Survey of recent developments

Abstract

Two major elections and the increasingly severe global financial crisis (GFC) will dominate politics and economics in Indonesia in 2009. The parliamentary election will be held in April, followed by the presidential election in July. The public is now experienced at voting, and these events are expected to be peaceful and successful. The impact of the GFC is of much greater concern.

The economy continued to perform well in 2008. With quite robust economic growth, commendable progress with administrative reform in the finance ministry, and higher than expected oil prices, both tax and non-tax revenues significantly exceeded their 2008 budget targets, leaving the government with unspent funds in excess of Rp 50 trillion. The banking sector also performed well, with lending continuing to expand rapidly. However, there was a significant fall in average capital adequacy as banks took on more risky assets and wrote down their capital in response to falling bond portfolio values.

Signs of economic slowdown began to emerge in the second half of 2008, however. The collapse of the global financial services firm Lehman Brothers in September sparked massive sell-offs on stock exchanges and foreign exchange markets around the world, including in Indonesia. In the fourth quarter the disruption in the global economy finally hit Indonesia's real sector. General slowdowns were felt in both the tradable and non-tradable sectors, although the quarterly data were distorted by strong seasonal effects. The robust annual growth of non-oil and gas exports over the last four years came to an abrupt end in the fourth quarter, but the same was true of imports. Thus, although the GFC and a weak rupiah are likely to have a negative impact on export-oriented and high import content industries in 2009, potential balance of payments pressures are more likely to originate in the capital account than in the current account.

With a growing expectation that the GFC's impact would intensify, a wide range of fiscal, monetary, finance and trade policy packages were announced in recent months. Financial sector safety net policies were given high priority initially, with the primary aim of supporting the balance of payments rather than avoiding worker lay-offs. Subsequently, fiscal stimulus packages have been introduced, expanded and modified, and the official stance of monetary policy has become more expansionary. However, institutional shortcomings and political bottlenecks seem likely to constrain the effectiveness of these policies as a whole.

A YEAR OF ELECTIONS

Two sets of elections will be held in 2009. They will influence both the political landscape and government efforts to deal with the global economic slowdown, which is expected to worsen during the year. Elections for the national parliament (DPR), the national-level Regional Representatives Council (DPD) and regional parliaments (DPRDs) at provincial and local government levels will be held on 9 April. The presidential election will follow on 8 July (Table 1). Given the strong possibility that, as in 2004, no president–vice-president pairing will obtain more than 50% of first-round votes, a second round will be held on 8 September and the winning team inaugurated on 20 October. In total, around 44 political parties are competing for over 18,000 parliamentary seats at national and regional levels.1 Despite its length and complexity, another season of successful and peaceful elections is expected (Fatah 2009), given that Indonesians are now experienced voters. Over 100 elections have been held annually on average during the last five years, with the average individual voting in seven or eight separate ballots.2

TABLE 1. Election Timetable for 2009

Legislative elections
12 July 2008–5 April 2009	Campaign period, with open political rallies only in last three weeks
9 April	Election of members
9 May	Announcement of provisional results
15–24 May	Dispute resolution and announcement of final results
1 October	Inauguration of DPD, DPR and DPRD members
Presidential elections (subject to issue of formal decree by Elections Commission)
10 May–9 June	Registration of candidate president–vice-president pairings
1 June	Announcement of candidate president–vice-president pairings
12 June–5 July	Campaign period for first round
8 July	First-round election
25 July	Announcement of provisional results of first round
26 July–7 August	Dispute resolution and announcement of pairings for second round
1–4 September	Campaign period for second round
8 September	Second-round election
25 September–7 October	Dispute resolution and announcement of final results
20 October	Inauguration of president and vice president
Sources: National Election Commission (Decree 20/2008); Koran Tempo, 28 January 2009.

