Consistent performance and strong growth prospects are precious in an economically volatile world. The 17thlargest economy in the world with a GDP of just over $1trn in 2013, according to estimates from the International Monetary Fund (IMF), Indonesia’s place as the largest economy in ASEAN presents a strong value proposition for investors. Already achieving one of the world’s most consistent economic growth rates of above 6% since 2007, with only a minor dip to 4.6% in the midst of the global financial crisis in 2009, Indonesia has continued impressing global investors as more export-oriented economies have wavered.
Indeed, it was the fastest-growing economy in the G20, behind China, in the first three quarters of 2012, with investment banks such as Goldman Sachs naming it as one of the “Next 11” engines of global growth. The IMF forecasts the economy will expand to $1.5trn by end-2015, while McKinsey expects Indonesia to become the world’s seventh-largest economy by 2030.
While none of the challenges that have traditionally beset the country has disappeared, during the recent series of bullish forecasts, the government has embarked on a series of measures to stimulate productive investment, ease infrastructure bottlenecks, and raise living standards and quality of human resources to become one of the 10 largest economies by 2025. With some 60% of the world’s fourth-most-populated country of 245m of working age in 2012 and a growing middle class, implementation of key reforms will be key for Indonesia to capitalise on its demographic dividend.
BROAD-BASED & CONSISTENT: While the slowdown in demand for key commodities affected Indonesia’s exports and broadened its current account deficit in 2012, a strong domestic consumption engine insulated the economy. Exports account for only 31% of GDP in 2011, far lower than Thailand’s 78% or Malaysia’s 97%, although some 65% of these are linked to mining, plantations, and oil and gas commodities. The shift in the trade balance from a surplus of $26bn in the year to November 2011 to a deficit of $500m in 2012 was counter-balanced by strong household consumption, which accounts for around 55% of GDP, and investment. Growth in fixed investment, which contributed nearly 30% to GDP in 2012, up from 25% in 2007, was 11% year-on-year (y-o-y) in the first half of 2012, faster than the 5% growth in consumer spending and 6.5% growth in public investment. The upgrade of Indonesia’s sovereign credit rating to investment grade by Fitch in December 2011 and Moody’s in January 2012 has resulted in higher inbound investment flows. The ratio of foreign direct investment (FDI) to portfolio investment has grown from one-fifth in the early 2000s to two-thirds by 2011. Domestic investment also rose rapidly, from Rp60.6trn ($6bn) in 2010 to Rp76trn ($7.6bn) in 2011 and Rp92.2trn ($9.2bn) in 2012, while FDI grew from Rp148trn ($14.8bn) to Rp175.3trn ($17.5bn) and Rp222trn ($22.2bn) during the same period of time (see analysis).
MANUFACTUING BASE: The largest contributor to growth was the manufacturing sector, with y-o-y expansions of 6.2% in 2011 and 6.4% in the third quarter of 2012, the fastest increase since 2004, driven by food and beverages, machinery, transport equipment and tobacco. Although the purchasing managers’ index dropped slightly, from 51.6 points in August to 50.5 points in September – due to lower export orders – strong domestic demand has supported manufacturing growth. With credit growth slowing slightly, from 27% in 2011 to a forecast of 24% in 2012, according to Bank Indonesia (BI), the economy also slowed marginally from 6.5% in 2011 to 6.5% in the first quarter of 2012, and 6.37% and 6.17% in the two following quarters, according to the Central Statistics Agency (BPS).
“Economic growth is expected to rise again, driven by domestic consumption and strong investment,” BI noted in its November 2012 monetary policy statement. The central bank expects growth to average 6.3% in 2012 and between 5.9% and 6.1% in 2013, while the government expects faster expansion of 6.3% to 6.5% in 2013. Domestic consumption still accounted for half of the headline growth rate in the first half of 2012, but authorities expect that domestic and foreign investment will overtake consumption as key drivers in 2013.
HOUSEHOLD SPEND: The key factor underpinning this consistent record has been Indonesia’s vast population of 245m, of which an estimated 15% are middle class – defined as spending between $4 and $20 a day – according to the World Bank. Already larger than the Malaysian population, this consumer class is expected to expand to 135m by 2030, according to a 2012 study by McKinsey Global Institute. With a low credit-to-GDP ratio of roughly 30%, sustained expansion in banks’ retail lending is supporting growth in spending, although loan portfolios have increasingly rebalanced towards financing firms’ working capital and investment, while consumer lending has slowed to below 20% y-o-y growth in the second half of 2012. “With low credit penetration and a middle class larger than Malaysia’s population, we expect sustained growth in consumer demand over the next decade, as long as banks continue to lend,” Fauzi Ichsan, managing director and senior economist at Standard Chartered Bank, told OBG.
