James Castle, Jakarta
After a decade of domination by domestic concerns, the major uncertainty for 2008 comes from abroad in the form of potential collateral damage from America’s sub-prime mortgage crisis. Although the crisis is centered in the U.S., it is reverberating through all of the world’s major financial centers.
Prospects for the economies of the U.S. and Europe are at their weakest in several years. The OECD’s December report cuts its 2008 U.S growth forecast to 2.0 percent and Europe’s to 1.9 percent. These are significantly lower than OECD’s May forecasts of 2.5 percent and 2.6 percent respectively.
While these growth levels hardly constitute a crisis, many other forecasts are even more gloomy. But even if the OECD’s forecasts prove optimistic and the U.S. slides into recession in a worst case scenario, developing Asia has little direct exposure to the crisis and Indonesia has almost none so the effect here should be marginal.
Indeed, whatever difficulties a weaker global economy may bring, Indonesia enters 2008 having recorded its highest growth rate in a decade. For the first time since 1996, the country’s gross domestic product (GDP) growth last year would most likely exceed 6 percent, providing a solid base for even higher growth in 2008.
In fact, the major clouds on Indonesia’s 2008 horizon come not from recession in the U.S. Rather, they come from the impact of high oil prices on the government’s unsustainable subsidy bill and the inflationary pressures that are pushing up domestic prices, endangering the recovery of consumer spending that is driving growth and harming the poor.
In this regard, a slowdown in global growth may actually prove beneficial here as the global rise in oil prices will at least slow and probably reverse. While an overall commodity price contraction will hurt the nominal value of some of Indonesia’s exports, it would be a net positive for the country as it would also reduce inflationary pressures on domestic manufacturers where margin squeezes are forcing prices up and reducing consumer buying power. In any case, Indonesia can do little about global oil prices, so it must find other ways to combat inflation.
A major factor in the inflation threat here comes from the failure of the Indonesian rupiah to follow most regional currencies that are appreciating against the U.S. dollar. Here, government and Bank Indonesia’s policies have a great deal of influence.
At first glance, it seems strange that the rupiah has not strengthened along with the baht, peso, rupee and Singapore dollar since Indonesia’s foreign exchange reserves, now over US$54 billion, are rising steadily, exports are up 13 percent so far last year and import growth was even stronger (up 17 percent through the third quarter), indicating greater investment. Despite this strength, the rupiah has actually depreciated over 3 percent against the fading U.S. dollar last year while the baht, peso, rupee and Singapore dollar had an average appreciation of over 10 percent.
So why has the rupiah lagged its regional neighbors? The reasons for its failure to appreciate are two-fold.
Firstly, there is great concern about the impact of the rising oil prices on the national budget due to the large fuel subsidy. Investors are worried both about the budget and the government’s policy response.
There is concern that the government’s unwillingness to raise fuel prices will increase the annual budget deficit above 2 percent and drain funds away from more important infrastructure and other social development plans. Most agree that another major fuel price hike like 2005 will harm consumers too much and damage the administration’s re-election prospects.
Still if oil prices stay at or above $95 per barrel, adjustments will have to be made. Restricted availability of subsidized gasoline in major urban areas is one likely tactic that could provide some short term relief.
Ultimately, the country needs a series of mild, steady price increase, perhaps along the lines of the indexing scheme that was imprudently abandoned by the previous administration in 2003 and unwisely rejected by the current government in October 2005.
Equally important, the market also sees Indonesian interest rates as being too low. With inflation running at 6.7 percent, the latest reduction in Bank Indonesia’s (BI) benchmark rates from 8.25 to 8 percent has narrowed the spread between interest rates and inflation, making short term yields unattractive. The current spread of only 130 basis points is below the spread of 200-250 basis points that the market would prefer.
While Indonesian yields remain high, the low interest rate policy is the main factor preventing an appreciation of the rupiah and keeping inflation high. Rupiah attractiveness is further reduced because the market fears that BI will remain too aggressive in its interest cuts because it tried to achieve its stated interest rate target of 5-7 percent last year and 4-6 percent in 2008.
In defense of lower rates, one can argue that the U.S. Federal Reserve will continue to lower rates and that oil prices will retreat further by mid-2008, taking some pressure off the budget. These arguments are likely to be true, but acting ahead of the fact is a gamble.
Central bankers, however, should not be gamblers and in the current uncertain environment caution is in order. The consumer and the real sector in Indonesia are much more sensitive to currency rates and inflation than interest rates. It would be more prudent for the central bank to signal a moratorium on further interest rate decreases and even start to prepare the market for possible increases if inflation stays above six per cent. This would be the focus back on reducing inflation and protecting the poor.
Aside from inflation, other broad economic trends are favorable. Trade remains robust as noted above and the merchandise trade surplus at over $20 billion is very solid and can easily withstand short term commodity price declines. Real sector growth continues to improve. Investment is slowly moving upward and should exceed 25 percent of GDP last year, according to the World Bank.
While well below an optimal level of 30 percent of GDP, this is a significant improvement. As recently as 2003, the ratio was below 20 percent. The government also has plans to increase transportation and public works spending by Rp 16.6 trillion or 48 percent this year. If realized, this will provide a tremendous boost to the country’s ailing infrastructure.
Cement consumption, another key real time indicator of economic activity, was up over seven per cent through October, a significant improvement over 2006. October consumer sentiment as measured by Danareksa showed its first increase since July and their quarterly Business Sentiment Index that had been flat at around 115 for over a year, moved up to 120 last March and was at 135 in September. All this bodes extremely well for strong growth this year.
Such bullish business sentiment is confirmed by the fact that investment approval figures from the Investment Coordinating Board (BKPM) for the first six months of last year ($29 billion) actually exceeded the total in 2006 ($28 billion).
The keys to higher growth in 2008 are reining in inflation, managing the budget deficit well in the face of significant fuel subsidy increases and pushing through as much of the budgeted increase in infrastructure spending as possible. Success in these areas will reinforce business and consumer sentiment and attract more private investment in both the financial markets and the real sector.
As a result, despite an uncertain global environment, investment should be up significantly this year. Consumer buying power should hold up. Job creation should increase and overall GDP growth is very likely to meet if not exceed the government’s target of 6.8 percent.
The writer is the founder of CastleAsia, past president of the American Chamber of Commerce and founding Chairman of the International Business Chamber in Indonesia.
