Statement by Aida Budiman, Alternate Executive Director for Indonesia and Iss Savitri Hafid, Advisor, October 7, 2011

The Indonesian economy proved resilient during the global financial crisis, and has since continued to grow at a robust rate. Increases in both foreign and domestic investment are expected to offset lower growth contributions from net exports as import demand rises. A key risk is deterioration in growth for advanced economies. Continued exchange rate flexibility will be important in managing volatile capital flows, and the build-up in reserves. Fiscal developments are consistent with the government’s firm commitment to sustainability and strong public finances.

Abstract

The Indonesian economy proved resilient during the global financial crisis, and has since continued to grow at a robust rate. Increases in both foreign and domestic investment are expected to offset lower growth contributions from net exports as import demand rises. A key risk is deterioration in growth for advanced economies. Continued exchange rate flexibility will be important in managing volatile capital flows, and the build-up in reserves. Fiscal developments are consistent with the government’s firm commitment to sustainability and strong public finances.

The Indonesian authorities would like to thank the IMF team for the fruitful dialogue during this year’s Article IV consultation and the useful inputs from the Staff Report and the Selected Issues paper. They welcome staff’s appraisal on the resiliency of the economy, garnered from adoption of prudent macroeconomic and financial measures, a series of structural reform policies, combined with a transition toward a more democratic and stable political system.

Recent Economic Development and Outlook

1. Despite the bleak prospect of the global economy which has intensified recently, the Indonesian economy continues to demonstrate an impressive progress as well as stability. The sources of economic growth have been more balanced as investment activity gains momentum, owing to stronger economic fundamentals and improved business climate. Government expenditure will continue to play an important role in providing stimulus to the economy, while at the same time preserving a prudent fiscal position. Nevertheless, the recent downward revision of global outlook has led the authorities to lower its GDP and inflation forecast, in particular for 2012. In 2011 and 2012, the GDP is forecasted to reach 6.6% and 6.5%, respectively; while for the inflation rate is 4.9% and 5%, respectively.

2. These developments have placed the economy on a better footing. The level of reserves has reached an all-time high, in which this position is sufficient to cover more than 7 months of imports and external debt services of the Government. Furthermore, external debt has been on a steady downward path, including public debt, in line with the medium-term fiscal target to build up fiscal space. The composition of capital inflows has furthered improved as reflected by FDI flows surpassing net portfolio flows beginning second-half of this year. This change in the nature of inflows to more longer-term flows will further enhance the resilience of the economy. In addition, financial stability continues to be preserved, as reflected by the high level of capital adequacy ratio and the markedly lower level of NPL. Likewise, government bond price and stock market index are on a rising trend. Backed by sound fundamentals, the Rupiah exchange rate has been on an appreciating trend, alleviated the temporary pressures due to global sentiment triggered by uncertainty of the US and Euro area economic prospects. Taking into account favorable growth prospects, Indonesia’s credit rating has been upgraded to one notch below the investment grade by two rating agencies this year and one rating at the end of last year.

3. The authorities are cognizant of the challenges that lie ahead and broadly agree with the staff’s assessment on the Indonesian economy. The authorities’ top priority is to sustain the growth momentum without compromising stability, while improving the quality of growth.

Monetary policy

4. The objective of monetary policy is always to achieve and safeguard price stability. The policy responses toward inflationary pressures would need to be assessed carefully in view of the uncertainties in the global economy, massive capital inflows and the possibility of capital reversal, as well as gaps in market development. The policy rate remains a part of the policy tool-kit to maintain macroeconomic and financial stability, in addition to other monetary and macro-prudential policies, including continued efforts to strengthen monetary policy operation and promote financial deepening. While authorities acknowledge the possibility of higher inflation pressures in 20121, two important factors should be taken into consideration in formulating policy responses to inflation going forward. First, any adjustment in administered prices should be viewed as a one-time and temporary shock. Second, authorities are also concerned over the possibility of a more pronounced global economic slowdown, hence less pressure from commodity and oil price. Due to these two considerations, the authorities will focus their attention to limit any second-round effects of this adjustment to headline inflation. Authorities have successfully demonstrated their ability to achieve this during the episode of food price increase in 2010.

5. Various indicators have been and will be closely monitored to ensure that price stability remains in check. To track demand side pressures, the decomposition of core inflation has been analyzed. The result shows that the current uptrend in core inflation has been mainly due to gold. Core inflation excluding gold as well as non-food core inflation excluding gold, are still in the low levels of 4.2% and 4% respectively, lower than core inflation of 5.2%. In addition, inflation expectation indicators also indicate a declining trend in public expectations for both for 2011 and 2012. Authorities will also ensure sufficient supply of food and its smooth distribution, while strengthening the communication strategy to ensure that public expectation is well-anchored. These efforts will be complemented by continued use of the exchange rate as an economic shock absorber, which so far has been effective in containing inflationary pressures and impact of capital flows.

