Indonesia economic quarterly : turbulent times

 64797 PERKEMBANGAN TRIWULANAN INDONESIA ECONOMIC QUARTERLY PEREKONOMIAN INDONESIA Turbulent times Masa bergejolak October Oktober 2011 INDONESIA ECONOMIC QUARTERLY Turbulent times October 2011 Preface The Indonesia 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 Indonesia 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 (commodity prices), Andrew Blackman (international environment, external sector and international spillovers), Andrew Carter (government revenues), Fitria Fitrani (external sector), Faya Hayati (prices and labor), Ahya Ihsan (fiscal expenditures and PPPs), David Stephan (national accounts and international spillovers) and Ashley Taylor. Additional contributions were received from Anna I. Gueorguieva, Yuliya Makarova and Wahyoe Soedarmono (sub-national expenditures), Dwi Endah Abriningrum (PPPs), Cut Dian Agustina and Ahmad Zaki Fahmi (East Java inclusive growth) and Jon Jellema (poverty). Arsianti and Ashley Taylor shared the editing and production. Enrique Blanco Armas, Mustapha Benmaamar, Alex Drees-Gross, Franz Drees-Gross, Gregorius D.V. Pattinasarany, Djauhari Sitorus, P.S. Srinivas, William Wallace and Andri Wibisono provided detailed comments and input. Farhana Asnap, Indra Irnawan, Jerry Kurniawan, Nugroho, Marcellinus Winata and Randy Salim organized the dissemination and Titi Ananto, Sylvia Njotomihardjo and Nina Herawati provided valuable administrative support. For more World Bank analysis 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. Table of contents Preface iii   Executive Summary: Turbulent times viii   A .   ECONOMIC AND FISCAL UPDATE 1  1.  The return of global growth downgrades and increased market turbulence 1  2.  Uncertainty has risen around a baseline outlook of solid domestic growth 3  3.  Capital inflows remained strong in Q2 while the trade surplus narrowed 5  4.  Recent international turbulence spilled over to Indonesia’s financial markets 7  5.  Headline inflation continued to fall as food price inflation shocks unwound 9  6.  Indonesia’s national poverty rate fell in the year to March 2011 11  7.  The 2011 deficit has been revised up on higher spending on energy subsidies 11  8.  As with the global economy, near-term risks to Indonesia’s outlook have risen 16  B.   SOME RECENT DEVELOPMENTS IN INDONESIA’S ECONOMY 17   1.  The potential spillovers from the deteriorating global outlook to Indonesia 17  a.  Thinking about potential scenarios for the global economy ..................................................... 17  b.  How might an international shock be transmitted to Indonesia? ............................................. 19  c.  Potential near-term impacts to the Indonesian economy .......................................................... 21  d.  The role for policy support and the importance of avoiding policy missteps ......................... 23  e.  Returning capital inflows in the medium-term give further incentive for continued progress on key structural reforms ............................................................................................................. 23  2.  Using PPPs to address Indonesia’s infrastructure challenges 24  a.  PPPs are at the core of Indonesia’s development agenda ........................................................ 24  b.  Progress has been made in establishing the regulatory and institutional framework for PPPs, but actual implementation is the main remaining challenge .......................................... 24  c.  International experience can offer lessons for successful PPP implementation .................... 27  d.  The way forward ............................................................................................................................ 29  C.   INDONESIA 2014 AND BEYOND: A SELECTIVE LOOK 30   1.  Sub-national spending is not delivering 30  a.  Sub-national spending has increased dramatically over the past decade ............................... 30  b.  Service delivery outcomes present a mixed picture .................................................................. 32  c.  Service delivery would be improved by better prioritization and efficiency. ........................... 34  d.  What is driving spending inefficiency and poor service delivery? ........................................... 35  e.  Concluding remarks ...................................................................................................................... 37  2.  Identifying constraints to inclusive growth in East Java 38  a.  The economic performance of East Java .................................................................................... 38  b.  Exploring the constraints to inclusive growth in East Java ...................................................... 40  c.  Policy options to promote further inclusive growth in East Java ............................................. 43  APPENDIX: A SNAPSHOT OF INDONESIAN ECONOMIC INDICATORS 45   LIST OF FIGURES Figure 1: Market concerns over Euro zone fiscal sustainability have risen .................................... 