INDONESIA: 2002 ECONOMIC TRENDS REPORT ---------------------- Summary & Introduction ---------------------- 1. The Megawati Administration made significant progress in stabilizing Indonesia's economy during its first year in office. It rejuvenated Indonesia's economic reform program and restored Indonesia's relationship with the IMF, which had deteriorated during the Presidency of former President Abdurrahman Wahid. From September 2001 to April 2002, the GOI pushed through several important economic reforms, including reducing fuel subsidies and selling a majority stake in Bank Central Asia, Indonesia's largest formerly private bank. In April 2002, the Paris Club of official creditors recognized the GOI's renewed commitment to economic reforms by agreeing to reschedule USD 5.5 billion in principal and interest payments falling due from April 1, 2002 to December 31, 2003. 2. The markets responded positively to the GOI's improved policy performance. Indonesia maintained positive GDP growth through the world economic slowdown in 2001, with year-on-year (YoY) GDP growth bottoming out in the fourth quarter of 2001 at 1.6 percent, and first and second quarter 2002 GDP growth figures exhibiting signs of a strengthening economy. GDP grew 3.51 percent YoY in Q2 2002, improving on first quarter YoY growth of 2.47 percent. Higher spending by government and consumers, up 9.4 and 6.3 percent YoY respectively, drove growth. 3. Despite the uncertain international environment, Indonesia's export performance began recovering in the first half of 2002 from its Q4 2001 low. Non-oil and gas exports showed back-to-back increases in Q1 and Q2, with exports in the latter quarter 18.6 percent above their levels in Q4 2001. Increased political stability and more decisive monetary policy performance by Bank Indonesia (BI) led the rupiah to appreciate over 14 percent through the end of August 2002, stabilizing near the Rp 8,800/USD level. During the same period, YOY CPI inflation rates fell from a two-and-a-half year high of 15.1 percent in February 2002 to 10.6 percent in August. 4. The Government's FY 2002 budget implementation was on track through the first half of the year, with the full year deficit projected to fall slightly below the GOI's Rp 42.1 trillion target (equivalent to 2.5 percent of GDP.) In August 2002, the GOI unveiled a conservative Rp 354.1 trillion (USD 40.7 billion) draft FY 2003 budget that forecasts a Rp 26.3 trillion deficit, equivalent to 1.3 percent of projected 2002 GDP. In recognition of the GOI's improving fiscal position, several international rating agencies upgraded Indonesia's sovereign ratings in August and September 2002. -------------------------------------- GDP Growth: Future Prospects Uncertain -------------------------------------- 5. Despite the Megawati Administration's success in stabilizing the economy, concerns mounted in 2002 about Indonesia's short and medium-term GDP growth prospects. Indonesia's YoY GDP growth rates have remained in the 3-3.5 percent range since the beginning of 2001, with few signs of take-off to the 7.2 percent average GDP growth Indonesia experienced from 1990-96. A sustained period of strong economic growth and low inflation would give the GOI much needed room to consolidate its recovery from the 1997-98 financial crisis, reach a balanced budget, further reduce the country's debt/GDP ratio, and continue corporate restructuring. 6. With household consumption already growing more than six percent a year and the outlook for robust export growth clouded by an uncertain world economy, reviving business investment is the key to restoring GDP growth to pre-crisis levels. However, investment statistics through the first eight months of 2002 were very weak. Foreign investment approvals declined 39 percent from the same period in 2001 to USD 3.55 billion. The 39-percent decline came on the back of a 42 percent decrease in foreign investment approvals in 2001. Provisional balance of payments (BOP) statistics for 2001 indicate that while Indonesia's private capital deficit narrowed from its 2000 level, net foreign investment remained strongly negative during the year at USD -5.9 billion. 