6. Expansion in credit growth is important to boost the economic capacity. Unlike the situation in 2009 where credit growth was dominated by consumption loan, the rapid credit growth in 2010 and 2011 has witnessed broad-based expansion, including in working capital and investment loans. Taking into account the share of credit, most funds are channeled to productive sectors which in turn will boost the economic capacity and address infrastructure bottlenecks.

Fiscal Policy

7. The authorities are firmly committed to ensuring fiscal sustainability as improving public finance management. This is of utmost importance in order to achieve the medium-term fiscal strategy of attaining public debt consolidation and improving the quality of government expenditure. Public debt to GDP has steadily declined from 36.9% in 2007 and is targeted to fall to less than 24% at the end of 2011. On the revenue side, authorities continue their efforts to increase the tax revenue ratio, including through broadening tax base and continuing administration reform agenda. Meanwhile, the improvement in the budget structure will be addressed through implementation of a gradual phase-out of subsidies, reallocation of spending towards infrastructure and alleviation of poverty and unemployment. To support these efforts, authorities are currently seeking TA programs that may help to design the blueprint and implementation strategy for strategic government projects.

8. Efforts to adhere to good corporate governance in fiscal operation are in progress. To enhance the effectiveness and efficiency of budget management, the authorities are implementing a multi-year performance-based budgeting (PBB) and a medium-term expenditure framework (MTEF) in the period 2010-14. Further, a Presidential Decree on procurement was adopted in 2010 to maintain governance while aiming to streamline procurement-related regulations. However, owing to the transitional period and operational guidelines, the new regulation contributed to the current low execution of government spending. Realizing this condition, corrective actions have been taken, among others by introducing an incentive system to ministries and government institution that are capable of optimizing their budget by March 2011. In addition, the Ministry of Finance has delegated some authority for budget virement to Treasury regional offices and line ministries.

Financial Sector Policy

9. The authorities have sustained efforts to optimize the intermediary function of the financial system while continuously maintaining the financial stability. Indonesia has undertaken intensive financial sector reform and is in the stage of implementing the FSAP recommendations. In this regard, the authorities welcome TA programs to help address concerns in the priority sectors. Likewise, reforms in the banking sector, such as Basel II implementation and principle-based supervisory approach, have progressed according to the timeline. On the capital market side, the Bapepam-LK continues to implement the five-year development plan with five area for development, namely increasing accessible and efficient source of fund, improving ease of transaction, promoting a stable, resilient and liquid industry, enhancing fair and transparent regulatory framework which guarantees legal certainty, and promoting a credible, reliable international standard infrastructure.

10. Despite the sound and solid banking condition, the authorities continue to strengthen the Crisis Management Framework. In view of the pending enactment of the Financial Stability Safety Net Law, a concerted effort has been made to establish a national crisis management protocol, and is in the progress of harmonizing this protocol among related agencies. In the banking sector, Bank Indonesia has revamped the system for individual banking and sharpened the Prompt Corrective Action measure with the introduction of Risk Based Bank Rating (RBBR) to preemptively determine bank supervisory status and exit policy. In terms of the government bond market, the Ministry of Finance and Bank Indonesia have taken a coordinated initiative to provide back-stop mechanism as it deems necessary, to avoid excessive volatility in the market. This initiative is considered important as bond price fluctuation has significant role in building up market expectations.

Structural reform

11. Understanding the need to address the infrastructure bottlenecks, the government has strengthened the provision of government guarantees and direct contribution for infrastructure projects, as well as accelerated and streamlined the procurement process. A clear target for infrastructure development is set annually. The 2011 target is projects related to national food security, transportation connectivity, communications, energy security, water resource and flood management. Efforts towards achieving investment grade status are in progress. The authorities have intensified the engagement with investors by actively improving communication channels and data transparency. Based on the IIF’s 2011 assessment, the Investors Relations Unit of Indonesia has been ranked first, together with a few other emerging market countries. This positive achievement is expected to contribute to increased longer-term financing from abroad, including those supporting the most needed infrastructure financing, and at better cost.

To conclude, Indonesia has successfully weathered the deep global crisis in 2008 and registered continued notable economic growth. This progress is a result of intensive reform and prudent macroeconomic policies which lays a solid foundation to entail sustainable economic growth. In years to come, the authorities envisage to improve the quality of growth, aiming to bring more people out of poverty line so as to deliver equality in social welfare. Indonesia also resolves to play a greater role in cushioning a potential global economic slowdown, together with other EMDCs.

Indonesia: 2011 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Indonesia
Author: International Monetary Fund