1  Figure 2: Growth in Indonesia’s major trading partners has weakened .......................................... 2  Figure 3: Driven by troubles in developed economies, the global growth outlook has been downgraded .................................................................................................................... 2  Figure 4: Equity markets have fallen sharply and volatility has increased… .................................. 2  Figure 5: …and investors have shifted towards safer assets such as US Treasuries .................... 2  Figure 6: Global commodity price declines have focused on metals and raw materials ............... 3  Figure 7: Quarterly GDP growth remained at 6.5 percent in the second quarter of 2011… ........... 4  Figure 8: …driven by net exports, private consumption and investment ........................................ 4  Figure 9: Financial account inflows rose in the second quarter of 2011 but the current account surplus narrowed ........................................................................................................... 6  Figure 10: Asset prices weakened sharply in September… .............................................................. 7  Figure 11: …falling from historically high levels ................................................................................ 7  Figure 12: The recent fall in Indonesian equities has been large but of a similar order to some regional peers… ............................................................................................................. 8  Figure 13: …while the Rupiah’s depreciation has been relatively limited compared with regional peers ................................................................................................................................ 8  Figure 14: Portfolio flows reversed sharply in August and September ........................................... 8  Figure 15: Inflation has declined through 2011 but edged upwards in August… ........................... 9  Figure 16: …as monthly inflation picked up, in part due to rising core inflation ............................ 9  Figure 17: Indonesia’s national poverty rate fell in 2011 ................................................................. 11  Figure 18: Weak disbursement on core programs and higher energy subsidy spending continues ...................................................................................................................... 12  Figure 19: Capital expenditure disbursement improved in recent months, but its rate is still below previous years… ............................................................................................... 12  Figure 20: Central government infrastructure spending on transportation, energy and irrigation declined in 2010 ............................................................................................................ 13  Figure 21: Scenarios for the external outlook include continuing financial market turmoil through to a severe global slowdown ........................................................................ 18  Figure 22: Indonesia’s exposure to capital outflows increased as reserves were accumulated . 21  Figure 23: Indonesia’s private infrastructure investment has only partially recovered since the 1997-98 crisis… ............................................................................................................ 25  Figure 24: …and remains relatively low compared with other emerging economies, particularly Brazil and India ............................................................................................................. 25  Figure 25: The realization of PPP projects in Indonesia has lagged behind announced plans ... 27  Figure 26: Sub-national governments manage half of total public spending in key sectors ....... 30  Figure 27: Sub-national spending is equal to core central spending ............................................. 31  Figure 28: Central government transfers, in particular the DAU, finance the majority of sub- national revenues ......................................................................................................... 31  Figure 29: The correlation between increases in spending and increases in service delivery outcomes is not statistically significant..................................................................... 33  Figure 30: Although infrastructure’s share has risen, government administration still accounts for the largest share of sub-national spending by sector......................................... 34  Figure 31: Some districts could deliver much higher outcomes with the same level of inputs... 35  Figure 32: High staff expenditures at the sub-national level are driven by the government apparatus and education sectors ............................................................................... 36  Figure 33: Economic growth in East Java has tracked the national rate in recent years ............. 38  Figure 34: An example of the HRV growth diagnostics framework ................................................ 