Indonesia at a Glance: 2001-02

COUNTRY REPORT

Indonesia At a glance: 2001-02

OVERVIEW President Abdurrachman Wahid’s gamble of replacing his “rainbow” cabinet with a new cabinet of party loyalists in the aftermath of the August session of the People’s Consultative Assembly has paid off in the short term by allowing him to consolidate his position. Over the longer term, however, his decision to leave out representatives of other major political parties runs the risk of antagonising important players. Another, more determined attempt at impeachment within the forecast period cannot be ruled out. Strong export growth and a hesitant recovery in the domestic economy will push GDP growth close to 4% this year, and the rate of expansion will further accelerate in 2001-02. Strong export growth will push up the merchandise trade surplus over 2001-02, but a more rapid increase in the income deficit will erode the current-account surplus. The decision to raise fuel prices and civil service salaries in October will push up consumer price inflation in 2000-01, but this will moderate in 2002. Key changes from last month Political outlook • President Wahid sacked chiefs of both the army and navy on October 9th, replacing them with their deputies. But this decisive act should not be taken as evidence that the political accommodation between the president, his vice-president and the MPR will be effective in the long term. Economic policy outlook • The government annoyed the IMF in early October by postponing the sell-off of stakes in two major banks. The IMF has also questioned a debt restructuring deal, but relations will recover. The draft 2001 budget was released at the start of October. This includes plans for a further cut in fuel subsidies, and for raising excise duties, notably on cigarettes. Economic forecast • Evidence of sustained export growth has led us to edge up our 2000 GDP growth forecast to 3.8%. September consumer price inflation data was consistent with our existing forecast of a year-end inflation rate of 8.5% this year.

October 2000

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Outlook for 2001-02

Political outlook

Domestic politics The new system of executive government introduced after the two-week annual session of the People’s Consultative Assembly (Majelis Permusyarawatan Rakyat, MPR) that began on August 7th appears to be working better than expected. Early fears that President Abdurrachman’s decision to appoint only his own party loyalists to his new cabinet and exclude representatives from other parties would prompt an escalation of political opposition have not been borne out—so far.

The decision to cede the day-to-day running of government to vice-president Megawati Sukarnoputri with the support of the two new co-ordinating ministers, the economics minister, Rizal Ramli, and the security minister, Susilo Bambang Yudhoyono, also appears to be bearing fruit. Although Mr Abdurrachman is continuing to test the limits of the restraints placed on him by this agreement, inter alia by taking unilateral decisions on the appointment of senior police and military officers (he dismissed both army and navy chiefs on October 10th), the embryonic system of checks and balances imposed on him by this new system has reduced policy-making volatility.

Numerous problems nevertheless remain. The new cabinet is not free of the taint of corruption or cronyism. The powerful speakers of the two houses of parliament, Amien Rais and Akbar Tanjung, have begun to transform their parties, the National Mandate Party (PAN) and Golkar respectively, into opposition vehicles after they too were excluded from the cabinet. Mr Abdurrahman could easily clash with the military on such fundamental issues as tackling separatism and bringing soldiers accused of human rights abuses to account.

Meanwhile, the economy is still seriously ailing, separatist sentiment in Papua and separatist violence in Aceh are, if anything, on the rise, and the sectarian conflict in Maluku is raging out of control. Even at the centre, public discontent with the slow pace of legal action on the allegations of corruption and abuse of power against the former president Suharto are provoking continued street protests. At the same time, a spate of bombings, most recently in the Jakarta Stock Exchange Building on September 13th, are being ascribed to supporters of the former president.

To differing degrees, the economy, the regions and the security situation have slipped out of government control. To stand a chance of regaining control of the economy, the president will have to take a firm hand with key state institutions such as Bank Indonesia (the central bank), the Indonesian Bank Restructuring Agency (IBRA), the staples procurement agency, BULOG, and the courts. His team will have to handle the bumpy transition to greater regional autonomy over the next year. But more difficult still will be defusing separatism and sectarianism in the “outer islands”, where if any arm of government holds sway, it is the military. Partly because of its convincing

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claim to indispensability in these “security situations”, the military reform process appears to have stalled for now

International relations Mr Abdurrahman has seemed to be putting a higher priority on Indonesia’s relations with the US, the EU and Japan. The president’s frenetic travels since coming to power have tried to establish international confidence in his government, particularly in the influential capitals of the West and Japan. His efforts have paid off, and he is still generally perceived as Indonesia’s best hope for a successful democratic transition.

