Indonesia’s road to growth

The nation’s economy is resilient but governance and infrastructure must improve.

By Rupert Walker  |  FinanceAsia.com  |  2 May 2008 

After the bombings at the Marriott Hotel in Jakarta in 2003 and the Australian embassy the following year, security checks were introduced at major foreign-owned commercial and consular premises. They included car examinations and then a body frisking. Perhaps surprisingly, five years later, they still take place. It might also be a sign that the Indonesian authorities mean business, and intend to persevere with their goal to reform the country’s economy and even its behaviour.

Prakriti Sofat, Indonesia economist at HSBC, writes that “the Indonesian economy is enjoying its strongest and most sustained period of growth since before the dark days of the Asian crisis a decade ago”. Nor does he anticipate much that could go badly wrong. Domestic demand has been boosted by interest rate cuts of 475bp since May 2006 and an expansionary budget earlier this year, which raised public sector wages and development spending. Foreign direct investment reached a record $10.3 billion in 2007, up from $6 billion in the previous year.

Indonesia’s trade exposure to the US is among the lowest of Asian countries, and the current account surplus in the final quarter of last year was a healthy 2.9% of GDP. But although Indonesia is a leading exporter of LNG and its gas balance is comfortably in surplus, its oil production has been falling partly due to poor investment, and its import bill has consequently risen.

The authorities are focusing more on achieving its growth target of 6.8% rather than the central bank’s 4% to 6% inflation objective. But, two-to-three-million people are entering the workforce every year so 6% GDP growth is not enough. Unemployment is at 9% to 10% and rising, and is probably under-stated because of under-employment, points out a Jakarta-based analyst.

A 1% fiscal deficit might increase to 2% because of oil and gas subsidies. Official estimates put the cost at Rp160 trillion ($18 billion) this year – more than 3% of GDP, but the figure is based on an unrealistic average oil price of $83. However, few expect the subsidies to be reduced ahead of the 2009 election.

Yet, the country head of a European bank in Jakarta reckons that too much is being made of the effect of high oil prices and subsidies on the budget deficit. He argues that as a counter-balance, Bank Indonesia is getting monetary policy right by not cutting interest rates in step with US Fed Reserve - all in order to cap inflation and prevent the erosion of purchasing power.

HSBC estimates that each $1 billion cut in the subsidy would add 1 to 1.5 percentage points to inflation. The bank forecasts an average inflation rate of 8.5% this year. And inflation is a concern.

Bucking the trend of appreciating Asian currencies, the rupiah depreciated by about 4% against the US dollar last year – despite a widening current account surplus and higher earnings from its own commodity prices – and the country is vulnerable to higher food prices. The currency continues to be largely driven by portfolio flows, so could be further susceptible to repatriation as investors reduce their exposure to riskier equity markets. Bank Indonesia might be forced to raise interest rates in the second half of the year in order to cap inflation, but is likely to be constrained by the global outlook.

Corruption is still a temptation

Increased government scrutiny of companies should be a good thing. But in Indonesia, says one Jakarta-based commentator, it is not about policing and improving corporate governance but rather to identify opportunities for graft. A concomitant of economic prosperity is a more profitable corporate sector – and some government officials and civil servants, at the national and provincial level, are looking for ways to seize assets for personal gain. But if a company goes public, he says, it can acquire a shareholder list containing powerful foreign names, making it harder for local officials to steal assets or demand backhanders.

But another Jakarta-based banker provides a reality check, pointing out that any of the companies that defaulted on their debts after 1998 were publicly quoted. It’s not that he’s cynical. He may be sceptical about listing as a graft-resisting tactic, but he reckons high-level corruption actually is much reduced, even if it’s rife at the low end.

For instance, Aburizal Bakrie, boss of the eponymous company and also coordinating minister for people’s welfare in President Susilo Bambang Yudhoyono’s cabinet, was not allowed to sell the subsidiary of his conglomerate responsible for the mud eruption in east Java last year. Efforts are being made to make people and companies accountable, and corruption is being tackled, if the daily Indonesian newspaper reports of on-going investigations are a true indication.

But solemn pronouncements against corruption are one thing, practice away from public examination is another. For instance, palm oil and other plantations are booming and they are lucrative cash businesses. A problem is that permits for plantations have been granted within protected forests – and then a recipient needs approval from the ministry of the environment before it can exploit it. But Indonesia is vast and many areas are hard to monitor, so illegal planting almost certainly takes place. Central and provincial governments also clash. For example, Golden Agriculture Resources Group, which is owned by the powerful Widjaya family, had a one-million-hectare concession in Papua but most of it was in protected area. Last year, the environment minister refused permission to plant in the area, but the local governor said yes, as long as felling jobs were given to locals.

Infrastructure needs priority

In 2005, the government drew up plans for $150 billion of investment in 91 infrastructure projects over the following five years. But none of them have been confirmed, although 10, including power plants and a trans-Java toll-road, have been prioritised. But, procrastination and delays mean slow progress, as does official policy. For example, the government won’t give full guarantees for power projects, but investors, including Chinese, insist on explicit guarantees.

Power capacity of 14,000 to 15,000 megawatt capacity is far too low, yet coal is being exported, rather than used to fuel domestic energy needs. Roads are not being built because single-house owners refuse to sell their land – and there is no provision for compulsory purchase orders.

Reform in other areas of the economy has also been less than impressive. Tax reforms have stalled (corporate taxes are among the highest in the region), as have proposed labour market changes, and laid off workers continue to receive up to nine-months severance pay.

Private investment in education is increasing, as the authorities recognise the need to improve human capital. By law, the government is required to spend 20% of its budget on education, but it has consistently missed that target.

Politics at play

President Yudhoyono is seen as clean but not tough or decisive enough by the population. He has powerful rivals both outside the government in Megawati Soekarnoputri, leader of Indonesian Democratic Party-Struggle (PDI-P), and within, as his vice president, Jusuf Kalla, leads the majority Golkar Party. Mulyani Indrawati, minister of finance and Mari Pangestu, minister of trade, are both widely respected for their integrity, skills and energetic attempts to push through reform and drive the economy forward.

The democratisation process that has evolved since the removal of former president Suharto in May 1998 is unlikely to be reversed. “The process has moved forward irreversibly,” says a Jakarta-based political commentator. But there are growing pains: regions and sub-regions insist on more local autonomy and money politics is an entrenched feature. And as the commentator adds, “the current generation of legislators are stuck in the past; but the younger generation will be better and have a greater understanding of accountability”.

This story is part of an Indonesia Report that was published in the April issue of FinanceAsia magazine.