39  Figure 35: In 2008 one third of East Java’s district roads were in poor or very poor condition .. 41  Figure 36: In East Java a relatively high share of the labor force only has primary school education or lower ....................................................................................................... 42  Figure 37: User charges and local taxes are relatively low in East Java ....................................... 43  LIST OF APPENDIX FIGURES Appendix Figure 1: Quarterly and annual GDP growth ................................................................... 45  Appendix Figure 2: Contributions to GDP expenditures ................................................................. 45  Appendix Figure 3: Contributions to GDP production..................................................................... 45  Appendix Figure 4: Motor cycle and motor vehicle sales ............................................................... 45  Appendix Figure 5: Consumer indicators ......................................................................................... 45  Appendix Figure 6: Industrial production indicators ....................................................................... 45  Appendix Figure 7: Real trade flows ................................................................................................. 46  Appendix Figure 8: Balance of Payments ......................................................................................... 46  Appendix Figure 9: Trade balance ..................................................................................................... 46  Appendix Figure 10: International reserves and capital inflows ..................................................... 46  Appendix Figure 11: Monthly terms of trade and chained Fisher price indices ............................ 46  Appendix Figure 12: Inflation and monetary policy ......................................................................... 46  Appendix Figure 13: Monthly breakdown of CPI .............................................................................. 47  Appendix Figure 14: Inflation among neighboring countries ......................................................... 47  Appendix Figure 15: Domestic and international rice prices .......................................................... 47  Appendix Figure 16: Poverty and unemployment rate .................................................................... 47  Appendix Figure 17: Regional equity indices ................................................................................... 47  Appendix Figure 18: Dollar index and Rupiah exchange rate ......................................................... 47  Appendix Figure 19: 5 year local currency government bond yields ............................................. 48  Appendix Figure 20: Sovereign USD bond EMBI spreads ............................................................... 48  Appendix Figure 21: International commercial bank lending ......................................................... 48  Appendix Figure 22: Banking sector indicators ............................................................................... 48  Appendix Figure 23: Government debt ............................................................................................. 48  Appendix Figure 24: External debt .................................................................................................... 48  LIST OF TABLES Table 1: In the baseline scenario growth is projected to moderate in 2012 .................................... ix  Table 2: Baseline GDP growth projections for 2011 have been downgraded, risks around the outlook have risen further ............................................................................................. 5  Table 3: Balance of payment inflows are set to moderate in 2011 and 2012 in the baseline scenario........................................................................................................................... 6  Table 4: Deficit projections for 2011 have been revised upwards, primarily due to higher energy subsidy spending ......................................................................................................... 15  Table 5: Different scenarios for the global economy could have a range of spillovers to Indonesia....................................................................................................................... 18  Table 6: Indonesia’s exposure to downturns in the US and EU is direct and via their importance as sources of external demand for Indonesia’s other trading partners .................. 19  Table 7: Manufacturing is most directly exposed to the EU and US with commodities more reliant on regional demand.......................................................................................... 20  Table 8: A severe global downturn would likely lead to a sizeable decline for domestic economic growth .......................................................................................................... 