7. Analysts cite a number of factors contributing to Indonesia's prolonged business investment slump. These include slowing structural reforms, rapidly rising labor costs, the lack of an efficient and transparent legal system, widespread official corruption, signs of impending infrastructure shortages, uncertainties stemming from Indonesia's decentralization program, and competition from other labor-intensive economies in Asia, especially China and Vietnam. Although the GOI has held dialogues on doing business issues with domestic and international business groups, through mid-2002 it made little progress in formulating and implementing a meaningful reform program that would encourage potential investors. Focusing on improving Indonesia's investment climate has emerged as the GOI's top short-term policy challenge. ------------------------------ Implications for U.S. Business ------------------------------ 8. Despite the many challenges facing the GOI, Indonesia retains most of the advantages that fueled rapid economic growth during the 1980s and early 1990s. These include generally adequate infrastructure, ample natural resources, an adequately trained work force, a strategic geographical location in the heart of South East Asia, and a large and expanding internal market of approximately 220 million people. These factors will remain attractive for many U.S. firms, particularly if the GOI makes significant headway on the policy issues described above. ---------------------------------- GDP Growth: A Tentative Expansion ---------------------------------- 9. Economic growth picked up moderately in the first two quarters of 2002, improving chances that the GOI will achieve its 4-percent growth target for the year. According to Central Bureau of Statistics (BPS) figures, GDP grew at 3.51 percent YoY in the second quarter of 2002 after expanding 2.47 percent in Q1. Rising government and consumers spending, up 2.3 and 1.2 percent respectively from Q1 levels, drove growth in the second quarter 2002. Consumer spending continued its post-1999 pattern of strong growth reaching 5.9 percent for 2001. YoY Household consumption grew 9.9 percent in the first quarter 2002 and grew 6.3 percent in the Q2 2002 compared with Q2 2001. On the production side, growth was fairly evenly spread in the first two quarters, with manufacturing, transportation and communications, and retail, hotels, and restaurants showing the most consistent growth. 10. Indonesia's quarterly YoY GDP growth rate has increased in three consecutive quarters since Q4 2001, when growth bottomed out at 1.6 percent. Table 1 outlines Indonesia's Q2 2002 real GDP performance by production and expenditure category: ------------------------------------------------- Table 1: Indonesian Real GDP, Q2 2002 vs. Q2 2001 ------------------------------------------------- A. By Production Category - Percent Change - Q2 Q2 Share Production Category 2002 vs. 2001 of GDP ---------------------------------------------------- Manufacturing 2.5 25.8 Agriculture 6.3 17.9 Retail, Hotel, Restaurant 3.7 16.5 Mining 1.8 12.5 Services 0.4 8.2 Finance and Leasing 2.6 6.2 Construction 2.4 5.6 Transportation and Comm. 8.2 6.0 Electricity, Gas, Water 4.7 1.3 ---------------------------------------------------- Total (categories weighted) 3.5 100.0 B. By Expenditure Category - Percent Change - Q2 Q2 Share Expenditure Category 2002 vs. 2001 of GDP ----------------------------------------------------- Household Consumption 6.3 70.0 Government Expenditure 9.4 6.9 Investment -1.0 19.1 Exports -7.1 34.0 Change in Stock --- -4.8 Imports -21.6 -25.0 ----------------------------------------------------- Total (categories weighted) 3.5 100.0 Source: Central Bureau of Statistics (BPS). --------------------- Exports: Bottomed Out --------------------- 11. When measured in dollar terms, Indonesia's exports in the first half of 2002 fell 6.7 percent to USD 27.3 billion compared to the same period in 2001. Non-oil and gas exports declined 2.7 percent to USD 21.5 billion during the first half of 2002, while oil and gas exports fell 19.5 percent to USD 5.63 billion. Second quarter 2002 non-oil and gas exports remain 10.8 percent below their post-crisis peak in Q3 2001. However, YoY growth figures disguise a modest export recovery since the final quarter of 2001, when total exports fell to their lowest level in more than three years. Non-oil and gas exports rose in both Q1 and Q2, with exports in the latter quarter 18.6 percent above their levels in Q4 2001. Total exports topped the USD 5 billion monthly in both June and July 2002 for the first time since August 2001. 