In the midst of turbulent international economic conditions, Indonesia’s growth and investment potential is increasingly attractive. Authorities seek to leverage on the economy’s key competitive advantages to attract the long-term investment needed to realise their goal of turning the country into one of the top 10 economies by 2025. Already the world’s 17th largest with a nominal GDP of Rp6400trn ($768bn) in 2010, Indonesia’s economy is one of the three fastest-growing in Asia.
A PRUDENT RECORD: The country’s young demographic structure, significant resource base, low leverage ratio and resilient consumer demand have long been recognised by investors. With Asia widely expected to contribute some 50% of global growth over the next five years, Indonesia’s changing trade and investment flows are in the process of adapting to new partners in the region. The government’s strong record in prudent macro-economic management has added to the sustainability of the archipelago’s long-recognised growth story. The fundamentals of the Indonesian economy have improved significantly since the 1997-98 Asian financial crisis. Soon to be upgraded to an investment-grade credit rating, it has made Goldman Sachs’ “next 11” list, and has been spoken of as the “next I in BRIC” – the grouping of Brazil, Russia, India and China, key drivers of current global growth.
The archipelago has a key advantage in the global economic climate of 2011, as by regional standards it is a relatively closed economy. Exports account for only 25.5% of GDP, down from roughly 30% in 2008. This pales in comparison to more than 70% in Thailand or 120% in Malaysia. The country’s approximately 240m consumers provide a strong engine of domestic growth in the face of turbulent global conditions. “The global crisis has not hit our real sector except for the financial market,” Darmin Nasution, governor of Bank Indonesia (BI), the country’s central bank, said in October 2011. Meanwhile, inflationary pressures that were high on investors’ radar until mid-2011 remain a latent concern, yet Indonesia has taken long strides in establishing its credibility in defending a more stable environment when it comes to inflation (see analysis).
RESILIENT GROWTH: Growth is well on track to exceed that of last decade, averaging 6.1% in 2010 and on track to reach between 6.3% and 6.5% for 2011 as a whole – the economy has expanded more than 6% year-on-year (y-o-y) from the fourth quarter of 2010, when growth peaked at 6.9%. While the rate fell slightly to 6.49% in the second quarter, analysts such as the Danareksa Research Institute expect it to remain above 6% well into mid-2012 based on the domestic economy’s inertia and commodity exports, which together account for more than 70% of Indonesia’s GDP. The 6.2-6.5% annual growth projected by analysts in the period 2012-15 would fall short of the government’s ambitions of 6.5-6.9% yet would still be the fastest sustained growth since the 1997-98 crisis.
The services and primary sectors have registered strong growth since late 2009. Services grew by 8.4% in 2010, accounting for 3.8 percentage points of GDP growth, while transport and communications achieved double-digit growth. Although 2010 was a bumper year for foreign investment, portfolio investment and consumer demand, the agriculture and mining sectors in particular faced tailwinds caused by poor weather.
This caused agriculture to register its weakest growth in five years, at 2.9%. But improved conditions in 2011 and greater foreign interest have sustained a better performance. Manufacturing recovered to pre-crisis output levels in the second quarter of 2011. The services sector has softened slightly in 2011 but remains buoyant on the back of Indonesian consumer demand.
The central bank estimates that a cut in global growth in 2011 from 4.5% to 4% would simply reduce expansion to 6.3%, from the 6.5% in the revised May 2011 budget. While the Ministry of Finance still targets 6.5% and BI expects 6.6%, the IMF downgraded its forecast in September to 6.4% for 2011 and 6.3% for 2012.
This would still make it the top performer in ASEAN for 2011, according to the Asian Development Bank.
Indonesia’s economy reached the milestone of $3000 GDP per capita in 2010, although significant divergences in income distribution persist. In the run-up to an election cycle in 2014, the government is seeking to spread the dividends of growth more evenly, although the unemployment rate has fallen from 7.9% in August 2009 to 6.8% in mid-2011. Jakarta has made some inroads in its efforts towards achieving the UN Millennium Development Goals, expanding two key social assistance programmes in 2011 to an additional 1.1m people. The incidence of poverty has dropped from 17.8% in 2006 to roughly 13% in 2010, and it is expected to fall further to 11.5% in 2011.
While no significant wage inflation has emerged in 2011, the 2004 Labour Law stands as one of the barriers to investment, restricting the flexibility of hiring workers. This has encouraged internal migration as some investors have moved from more unionised centres such as Bandung, Surabaya and Jakarta estates towards more mixed and fragmented populations like those in Semarang, Central Java. Indonesia has seen stronger growth in its commodity exports than in the job-creating manufacturing sector in recent years – almost two-thirds of its labour force remains informal.