22  Table 9: Ready-for-offer projects account for half the value of Indonesia’s 2011 PPP projects plan ................................................................................................................................ 26  Table 10: East Java’s share of private investment has remained relatively low ........................... 40  LIST OF APPENDIX TABLES Appendix Table 1: Budget outcomes and estimates ....................................................................... 49  Appendix Table 2: Balance of Payments .......................................................................................... 49  LIST OF BOXES Box 1: Potential benefits of PPPs for delivery of infrastructure services............................................ 24  Box 2: PPP experience in India ............................................................................................................ 28  Box 3: An overview of current transfer mechanisms in Indonesia from the central to sub- national governments .................................................................................................. 32  Box 4: A brief introduction to inclusive growth diagnostics ........................................................... 39   ABBREVIATIONS AND ACRONYMS APBD Anggaran Pendapatan dan Belanja Daerah MoF Ministry of Finance (Sub-national budget) APBN Anggaran Pendapatan dan Belanja Negara MP3EI Masterplan Percepatan dan Perluasan (State Budget) Pembangunan Ekonomi Indonesia (Masterplan for Acceleration and Expansion of Indonesia Economic Development) APEC Asia-Pacific Economic Cooperation MSME Micro, small, and medium enterprises ASEAN The Association of Southeast Asian Nations MTP Major trading partners BAPPENAS Badan Perencanaan Pembangunan LDR Loan-to-deposit ratio Nasional (National Development Planning Agency) BI Bank Indonesia LHS Left hand side BOS Bantuan Operasional Sekolah (School NER Net enrollment rate Operational Assistance) BPS Badan Pusat Statistik (Central Bureau of NPL Non-performing loan Statistics) Bulog Badan Urusan Logistik (National Logistics OECD Organization for Economic Co-operation Agency) and Development CPI Consumer price index O&M Operations and Maintenance DAK Dana Alokasi Khusus (Special Allocation PDF Project Development Facility Funds) DAU Dana Alokasi Umum (General Allocation PISA Program for International Student Funds) Assessment DBH Dana Bagi Hasil (Revenue Sharing Fund) PPIAF Public-Private Infrastructure Advisory Facility DEKON/TP Dekonsenstrasi (Deconcentration) and PPI Private Participation in Infrastructure Tugas Pembantuan (Co-Administered Tasks) DID Dana Insentif Daerah (Local Incentive P3CU Public Private Partnership Central Unit Grants) DPRD Dewan Perwakilan Rakyat Daerah (Regional RHS Right hand side House of Representative) EFSF European Financial Stability Facility RMU Risk Management Unit EMBIG Emerging Market Bond Index Global SBI Sertifikat Bank Indonesia (Bank of Indonesia Certificate) EME Emerging market economies SD Sekolah Dasar (Primary School) EU European Union SIKD Sistem Informasi Keuangan Daerah (Regional Financial Information System) FDI Foreign direct investment SMP Sekolah Menengah Pertama (Junior High School) GDP Gross domestic product SMK Sekolah Menengah Kejuruan (Vocational High School) GoI Government of Indonesia SMU Sekolah Menengah Umum (Senior High School) HRV Hausmann, Rodrik and Velasco SUNs Surat Utang Negara (government securities) IDR Indonesian Rupiah Susenas Survey sosial ekonomi nasional (National Household Socioeconomic Survey) IEQ Indonesia Economic Quarterly TIMSS Trends in International Mathematics and Science Study IGF Indonesia Guarantee Fund UKP4 Unit Kerja Presiden Bidang Pengawasan dan Pengendalian Pembangunan (The Presidential Working Unit for Supervision and Management of Development) IMF International Monetary Fund USAID United States Agency for International Development KKPPI Committee for the Acceleration of US United States Infrastructure Provision KPPOD Regional Autonomy Watch Committee USD US dollar LARF Land Acquisition Revolving Fund VAT Value Added Tax LDR Loan-to-deposit ratio WB World Bank MICI Monitoring Investment Climate in Indonesia yoy year-on-year Executive Summary: Turbulent times How will the deterioration External events have dominated economic developments for Indonesia over the past in the global economic quarter. The outlook for global growth has weakened and the Euro zone sovereign debt and financial outlook crisis has intensified. International risk aversion and market volatility have increased, impact Indonesia? although they remain well below levels seen in late 2008. Equity markets have fallen and emerging markets have seen capital outflows, putting downward pressure on their currencies. Indonesia’s domestic economic performance has continued to be strong but, as in other countries in the region, its financial markets have not been immune from this turbulence. On 22 September Indonesian equities suffered their largest daily decline since October 2008, and non-resident investors’ equity and bond holdings have been reduced. Looking forward, how will the