Indonesia Economic QuarterlyBuilding Momentum

Shubham ChaudhuriLead EconomistWorld Bank

8 April 2010Jakarta Indonesia

Outline

Indonesia’s economic momentum built through 2009

Policy has generally supported this momentum, and near-term risks may be smaller than they first appeared

Strong capital inflow

China-ASEAN FTA

Fiscal stimulus

Impact of windfall revenue on the Budget

The improving near-term economic outlook allows focus to shift to building the current momentum into the medium term

The Government’s medium development plan (RPJMN)

Infrastructure

Social protection

Building momentumIndonesia’s growth built through 2009 Indonesia’s economy accelerated each quarter of 2009, ending the year

outpacing the past decade’s average Economy expanded by 4.5% in 2009

Growth has been broad based across all components of GDP

Indonesia’s trading partners have also recovered, supporting trade volumes

Sources: BPS via CEIC, World Bank

-8

-4

0

4

8

-8

-4

0

4

8

Dec-02 Sep-04 Jun-06 Mar-08 Dec-09

QoQ Seas. Adjust.

Year on year

Per cent Pe cent

0

2

4

6

8

0

1

2

3

4

Dec-02 Sep-04 Jun-06 Mar-08 Dec-09

Per cent Per cent

QoQ seas. adjust (LHS)

Year on year (RHS)

Average (LHS)*

Building momentum …and other domestic indicators are strong

Sources: CEIC, World Bank

-30

-20

-10

0

10

20

30

-30

-20

-10

0

10

20

30

Jan-07 Oct-07 Jul-08 Apr-09 Jan-10

Industrial production

Electricity (industrial)

Cement sales

Per cent Per cent

Other economic indicators have stabilized at high levels

Consumer indicators are around record highs

Industrial indicators are strong

0

20

40

60

80

0

200

400

600

800

Feb-06 Feb-07 Feb-08 Feb-09 Feb-10

'000

Motor vehicles (RHS)

Motor cycles (LHS)

'000

110

150

190

230

60

80

100

120

Feb-06 Feb-07 Feb-08 Feb-09 Feb-10

Index Index

BI Retail sales

BI Consumer Survey Index

Building momentumInflation has fallen to decade lows

Headline inflation has picked up from its low point

Core inflation has continued to fall, to decade lows of 3.6% year to March

Inflation picked up at the start of the year, largely because the seasonal increases in food prices were larger than normal, and this affected poorer households especially

As the harvest comes in andglobal growing conditionsimprove, these increases shouldunwind

But inflation remains higher thanin most of Indonesia’s neighbors

And Indonesia has delayedpassing on to consumers lastyear’s recovery in globalenergy prices

Source: BPS

Building momentumFinancial markets have bounced back Yields on Indonesian debt have returned to pre-crisis

Spreads have narrowed further than other emerging markets

In January, yields on five year IDR sovereigns hit their lowest level since these bonds were first issued in 2003

Agencies have raised their sovereign debt rating for Indonesia

Sources: BPS via CEIC, World Bank

-200

-100

0

100

200

300

400

0

200

400

600

800

1000

1200

Jan-05 Nov-05 Sep-06 Jul-07 May-08 Mar-09 Jan-10

Indonesian EMBI USD Bond Spreads(LHS)

Indonesian Spreads Less Global EMBI Average(RHS)

Basis points Basis points

0

3

6

9

12

15

18

21

24

0

3

6

9

12

15

18

21

24

Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

Indonesia

Philippines

Thailand

Malaysia

United States

Percent Percent

Building momentum2009 budget deficit was smaller than expected

Sources: BPS via CEIC, World Bank

Revenue surged at the end of 2009, while expenditure was only a little weaker than expected cutting the budget deficit to 1.6 per cent of GDP The government spent about 95 per cent of the revised Budget

Programmatic spending was up on previous years; subsidies and interest costs down

The fiscal stimulus is estimated to have added as 1 percentage point to GDP growth