A number of changes in the election laws have been approved. First is the introduction of a ‘closed’ campaign period of about eight months, to precede the three-week period in which open campaign rallies may be held (as in the 2004 DPR elections). This lengthy campaign period is proving a boon to advertising agencies, media production houses and television stations, with several political parties buying considerable television air time. The second change relates to parliamentary and electoral thresholds. Only those political parties securing at least 2.5% of the vote can gain a seat in the DPR, and president–vice-president candidate pairings can only be nominated by a political party or parties securing at least 20% of DPR seats or at least 25% of the vote, compared with only 3% of seats previously.

These new measures are expected to limit the number of political parties in the parliament and of president–vice-president candidate pairings: had the 2.5% DPR threshold been introduced in the 2004 election, there would have been eight parties in the parliament instead of 16 (Fatah 2008). The tighter requirement for president–vice-president candidate pairings is likely to constrain the emergence of newcomer candidates relying on the support of newly established parties. It may also force President Susilo Bambang Yudhoyono and his Democrat Party to be more accommodative in securing the support of other political parties (especially the Golkar Party) in order to surpass the 20% electoral threshold. On the other hand, if the Democrat Party can exceed this threshold, the president will be freer than in 2004 to choose his own vice-presidential running mate, though he will still need to concern himself with maintaining majority support in the DPR.

In the 2004 DPR elections, members gained seats based on their party's internal candidate ranking rather than the number of votes they received, although candidates could circumvent the party ranking if they reached a full electoral quota. Article 214 of Law 10/2008, which governs procedures for electing DPR members, lowered that threshold to just 30% of an electoral quota, but the Constitutional Court annulled this stipulation in December 2008. The process is now much more transparent, such that seats won by each party are allocated in accordance with the number of votes obtained by its candidates. There has been some resentment of this decision, particularly because it reduces the opportunity for political parties to secure DPR seats for their preferred cadres and to implement affirmative action to increase the number of female members. On the other hand, many expect the new ruling to encourage more active campaigning and more explicit policy platforms.

MACROECONOMIC OVERVIEW

The economy maintained moderately high growth in 2008. However, by the fourth quarter (Q4) the rapidly accelerating downturn in important trading partner countries (particularly the US, Europe and Japan) and turmoil in global financial markets were beginning to have an impact. This became apparent with a rapid decline in prices on the Indonesia Stock Exchange, followed by significant disturbances in the bond and foreign exchange markets. But the negative impact on the real sector remained surprisingly mild until Q4. The most obvious explanations for this are that Indonesia's economy is less tied to world markets through international trade than those of some other Asian countries, and that the financial sector remained in fairly good shape after all the major banks were recapitalised in the late 1990s.

The suddenness of the plunge into recession of some major world economies leaves no room for complacency, however. The authorities have moved quickly to introduce policy responses designed to offset rapidly falling export demand and prevent collapse of the financial system. But seemingly straightforward textbook prescriptions for dealing with an unexpected decline in aggregate demand turn out to be not at all straightforward in reality. In Indonesia, as elsewhere, few policy responses are uncontroversial or unambiguously correct.

It is widely agreed that policy should try to stimulate aggregate demand in order to offset the sudden and probably continuing fall in demand for Indonesia's exports. Beyond that, opinions differ as to the relative efficacy of fiscal and monetary stimuli and, on the fiscal side, of additional government spending compared with tax reductions and transfers intended to boost private sector spending. The official responses so far suggest that the government is concerned to minimise not only the job losses and wage cuts that would result from declines in aggregate demand, but also any loss of international reserves or depreciation of the rupiah. It is by no means clear whether this second set of objectives is achievable or even makes good sense.

Assuming the government resists the temptation to strengthen controls on capital outflow or to impose additional barriers to imports, further reductions in international reserves seem inevitable, as does further depreciation. Moreover, depreciation would provide a boost to the producers of tradable goods and services, which is precisely what the government seeks to achieve through fiscal stimulus measures. Indeed, a flexible exchange rate acts as an automatic stabilising mechanism in response to declining export demand. In any case, the balance of payments impact of falling export demand should not be over-stated. Indonesia's exports have a high import content, so it is not surprising that declining export growth has been roughly matched by declining growth of imports. Providing high inflation can be avoided, therefore, it is by no means obvious that there will be major disturbance to the balance of payments from the current account.