deterioration, and increased uncertainty, in the global economic environment impact Indonesia over the near-term? In the near-term it is How events unfold in the US, the Euro area and China will be a primary determinant of the expected that nature and extent of the external headwinds that Indonesia may face in the near-term. international financial With the policy solution to the Euro zone debt crisis still evolving, ongoing financial turmoil market turbulence will and volatility, and moderation in commodity prices, would seem to be a reasonable continue but there are also risks of less likely, baseline scenario. This turbulence could dissipate over time if there is supportive policy but more adverse action, boosting confidence, investment and growth. However, there is a risk that a major scenarios negative event, such as a disorderly resolution to the situation in the Euro zone, triggers an international financial crisis, similar to that experienced in late 2008. With policy responses constrained in many countries, global growth, trade and commodity prices would likely take a further hit. In an extreme scenario this could lead to a severe global growth slowdown if major emerging economies such as China and India do not support global demand, as they did in 2009, but instead their growth also suffers a hard landing. Indonesia enters this Indonesia’s domestic drivers of growth, its solid fiscal position, accumulation of reserves, period of heightened and strengthened financial sector performance make it relatively well-placed to deal with uncertainty in a relatively shocks arising from the above scenarios. This improved resilience to external shocks, and strong position… a strong policy response, was seen during the 2008-09 crisis. …with robust recent GDP growth in Q2 2011 was unchanged from Q1 at 6.5 percent year-on-year. Private growth performance and consumption and investment remain robust. Non-tradable sectors continue to drive growth declining inflation,… but manufacturing growth also moved above 6 percent in Q2 for the first time in six years. With food price inflation declining, headline inflation has moved down to 4.8 percent in August 2011. Notwithstanding the adverse impact of previous higher food prices on net food consumers, the strength of the domestic economy contributed to a decline in the national poverty rate to 12.5 percent in March 2011 from 13.3 percent a year earlier. …a strong fiscal Indonesia’s government debt to GDP ratio is low, at around 25 percent, and on a position,… downward trajectory. This is in contrast with the worsening fiscal position of many countries since 2008. The deficit is projected to fall from 2.1 percent of GDP in the 2011 revised Budget to 1.5 percent in the Government’s 2012 proposed Budget. Energy subsidy spending remains vulnerable to higher oil prices, as seen in the increase in the deficit in the 2011 revised Budget from the original Budget level of 1.8 percent of GDP. However, core expenditures, particularly infrastructure, are constrained by disbursement problems. The fiscal financing position also appears able to weather short-term market volatility, after over-financing in 2010 and pre-financing through 2011. …the accumulation of Entering the market turbulence of September, Indonesia’s reserves were USD 125 billion, reserves on the back of over twice their level in August 2008. Total balance of payment inflows posted another record balance of high in the second quarter of 2011, on the back of record financial account inflows. In payment inflows over addition to portfolio inflows, FDI has been on an upward trend. The current account 2010 and the first half of 2011,… surplus has narrowed however, although mainly due to a widening of the income deficit. ..and strengthened Indonesia’s strengthened financial sector performance serves as a buffer against real financial sector spillovers from the recent market instability. This is in part due to efforts to implement and performance enforce improvements in the overall regulatory and supervisory framework. Banking sector capital adequacy is high and NPLs have come down. Liquidity for the system is also high but needs to be monitored as levels of liquidity are not even across banks. International International shocks can be transmitted to Indonesia through a variety of channels, developments are including trade linkages. Indonesia’s direct trade exposure to the US and EU is limited but however likely to affect indirect effects on Indonesia through other trading partners could be more significant. Indonesia’s near-term Falls in global commodity prices and lower demand from major emerging economies, growth prospects through their impact on particularly China, present another transmission channel which could affect Indonesia’s external demand, exports and also its fiscal balances, domestic investment, consumption and inflation. commodity prices and capital flows As highlighted above, financial market spillovers to Indonesia have already been seen. Indonesia’s exposure to portfolio outflows has increased in parallel with the build-up of reserves over