Bright, but structural reforms needed in Indonesia

Indonesias relatively low reliance on external demand means that it should be largely unaffected by a possible slowdown in global growth.

Madrid - 19-dez-2011

Indonesia has a first directly elected president since July 2009. However, his cabinet is reliant on a coalition of six parties, of which the Golkar party in particular has often acted as a brake on economic reforms. Currently the Democratic Party is struggling with several corruption scandals, and this is eroding its power to control the already fragile coalition, with damaging criticism coming from coalition partners. This internal wrangling is seriously undermining the administrations decisiveness and decision-making, threatening to derail president´s reform agenda.

The three main parties all endorse the Pancasila principle, and thus the secular character of Indonesian politics. But the influence of radical Islam on society has increased gradually in the last couple of years. However, the risk of terrorist attacks appears to have decreased, thanks to effective action by the Indonesian police to combat terrorism. Despite major improvements, Indonesia remains vulnerable to separatism, especially in West Papua.

Indonesia owns large oil and natural gas reserves. The country is almost self-sufficient in oil production and remains a net energy exporter, owing to its large exports of liquefied natural gas. As the economy is not excessively dependent on exports, with domestic consumption accounting for about 60% of GDP, Indonesia weathered the global crisis relatively well. GDP grew by 4.6% in 2009, down from 6.0% in 2008, as domestic consumption picked up, with the help of a US$ 6.4 billion stimulus package. Economic growth increased to 6.1% year-on-year in 2011.

According to the Indonesian Central Bureau of Statistics, the economy grew 6.5% year-on-year in the second and in the third quarter of 2011 on the back of continued strong domestic consumption, accounting for 60% of GDP, and investments, confirming Indonesias resilience to a weaker global growth. In Q3 of 2011 private consumption increased 4.8%, government consumption 2.5% and investments rose 7.1% year-on-year. Exports also contributed to growth, as they rose 18.5%.

After reaching 9.9% in 2008, inflation declined to 4.8% in 2009 as the price of commodities and staple items decreased. Consumer prices rose slightly in 2010 to 5.1%, but increased by only 4.4% year-on-year in October 2011, after 4.6% in September and 4.8% in August. Overall, inflation is expected to be around 5% for 2011. In October 2011, Bank Indonesia lowered its benchmark interest rate by 25 basis points - to 6.5% - to support the economy amid signs of weakening global economic growth and the decelerating trend of inflation. It has repeated this step early November 2011, lowering the interest rate to 6%.

Exchange rate has stabilised

The banking sector has improved significantly over the last decade. State-owned banks account for only a third of the total banking sector and the non-performing loans ratio has improved rapidly: to 6%. However, state-owned banks are still highly exposed to state-owned enterprises. The exchange rate of the rupiah has been very volatile over the last five years - and came under serious pressure in 2008 and the first half of 2009 - but has stabilised again since then. Bank Indonesia frequently intervenes to support the currency.

A lack of structural reforms still weakens the business environment

Red tape, widespread corruption, a poor legal system, an inflexible labour market and poor infrastructure continue to limit growth. During his first term, the president made some promising progress on economic reforms [e.g. reducing politically sensitive fuel subsidies], but other reforms, such as a reduction of other subsidies and labour market reform, were postponed following popular pressure and political resistance. Despite presidents repeated promises to combat corruption, this remains widespread in society and business alike.

There are still too many barriers to foreign direct investment [FDI], which is severely hampered by the poor infrastructure and energy supply, so it is no surprise that investment in oil extraction capacity and infrastructure remains disappointing. Although Indonesia has made significant progress in reforming its tax system, observing international trade rules and dealing with licences, a further improvement in the still very poor business environment is needed to attract more FDI.

Outlook: Strong growth continues, but will it last in the long term without reforms?

Indonesia shows strong macroeconomic fundamentals that bode well for the future: continued economic growth [GDP forecast to grow 6.3% in 2012], a manageable inflation rate [2012: 5.2%], paired with low foreign debt, ample liquidity and current account surpluses. Indonesias relatively low reliance on external demand means that it should be largely unaffected by a possible slowdown in global growth.

The recent interest rate decrease by the central bank early November is aimed at increasing domestic spending, as global uncertainties [Europeans debt crisis, US economic performance] threaten exports. However, this move could also trigger rupiah depreciation and increase imported inflation pressures.

In order to secure sustained growth, more long-term foreign direct investment is needed to bolster domestic capital. This will require a major improvement in Indonesias investment climate, i.e. to overcome endemic corruption and shortcomings in the legal system, infrastructure and energy supply. However, with the current political situation, such radical improvements seem unlikely.

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