Following a relative trough from February to June 2012, the consumer confidence index rebounded strongly to reach 117.7 by September 2012, close to the January 2012 record. Retail sales have continued to grow on the back of strong consumer confidence, achieving 22% month-on-month growth in September on the back of household appliance sales. While new caps on consumer lending for vehicles and property coincided with a slowdown in motorcycle purchases, sales of four-wheel vehicles and real estate have sustained their growth throughout 2012, with car sales growing 23% y-o-y in the first eight months of 2012 (see analysis). Yet, while domestic consumption and investment have been resilient, slowing growth in Asia and the West have weighed on export earnings.
REBALANCING TRADE: With some 65% of exports linked to commodities, Indonesia’s current account has suffered from the downturn in prices and global demand for commodities from the first quarter of 2012 onwards. While the share of Indonesia’s exports to the US and the EU declined to 10% and 12% of total exports, respectively by 2011, growth in exports to major emerging economies continued to counter-balance the decline in traditional trading partners, led particularly by exports to India, China and, increasingly, albeit from a low base, the Middle East and Africa.
Exports to India and China alone grew by 35% and 27% respectively y-o-y in 2011, although this exposes Indonesia to a greater impact from the slowdown in Asia in 2012. “Any slowdown in China directly affects our major export commodities,” Bambang Brodjondegoro, head of the Ministry of Finance’s Fiscal Policy Office, told a G20 gathering in November 2012. In the first eight months of 2012 India and China, which account for 8% and 13% of total exports, exerted downward pressure on Indonesia’s export position as the price of key exports like tin, nickel, oil and gas, and palm oil declined. By the second quarter of 2012 exports to India were falling 26.1% y-o-y while those to China were growing only 2.5%. Total exports were down 7.6% y-o-y by September 2012, before rebounding slightly in October, with the net fall in exports, which totalled $143bn, reaching 6.06% y-o-y. Exports for 2012 as a whole are expected to fall some 20% short of the $220bn goal set by the Ministry of Trade.
A member of ASEAN and thus of the China-ASEAN free trade agreement in force since 2010, Indonesia has seen rapid growth in intra-ASEAN trade in recent years, although it continues to record a trade deficit within ASEAN, reaching $720m in the first eight months of 2012. The immediate region presents strong growth potential for Indonesian exports. Meanwhile, exports to new partners like Cote d’Ivoire, Ethiopia, Nigeria, Libya and others have staged strong growth that the government hopes to harness. Authorities are leveraging the rebalancing of Indonesia’s trade towards emerging economies further in coming years. “The traditional largest export markets like China, Japan and the US will still remain, but non-traditional markets are where the focus is moving towards,” Zaafril Amir, president director of Indonesia’s export credit guaranty agency (ASEI), told OBG. “We expect intra-ASEAN trade to be the most profitable in 2013, followed by an expansion in exports to other Asian markets like China, Japan and India.” While ASEI’s traditional role as export credit guaranty agency has been broadened to cover imports as well and act as a counterparty for foreign export-import schemes, the agency is also exploring means of supporting a further diversification of export destinations. “The expansion of the economy is backed by the government's efforts to develop new industries," Dessi Natalegawa. the president director of the coal producer, Permata Resources Group. "For large corporations immersed in new sectors or opportunities, it will become essential to strengthen their asset management functions through prudent capital allocation as they go through the diversification process.
TAX HIKE: While diversification is key for the Ministry of Trade, higher-value-added non-commodity exports are also a priority as authorities seek to attract more manufacturing domestically. Exports of metallic mineral ore (21 products), non-metallic minerals (10 products) and rocks (34 products) are subject to 20% export duty. Mixed mineral ores containing two or more kinds of mineral ores may be subject to 20% export duty. This duty is expected to prompt investments in associated downstream processing and production. Taken alongside other measures such as caps on single ownership of banks, the disbanding of the upstream oil and gas regulator, restrictions on foreign fruit and vegetable imports, and a requirement for foreign strategic mine owners to sell 51% of their operation to local interests within a decade have raised the spectre of growing resource nationalism ahead of the 2014 presidential election. Yet, as these measures have been implemented, foreign investors have realised that their effect will not discriminate against foreign interests in particular. The 20% tariff on commodity exports has not affected exports of high-quality minerals for instance, instead penalising low-quality and informal exports often produced by domestic firms.