At the same time, however, anti-Western sentiment exists at all political levels in Indonesia, tapping into resentments over the handling of the 1997-98 regoional financial crisis and the “loss” of East Timor. As well as Australia, the US has also been increasingly criticised.

Economic policy outlook

Policy trends Over the next two years, monetary policy will remain mildly accommodating, as the desire not to undermine the recovery and add to the government's already heavy debt-servicing burden outweigh other considerations. Despite higher than previously expected oil prices, the government's room for fiscal manoeuvre will remain limited. The economy’s prospects will therefore depend heavily on the success of the bank and corporate restructuring programmes, something which the draft 2001 budget released in October, recognises. Corporate restructuring is expected to benefit from the more flexible approach to debt settlement now being encouraged by the IMF and the World Bank. But bank lending is expected to continue to be severely constrained by relatively high interest rates and caution about lending to the still-weak corporate sector.

Fiscal policy The assumptions underlying the budget for 2000 (which covers only the nine months from April to December 2000 in order to allow a change to a calendar year period in 2001) will clearly not be met. The government budget was in fact in surplus in the first six months of fiscal year 2000, but his was due to severe underspending; a deficit is forecast for the full fiscal year, but this will narrow in 2001.

The budget has for some time also looked overoptimistic in some of its revenue projections, particularly those from asset disposals by the Indonesian Bank Restructuring Agency (IBRA), privatisation and state enterprises’ dividend payments. The likelihood of these targets being met was further reduced by a parliamentary decision on October 5th (to the annoyance of the IMF) to delay indefinitely the government’s sale of two of the largest banks under the control of IBRA, PT Bank Central Asia and PT Bank Niaga, owing to the unfavourable market environment, which will make it difficult for the government to obtain an acceptable price for these assets. Similarly, the revised 2000 budget’s estimates of the cost of bank recapitalisation, based on the assumption of stable interest rates and strong investor interest in buying into the banks, also look unlikely to be attained.

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However, the budget’s oil price assumption of US$20/barrel now looks certain to be an underestimate, and its budgetary impact in rupiah terms will be boosted further by the weakness of the national currency. Similarly, the weak rupiah will also raise the local value of the Indonesian government’s foreign aid receipts. On the other hand, however, it will raise the cost of the fuel subsidy required to limit the increase in oil product prices to the 12% envisaged in the budget, which came into effect on October 1st amid only limited public protests. In addition, the weak rupiah will raise interest costs, and the greatest constraint on spending over the next two years will continue to come from the servicing costs of the ballooning government debt, estimated to absorb close to 40% of total government expenditure.

The 2001 budget, presented to parliament at the start of October, calls for a reduction in the overall deficit from 4.8% of GDP in the current year to 3.7% in 2001. Interest payments on foreign debt and bonds issued to recapitalise the ailing banks will constitute the largest item of expenditure, amounting to some 5.5% of GDP. Almost the same amount of public revenue, equivalent to 5.3% of GDP, will be transferred to provincial governments under a fiscal decentralisation programme intended to quell the rising separatist tide in the provinces.

As in the previous year, the main casualty of the required cutbacks is likely to be public investment. In order to minimise the cost of subsidies, the government is also proposing to raise fuel prices by a further 20% in April 2001. The remaining deficit of Rp52.12 trillion is to be covered by foreign assistance.

Monetary policy Rising global interest rates, the weak rupiah and the tight monetary targets agreed with the IMF will all exert upward pressure on domestic Indonesian rates. Recognizing the threat to economic recovery posed by such a rise in interest rates, which will threaten the return to health of Indonesia’s banking and corporate sector, as well as increasing Indonesia’s already-heavy domestic debt-servicing obligations, the monetary authorities will seek to limit interest rate increases to the absolute minimum necessary to maintain economic stability. The real impact of the rise in nominal interest rates will be further alleviated, moreover, by the expected acceleration in inflation due to such cost- push pressures as the gradual reduction in consumer subsidies.