CLEARING BOTTLENECKS: To attain growth in the 7-8% range necessary to achieve the targets of Master Plan for the Acceleration and Expansion of Indonesia’s Economic Development (MP3EI) 2025, the archipelago will have to address the infrastructural weaknesses that continue to hinder manufacturers, exporters and consumers. The government, conscious of the need to engage private finance in bridging these gaps, has sought to clarify rules for public-private partnerships (PPP) in infrastructure.
Increasing spending is necessary, given the 50% drop in public infrastructure spending over pre-1997 levels – public expenditure on infrastructure has averaged 4% to 5% of GDP over the past five years. Much of fiscal spending has focused on reducing the public debt overhang, energy subsidies and poverty alleviation and education programmes, to the detriment of infrastructure development. This has contributed to a rise in logistics costs, which now account for around 14% of total production costs (see Transport chapter).
A large part of this stems from the legacy of decades of under-investment under Suharto’s dictatorial rule, but decentralisation at the start of the millennium contributed its own challenges by fragmenting funding and governance. A key plank of the MP3EI plan is to coordinate federal, provincial, district and mayoral jurisdictions to expedite completion of infrastructure projects, particularly in transport and utilities.
GROWTH CORRIDORS: The aim of the plan is to accelerate the distribution of the dividends from Indonesia’s economic growth geographically and socially to reduce disparities. The blueprint is structured around six corridors – Sumatra, Java, Kalimantan, Sulawesi, Bali-Nusa Tenggara and Papua-Maluku – to cluster activity. Eight industries that drive growth are being targeted for expansion: mining, energy, agriculture, industrial, marine, tourism, telecoms and the development of strategic areas such as Jabodetabek and the Sunda Straits. Key to the plan’s success will be boosting input in existing strengths in agriculture and mining and improving national linkages by addressing weaknesses in infrastructure and developing human resource capacity.
An integrated approach is planned to both develop the intra-island physical infrastructure, but also to streamline the republic’s soft infrastructure. Authorities will act as facilitators – providing roughly a third of the financing over the term of the 15-year plan and simplifying regulations – while the private sector is being invited to lead project development. The plan, steered by the National Economic Committee and the National Innovation Committee under the presidency, runs from 2011 to 2025 and seeks to redress historical shortfalls in gross capital investment. The share of gross fixed investment in GDP in the past decade has remained below rates achieved in the heyday of the early 1990s (24% annually from 2001 to 2009 compared to 26% from 1991 to 2000). Yet investment has picked up since 2010, reaching 32.2% that year.
The government’s medium-term programme for the five years to 2014 requires Rp1429trn ($171.5bn) in infrastructure financing, of which roughly 41% is to stem from PPPs. The amount budgeted for public investment in 2011 already represents a 30% rise on 2010 levels . Improvements in Indonesia’s investment climate and the prospects of a strengthening currency have driven credit growth and new investment.
Fixed capital investment grew a solid 8.5% in 2010, contributing 2 percentage points to GDP growth – it is expected to sustain an 8.6% annual expansion for years to come. Funding for construction, including infrastructure, increased 7% in 2010. Investment in equipment and machinery jumped 17.1% that year, recovering from its sharp drop in 2009. In 2011 aggregate investment grew 27% y-o-y in the first quarter. By the end of first-half 2011, working capital loans grew by 23.8% y-o-y, consumer loans 23.2% and investment loans 20.8%. Loan growth could yet exceed the forecast 23.5% for financial year 2011, banks having met 56.84% of their yearly loan targets by mid-August 2011.
BI has been frustrated by the still high commercial lending rates as it seeks to channel loans towards productive investment, to drive multiplier effects such as employment. “In promoting infrastructure financing while keeping sound banking practices, we have relaxed our regulations with regard to the legal lending limit from 25% to 30% of bank’s capital applied only for loan provisions to state-owned enterprises (SOEs) engaging in development projects,” Nasution told OBG.
SPENDING THE BUDGET: Yet disbursement of budgeted capital expenditure remains chronically low – it stood at some 26% of the budgeted amount in late September 2011, for instance. The state has scope to boost spending and plans to raise its budget deficit to 1.2% of GDP (less than the originally budgeted 1.8% of GDP in 2011), up from 0.6% in 2010. Such low deficits (much lower than the constitutional cap of a 3% budget-deficit-to-GDP ratio) are partly due to inefficient budget disbursement by the Ministry of Finance. Indonesia has undershot its budgeted fiscal spending by an average of 1% of GDP a year over the past five years. Yet the final deficit figures compares favourably to excessive budget deficits in other countries in the eyes of foreign investors. So does the aggregate public-debt-to-GDP ratio of 26% in 2011, down from 90% in 2000.