CURRENCY ADJUSTMENT: Trouble in Indonesia has traditionally originated from pressures on the balance of payments, with the widening current account deficit causing concern for investors (see analysis). While the country’s growing trade deficit was more than offset by inflows through the capital account, concern over the sustainability of the current account imbalance caused the currency to slump in 2012. Dropping some 6% on a trade-weighted basis in the first 10 months according to the World Bank, the rupiah fell from around Rp9100 to Rp9650 to the dollar. The worst declines came in the second and third quarters of 2012, as foreign investors repatriated earnings from equity and bond markets before a rally in September. Indonesia’s shallow financial markets and thin trading of the rupiah offshore have exacerbated currency declines.
Yet government efforts to improve trading of onshore government bonds and an increase in foreign bond holdings have gradually deepened the markets. The six-month minimum holding period for central bank certificates (SBIs) implemented by BI in 2011, up from one month previously, has encouraged a flow of foreign funds to government bonds.
Following a sharp slump in the currency in the second quarter of 2012, BI intervened more forcefully through open-market operations from July, narrowing fluctuations around the Rp9600 to the dollar mark. While the slumping currency has only had a marginal impact on the export position, given subdued global demand for commodities, it has also pushed up the import bill, particularly for subsidised domestic fuel from September 2012 onwards, with growing albeit modest upward pressure from imported inflation.
BALANCING PRICE STABILITY : Low inflation, to which consumer spending is inversely correlated in urban areas, according to Citigroup research, has also supported improved confidence. Traditionally subject to high inflationary pressures due to inefficient supply chains, poor infrastructure and excessive credit growth, monetary policy authorities have cautiously worked to contain inflation over the past decade. Average inflation has dropped from 7.42% in the five years to 2007 to 5.49% in the 2007-12 period, according to BI. Although inflation heated up in the second quarter of 2012 on the back of expected cuts to fuel subsidies in April 2012 and a falling currency, with y-o-y growth in the consumer price index rising from a trough of 3.6% in January to 4.5% in May that year, inflation remained within the central bank’s target range of 3.5-5.5%.
While monetary policy has remained loose, albeit with a slight rise in BI’s deposit facility rate from 3.75% to 4%, the government has sought to address supply-side factors that contribute to inflationary pressure through the state-owned food stock logistics agency Bulog. “We have revitalised Bulog to minimise the impact of seasonality on the price of foodstuffs,” Hatta Rajasa, coordinating minister for economic affairs, told OBG. The government restructured the agency, traditionally responsible for distribution of rice, to allow it to intervene in the markets for soybeans, sugar and cocoa. The central bank has meanwhile established monitoring teams at both the federal and provincial levels to track inflation and send early warnings to allow for adjustments in the distribution of goods such as food.
With inflation cooling in the year to the first half of 2012, BI loosened monetary policy in the face of growing uncertainties on the external front. Cutting benchmark interest rates a total of 100 basis points to 5.75% between September 2011 and February 2012, Indonesia benefitted from the most aggressive monetary policy easing in Asia according to Citigroup. With rates on hold since then, BI has adopted a wait-and-see approach to monetary policy with banks only expecting a further 25-basis-point rise in interest rates in 2013, while room for further monetary easing has become constrained by solid economic growth and resurgent inflationary pressures in the second half of 2012.
CHALLENGES REMAIN: Inflation remains under control, despite rising to a 13-month high of 4.61% y-o-y in October, but a number of downside risks are emerging for 2013. The 15% rise in electricity prices should only add 50 basis points to headline inflation according to Bank Danamon, but a rise in fuel prices would add more – between 80 and 270 basis points for a price increase of Rp500 ($0.05) or Rp1500 ($0.15) a litre. While it remains unclear whether the government will adjust fuel prices, further pressure will come from salary inflation given the adjustments to the minimum wage agreed in November 2012. A 20-30% increase in regional minimum wages to Rp2.2m ($220) in Jakarta is expected to push inflation above 5% in 2013, according to Bank Central Asia – higher than BI’s target of 4.9%. While the broad framework for monetary policy has remained stable since February, BI raised its deposit facility rate by 25 basis points to 4% in July 2012 to dampen inflationary pressures witnessed in the first half of the year and resumed more active open market intervention to reduce currency fluctuations. With foreign reserves at $110.2bn by September 2012, or 6.1 months of imports, the apex bank certainly has more room to manoeuvre than in 2009, when reserves reached a low of $51.6bn.