Economic forecast

International assumptions The global environment will be generally favourable for Indonesia over the next two years. The Japanese economy will gradually pick up momentum; the EU will still continue to expand at around its trend rate despite some moderation of growth next year; and the recovery that got under way in North-east and South-east Asia in 1999 will be consolidated. These underlying strengths will be reflected in rapid world trade growth and the bottoming out of prices for manufactured exports and commodities. Average oil prices in 2000 (Brent) are now expected to rise by 62% on their 1999 level, before falling back by about 12% in 2001. Rising interest rates, to take some steam out of the US

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and EU economies, will affect Indonesia’s own domestic rates as well as its capacity to tap international capital markets.

International assumptions summary (% unless otherwise indicated) 1999 2000 2001 2002 Real GDP growth World 3.5 4.9 4.2 4.1 OECD 2.9 4.1 3.1 2.7 EU 2.3 3.4 3.0 2.6 Exchange rates (av) ¥:US$ 113.9 106.7 104.0 102.0 €:US$a 0.939 1.072 1.058 0.952 SDR:US$ 0.731 0.768 0.775 0.738 Financial indicators ¥ 2-month private bill rate 0.27 0.26 0.43 0.98 US$ 3-month commercial paper rate 5.18 6.40 6.55 5.25 Commodity prices Oil (Brent; US$/b) 17.9 28.9 25.4 19.4 Gold (US$/troy oz) 278.8 283.2 275.0 270.0 Food, feedstuffs & beverages (% change in US$ terms) –18.6 –6.1 4.2 10.4 Industrial raw materials (% change in US$ terms) –4.3 14.9 8.7 2.3

Note. Regional aggregate GDP growth rates weighted using purchasing power parity (PPP) rates. a Ecu before 1999.

Economic growth In the first half of 2000 GDP grew by 3.7% year on year, as second-quarter growth accelerated to 4.1% from 3.2% in the first quarter. Based on these trends, the finance minister raised the government’s initial growth forecast for the current year from 3.8% to 4.9% in late September. However, the EIU does not expect GDP growth to continue to accelerate in the second half, partly because the second half of 1999, when the recovery began, provides a relatively high base, and partly because investment growth is unlikely to be sustained at its first-half rate. Continuing political instability will deter foreign investors, while the combination of a weak rupiah, high real interest rates and accelerating inflation will abort the recovery of credit growth. However, due to evidence of sustained export growth in recent months, we have eased up our forecast of GDP growth in 2000 from 3.4% to 3.8%. On the back of strengthening domestic demand, GDP growth is then forecast to rise to 5.6% in 2001 and 5.7% in 2002.

In the second quarter, consumption growth, which returned the overall economy to growth in the second half of 1999, lost more of its momentum, confirming the view that the consumption-led recovery could not be sustained. However, encouragingly, the two expenditure components that provide the key to a sustained recovery, investment and exports, both expanded very strongly. Exports recorded their third successive quarter of real growth and investment growth accelerated sharply, after expanding for the first time since mid-1997 in the first quarter. The weaker rupiah will continue to boost export volumes in the second half, but persisting doubts about political stability will pull down fixed investment growth. On the production

side, we now expect agriculture to contract as a result of the sector’s structural problems, which are related to the squeeze on agricultural credit and disruption to estate and forestry production caused by social unrest in the outer islands. However, we continue to expect manufacturing growth to pick up to 7% in 2000, thanks to export growth.

Forecast summary (% unless otherwise indicated) 1999a 2000b 2001c 2002c Real GDP growth 0.3 3.8 5.6 5.7 Industrial production growth 25.1 7.5 7.5 7.9 Gross agricultural growth 2.1 –2.0 2.5 2.4 Unemployment rate (av) 17.5 13.0 9.5 9.0 Consumer price inflation Average 20.5 3.9 7.8 7.6 Year-end 1.9 8.5 7.5 8.2 Short-term interbank rate 27.7 22.0 21.0 19.0 Government balance (% of GDP) –3.9 –4.3 –4.0 –3.4 Exports of goods fob (US$ bn) 51.2b 61.5 68.0 74.7 Imports of goods fob (US$ bn) 30.6b 35.6 41.5 47.0 Current-account balance (US$ bn) 5.8b 7.7 6.8 5.5 % of GDP 4.1b 4.8 3.9 2.9 External debt (year-end; US$ bn) 141.2b 139.6 145.1 145.9 Exchange rates Rp:US$ (av) 7,855.2 8,184.8 8,573.9 9,002.6 Rp:¥100 (av) 6,896.1 7,673.2 8,244.2 8,826.1 Rp:€ (year-end)d 7,117.6 7,464.4 8,876.2 10,009.1 Rp:SDR (year-end) 9,724.2 10,500.1 11,701.2 12,651.1