12. Table 2 outlines Indonesia's post-crisis quarterly export performance. --------------------------------------------------- Table 2. Indonesia: Post-Crisis Export Performance --------------------------------------------------- | | | YoY Oil/ | Non- | |Percent Change(2) Quarter Gas(1)|Oil/Gas(1)|Total(1)|(Non-Oil/Gas) --------------------------------------------------- 97-Q3 2.7 11.3 14.0 16.5% -Q4 2.9 11.0 13.9 12.2% 98-Q1 2.3 10.0 12.3 17.6% -Q2 1.8 10.3 12.1 -12.7% -Q3 1.9 10.8 12.7 -4.4% -Q4 1.9 9.7 11.6 -11.8% 99-Q1 1.9 8.3 10.1 -17.0% -Q2 1.9 9.6 11.5 -6.8% -Q3 2.8 10.5 13.3 -2.8% -Q4 3.2 10.3 13.5 6.2% 00-Q1 3.3 10.8 13.9 30.1% -Q2 2.1 12.0 14.1 25.0% -Q3 2.3 12.9 15.2 22.9% -Q4 4.7 12.0 16.7 16.5% 01-Q1 3.9 10.9 14.8 0.9% -Q2 3.2 11.2 14.4 -6.7% -Q3 3.0 11.3 14.3 -12.4% -Q4 2.6 9.7 12.3 -19.2% 02-Q1 2.7 10.0 12.7 -8.3% -Q2 3.0 11.5 14.5 2.7% (1) USD billions. Source: BPS. (2) YoY percentage change of non-oil and gas exports, an indicator of manufacturing performance. 13. Indonesia's export mix remains predominantly low technology manufactured goods and commodities. Manufactured goods represent approximately two-thirds of total exports. Given continuing economic uncertainty in Indonesia's export markets, many analysts forecast flat full-year export performance in 2002. ---------------------------- Uncertain Prospects for 2003 ---------------------------- 14. Given recent growth trends, most economists are forecasting full year 2002 GDP growth rates of 3.5-4.0 percent. The GOI forecast 2003 GDP growth of 5.0 percent in its FY 2003 draft budget. However, with household consumption already growing more than six percent a year and the outlook for robust export growth clouded by an uncertain world economy, reaching the 2003 target will require a significant revival in business investment. Many economists have stated that the GOI's 5-percent target is too high given the lack of evidence to date of an expansion in investment. 15. Indonesia needs a sustained period of strong economic growth and low inflation in order to consolidate its recovery from the 1997-98 financial crisis. A period of robust economic growth would give Indonesia's troubled corporate and banking sectors room to recover and restructure their operations along more efficient lines. Equally importantly, a period of sustained GDP growth would provide employment opportunities to Indonesia's millions of unemployed and under-employed workers. 16. Economists calculate that Indonesia's labor force is increasing by 2.2 - 2.7 percent a year, a growth rate equivalent to 2 - 2.5 million new job seekers each year. The National Development Planning Agency (BAPPENAS) in turn estimates that 4 percent GDP growth translates into an increase in the demand for labor of 2.4 percent, or 2.2 million new job opportunities per year. These figures make it clear that in order to re-employ large numbers of workers who lost their jobs during the 1997-98 crisis and absorb new labor market entrants, Indonesia needs a sustained period of GDP growth well above 4 percent. -------------------------------------------- Monetary Indicators: Significant Improvement -------------------------------------------- 17. Increased political stability after President Megawati assumed office coupled with more decisive monetary policy by BI led to significant improvements in Indonesia's monetary indicators during the first eight months of 2002. YoY base money growth declined rapidly from its September 2001 peak of 24.6 percent, reaching single digits by May 2002, and Indonesia has consistently met its IMF base money targets in 2002. At the same time, the rupiah appreciated 14.4 percent through August 2002 from its year-end 2001 level, stabilizing near or above Rp 9,000/USD for much of the second quarter. 