IMF Executive Board Concludes 2008 Article IV Consultation with IndonesiaPublic Information Notice (PIN) No. 08/106
August 12, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On August 1, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the 2008 Article IV consultation with Indonesia.1
Since the conclusion of the last Article IV consultation in mid-2007, Indonesia's growth performance has remained strong despite the deteriorating global environment. Growth of 6.3 percent in 2007, the highest growth rate in a decade, was driven by domestic demand, both robust private consumption and a rebound in investment that included a strong rise in foreign direct investment. While exports performed strongly, supported by continuing demand for Indonesia's commodities, the recovery of imports in the second half of the year reduced the contribution of net exports to growth. The growth momentum was maintained in the first quarter of 2008. As a result, poverty and unemployment have declined significantly, though they remain high at 15.4 percent and 8.5 percent, respectively.
Nevertheless, new challenges have emanated from rising commodity prices. Government bond yields have risen by about 250 basis points since end-February as investor sentiment deteriorated due to surging fuel subsidies and inflation concerns. Domestic fuel prices were subsequently increased by about 29 percent. Headline inflation has accelerated to 11.0 percent at end-June, while core inflation reached 8.7 percent at end-May (latest available data), well above Bank Indonesia's (BI) 4-6 percent target range for end-2008. After lowering interest rates to 8 percent and then holding them unchanged since late 2007, BI hiked rates three times since May by a total of 75 basis points in response to rising inflation. Nevertheless, the real policy interest rate calculated on the basis of core inflation has been declining over the year and is currently around zero. Meanwhile, uncertainty remains as international oil and food prices have continued to rise, global growth is expected to slow in 2008.
The external position remains generally strong. Staff estimates that the real exchange rate is moderately undervalued. Nevertheless, the nominal effective exchange rate (NEER) depreciated further (by 10 percent) in 2007, which likely contributed to inflationary pressures, while Indonesia accumulated US$14 billion of reserves. However, in 2008 BI has slowed the accumulation of reserves and the NEER has remained stable. While the current account recorded a surplus of 2.5 percent of GDP in 2007 supported by gains in the price of major commodity exports, there have been some episodes of capital outflows and external financing conditions have tightened somewhat as a result of the global financial market turmoil.
Fiscal performance has been strong despite rising fuel subsidies. Energy subsidies rose to 3 percent of GDP in 2007 (almost a third of total current spending). Nevertheless, the fiscal deficit was contained to 1.2 percent of GDP, well below the government's target. Revenue performance was buoyant, with an across the board surge in non-oil and gas revenue being a testament to both the underlying strength of the economy and payoff from ongoing reforms in tax administration. Budget execution has also improved noticeably, in particular in the area of development expenditure.
Indonesia's financial sector has displayed resilience in the face of the global credit market turmoil. Several factors have limited the transmission of global financial shocks, including (i) reduced external vulnerabilities, (ii) low exposure to structured credit and derivative products, (iii) ample domestic liquidity, and (iv) relatively low reliance on external financing. Financial soundness indicators have improved, with banking sector profitability increasing, and gross non-performing loans (NPLs) declining to 4 percent amid strong private credit growth. The stock market index remains about 6 percent above the level at end-June 2007. Nevertheless, volatility has increased, and since end-February, Emerging Markets Bond Index (EMBI) and Credit Default Swaps (CDS) spreads have widened more than in other emerging market countries and the government bond market came under stress in March, reflecting largely investors' concerns about inflation and fuel subsidies.
Executive Board Assessment
Executive Directors welcomed the resilience of the Indonesian economy to the global slowdown and financial market turmoil, underpinned by strong macroeconomic fundamentals and the highly liquid and well-capitalized banking system. Robust domestic demand and buoyant exports supported by high commodity prices have contributed to this commendable performance, and are expected to continue to sustain the growth momentum. Downside risks are associated with a less favorable external environment, a possible slump in commodity prices, and remaining vulnerability to spikes in global risk aversion and contagion from other emerging markets.
Directors saw as a key immediate challenge the need to rein in the inflationary pressures stemming from the large increases in food and fuel prices and strong domestic demand. They welcomed the recent increases in interest rates, and considered that further monetary policy tightening will be needed to put inflation back on a firmly declining path. Directors encouraged the authorities to continue to strengthen the inflation targeting framework, through effective communication, publication of inflation forecasts, and a strong commitment to the medium-term targets. They agreed that the shift of the operational target to the interbank overnight rate has been managed well and will enhance the effectiveness of monetary policy.
Directors considered Indonesia's flexible exchange rate policy appropriate. Noting the staff's assessment that the real effective exchange rate may be somewhat undervalued, Directors welcomed the new policy of increased reselling of oil receipts, which should help strengthen the currency and support monetary policy in dampening inflationary pressures. They underscored that such a policy should be pursued with care to avoid creating perceptions of specific exchange rate targets. At the same time, efforts should continue on the structural front to strengthen external competitiveness. While reserve levels are broadly adequate, some additional accumulation over the medium term could further reduce vulnerabilities.
Directors welcomed Indonesia's strong fiscal performance. They considered the fiscal stance appropriate and consistent with a substantial reduction of the public debt burden. Directors commended the authorities for addressing the challenge of energy subsidies through the recent fuel price increase, accompanied by cash transfers to the poor. Going forward, Directors encouraged the authorities to move toward an automatic fuel price adjustment mechanism, which would be the preferred solution to ensure fiscal space for capital and social expenditures and guard against emerging concerns about the sustainability of subsidies. In the interim, further ad-hoc adjustments would help reduce the cost of fuel subsidies. Directors welcomed the progress made in public finance reforms, and looked forward to the completion of the pending reforms of the tax system and tax administration. To further enhance fiscal transparency, the authorities were encouraged to consider participating in the Extractive Industries Transparency Initiative.
Directors observed that Indonesia's banking system remains relatively resilient to macroeconomic shocks and exchange rate risks. They agreed that the rapid credit growth calls for close monitoring and strict adherence to prudential regulations in line with international standards. Directors supported the planned gradual transition to Basel II, and welcomed the review of the financial safety net, with a view to ensuring timely responses in case of a crisis. They looked forward to Indonesia's early participation in the Financial Sector Assessment Program (FSAP).
Directors welcomed progress toward implementing structural reforms over the past year. Further efforts will nevertheless be needed to achieve higher sustainable GDP growth, aimed particularly at improving the business climate and accelerating infrastructure development. In that regard, Directors viewed the recently announced policy packages as a welcome signal of the authorities' intention to press ahead with the structural reform agenda.