Taimur Baig, Singapore
The Indonesian economy steps into 2008 with strong momentum. Buoyed by supportive policies, a largely favorable export environment, and strong consumption and investment sentiment, economic growth has accelerated in the first three quarters of 2007, and was on track to expand by over 6 percent for last year.
This would be an outcome of note, as it would mark the fastest growth rate seen in this decade. Indonesia appears to be emerging from the shadow of the financial crisis of the late 1990s and displaying considerable intrinsic strength.
The critical question for Indonesia is whether the growth momentum will be maintained in 2008 in the face of several external risks.
First, as developed economies slow down (primarily due to housing-led difficulties), export performance will likely weaken in 2008.
Second, if world oil prices remain high, fiscal policy will be constrained as subsidy demand soars, and if the subsidy burden becomes onerous, and oil prices are passed through, inflation may rise.
Third, the exchange rate could come under pressure if investors become weary of their exposure to Indonesia as inflation rises and export oriented businesses are impacted by waning external demand.
For growth to be sustained in 2008, domestic demand has to compensate for a likely slowdown in exports. We see a number of signs that this could indeed be the case.
First, private consumption should remain strong in the midst of strong consumer sentiment and favorable employment conditions.
Second, the government’s ambitious expenditure program in 2008 — especially in the areas of development and capital spending — should provide strong impetus through rising public consumption and job creation.
Third, strong domestic and external interest in investing in Indonesia’s resource economy should persist, especially as liquidity conditions are likely to remain favorable.
The prevailing strength in employment and income conditions has boosted consumer confidence. Since dipping sharply in 2005 when inflation spiked due to a substantial domestic oil price adjustment, surveys have reported a steady increase in confidence on the perception of overall economic conditions. Bank Indonesia’s consumer confidence survey reported its highest reading in a year in November. We expect the reading to remain high in the coming months, underpinning consumption and business activities.
Business activities are on an upswing. According to the survey of business activities, broad based improvement has been continuing since late 2006 in the growth critical areas of agriculture, mining, financial services, and manufacturing. Momentum in these types of activities should persist short of a major economic shock.
Bank Indonesia has made significant progress in recent years with respect to monetary policy implementation, including the adoption of an inflation target framework in 2005. Since then, the central bank’s track record has been mostly positive, especially in late 2005 and 2006 when the policy interest rate had to be kept at a high level as inflation spiked. How the bank tackles inflation in 2008 will be a significant test, given the various challenges ahead.
First and foremost among these challenges is to control inflation expectations at a period when domestic demand is very strong. Inflation bottomed out in the middle of 2007 and has since risen appreciably. While a sharp resurgence in food price inflation has been the most striking factor in inflation picking up since then, strong demand has been pushing up most prices, leading to a generalized trend increase in core prices. Indeed, core inflation has continued to rise unabated since June.
Fueling additional actual and expected inflation has been a sustained rise in world oil prices. Being a large importer of refined oil products, Indonesia spends a substantial amount of resources (both in terms of subsidies and administration) by keeping fuel prices controlled in most parts of the economy. If world oil prices remain high, there could well be a point when the authorities are forced to pass on some of the prices, which may then lead to a jump in inflation.
Our analysis, drawing on the experience from the 2005 price hike, suggests that a 10 percent increase in domestic fuel prices can add as much as 2.5 percent to headline inflation. As 2008 progresses, movements in world oil prices will remain the principal driver of inflation expectations in Indonesia.
The central bank is on record that it is comfortable with real interest rates between 1 percent and 2 percent. Real rates are toward the bottom of the central bank’s comfort zone (after the December rate cut), while growth has accelerated. Any further decline in the real rate could exacerbate inflationary impulses. We don’t expect BI to cut its policy rate any further.
We expect broad based inflation pressure to persist in 2008. Hence our baseline inflation forecast is 6.5 percent, i.e. we expect the central bank’s inflation target of 4-6 percent to be breached. We also consider that the risks to the inflation outcome are skewed to the upside.
Oil prices and strong domestic demand could push up prices further during the course of the year. Some downside risks to inflation could materialize too, if the exchange rate appreciates, if productive investments made recently begin to help capacity, and if the economy slows down in response to a sharper slowdown in global growth.
Lately, as world oil prices have surged, the focus of fiscal policy has shifted from much needed priority expenditure to financing the increase in energy subsidies. The deficit outlook for 2008 is subject to some uncertainty due to surging oil prices.
A presentation by the concerned ministries in late-November revealed the seriousness with which the government is examining the potential impact of oil prices on the fiscal position. We found the multiple scenario analysis of the fiscal risks and mitigating measures presented by the authorities informative and transparent.
Nevertheless, our projection for 2008 is for the deficit to be somewhat worse than the 1.7 percent of GDP expected by the authorities. Given the very large increase in expenditures planned for the year (e.g. social plus capital spending are programmed to rise by 42 percent), we are sure that there will be room available for savings on the spending side, but given the run-up to the 2009 election, the scope for that may be limited.
Our baseline forecast for the 2008 fiscal outcome, built on our in-house average oil price projection of around US$75 and the above discussed factors, is for the deficit to rise to 2 percent of GDP. If oil prices jump to $100 and full subsidies are maintained along with some mitigating measures, the deficit would worsen by another half percentage point of GDP. A partial pass-through could reduce the deficit, but that would be accompanied by increased inflation and possibly a slowdown in economic activities.
All in all, in 2008, Indonesia’s policy makers will find themselves balancing rising domestic demand impulse against strong price pressure and waning external demand.
We see the authorities as capable of performing this balancing act, through careful monitoring and policy action, if necessary, to ensure that inflation does not accelerate in the face of strong domestic demand, or the fiscal position is not undermined by rising subsidies demands.
The writer is a director at Global Markets Research, Deutsche Bank. This is a personal view.