The outlook for the financial sector is less clear. Both the stock market and the bond market have suffered severe declines in recent months. And although the official data suggest that the banks are in good shape, market participants appear to have serious reservations about the accuracy of these numbers. There are reports that smaller domestic banks and even some foreign banks are now finding it difficult to borrow in the inter-bank market–a sure sign of concern about their solvency. The authorities have responded to this by substantially reducing the minimum reserve requirement (thereby boosting liquidity) and by greatly increasing the size of guaranteed bank deposits (thereby reducing the likelihood of a run on the banks). Even so, the guarantee does not cover deposits above Rp 2 billion, which, although small in number, account for a large proportion of total deposits. It is precisely these large deposits that can be expected to be extremely sensitive to changing risk perceptions, so a run on the banks cannot be ruled out.

An unresolved policy issue is whether to extend the guarantee to cover all deposits and, if not, how to handle a bank run should it eventuate. Policy makers are mindful of the huge losses the general public incurred as a result of the blanket guarantee introduced in January 1998, and are understandably reluctant to go down this road again. Nonetheless, they are conscious that blanket guarantees have been introduced in other countries–including some of Indonesia's near neighbours–which increases the likelihood of a run. Related to this is the choice of response to potential further bursts of capital flight: ‘defend the currency’ by selling off international reserves; leave it to market forces to determine a new value for the rupiah; or impose controls on capital flows and barriers to imports. At the same time, choices need to be made about monetary policy. If the policy stance is expansionary (because of the perceived need to encourage private sector spending), liquidity may be used instead to finance purchases of foreign assets, resulting in even further declines in reserves or depreciation of the currency.

Growth

Given the severity of the global slowdown, the year-on-year growth rate of quarterly GDP remained remarkably strong in the last two quarters of 2008 (Table 2A). The economy expanded at an average rate of 5.8% p.a. in the second half, putting Indonesia among the fastest-growing emerging market economies in Asia. Signs of an economic slowdown emerged in the last quarter, however, when output declined by 3.6% (3.8% if the oil and gas sectors are excluded) (Table 2B). Exports fell in the face of accelerating downturns in key trading partner economies and a worsening of the terms of trade owing to rapidly declining prices of key commodities in world markets. But the contraction of exports was more than offset by a much larger contraction in imports, implying a positive impact of net exports on GDP. Investment spending grew very modestly in Q4, but its deceleration was more than offset by a huge jump in government consumption. This fortuitous outcome reflects a well-established pattern in which inefficient budgetary processes in government departments and agencies prevent budgeted spending from getting under way early in the year.

TABLE 2A. Components of GDP Growth (2000 prices;% year on year)

	Sep-07	Dec-07	Mar-08	Jun-08	Sep-08	Dec-08
Gross domestic product	6.6	5.8	6.2	6.4	6.4	5.2
Non-oil & gas GDP	7.0	6.5	6.7	6.9	6.9	5.6
By expenditure
Consumption	5.3	5.0	5.5	5.5	6.3	6.4
Private	5.1	5.5	5.7	5.5	5.3	4.8
Government	6.5	2.0	3.6	5.3	14.1	16.4
Investment	9.7	12.4	13.7	12.0	12.2	9.1
Of which:
Building construction	8.3	9.9	8.0	8.1	7.6	5.7
Machinery & equipment	25.2	30.5	39.6	24.3	24.5	15.7
Transport	−9.9	2.4	23.4	27.8	40.6	37.0
Exports	7.4	7.9	13.6	12.4	10.6	1.8
Imports	7.0	13.9	18.0	16.1	11.0	−3.5
By sector
Tradables	4.9	2.3	3.8	3.6	3.7	2.6
Agriculture, livestock, forestry & fisheries (ALFF)	7.7	2.0	6.3	4.8	3.4	4.7
Mining & quarrying	1.0	−2.0	−1.7	−0.5	2.1	2.1
Manufacturing	4.5	3.8	4.3	4.2	4.3	1.8
Excluding oil & gas	1.6	4.7	4.6	4.6	4.6	4.9
Non-tradables	8.4	9.4	8.8	9.3	9.2	7.6
Electricity, gas & water supply	11.3	11.6	12.3	11.8	10.4	9.3
Construction	8.3	9.9	8.0	8.1	7.6	5.7
Trade, hotels & restaurants	8.0	8.6	6.9	8.1	8.4	5.6
Transport	4.7	5.4	10.0	3.9	−1.1	−1.0
Communications	28.0	25.5	27.1	31.4	33.3	32.9
Financial, rental & business services	7.6	8.6	8.3	8.7	8.6	7.4
Services	5.2	7.2	5.9	6.7	7.2	6.0
Source: CEIC Asia Database.