GROWTH CORRIDORS: With a broadly stable macroeconomic framework, the government’s priority has been to ease structural constraints on long-term growth, most pressingly in the country’s infrastructure gaps. With public investment in infrastructure lagging at between 2% and 3% of GDP over the past decade, roughly half pre-1997 levels, the country’s infrastructure gap has grown. Announced in February 2011, the Master Plan for the Acceleration and Expansion of Indonesia’s Economic Development (MP3EI) seeks to channel public and private funding into six corridors on five major islands – mainly located along coastlines – to leverage natural advantages such as commodity extraction and geographic location to develop higher-value-added production in-country. The MP3EI will channel $250bn into infrastructure by 2016, of which some 40% is expected to come from public-private partnerships. The main focus is to foster the development of downstream industries that would help plug the current account deficit, generate employment, sustain domestic growth and boost exports (see Regions chapter).
According to the presidency some 135 projects had been launched by July 2012, of which 114 started in 2011 were worth total investment of Rp490trn ($49bn). “The MP3EI will make our supply side more elastic to meet growing demand,” Bimo Epyanto, the senior economic analyst at BI, told OBG. “The main question is how fast can these projects be completed, particularly the planned power plants, ports and roads.”
SPENDING THE BUDGET: As Indonesia’s fiscal position has improved over the past decade, with the debt-to-GDP ratio dropping from 90% in 2000 to 32.9% in 2009 and 25.7% in 2012 according to the World Bank, one of the government’s key efforts has been to improve actual disbursement of budgeted funds and accelerate both public and private infrastructure development. Wasteful subsidies on electricity and fuel are only slowly being reformed (see analysis). Yet the 2013 budget stands out for its significant increase in funding for infrastructure, but also education, health and defence equipment. “We have been reallocating funds initially allocated for unproductive activities to more productive ones,” Hatta Rajasa told OBG. The biggest increase in spending aside from defence, which will see a budget increase of 6.6% y-o-y to Rp77.7trn ($7.7bn) in 2013 after a 28% increase in 2012, is in infrastructure, where expenditure will rise from Rp169trn ($16.9bn) in the revised 2012 budget to Rp215.8trn ($21.6bn) in 2013, with the lion’s share earmarked for roads, rail, airports and power stations. While encouraging, the expenditure for infrastructure – at 2% of GDP – will remain lower than that on subsidies or those of regional peers like Vietnam, which spends over 9%.
“Infrastructure spending is still only 2% of GDP even with the 2013 increase, whereas analysts have called for it to be boosted to around 4%,” Eddy Handall, ratings director at Fitch, told OBG. It has remained challenging to boost capital expenditure when Indonesia still grapples with its legacy of poor budget disbursement. With parliament’s final passage of the budget is often delayed and contract tendering taking place well into the fiscal year, ministries also tend to face challenges of insufficient capacity for executing projects and over-cautiousness in awarding tenders, in a bid to ensure transparency – all of which delays spending. While total central government expenditure reached 84% of budgeted spending in 2011, the execution rate for capital expenditure was as low as 40%. The Cabinet has enacted a series of reforms to improve performance, establishing in 2011 a budget execution task force (TEPPA) reporting directly to Cabinet. Ranking ministries and agencies quarterly based on their implementation record, the group publishes its results and threatens to cut funding for poor-performing bodies. “Our name-and-shame approach to improving budget realisation, by establishing the TEPPA monitoring taskforce, has started to bear fruit: we expect up to 94% of the budget to be realised in 2012,” Luky Alfirman, head of the Ministry of Finance’s centre for macroeconomic policy, told OBG. Budget execution in October 2012 was 66%, up from 61% y-o-y.
The Cabinet also presented the 2013 budget to parliament earlier, in September, and started tendering contracts from November for the next year in a bid to start budget execution earlier. “Budget disbursement should improve given that tendering is starting in November from 2012, which should allow contracts to be signed by February,” Destry Damayanti, chief economist at Bank Mandiri, told OBG. “This should allow capital expenditure to start earlier, although ministries are still not fully rated by their disbursement performance.” While this will expedite project execution in 2013, authorities admit that some gaps in spending will persist – particularly given the ability of some ministries to implement projects at lower costs than other groups.
OVERCOMING DELAYS: The Ministry of Finance has begun tracking the reasons for project delays in a bid to improve institutional capacity. “We need to be realistic, budget disbursement will never reach 100% since ministries can achieve cost savings while some may not be able to execute some projects,” Luky Alfirman told OBG. Meanwhile, the new Ministry of State-Owned Enterprises (SOEs) is working to restructure the 142 SOEs into 72 holding groups by 2014, starting with fertiliser, agriculture and pharmaceutical firms. The effort is expected to improve efficiency, cut duplications and create commercially oriented firms. While more efficient public spending will certainly be key to realising authorities’ growth ambitions, expanding revenue streams has also emerged as a pressing concern.