18. CPI inflation continued to edge downward from its February 2002 YoY peak of 15.03 percent, declining to 10.05 percent YoY in July from 11.48 percent in June. Most economists believe the GOI stands a chance of reaching its YoY CPI inflation budget target of 9 percent. The appreciating rupiah played a key role in bringing down CPI inflation: approximately one-quarter to one-third of changes in the CPI index can be traced to the "pass through" effect from changes in the value of the rupiah. 19. Improving monetary indicators gave Bank Indonesia scope to begin reducing interest rates in January 2002, after raising interest rates on Bank Indonesia Certificates (SBIs) more than 500 basis points since June 2000 in an effort to control inflation and defend the value of the rupiah. BI's effort to drive down interest rates gathered steam after March 2002, and by the end of August, SBI rates had fallen over 320 basis points from their year-end levels, to 14.35 percent. Table 3 presents more detailed information on Indonesia's recent monetary indicators. ----------------------------------------------------- Table 3: Indonesia: Recent Financial and Monetary Indicators (Source: BI) ----------------------------------------------------- |Base |CPI(2) |Rupiah/USD| SBI(4) Month |Money(1) |Inflation| XR(3) |Int. Rate ----------------------------------------------------- Jan. 2001 17.7% 8.28% 9,450 14.74 February 18.0% 9.14% 9,835 14.79 March 16.1% 10.62% 10,400 15.58 April 20.6% 10.51% 11,675 16.09 May 18.3% 10.82% 11,058 16.33 June 17.0% 12.11% 11,440 16.65 July 17.3% 13.04% 9,525 17.17 August 20.9% 12.23% 8,865 17.67 September 24.6% 13.01% 9,675 17.57 October 19.0% 12.47% 10,435 17.58 November 19.1% 12.91% 10,430 17.60 December 11.9% 12.55% 10,400 17.62 Jan. 2002 11.8% 14.42% 10,320 16.93 February 13.7% 15.13% 10,189 16.86 March 12.7% 14.08% 9,655 16.76 April 10.8% 13.30% 9,316 16.61 May 9.0% 12.93% 8,698 15.51 June 8.6% 11.48% 8,730 15.11 July 6.7% 10.05 8,716 14.93 August 5.3% 10.60% 8,890 14.35 (1) Source: BI. YoY growth rate of base money. (2) Source: BI. YoY growth rate in CPI inflation. (3) Source: BI. End-month BI middle exchange rates. (4) Source: BI. End-month interest rate for one-month Bank Indonesia Certificates (SBIs). -------------------------------------- No Turnaround in Private Capital Flows -------------------------------------- 20. Preliminary balance of payments data for 2001 show a continuation of Indonesia's post-crisis pattern of large current account surpluses coupled with continuing capital account deficits. In the four years preceding the crisis (1993-96), net private capital inflows averaged USD 7.7 billion per year (see Table 4), or an average of over 4 percent of GDP. In 1997 this pattern reversed as imports and foreign investment (portfolio and direct) collapsed, resulting in average net capital flows of a negative USD 6.05 billion per year from 1998-2001. 21. Indonesia's exports fell 25 percent in 2001 from their record highs a year earlier. Coupled with a smaller reduction in imports, the decline in exports led to deterioration in the current account surplus from USD 8.0 billion in 2000 to an estimated 5.0 billion in 2001. The capital account deficit increased over the same period from USD -6.8 to -8.9 billion. According to BI, two factors led to the deterioration in the capital account: a large decrease in net official capital inflows (largely the result of a slowdown in drawings of program loans offered by the Asian Development Bank, World Bank, and Japan), and continued negative net foreign investment flows. ---------------------------------------------------- Table 4. Indonesia: Summary Balance of Payments Information (USD Billions, Source: BI.) ---------------------------------------------------- Year 94 95 96 97 98 99 00 01(2) ---------------------------------------------------- Current Account -3.0 -6.8 -7.8 -5.0 4.1 5.8 8.0 5.0 Trade Balance 7.9 6.5 5.9 10.1 18.3 20.6 25.0 21.6 Capital 4.0 10.6 11.0 2.5 -3.9 -4.6 -6.8 -8.9 Account Private 3.7 10.3 11.5 -0.4 -13.8 -9.9 -10.0 -8.6 FDI(1) 2.1 4.3 6.2 4.7 -0.4 -2.7 -4.6 -5.9 Other 1.6 5.9 5.3 -5.0 -13.5 -7.2 -5.4 -2.7 Official 0.3 0.3 -0.5 2.9 10.0 5.4 3.2 -0.3 Errors/ Omiss. -0.2 -2.3 1.3 -1.7 2.1 2.1 3.8 2.6 Monetary Mvmt(3) -0.8 -1.5 -4.5 4.1 -2.3 -3.3 -5.0 1.4 (1) Foreign direct investment. (2) Preliminary data. (3) Monetary movement, minus (-) equals a