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Indonesia’s Economy: Strong with Room for Improvements

Reason to celebrate: Alorese from Indonesia perform a dance. Indonesia has emerged strongly from the global crisis (photo: Alison Wright/Corbis)

Economic Health Check

Indonesia’s Economy: Strong with Room for Improvements

By Thomas Rumbaugh, Laura Lipscomb
IMF Asia and Pacific Department

September 17, 2010

  • Prudent economic management steered Indonesia through crisis
  • Need to build on improved financial sector stability
  • Better infrastructure, targeted subsidies, social services vital for long-term growth

Indonesia is likely to experience accelerating economic expansion—with 6 percent growth predicted for 2010 and 2011—but the IMF has warned about the threat of inflationary pressures.

In their annual health check of Southeast Asia’s largest economy, IMF economists said Indonesia had emerged strongly from the global financial crisis due to robust domestic consumption and investment, and greater exports.

Last year Indonesia was the only country in the Group of 20 leading economies to lower its public debt-to-GDP ratio—a reflection of improved economic management over recent years, as well as appropriate policy responses during the crisis. But continued economic recovery has put upward pressure on prices.

The central bank needs to take a proactive approach to keeping inflation in check. Maintaining low inflation would help lower borrowing costs, supporting growth.

Inflation expectations for 2011 are currently at the top end of the 4—6 percent target range and could move higher. Since the crisis, the central bank has kept interest rates low, but in their report the IMF economists said it now needed to meet expectations that inflation would be kept within the target range.

Rapid growth attracts foreign funds

The country’s strong performance has attracted foreign investors who have been pouring into the country’s local government debt markets since mid-2009. However, Indonesia remains vulnerable to swings in investor sentiment. During the European debt crisis earlier this year, a large amount of foreign funds left Indonesia.

The authorities responded by allowing the exchange rate to adjust, while intervening to smooth sharp moves in the level of the Indonesian rupiah. They also announced regulations to reduce swift outflows in the future.

In their report, which followed a 10-day trip to the country in June, the IMF economists noted that funds had returned, but said this experience of capital flight underscored the need for preparedness. They called on the central bank to strengthen its balance sheet in coordination with the government, so that it would have more room for maneuver in the event of future volatility.

Improving the strength of the financial sector

The IMF also identified financial sector reforms to reduce future risks. This sector proved its resilience during the global downturn, and the banking system currently benefits from a large capital buffer and high profitability. However, the IMF suggested that Indonesia could improve the regulatory framework to ensure effective monitoring of important banks and financial conglomerates.

“Addressing weaknesses in the legal and institutional framework, governance, and protection for supervisors is needed to improve financial stability,” the economists stated in their report. They added that the government’s adoption of the Financial System Safety Net law, which would clarify the responsibilities of various regulatory agencies, was crucial to achieving greater financial stability.

The economists also suggested ways to create a deeper capital market, for example, by publicly listing state-owned enterprise shares. “Developing the capital market could help better channel foreign investor inflows into productive uses in the economy,” said Rumbaugh.

Next steps for promoting growth

The IMF economists identified some additional key areas to sustain the country’s strong performance.

• Bolstering monetary policy credibility. Continued effective communication of a proactive monetary stance would signal a commitment to lower inflation and reduce the volatility of inflation to levels comparable to that of Indonesia’s trading partners.

• Improving the financial regulatory framework. Strengthening supervision and governance structures in financial institutions are essential to enhanced stability. Stronger enforcement of creditor rights and developing a deeper capital market would help improve financial intermediation and promote long-term investment.

• Mobilizing government spending to support productive investments. While conservative government spending has put Indonesia in a good position in terms of public debt, the government needs to spend money on improving the country’s infrastructure (roads, railways, power plants) to support sustained growth.

Currently a significant portion of the annual budget goes to energy subsidies, which are politically popular but not well targeted at the poor. A better policy would be to improve social services and transfers directly to the poor, while investing in the country’s infrastructure needs, said the IMF economists.