a Actual. b EIU estimates. c EIU forecasts. d Ecu before 1999. The weakness of the rupiah and accelerating inflation, fuelled by political uncertainty, cast a shadow over both economic restructuring and the prospects for the real economy in 2001-02. However, we do not expect interest rates to approach anything like the levels they reached in 1997-99or to have a similarly dampening effect on the economy. The prospect of a protracted period of political uncertainty continuing throughout the forecast period will dampen growth. Export growth will, as it was this year, be narrowly focused on those export-oriented manufacturers who enjoy access to working capital from suppliers and customers. Agricultural and mineral commodity exports will continue to be disrupted by credit shortages and local disputes.

Inflation In September 2000 year-on-year inflation was estimated at 6.8%, and we expect the rate to continue to pick up during the remainder of the year, to reach 8.5% in December. The fuel price increases provided for in the 2000 budget took effect in October. Though some attempts have been made to moderate their impact on the poor, the average 12% increase will have knock-on effects on the prices of items ranging from food to cement during the rest of the year. However, the sharpest jolt to inflation during the rest of the year and into 2001 will come from the effects of the fall in the rupiah, particularly on rice prices.

We still expect inflation to average just 3.9% this year, but it will rise to average 7.8% in 2001 and 7.6% in 2002.

Exchange rates Hopes that the political and economic uncertainties that had weakened the currency might lift after the People’s Consultative Assembly (Majelis Permusyarawatan Rakyat, MPR) session have not been realised. In early October the currency was trading around Rp8,850:US$1, 23% below the Rp6,685:US$1 peak it reached soon after Mr Abdurrahman’s election. The new co-ordinating minister for the economy, Rizal Ramli, hopes that the rupiah will stabilise at around Rp7,300:US$1 next year, but there is little the government can do to achieve that. Though it has talked of both as possibilities, it is not capable of enforcing capital controls or defending a currency peg. At best, the central bank will take greater efforts to monitor foreign-exchange movements in the hope of securing the repatriation of a greater share of export earnings. Although these measures may provoke a modest recovery of the rupiah’s exchange rate to some Rp8,300-8,400:US$1 by the end of the current year, we do not expect them to be able to prevent a further 5% depreciation of the rupiah’s annual average exchange rate next year, to Rp8,574:US$1 from this year’s annual average of Rp8,185:US$1.

External sector Indonesia’s current account has been in unaccustomed surplus since 1998 and is expected to stay in credit over the forecast period. However, whereas in 1998-99 the widening merchandise trade surpluses, which underlay the current-account surpluses, were the result of an import compression that was more severe than the decline in exports, the surpluses that are expected over the next two years will be based on a recovery in both export and import growth and earnings.

Over the next two years we expect that earnings from manufactures, which accounted for about two-thirds of pre-crisis export earnings, will be boosted by the easing of financial and other supply bottlenecks, revived by demand in Asian and other markets, and (in 2001-02) higher dollar prices. A sharp upturn in trade-related services payments in 2001-02 will be only partly offset by a halting revival of the tourism sector. Net income payments will also rise quite strongly as repatriated profits and dividends pick up. Although the country’s debt profile has shifted away from short-term private to longer-term public debt, much of which has been rescheduled since 1998, interest payments will also rise as a larger amount of existing corporate debt is restructured and private borrowing resumes on a modest scale. By 2001 we expect the current- account surplus to have fallen back to US$6.8bn, 3.9% of GDP, before falling further to US$5.5bn, 2.9% of GDP in 2002.

Editors: Graham Richardson (editor); Danny Richards (consulting editor) Editorial closing date: October 13th 2000 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule