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IMFSurvey Magazine: Countries & Regions

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Indonesian Domestic Demand Likely to Sustain Robust Growth

Workers inspect tires at a factory in Bekasi, West Java, Indonesia. Reforming labor laws would create more employment, say IMF economists (photo: Mast Irham/epa/Corbis)

ECONOMIC HEALTH CHECK

Indonesian Domestic Demand Likely to Sustain Robust Growth

IMF Survey online

September 25, 2012

  • Indonesia in strong position to weather global uncertainty
  • Growth projected at 6 percent this year, and 6.3 percent in 2013
  • Sustaining growth will require further reforms

Prudent macroeconomic policy and structural reforms over the last decade, on top of solid fundamentals, have placed Indonesia in a strong position to deal with the continuing uncertainty in the global environment, say IMF economists in their regular assessment of one of Asia’s largest economies.

“Corporate and financial sector balance sheets are healthy, and the sharp reduction in the public sector debt burden has provided the authorities with room to respond with further stimulus if needed,” says the IMF’s mission chief for Indonesia, Sanjaya Panth.

Growth eases

In their annual health check of the country’s economy, also known as the Article IV report, the IMF’s economists said Indonesia’s growth is expected to ease to 6 percent in 2012 from 6.5 percent in 2011, with weaker external conditions likely to be offset by moderate fiscal stimulus.

The country’s growth rate is then projected to recover to 6.3 percent next year and, with the right policies, is expected to rise further over the medium term, provided global economic conditions remain broadly favorable.

But the report predicts that strong domestic demand, underpinned by robust credit growth, will likely push inflation to 5 percent by year end, and the current account is expected to shift to deficit this year due to weak global demand.

Over the medium term, it is likely to remain in deficit because of high levels of capital goods imports financed by foreign direct investment.

“The projected current account deficit is not due to any fundamental weakness in the Indonesian economy, but is to be expected given the authorities’ welcome plans to boost investment over the medium term, and to strengthen social protection schemes,” said Panth.

Risk perceptions remain elevated

But Panth also warned that risk perceptions remain elevated, contributing to a decline in international reserves in the past year, and underscoring the importance of addressing policy uncertainties.

“To a large extent, global factors lie behind recent weaknesses but domestic policies have also played their part,” he said.

Easier monetary conditions may have contributed to inflation momentum, say the IMF economists, who urged Bank Indonesia to continue to move back to a more neutral policy stance by steering money market rates toward to their announced policy rate.

They welcomed the recent introduction of stricter prudential controls, such as tighter limits on car and mortgage lending as steps to safeguard financial stability, but said they could not substitute for traditional monetary policy tools in addressing macroeconomic risks.

Fiscal deficit appropriate, but reforms needed

The IMF report said that the 2012 fiscal deficit of around 2 percent of GDP was appropriate, but noted there was scope to improve both the allocation and administration of government spending.

The report suggested that costly and inefficient energy subsidies could be replaced with direct cash transfers to the vulnerable. “This would create greater fiscal room to spend on pressing infrastructure, health, and education needs. It would also enhance economic equity,” said Panth.

Recent reforms aimed at reducing institutional constraints on government investment spending seem to be bearing fruit, says the report which called for these to continue.

Substantial progress has been made in strengthening financial supervision, but gaps remain. Most critically, a sound legal framework for the good management of a major financial crisis will require the passage of effective Financial Sector Safety Net legislation, while the smooth and successful transition of supervisory functions to the newly established Financial Services Authority will involve increased oversight and coordination among the existing regulatory agencies.

More investment, business reforms

Indonesia is reaping the benefits of a young and growing population, and a sustained recovery in investment levels. But achieving higher and more equitable growth will require further measures, says the report, which points to the possibility of increasing public infrastructure investment, identified by numerous business surveys as a major constraint in Indonesia.

More generally, maintaining the momentum of structural reforms will be critical for sustained, inclusive growth. Financial deepening will be key to mobilizing domestic savings to fund both private and public investment, as well as providing a greater range of financial products.

Reforming Indonesia’s labor laws, which are relatively rigid in international comparison, would help create greater formal and youth employment. Improved public spending on infrastructure, health, and education would also better equip the young for the formal labor market and lead to more equitable growth.

An open foreign trade and investment regime, along with improvements to the business climate, would also bolster Indonesia’s attractiveness to both domestic and foreign investors. Employment, incomes, and productivity should all rise on a sustained basis as public investment and structural reforms improved the comparative advantages of the Indonesian economy outside the resources sector.