-20

-18

-16

-14

-12

-10

-8

-20

-18

-16

-14

-12

-10

-8

Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09

Per cent Per cent

Realized growth

Growth excluding the VAT payment

Previous forecast

IEQ Q3IEQ Q2

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

J an Feb Mar Apr May J un J ul Aug Sep Oct Nov DecMonthly 2007 Monthly 2008 Monthly 2009 Monthly 2009

Monthly 2009 Cum. 2007 Cum. 2008 Cum. 2009

Government tax revenues Share of line ministries’ budget spent

The OutlookFaster growth, moderate inflation

Sources: BPS, CEIC, World Bank. World Bank projections

Outlook remains for gradual pick-up in growth

Major trading partner growth is expected to pick up and drive exports

Domestic demand, particularly investment, and more export processing activity, are expected to drive further import growth

Inflation should slowly pick up into 2011 on solid domestic demand and a more stable exchange rate

2009 2010 2011

Gross domestic product (Annual per cent change) 4.5 5.6 6.2

Consumer price index (Annual per cent change) 4.8 5.3 6.1

Poverty rate (Per cent of population) 14.2 13.5 11.4

Balance of payments (USD bn) 12.5 6.2 4.7

Budget balance (Per cent of GDP) -1.6 -1.3 na

Budget balance, government projection (Per cent of GDP) -1.6 -2.1 na

Major trading partner growth (Annual per cent change) -1.0 4.3 4.0

There are both risks to the outlook and near-terms issues to consider

10/16/08

Some risks for the outlook:

Withdrawal of global fiscal and monetary stimulus

Weak demand from OECD economies, as consumer and public debt levels are addressed

Ongoing economic reforms in the region so growth is more reliant on domestic demand

On top of these external risks to Indonesia’s economic outlook arenear-term issues challenging policy makers:

Strong capital inflows into Indonesia

Ongoing exposure of Indonesia’s budget to commodity price shocks

Fears that the ASEAN-China FTA will have a significant impact on domestic producers

The Outlook…and these risks impact the outlook for Indonesia

Annual GDP growth

There are both upside potential (from policy breakthroughs and stronger improvements in the global economy) and downside risks to the outlook

Scenarios

Sourcse: BPS, World Bank projections

3

4

5

6

7

3

4

5

6

7

2002 2004 2006 2008 2010

Low High Reference

Per cent Per cent

2010

Reference 4.3 17 1.0 9400 5.6

Low 3.1 14 0.8 11000 5.0

High 4.7 18 7.2 8500 6.2

2011

Reference 4.0 25 5.7 9400 6.2

Low 1.7 15 4.1 10000 5.6

High 4.9 31 14.8 9000 6.4

MTP* CreditExport prices

Rupiah (USD/IDR) GDP

The OutlookRisks remain to the global outlook

The medium term global challenge is to unwind the various stimuli used to fight the downturn:

Reducing the fiscal stimulus and developed country debt burdens is made more difficult by aging populations and political will

And unwinding monetary stimulus is difficult due to uncertainty around lags (too soon and recovery suffers, too late and inflation takes off) and the shift from goods inflation to asset price volatility

This implies that financial markets may remain volatile for some time (exchange rates, commodity prices, interest rates and so forth)

Indonesia is particularly vulnerable to this volatility

Still the volatility, and impact on the economy, is likely to be smaller than late 2008

And the longer term challenges

Addressing global imbalances – improving but are still large implying weaker world growth as OECD consumers save more and consume less

And a difficult structural adjustment to higher world capital and energy prices – compounded by higher carbon prices?

