Indonesia's Road to Growth

The nation's economy is strong, but the government must continue to watch for corruption, and infrastructure must improve in order to reach growth targets

by Rupert Walker

After the bombings at the Marriott Hotel in Jakarta in 2003 and the Australian embassy the following year, security checks were introduced at major foreign-owned commercial and consular premises. They included car examinations and then a body frisking. Perhaps surprisingly, five years later, they still take place. It might also be a sign that the Indonesian authorities mean business, and intend to persevere with their goal to reform the country's economy and even its behaviour.

Prakriti Sofat, Indonesia economist at HSBC, writes that "the Indonesian economy is enjoying its strongest and most sustained period of growth since before the dark days of the Asian crisis a decade ago". Nor does he anticipate much that could go badly wrong. Domestic demand has been boosted by interest rate cuts of 475bp since May 2006 and an expansionary budget earlier this year, which raised public sector wages and development spending. Foreign direct investment reached a record $10.3 billion in 2007, up from $6 billion in the previous year.

Indonesia's trade exposure to the US is among the lowest of Asian countries, and the current account surplus in the final quarter of last year was a healthy 2.9% of GDP. But although Indonesia is a leading exporter of LNG and its gas balance is comfortably in surplus, its oil production has been falling partly due to poor investment, and its import bill has consequently risen.

The authorities are focusing more on achieving its growth target of 6.8% rather than the central bank's 4% to 6% inflation objective. But, two-to-three-million people are entering the workforce every year so 6% GDP growth is not enough. Unemployment is at 9% to 10% and rising, and is probably under-stated because of under-employment, points out a Jakarta-based analyst.

A 1% fiscal deficit might increase to 2% because of oil and gas subsidies. Official estimates put the cost at Rp160 trillion ($18 billion) this year—more than 3% of GDP, but the figure is based on an unrealistic average oil price of $83. However, few expect the subsidies to be reduced ahead of the 2009 election.

Yet, the country head of a European bank in Jakarta reckons that too much is being made of the effect of high oil prices and subsidies on the budget deficit. He argues that as a counter-balance, Bank Indonesia is getting monetary policy right by not cutting interest rates in step with US Fed Reserve - all in order to cap inflation and prevent the erosion of purchasing power.

HSBC estimates that each $1 billion cut in the subsidy would add 1 to 1.5 percentage points to inflation. The bank forecasts an average inflation rate of 8.5% this year. And inflation is a concern.

Bucking the trend of appreciating Asian currencies, the rupiah depreciated by about 4% against the US dollar last year—despite a widening current account surplus and higher earnings from its own commodity prices—and the country is vulnerable to higher food prices. The currency continues to be largely driven by portfolio flows, so could be further susceptible to repatriation as investors reduce their exposure to riskier equity markets. Bank Indonesia might be forced to raise interest rates in the second half of the year in order to cap inflation, but is likely to be constrained by the global outlook.

Corruption is still a temptation

Increased government scrutiny of companies should be a good thing. But in Indonesia, says one Jakarta-based commentator, it is not about policing and improving corporate governance but rather to identify opportunities for graft. A concomitant of economic prosperity is a more profitable corporate sector—and some government officials and civil servants, at the national and provincial level, are looking for ways to seize assets for personal gain. But if a company goes public, he says, it can acquire a shareholder list containing powerful foreign names, making it harder for local officials to steal assets or demand backhanders.

But another Jakarta-based banker provides a reality check, pointing out that any of the companies that defaulted on their debts after 1998 were publicly quoted. It's not that he's cynical.