TABLE 2B. Components of GDP Growth (2000 prices;% quarter on quarter)

	Sep-07	Dec-07	Mar-08	Jun-08	Sep-08	Dec-08
Gross domestic product	3.7	−2.5	2.4	2.8	3.7	−3.6
Non-oil & gas GDP	3.8	−2.7	2.6	3.0	3.9	−3.8
GDP excluding (ALFF)	2.9	1.3	0.2	2.2	3.1	−0.3
By expenditure
Consumption	1.5	4.6	−4.3	3.8	2.3	4.7
Private	2.1	2.2	−0.2	1.3	1.9	1.7
Government	−2.6	23.2	−30.5	26.1	5.6	25.6
Investment	5.0	3.5	−0.2	3.2	5.2	0.8
Of which:
Building construction	3.7	3.8	−1.9	2.4	3.2	1.9
Machinery & equipment	9.4	−1.0	12.7	1.8	9.6	−8.0
Transport	10.4	14.7	−15.6	19.5	21.5	11.8
Exports	1.4	2.7	4.3	3.4	−0.1	−5.5
Imports	5.5	1.6	3.4	4.7	0.8	−11.7
By sector
Tradables	4.0	−7.2	4.5	2.7	4.1	−8.2
Excluding (ALFF)	2.1	−0.1	−0.2	1.3	2.8	−1.9
Agriculture, livestock, forestry & fisheries (ALFF)	8.6	−23.8	19.2	6.3	7.2	−22.9
Mining & quarrying	−0.7	0.0	−0.6	0.8	1.9	0.0
Manufacturing	3.0	−0.2	−0.1	1.4	3.1	−2.5
Excluding oil & gas	1.6	3.0	0.0	0.0	1.7	3.3
Non-tradables	3.4	2.3	0.4	2.9	3.3	0.8
Electricity, gas & water supply	3.6	1.7	1.6	4.4	2.3	0.8
Construction	3.7	3.8	−1.9	2.4	3.2	1.9
Trade, hotels & restaurants	4.6	0.1	−0.1	3.4	4.9	−2.6
Transport	7.2	1.9	−4.2	−0.8	2.1	2.0
Communications	5.0	7.4	7.0	9.0	6.5	7.0
Financial, rental & business services	1.9	3.1	1.9	1.5	1.8	2.0
Services	0.7	2.9	0.5	2.5	1.1	1.7
Source: As for Table 2A.

The non-tradables sector continued to out-perform tradables in the second half of 2008, as it has for several years now–maintaining modest positive growth in Q4 in the face of a large (8.2%) decline in tradables output (Table 2B). The latter is largely explained by the very high degree of seasonality in the agriculture, livestock, forestry and fisheries (ALFF) sector, which contracted by about 23% quarter on quarter in Q4–just as it did in 2007. Indeed, the apparently disappointing result for output growth in the December quarter seems overwhelmingly to be driven by this sector: GDP net of ALFF declined by just 0.3%. The mining and quarrying sector continued its disappointing performance, reflecting the government's inability to provide a satisfactory legal basis for mining activity.3 Surprisingly, the performance of non-oil and gas manufacturing improved towards the end of 2008: the decline in manufacturing output in Q4 was entirely the consequence of a drop in oil and gas manufacturing. That said, outcomes for the sub-sectors of non-oil and gas manufacturing varied considerably. Of particular concern is that labour-intensive industries–especially the textiles, leather products and footwear group–continued their poor performance of recent years, experiencing a second full year of contraction, including a large decline in Q4 2008. Within the non-tradables sector, communications continued to stand out, with remarkably rapid year-on-year growth throughout 2008–in contrast to notable deceleration in several other sub-sectors. Persistent, intense price wars among mobile communication service providers led to significant increases in demand for mobile phone voice and messaging services.