A major explanation for low disbursement has been the back-loading of spending, in the final quarter of the fiscal year. The government is trying to streamline the budget execution process, improve procurement by its agencies and move forward tendering and project execution by at least three months. The Ministry of Finance introduced incentives and penalties to encourage each ministry to achieve their spending targets, yet capital-expenditure disbursement remains a challenge. “The Ministry of Finance has moved forward the start of tendering from the first quarter of the budget year to the fourth quarter of the preceding year,” Baradita Katoppo, the country head Indonesia at Fitch Ratings, said. “The deadline for the budget plan is now two months before the budgeted year starts (November).”
With a fiscal deficit in the 0.5-2% range yearly and a debt-to-GDP ratio of below 25%, the Ministry of Finance can afford to speed up disbursement to clear some of its cash in hand of Rp200trn ($24bn). Despite the current six-month implementation period, disbursement has improved to above 90% for the full year, even with relatively low levels of actual capital expenditure. Indeed, expenditure fell 20.6% short of budgeted levels in 2010, causing a total budget-spending shortfall of 6.5%.
The country has been upgraded in the recent past by three major rating agencies to BB+ or the equivalent. Sound fiscal oversight, fast growth, rising savings and investments, combined with a sharply reduced debt burden have painted a rosy macro-economic picture for ratings agencies, in stark contrast to the successive rating downgrades of some developed economies. Indeed, in December 2011 the republic received an investment-grade sovereign debt rating from ratings agency Fitch. This improvement to investment grade should lower the cost of credit and bring down the country’s sovereign credit default swap. Yet the main effect will likely be on the currency, expected to strengthen, and equity inflows.
EXPORT STRENGTHS: Exports have been a key driver of GDP growth after domestic consumption. Despite weaker global growth in 2011, analysts expect exports to just sustain double-digit growth into 2012. While the global economic slowdown post-August 2011 caused many to expect commodity prices to plateau, prices for coal and crude palm oil (CPO), two of Indonesia’s key exports, sustained their rise albeit at a slower pace as of October. The volume of key commodity exports continued to grow, driven by the two main buyers of India and China, sustaining consumption beyond Java in commodity-producing regions such as Sumatra and Kalimantan. Meanwhile, reconstruction in Japan following the early 2011 earthquake and tsunami is expected to stimulate demand for Indonesia’s commodity exports.
Commodity price inflation has proved positive for primary goods exporters in Indonesia – Malaysia and Indonesia for instance, accounting together for some 90% of global crude palm oil exports, have witnessed improving terms of trade. Following the crisis, its exports of natural rubber doubled, while that of CPO, coal and metal ore jumped by a third. Resilient Chinese demand for these commodities fed double-digit growth in 2010.
The export position has also remained resilient into late 2011 – key markets in Asia such as Japan, China, South Korea and India have sustained their sharp rebound since 2009. It is as yet unclear whether growth drivers like Japan’s rebuilding of its tsunami-devastated economy will be sufficient to counterbalance slightly weakening production orders in China in late 2011. While the picture remains uncertain for commodity export prices, analysts do not expect too sharp or prolonged a correction for either coal or CPO.
The tightening of the trade balance to 1% in third-quarter 2011 was mainly due to a slowdown in oil and gas exports, yet high prices for Indonesia’s non-oil exports, particularly to emerging Asian giants, counterbalanced the loss of earnings. This offset between oil and non-oil commodity cycles has mitigated the impact of strong consumer demand on the country’s current account balance. Analysts expect a current account surplus of 1% annually in the next few years.
TAX & SPEND: Indonesia’s tax take increased to 11.7% of GDP in 2010, up from 11% in 2009, but it remains low relative to the regional average of between 15% and 18%. The narrowness of the tax base is due to the fact that less than half of Indonesia’s estimated base of 40m actually pays tax, according to the Ministry of Finance. The state is seeking to bring parts of the large informal sector into the tax base, as it is widely estimated to represent roughly half of the economy. The government has already achieved some success thus far by expanding the tax pool by 13m Indonesians from 2006 to 2010. It has also sought to speed up the payment of tax returns in recent years, especially on exports, although this strategy has run into some delays in 2011. The aim is to implement new systems for better compliance with tax policies. Authorities have also implemented a tax holiday system, effective December 2011, for new companies established in six key sectors.
OUTLOOK: Amidst global economic uncertainty Indonesia has shored up its credibility as a viable investment destination. Prudent management and a convincing growth story have raised the profile of this large economy for investors hungry for emerging market returns. If the state is successful in addressing the lingering bottlenecks in infrastructure and human resources, the sleeping giant will surely awake. Developments illustrate that private capital has a clear role to play.
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