Consultative Group Meeting for IndonesiaStatement by Stephen Schwartz
IMF Senior Resident Representative
June 14, 2006
1. It is a pleasure to represent the IMF at this CGI meeting. At the outset, I would like to take this opportunity to express our deepest condolences for the loss of life and destruction from the earthquake that struck Yogyakarta and Central Java on the morning of May 27. Sadly, expressions of condolences have become a common feature in our CGI statements over the past few years, with the earthquake being the latest in a series of calamities to hit Indonesia. The authorities' swift response and the resilience of the Indonesian people are once again serving as an example to the international community.
2. In this statement we would like to provide a brief overview of economic developments since the Interim CGI meeting last October, and an update to the outlook. At that time, we joined others in welcoming the authorities' strong measures to address financial market and balance of payments pressures, including the courageous adjustment of domestic fuel prices and the sharp increase in interest rates. Although Indonesia remains vulnerable to market volatility, as demonstrated over the past several weeks, those measures strengthened the external and fiscal positions and led to a significant buildup of international reserves. The short-term side effect, however, has been a temporary slowdown in domestic demand and economic growth. And business sentiment appears to have been further eroded by slow implementation of key structural reforms needed to improve the investment climate.
3. This statement draws on the results of an IMF mission last month to Jakarta for the annual Article IV Consultation. The mission's work focused on the economic outlook, and on macroeconomic and structural policies to address the economic slowdown and sustain medium-term growth. The associated staff paper will be presented to the IMF Executive Board in late July.
Recent Macroeconomic Developments
4. As noted above, GDP growth has slowed in recent quarters. After reaching 5.6 percent in 2005, GDP growth in the first quarter of 2006 slowed to only 4.6 percent (year-over-year). With purchasing power undermined by the sharp fuel price increase and inflation, and credit demand weakening, private consumption and investment both slowed in the first quarter. On the external side, the fuel price increase and weaker activity led to a decline in import growth which, together with robust export growth, helped to keep the current account in surplus. Meanwhile, the higher interest rates and improved market confidence attracted portfolio inflows, helping to boost reserves from a low point of around $30 billion last September to around $44 billion recently.
5. After rising sharply earlier in the year, the rupiah and financial markets have weakened in recent weeks. These trends have been associated with an increase in global financial market volatility owing to a reassessment by fund managers of their risk appetite toward emerging markets, and in part may reflect a healthy correction of asset prices. Given the magnitude of recent portfolio inflows Indonesia remains highly susceptible to shifts in sentiment, despite improving macroeconomic fundamentals.
6. Notwithstanding the recent volatility, the authorities deserve praise for their sound macroeconomic policy management. Bank Indonesia's (BI's) cautious monetary policy since the "mini-crisis" of August/September has succeeded in containing inflation, which has been running in the 7 percent range on an annualized monthly basis since the beginning of the year (although year-on-year rates remain high because of base effects). Working within its forward-looking inflation targeting framework, these trends have enabled BI to begin a gradual easing of interest rates, and BI's policy rate (one-month SBI rate) currently stands at 12.50 percent, a reduction of 25 basis points since April. Given the recent pickup in financial market volatility and uncertain outlook for global interest rates, however, BI has rightly emphasized a gradual approach to further interest rate reductions, as evidenced by its decision last week to defer a further reduction in its policy rate for the time being.
7. The 2005 budget deficit was significantly lower than the planned deficit of 1.3 percent of GDP (IMF definition). This outturn was largely due to underspending on purchases of goods and services, which has continued through the first four or five months of 2006. The spending delays appear to reflect a slow procurement process and caution resulting from the government's anti-corruption efforts. While the lower deficit resulted in a further welcome decline in the debt-to-GDP ratio, to 47 percent at end-2005 (from a peak of over 90 percent in 2000), it has meant that government spending at both the central and regional levels has failed to provide support to domestic demand, which would be appropriate given the current softness of activity. Lower than planned spending has also partially undermined the government's efforts to reorient spending toward higher priority areas following the fuel price increase.
8. Based on the recent GDP figures, we have fine-tuned our growth projection for 2006 to 5.2 percent, rising to 6.0 percent in 2007 (Table 1). Our projection assumes that the recent market turbulence will not significantly affect the global growth outlook and that a steady pickup in domestic demand will occur during the year, as interest rates are reduced and the adjustment to last year's abrupt oil price increase wears off. With recent economic indicators still showing weakness, and the ongoing financial market volatility, the projection is subject to downside risks (see paragraph 10 below). The direct economic impact of the earthquake on the national economy is not expected to be significant, given that Yogyakarta accounts for just over 1 percent of Indonesia's GDP, but the effect on the tourism sector, which was already reeling from the fallout of last year's Bali bombings, will need to be monitored. Assuming continued monetary prudence, and despite some upward pressure on prices from the recent unwinding of the rupiah's earlier appreciation, we expect inflation by end-year to fall to the within BI's 7-9 percent target range, and to 6-8 percent in 2007.