Budget outcome

The realised budget outcome for 2008 recorded a negligibly small deficit of around 0.1% of GDP, far lower than the initially projected 2.1%, because revenues were about 10% higher than in the revised budget announced in April 2008 (Table 3). Presumably the 8.1% increase in tax revenues reflects the significant bureaucratic reform being undertaken in the finance ministry, the ‘sunset policy’ (which eliminated penalties for unsubmitted, late or incorrect tax returns for previous years) and the drive to encourage individuals to obtain taxpayer registration numbers (and thus avoid paying tax at a higher rate from 2009).4 The 13.2% increase in non-tax revenues is due mainly to much higher than expected average world oil prices in 2008.

TABLE 3. Planned and Actual Budget for 2008 (Rp trillion)

	Revised Budget	Actual	Actual as% of Revised Budget
REVENUE AND GRANTS	895.0	981.0	109.6
Revenues	892.0	978.7	109.7
Tax	609.2	658.7	108.1
Non-tax	282.8	320.1	113.2
Grants	2.9	2.3	79.3
EXPENDITURE	989.5	985.3	99.6
Central government	697.1	692.6	99.4
Personnel	123.5	112.4	91.0
Goods & services	67.5	57.0	84.4
Capital expenditures	79.1	72.3	91.4
Interest payments	94.8	88.6	93.5
Domestic	65.8	59.9	91.0
External	29.0	28.7	99.0
Subsidies	234.4	275.3	117.4
Energy	187.1	223.0	119.2
Fuel (Pertamina)	126.8	139.1	109.7
Electricity (PLN)	60.3	83.9	139.1
Non-Energy	47.3	52.3	110.6
Social assistance	59.7	56.8	95.1
Other	38.0	30.2	79.5
Transfers to regional governments	292.4	292.6	100.1
Equalisation funds	278.4	278.9	100.2
Revenue sharing	77.7	78.6	101.2
General funds allocation	179.5	179.5	100.0
Special funds allocation	21.2	20.8	98.1
Special autonomy & adjustment funds	14.0	13.7	97.9
DEFICIT	−94.5	−4.2	4.4
FINANCING	94.5	55.5	58.7
Domestic	107.6	74.6	69.3
Banks	−11.7	−11.7	100.0
Non-banks	119.3	86.3	72.3
Privatisation (net)	0.5	0.1	20.0
Bank restructuring asset sales	3.9	2.8	71.8
Government bonds	117.8	85.9	72.9
Government investment funds	−2.8	−2.5	89.3
External	−13.1	−19.1	145.8
Gross drawings	48.1	44.1	91.7
Amortisation (less)	−61.3	−63.2	103.1
EXCESS FINANCING	0.0	51.3
Memo items:
Deficit as% of GDP	−2.1	−0.1
Expenditure of ministries/agencies	290.0	265.3	91.5
Subsidies as% of total spending	23.7	27.9	117.9
Source: Office of the Coordinating Minister for Economic Affairs (2009).

Whereas total expenditure came in almost right on target, spending by ministries and government agencies fell short of the budgeted amount by 8.5%, or around Rp 25 trillion. Surprisingly, spending on personnel was 9% less than budgeted, but there were also significant shortfalls in spending on goods and services, capital items, social assistance and ‘other’ items. There was a substantial saving on interest payments on the government's domestic borrowing, not least because the net amount of bonds issued was far lower than expected. On the other hand, outlays on subsidies were 17% higher than budgeted, mainly because of the dramatic increase in the world oil price early in the year and the government's considerable reluctance to adjust the domestic prices of fuels and electricity commensurately. Subsidies accounted for well over a quarter of total spending; in particular, subsidies to electricity consumption were almost 40% higher than the budgeted amount. Although official kerosene prices were held far below equivalent world prices, the government kept the total subsidy to kerosene much smaller than this implies by limiting availability (box 1).