TAX TAKE: While the 6.8% growth projection in the 2013 budget looked optimistic in late 2012, the government has ample space to finance a budget deficit that has grown from 1.3% of GDP (roughly $16.8bn) in 2011 to 2.2% projected by the World Bank for 2012, but is budgeted at 1.6% in 2013. However, with a tax-to-GDP ratio of roughly 12.9% in 2012, according to the Organisation for Economic Cooperation and Development (OECD), the country’s low tax take has caused concerns from both ratings agencies and the IMF even though it has grown in recent years.
“Tax revenues have been increasing by around 17% a year over the last 10 years and despite a slight economic slowdown we expect this trend to continue over the medium term,” Yon Arsal, deputy director of policy impact at the Directorate General of Taxes, told OBG. While commodity prices have caused an estimated 4-5% drop in associated tax income in 2012 according to the tax authorities, this has been counter-balanced by a 7% rise in non-oil income tax and a 20% hike in value-added-tax (VAT) proceeds. Although progress in expanding fiscal revenue has been slow, the government has successfully lowered its cost of funding from capital markets both domestically and offshore, given greater global demand for its sovereign bonds following its upgrade to investment status by two of the three major international ratings agencies at the start of 2012 (see Capital Markets chapter).
The government expects growth of its tax revenues to accelerate to 21.6% y-o-y in 2013, growing from Rp885trn ($88.5bn) in 2012 to Rp1042trn ($104.2bn), on the back of improved tax administration. “While we only expect amendments to the tax code after the 2014 election, we are focusing on improving our tax administration,” Luky Alfirman told OBG. Several initiatives have been launched to improve compliance. Since 2008 firms tendering for state contracts have had to show proof of tax payment. The tax office also launched tax audits in 2012 to identify tax evaders and informal small and medium-sized enterprises (SMEs) that are not covered in the current tax take. The implementation of the export earnings repatriation system from June 2012, requiring all firms exporting or with operations in offshore jurisdictions to repatriate their dividends to an onshore bank, before then being able to reinvest earnings abroad, has also given the tax authorities a more accurate view of actual export figures. Meanwhile, reforms of income tax in 2009 and of VAT in 2010, creating a single rate for both, are also expected to expand the tax base. These reforms will be crucial over the longer term in order to fund government reforms of the social security system, expected to reach all low-income earners by 2014.
SOCIAL SAFETY NET: Following three years of review, parliament passed a new law on social security in October 2011 in a bid to extend basic services to the entire population and address pressing human development challenges. The number of Indonesians over 60 rose to 8.5% in 2010 (24m people) and is expected to reach 23% by 2040 (68m), according to the UN Population Fund. Thus, the 2011 law establishes the principle of five benefits for all Indonesians: death, accident, health, old age savings and pensions. The sector will be restructured into two social security administrative bodies (BJPS) that will incorporate and extend the reach of the five existing bodies, transforming them from SOEs to non-profit public entities reporting directly to the presidency (see Insurance chapter). A first step in the reform process was taken in 2012 when the government merged the databases of the SOEs into a national social security database. The next step, due in 2013, will be to establish the new structures. “We have budgeted Rp2trn ($200m) in 2013 to prepare for social security reform, starting with merging the SOEs,” Luky Alfirman told OBG. While the cost to government will be substantial (and as yet uncalculated), particularly when factoring in the significant investments in treatment facilities required, employers will also need to shoulder a greater cost once the scheme is operational in 2014. Current contributions of 10% of salary to the Employees’ Social Security System will likely rise to as much as 15%, according to the Indonesian Credit Rating Agency.
OUTLOOK: Indonesia’s steady growth path has remained relatively unscathed by global economic turmoil in 2012, but politicians need to be cautious about preserving domestic consumption and foreign investor goodwill as they enter the 2014 election season. High capital spending and an improvement of the nation’s fiscal performance are crucial to implementing a master plan that promises to ease chronic infrastructure bottlenecks. Furthermore, integration into regional production chains and a diversification from commodity exports will be crucial to developing the higher-value-added production that is required to support buoyant domestic consumption in the coming years. New taxes are in place to promote this virtuous dynamic and, should it emerge, labour tensions may give way to a new social compact supported by a strong safety net that will prove conducive to foreign investment. Meanwhile, the locomotive of domestic spending will keep growth rates among the world’s highest and most consistent.
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