade. Capital flows and Developments in May made stark how the fragile global environment creates risks for financial markets were Indonesia's economic outlook. After months of large capital inflows, the rise in global especially volatile in financial market volatility in the first weeks of May prompted non-resident investors to May, and policy makers withdraw USD 5.1 billion net from their holdings of SBIs (short-term central bank appear to have managed this adeptly certificates). The outflow saw much of April's increase in reserves drawn down, and the exchange rate weakened from IDR 9000 to IDR 9375 per USD. Investments in other financial market assets (equities and government bonds) seemed less footloose, at least through May's round of increased risk aversion. In contrast to other major emerging economies, Bank Indonesia continued to eschew explicit capital controls, instead changing regulations in a way that is not explicitly discriminatory against non-residents, for example to make investments in the shortest term central bank instruments less attractive and to encourage banks to use the interbank market rather than BI for intermediation. Growth, while milder Quarterly growth in moderated in Q1 from the strength of late 2009 by a little more than than late 2009, remains expected, to 1.3 percent. This was still stronger than Q1 2009, lifting the year-on-year solid (YoY) growth rate to 5.7 percent. Indonesia's trading partners generally showed greater moderation in their growth after the larger rebounds of mid and late 2009