recent years. The volumes and direction of portfolio flows, and the cost of financing for the Government and Indonesian firms, are sensitive to international investor sentiment but also to the domestic economic situation and policy environment. Similarly for FDI, Indonesia’s attractiveness as a destination will likely remain but a sustained weakening of corporate conditions in source countries could affect inflows. The World Bank’s In the baseline scenario of continued international financial market turbulence, the World baseline growth Bank projects Indonesia’s growth at 6.4 percent in 2011 before moderating to 6.3 percent projection for 2012 has in 2012 (Table 1). The 2012 growth projection has been downgraded from 6.7 percent in been lowered to 6.3 the June IEQ due to a weaker outlook for major trading partner growth and commodity percent prices, but is still at a solid level. Under a more pessimistic scenario including a major international financial crisis and further weakening of external demand, Indonesia’s 2012 growth is projected to decline to around 5.5 percent. Finally, in an extreme scenario where such a crisis leads to a severe global growth downturn in which China and India also suffer a sharp decline in growth, Indonesia’s growth in 2012 could drop markedly, although the projection remains just above 4 percent. Table 1: In the baseline scenario growth is projected to moderate in 2012 2009 2010 2011 2012 Gross domestic product (Annual percent change) 4.6 6.1 6.4 6.3 Consumer price index* (Annual percent change) 2.6 6.3 5.0 5.5 Budget balance** (Percent of GDP) -1.6 -0.6 -2.1 -1.5 Major trading partner growth (Annual percent change) -1.0 6.6 3.3 3.9 Note: * Q4 on Q4 inflation rate. ** 2011 figure is approved revised Budget and 2012 is the Government’s proposed Budget Source: Ministry of Finance, BPS via CEIC, Consensus Forecasts Inc., and World Bank A strong and consistent The Government and Bank Indonesia (BI) have already put in place a number of policies domestic policy to deal with capital outflows, including purchasing domestic government bonds. Previous response can limit the measures include lengthening maturities and extending the minimum holding period on BI spillovers of any external certificates. BI has also been pursuing a range of other macro prudential policies. Room shocks and mitigate their impact for fiscal stimulus is also there, if required, but, additional spending could be hampered by disbursement problems. However, Indonesia’s solid macro fundamentals and existing policies are some of the strongest defenses to weather current and future turbulence. Further strengthening of the authorities’ ability to address risks would be beneficial. Current volatility makes it even more important to avoid policy uncertainty, particularly relating to changes in restrictions on foreign investment and the regulatory and governance environment. Maintaining progress on Indonesia’s underlying economic fundamentals remain strong and the projection for reforms to improve the medium-term growth of 6.5 percent or higher remains. Continued progress on signature investment climate, structural reforms, such as energy subsidy reform, land acquisition and infrastructure infrastructure and public financing, is key to moving these potential growth rates higher and can also play an service delivery can also help to boost investor important role in maintaining investor confidence in the near-term. This edition of the IEQ confidence and enhance features a number of pieces on such medium-term issues. The first discusses how the Indonesia’s medium-term framework for Public Private Partnerships in Indonesia and their implementation could be growth outlook strengthened so as to help the Government meet its targets for private sector infrastructure investment. The second piece examines the central role of sub-national governments in public service delivery in areas such as infrastructure, health and education and the current constraints on the efficiency of sub-national spending. The final piece looks at the core development challenge of how to make growth more inclusive, as well as higher, focusing on an analysis of the province of East Java. ix A. ECONOMIC AND FISCAL UPDATE 1. The return of global growth downgrades and increased market turbulence The global economic The past quarter has seen the intensification and widening of the Euro zone sovereign environment has debt crisis and a weakening in the growth outlook for the US and EU, but also for some of weakened markedly over the major emerging economies. The health of the European banking sector remains a the past quarter and major concern and its funding costs have risen. Policy uncertainty, particularly in relation become more uncertain… to the response to the Euro zone debt crisis and on US fiscal policy (as seen in the federal debt ceiling negotiations), clouds the near-term outlook and weighs heavily on investor sentiment. Financial market volatility picked up sharply over the quarter. Large-scale sell- offs of equities were seen as rising risk aversion prompted a “flight to quality