9. Fiscal policy is expected to be suitably balanced between continued fiscal consolidation and providing support to aggregate demand. We believe that the government's plan to revise the 2006 budget deficit target to around 1.3 percent of GDP is appropriate, as a deficit of this magnitude is financeable and would keep the public debt-to-GDP ratio on a firmly downward path, to about 40 percent of GDP at end-2006. The challenge going forward will be to step up spending in line with budgeted levels; otherwise, there is a risk that the anticipated fiscal stimulus will fail to materialize. In this regard, we welcome the government's plans to address spending bottlenecks and to expand the fuel cash compensation program (set to expire in the third quarter of the year) to low income families. Also, efforts by the central government would be helpful to assist the regions in spending their surpluses to support growth, especially on high priority infrastructure and social needs.
10. Risks to the outlook stem from higher international oil prices, a further tightening of global financial market conditions, and a slowdown in the U.S. At the IMF, we expect oil prices to remain in the $65-70 dollar per barrel range for the foreseeable future, although with continuing geopolitical tensions, there is a risk of even higher prices. If prices were to rise significantly further, pressures on inflation, the budget, and the balance of payments could reemerge, requiring timely policy adjustments. Financial market developments over the past few weeks also provide an indication of the kind of impact a tightening in global financial market conditions could have. In particular, a further significant tightening could put further downward pressure on the rupiah and international reserves, as well as on domestic equity and bond prices. While the risks described above should be manageable with prompt policy action, especially in view of increased foreign exchange reserves, they would inevitably result in a higher inflation rate and lower growth. On the domestic policy side, lack of progress in implementing structural reforms is a key risk to growth over the medium term.
11. As discussed on previous occasions, we believe that the government has adopted a sound medium-term macroeconomic framework. Moreover, with steady implementation of structural reforms to improve the investment climate (see below), we believe that Indonesia can achieve its potential growth of 6-7 percent in the coming years. While vulnerabilities remain, Indonesia's macroeconomic fundamentals are continuing to improve, with the debt-to-GDP ratio set to decline further, to around 30 percent by 2010, and the overall external position continuing to strengthen, even as the current account gradually moves toward modest deficits over the medium term.
12. Notwithstanding the authorities' continued sound macroeconomic policy management in recent months, growth remains below potential, and unemployment and poverty are still high. To bring Indonesia's growth performance up to its potential, implementation of the government's structural agenda will be needed to increase domestic and foreign investment. The Policy Package for Improvement of the Investment Climate is a welcome step, targeting important improvements in infrastructure, approval of the Investment Law, fairness in tax administration, improvements in customs procedures, and labor market flexibility. While implementation is never easy, it is encouraging that the economic team has enlisted business and labor partners in implementing reforms. Given the business community's apparent skepticism about quick implementation, early successes in implementing the package would be helpful in enhancing confidence. Similarly, strong leadership will be required to build consensus for reform.
13. While financial indicators in the banking system have weakened since mid-2005, the system remains well capitalized. The combination of high interest rates, a slowing economy, and a tightening of loan classification rules led to a doubling in nonperforming loans (NPLs) to 10.3 percent at end-2005, with NPLs at the two largest state banks rising much more significantly.
14. We very much welcome the government's forthcoming package of financial sector measures. The package will foster improvements in banking supervision and the development of the nonbank financial sector; it will also address the pressing issue of NPLs at the largest state banks. In particular, we welcome the government's efforts to provide the state banks the authority to grant discounts (haircuts) in the debt restructuring process, which would put them on a level playing field with private banks. Beyond this, we continue to support the government's ongoing steps to improve state bank governance. We would also encourage the development of a medium-term strategy for these banks, with consideration to allowing a greater role for the private sector in the management of these banks over time.
15. We continue to maintain a close policy dialogue with the authorities, and to devote substantial technical assistance resources. With respect to the latter, our activities include the areas of tax administration and treasury management, monetary policy and operations, banking reforms, and economic statistics. We would also like to congratulate the authorities on their decision to undertake a Fiscal Transparency ROSC, the results of which will be presented to our Executive Board in July.
16. In concluding, we would like to emphasize our support of the authorities' macroeconomic policies since the Interim CGI meeting. At the same time, as recognized by the government, further efforts will be needed to raise Indonesia's growth performance to its potential, in order to address the still-high levels of unemployment and poverty. In this regard, we look forward to continuing to work closely with the international community in support of the authorities' efforts.