The proposed revised BudgetVolatile oil prices again expanding the deficit

Sources: MoF and BPS. World Bank 2010 projections

The proposed revised 2010 Budget projects a wider deficit of 2.1% of GDP

Mostly due to higher oil price projections, repeating past years’ experience

Total expenditure is expected to increase by around 3 per cent in 2010

Mostly due to higher energy subsidies and transfers to subnational governments

Delayed reform of regulated energy prices and higher outlook for global oil prices are expected to increase subsidy costs by 30%

0

1

2

3

4

5

2004 2005 2006 2007 2008 2009 2010

APBN Realized%

* projected

*

Energy subsidies, as % of GDP

The proposed revised BudgetVolatile oil prices again expanding the deficit

Sources: BPS via CEIC, World Bank

Tax revenues are expected to increase significantly as incomes recover

With a stronger exchange rate and given past patterns, revenues may be event stronger than projected

There are upside risks to the government’s projections; stronger assumptions about the economy and for revenues reduce the deficit towards 1% of GDP

The wider deficit can be easily financed from the 2009 financing surplus

And the government is well-advanced on its commercial debt sales, selling debt at sharply lower interest rates and for longer terms

The proposed revised Budget Volatile revenues hinder effective budgeting

A large spike in revenues with, eg, higher oil prices means more funds need to be allocated to the education budget under the ’20% rule’

Some of the problems with these ‘windfalls’ to the education budget have been addressed:

The Government’s early revision to the state budget reduce the risk of a large windfall arising late this fiscal year

The revised budget establishes an education endowment fund to help ensure that ‘windfalls’ are managed and spent well

Strengthening budget contingency planning in MoNE and MoRA could also help to better manage the problem

Windfalls for the education budget are part of a broader problem, namely, volatility in the budget caused by energy subsidies and fluctuations in resource revenues

Some policy challengesFinancial markets continue to rebound, bringing large capital inflows USD 6.6 billion of foreign capital has flowed into Indonesian financial

assets since June 2009

In this time the Rupiah appreciated 9%

And the central bank has allowed its foreign exchange reserves to grow, while ‘sterilizing’ these increases

The cost of this sterilization is estimated to be low…so far

Sources: BPS via CEIC, World Bank

15

30

45

60

75

-40

-20

0

20

40

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

IDR trillion USD billion

Total Reserves (RHS)

Net Foreign Capital Inflows (LHS)

June 2009

8500

9500

10500

11500

1250025000

35000

45000

55000

65000

75000

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10

IDR/USD (RHS)

Total Reserves (LHS)

IDR Appreciation

USD million IDR per USD

June 2009

Some policy challengesLimited impact from the ACFTA

Sources: MoF

Cuts in tariffs on goods imported from China start in 2005 and another round occurred on 1 January 2010.

The cuts in January were relatively small and follow gradual reduction; higher tariffs remain on some ‘sensitive’ goods

Few traders are using the lower rates available under the agreement

…suggesting this round of tariff reductions is likely to have a small impact

The agreement offers large potential benefits to Indonesia

Since tariff reductions began in 2005, Indonesia’s exports to China have increased by almost 70%

The agreement also promiseslower prices forIndonesianconsumers andproducers, andbetter access toChina's markets

2004 2005 2006 2007 2008 2009 2010 2011 2012Agriculture 11.9 10.5 9.6 9.4 9.4 6.9 6.8 6.8 6.7Chemicals 6.5 6.5 6.5 5.4 5.4 2.4 1.5 1.5 1.2E. Machinery 6.8 6.8 6.8 4.6 4.6 2.1 0.5 0.5 0.4Fish 4.7 0.1 0.1 0.2 0.2 0.1 0.1 0.1 0.0Leather, Rubber, Footwear 8.7 8.7 8.7 7.3 7.3 4.3 3.5 3.5 3.0Other Manufacturing 7.3 7.3 7.3 5.5 5.5 2.2 0.6 0.6 0.2Metals 9.8 8.9 8.9 6.5 6.5 3.2 1.7 1.7 1.3Minerals 5.1 6.0 6.0 5.0 5.0 1.9 1.2 1.2 1.1NE Machinery 2.6 2.6 2.6 2.0 2.0 0.8 0.3 0.3 0.2Petroleum 5.0 3.2 3.2 1.2 1.2 1.2 1.2 1.2 1.2Textiles & Clothing 10.8 10.8 10.8 7.6 7.6 4.3 1.6 1.6 1.1Transport Equipment 28.7 28.7 28.7 18.8 18.9 18.5 18.4 18.4 18.1Wood, Pulp, Paper, Furniture 4.7 4.7 4.7 4.3 4.3 1.1 0.4 0.4 0.0Average 9.9 9.6 9.5 6.4 6.4 3.8 2.9 2.9 2.6