surplus. ------------------------------------------ Indonesia's Official Debt: Modest Progress ------------------------------------------ 22. Indonesia's official debt burden increased from 27 percent of GDP prior to the financial crisis to approximately 100 percent of GDP at the end of 2000 (Table 5). Virtually all of the increase came in the form of the Rp 658 trillion (USD 74.8 billion) in bonds the GOI issued to domestic banks and BI to cover the costs of Indonesia's banking sector bailout. The budgetary burden of Indonesia's debt service payments is very heavy: the GOI forecasts that total interest payments will account for almost 35 percent of central government expenditures in 2002-03. Indonesia's debt burden has become politically controversial, with some commentators urging the GOI to repudiate the country's foreign debt or limit repayments to an arbitrary percentage of GOI revenues. The GOI has made reducing Indonesia's official debt a national priority. 23. A combination of continued GDP growth, the appreciation of the rupiah/USD exchange rate, and the depreciation of the Japanese yen vis-à-vis the U.S. dollar (one-third of the Indonesia's official debt is yen-denominated) resulted in a decrease in Indonesia's debt/GDP ratio in 2001 for the first time since the financial crisis. The IMF and other analysts have predicted that Indonesia's debt/GDP ratio will fall further in 2002 to an estimated 75 percent of GDP. The IMF estimates that if the GOI can maintain a balanced budget and achieve 5-percent GDP growth in 2004 and 6-percent GDP growth in 2005-7, Indonesia's debt/GDP ratio could fall below 50 percent by 2007. Key to achieving this result will be maintaining budget discipline. Also important will be finalizing an agreement in principle between the Government and Bank Indonesia to restructure the Rp 228 trillion of GOI bonds held by BI in compensation for losses on BI liquidity credits. -------------------------------------------------- Table 5: GOI Foreign and Domestic Debt, 1995-2001 (USD Billions) -------------------------------------------------- | | | | Debt/GDP Year | Foreign | Domestic | Total | Ratio -------------------------------------------------- 1995 63.5 0.0 63.5 31% 1996 56.3 0.0 56.3 25% 1997 57.9 0.0 57.9 27% 1998 67.3 0.0 71.5 72% 1999(1) 75.8 68.7 144.5 102% 2000(2) 74.8 78.0 152.8 100% 2001(2) 71.4 64.2 135.6 93% (1) 1999 domestic debt figure based on Rp 312 trillion in bank recapitalization bonds issued, plus Rp 228 trillion in bonds issued to BI, converted at the 1999 average exchange rate of Rp 7855/USD. (2) 2000-01 domestic debt figures based on Rp 430 trillion in bank recapitalization bonds plus Rp 228 trillion in bonds issued to BI, converted at the exchange rate of Rp 8430/USD for 2000 and Rp 10,255/USD for 2001. Source: Bank Indonesia. 24. In recognition of the GOI's continued budget discipline and the country's improving debt situation, several international rating agencies upgraded Indonesia in 2002. In August, Fitch Ratings upgraded Indonesia's long-term and short-term foreign currency ratings to B from B-. Fitch also upgraded Indonesia's long-term local currency rating to B. In September, Standard & Poor's upgraded Indonesia's long-term and short-term foreign currency ratings to CCC+ and C respectively. 25. In order to reduce the short-term budget burden of debt service costs, Indonesia has concluded three consecutive debt-rescheduling agreements with the Paris Club group of official bilateral creditors. In September 1998, the GOI and Paris Club agreed to reschedule USD 4.6 billion in principal payments falling due from August 1998 to March 2000. In April 2000, they concluded a similar agreement rescheduling USD 5.8 billion in principal payments falling due from April 2000 to March 2002. In April 2002, the GOI and Paris Club agreed to reschedule USD 5.5 billion in principal and interest payments falling due between April 1, 2002 and December 31, 2003. -------------------------------------------------- Short-Term Policy Challenges: Fostering Investment -------------------------------------------------- 26. The key challenge facing GOI policymakers in mid-2002 is taking advantage of Indonesia's hard-won macroeconomic stability to enact effective policies to boost business investment. Indonesia's investment performance has been poor in 2002: in the first eight months of the year, foreign investment approvals declined 39 percent to USD 3.55 billion from the same period in 2001. Realized foreign investment in 2001 reached only USD 70 million, indicating that approved investment--if it is ever realized--is spread out over a long time horizon, or may be exaggerated. Many Indonesian commentators have criticized the lack of dynamism in the "real economy," but the GOI's response to lagging business investment has been tentative. 