Demystifying the so-called economic 'missing link'

The Jakarta Post

Purbaya Yudhi Sadewa, Chief economist

The macroeconomic situation has been improving. Some economists, however, have claimed that the Indonesian real sector has not improved. Is there a "missing link" between the overall macroeconomic situation and the real sector?

Latest GDP data show that the Indonesian economy is still expanding. The Indonesian economy grew by 6 percent year-on-year (YoY) in the first quarter of 2007, slightly slower than the 6.1 percent recorded in the fourth quarter of 2006. In the first quarter of 2007, household consumption posted strong growth of 4.5 percent (YoY). In the same period, exports grew by 8.9 percent, and investment grew by 7.5 percent. Meanwhile, government spending was up by 4.3 percent.

The main driver of this relatively firm economic growth is lower interest rates. In this regard, consumers and corporations are more willing to borrow from the banks as the cost of borrowing is not as high as before.

At the same time, those who have excess savings (both households and consumers), have more incentive to spend their money (on consumption goods or by making investments), as the interest earned on their savings in the bank will not be as much as before.

And with the prospect of benign inflation (Danareksa Research Institute expects inflation of around 5.8 percent by the end of the year), and lower interest rates (Danareksa Research Institute expects around a 7.5 percent interest rate by the end of the year), investment will likely increase further in the near future.

This will make the engines of economic growth for 2007 more balanced, thus making the current economic expansion more sustainable.

Nevertheless, some economists and analysts are still skeptical about the recent macroeconomic developments. They claim that the Indonesian real sector is still in the doldrums. Some have even suggested that the real sector has not grown at all. This, according to these economists, has resulted in increasing unemployment and higher poverty rates.

The improvements, they further argue, have only occurred at the macro level in the form of a booming stock market, strengthening rupiah, lower inflation, and improving GDP growth. In short, they claim there is a "missing link" between the macroeconomic situation and conditions in the real sector.

The argument that the Indonesian real sector is not improving despite the better macroeconomic situation is rather misleading. First of all, the macroeconomic situation is the aggregation of microeconomic conditions (including the condition of the real sector). As such, it is very unlikely that the macroeconomic situation can be good, while general conditions at the micro level are bad.

Furthermore, the statement that the real sector has not grown is not true. On the contrary, almost all sectors of the economy have been growing significantly since the third quarter of 2006. The manufacturing sector, for example, grew by 5.9 percent YoY in the fourth quarter of 2006 and by 5.4 percent YoY in the first quarter of 2007. The construction sector grew by 10.4 percent YoY in the fourth quarter of 2006 and by 9.3 percent YoY in the first quarter of 2007. Meanwhile, the trade, hotel & restaurant sector grew by 7.0 percent YoY in the fourth quarter of 2006 and by 8.5 percent YoY in the first quarter of 2007.

If we assume that the definition of the real sector is all sectors excluding the financial sector (which grew by 7.1 percent YoY in the first quarter of 2007), and the services sector (which grew by 7.0 percent in the first quarter of 2007), then the figures quoted above provide compelling evidence that activity in the real sector has picked up.

If the Indonesian economy is expanding, why then has the unemployment rate not fallen significantly, and why do some economic pundits still maintain that the real sector is not moving?

The main reason is that the economy has not been growing fast enough. According to our calculations, the Indonesian economy needs to grow by at least 6.7 percent just to provide jobs for the new workers coming onto the job market. Accordingly, as long as the growth rate is below that level, it is very likely that the unemployment rate will stay at its currently high level. In fact, the unemployment rate will even tend to increase. Under these conditions, it is difficult to see how a significant reduction in poverty can be brought about.

Meanwhile, there are some weaknesses in the economy that have become apparent since the last quarter of 2006 on the back of a prolonged dry season. This led to a delay in the rice (and other crop) planting season, which to some extent explains the year-on-year contraction in the agricultural sector of 0.5 percent in the first quarter of 2007. This has eroded the income and purchasing power of farmers.

In addition, the delay in the rice planting season resulted in increases in rice prices starting in December, which has had a negative impact on overall consumer purchasing power. Under normal conditions, the impacts of rice price increases on purchasing power are not usually significant and only last for a month or two. This time around, however, the impact has been more severe than usual (the negative impact lasted for at least five months).

The adverse impact of high rice prices on consumer purchasing power is clear from the Danareksa Consumer Confidence Survey. Our survey shows that the Consumer Confidence Index (CCI) started to fall in December, and that it continued to decline in the following months. By April 2007, the CCI had fallen to 80.7 from 91.6 in November 2006 (down 11.9 percent).

Against this backdrop, economic activities in the first quarter of 2007 did not grow as fast as they otherwise would have. And, accordingly, the number of new jobs created was not as high as expected. This has led to the inaccurate impression of sluggish conditions in the real sector.

In summary, there is no missing link between the macroeconomic situation and the real sector. In line with the positive developments in the macro situation, the real sector has also grown strongly. However, the growth rate has not been high enough to significantly reduce unemployment and poverty levels.