Realizing the development agenda

The improving economic environment allows Indonesia to shift focus to the medium term development issues

Indonesia is poised for government-catalyzed and private sector- driven investment and growth with the right policy improvements for the investment climate and complementary public investments

The Government focuses on these issues in its new medium term development agenda (RPJMN)

The improved economic environment allows Indonesia to spend more on its development priorities

Indonesia’s fiscal and debt position is strong…

…and there are resources to be had if energy subsidies are redirected towards targeted social spending and infrastructure investments

Realizing the development agendaAccelerating investment climate reforms and attacking coordination problems

More aggressive stance toward facilitating domestic and foreign investment: Foreign direct investment levels are relatively low; these investments are

far less footloose than short-term inflows into capital markets

Lower entry barriers, including the time and cost to start a business, the Negative List

Lower operating costs with a focus on actionable steps to improve logistics,

Improve trade facilitation through the National SingleWindow

and control the proliferationof non-tariff barriers that raisecosts and reducecompetitiveness

Solution for Coordination:Regulatory Reform Commission

10/16/08

Foreign direct investment as % of GDP, 2004-2008

0

1

2

3

4

5

6

7

Vie

tnam

Thailand

Mala

ysi

a

Chin

a

India

Indonesi

a

Philip

p's

%

Sources: UNCTAD, World Bank

Realizing the development agenda…supporting investment growth As China rebalances from investment to consumption-led growth,

Indonesia will want to spur investment and net exports

Contributions to annual average growth, 2003-2008

Source: World Bank

-2

0

2

4

6

8

10

12In

donesi

a

India

Chin

a

Net exports

Investment

Private consumpt'n

Total growth

%

Realizing the development agendaPolicies need to support economy-wide growth

Sectors with the greatest reforms grew faster last decade

Service sectors, many deregulated at the start of the decade, have been growing much faster than the rest of the economy

Telecoms, retailing and domestic airlines all experienced rapid growth

But partly the reflects that other sectors, especially mining and manufacturing have not been doing as well

10/16/08

(average annual growth)

0

2

4

6

8

10

2000-02 2002-05 2005-09

Agriculture, mining & manufacturing Services%

Source: BPS via CEIC

Putting in place a Social Protection System consistent with Middle Income Status

Opportunities and Challenges

Indonesia has the resources and institutional capacity to develop effective social protection systems

as demographic and epidemiological challenges mount

Key elements

Build proven and successful social assistance and poverty alleviation programs (PNPM, BOS, BLT,…) into a comprehensive social assistance program

Lay the groundwork for a future National Health Insurance System that is clear, feasible and affordable

And put in place a grand bargain between employers and workers on severance pay that provides worker’s security without discouraging job creation

10/16/08

But all of this will require a bigger push on Institutional and Civil Service Reforms

Replicate models of institutional reform underway (at the Ministry of Finance – especially Tax and Treasury) in other institutions with significant contact with the public—Customs, BPOM, Manpower, Trade and Industry…

Complement ongoing bureaucracy reforms at the institution level with a modernized regulatory framework and central institutional set-up for civil service policy making, regulation and management

Improve compensation, recruiting and promotion but link it to accountability

Allowing fit for function institutions (not one size fits all)

10/16/08

Indonesia Economic QuarterlyBuilding Momentum

Shubham ChaudhuriLead EconomistWorld Bank

8 April 2010Jakarta Indonesia

Slides not used

10/16/08

These development items are consistent with the Government’s development plan

The Government’s 11 priorities;

i) Bureaucracy and governance reform,

ii) Education,

iii) Health,

iv) Poverty reduction,

v) Food security, vi) Infrastructure,

vii) Investment and business climate,

viii) Energy,

ix) Environment and disaster management,

x) Least developed, frontier, outer, and post conflict areas, xi) culture, creativity, and technological innovation.

10/16/08