27. Analysts generally agree that GOI progress in the following core areas would greatly increase the prospects for sustained and robust business investment in Indonesia: -- Legal and Judicial Reform: Foreign observers cite Indonesia's inefficient and opaque legal system as a major obstacle to attracting foreign investment. In a serious abuse of the bankruptcy law, in June 2002 the Jakarta Commercial Court declared bankrupt a local subsidiary of the Canadian insurance firm Manulife Financial, even though the Ministry of Finance declared it was solvent. Although Manulife's Supreme Court appeal was successful, few observers rule out the occurrence of similar cases in the future. Although the GOI has repeatedly recognized the importance of legal and judicial reform, it has moved very slowly and progress to date has been minimal. --Resolving Labor Problems: Back-to-back annual minimum wage hikes of 30 and 39 percent in Jakarta, coupled with similar rises in other major cities, have reduced Indonesia's competitiveness for labor-intensive manufacturing. Extremely generous severance pay provisions have further boosted labor costs. Labor activism has also increased significantly as Indonesia's labor unions adjust to a more democratic political environment. The GOI attempted to enact a new labor law in July 2002 to deal with these problems, but the draft law effort collapsed under opposition from both labor and business groups. --Reducing the Uncertainty from Fiscal Decentralization: Indonesia's ambitious fiscal decentralization program, implemented in January 2001, continues to create uncertainty for foreign investors, particularly in the mining and petroleum sectors. Many local governments have enacted taxes that discriminate against foreign investors and restrict internal trade. The Ministry of Home and Regional Affairs (MOHRA) and the Ministry of Finance (MOF) have been reluctant to nullify taxes that violate Indonesian laws or overly burden business or commerce. In addition, local governments now have the authority to approve investments in all areas except in the financial and petroleum sectors, which remain the preserve of the central government. Despite the transfer of investment approval authority, investment rules and procedures -- approval criteria for new investments, licensing arrangements, etc -- remain unclear. --Reforming the Banking Sector: The GOI completed its Rp 430 trillion bank recapitalization program in October 2000, but the banking sector remains fragile. Reports of solvency problems at a number of banks continued in 2002, including at six of the eleven banks owned by the Indonesian Bank Restructuring Agency (IBRA). Despite continuing management problems at state and IBRA-owned banks, the GOI's bank privatization program stalled after the April 2002 sale of Bank Central Asia. Re-privatizing the bulk of Indonesia's banks and ending the blanket GOI guarantee on bank liabilities is crucial for resuming commercial lending to the real economy and reducing the risk to the GOI's finances from potential bank failures. --Infrastructure bottlenecks: Indonesia has seen very little investment in infrastructure since foreign financing dried up in the wake of the 1997-98 financial crisis. Four years later, there are signs that the country's ports, roads, and other infrastructure are becoming overloaded. The problem is most acute in the area of electric power generation, and some experts predict power shortages in the Java-Bali grid by 2004. Although the GOI has announced the resumption of some projects suspended during the crisis, it has not developed a strategy for boosting infrastructure investment to pre-crisis levels. END-OF-REPORT