BOX 1 Fuel subsidies: smoke and mirrors

One of the dangers of holding fuel prices low is that it encourages additional consumption, implying an even higher total amount of subsidy. In response to this, the government's policy has been to control quantities as well as consumption. To this end, the subsidy it pays to the state-owned oil company, Pertamina, to distribute fuels at prices below equivalent export prices is based on fixed quantities (‘quotas’) determined before the beginning of the year, multiplied by a per unit fee (‘alpha’) that depends on the forecast world price of oil. Of course, the price actually paid by consumers depends on supply to the market. In the case of gasoline and diesel, most of which is sold at the retail level by Pertamina itself, the quantities supplied appear roughly to match demand at the subsidised prices. But most kerosene is sold ‘on the street’ and in markets by very small traders, and the actual retail price recently has been far above the nominal subsidised price because the amount supplied in total is far lower than the level of demand at this price. In turn, this is because the government wants to encourage households to convert from using kerosene to using liquefied petroleum gas (LPG). Rather than suffer the odium that would attend the announcement of a big price increase for kerosene, the government has chosen to achieve the same practical result by restricting the supply.

The higher than expected revenues averted the need for the government to confront much tighter conditions in the global financial market, which would have increased significantly its cost of borrowing internationally–or even limited its capacity to do so. It was able to cease issuing bonds early in Q4, and ran down its outstanding foreign borrowings by the equivalent of Rp 19 trillion during the year. In the event, the total amount of financing obtained was more than 60% below the planned amount, notwithstanding some Rp 28 trillion of bilateral and multilateral external loans disbursed in December. Despite this, the very small realised deficit of Rp 4.2 trillion left the government with a surplus cash flow for the year of around Rp 51.3 trillion.

Manufacturing sector: the threat of job losses

The threat posed by the GFC prompted the Ministry of Industry to revise its forecast for growth in non-oil and gas manufacturing sector output in 2008 slightly downward, from 5% to 4.8%; the final outcome fell between these two numbers. The forecast for 2009 is considerably lower, at 3.6%. To get a better sense of the likely sectoral pattern of the GFC's impact on manufacturing we begin by calculating two indicators: namely, the import content (imports as a share of total material inputs) and market orientation (domestic or export) of Indonesia's manufacturing industries, based on the recently published 2006 Industrial Statistics (BPS 2008).5 We then classify large and medium-scale manufacturing into four major categories (Table 4): low import content and export oriented (LIX); low import content and domestic oriented (LID); high import content and export oriented (HIX); and high import content and domestic oriented (HID), where the demarcations between ‘high’ and ‘low’ are the relevant average values. Given recent and expected declines in global demand and the likelihood of a continuing weak rupiah, the severity of the GFC's impact on Indonesia's manufacturing industries is likely to depend on which of these four categories they belong to.

TABLE 4. Major Manufacturing Industries’ Exposure to Global Trade^a

Export orientation (Average = 26%)	Import content (Average = 31%)
	Low (Average = 9%)	High (Average = 50%)
High	LIX	HIX
(Average = 49%)	Pulp (for manufacturing paper)	Clothing & textiles
	Crumb rubber	Newsprint & printed writing paper
	Cement
	Cocoa peeling, cleaning & drying	Spinning
	Plywood	Electronic tubes, valves & components
	Palm oil based cooking oil	Cigarettes (non-kretek)
	Wooden furniture	Radio, TV, voice & video recording equipment
		Steel pipes & pipe fittings
		Sports shoes
Low	LID	HID
(Average = 9%)	Kretek cigarettes Animal & vegetable cooking oils	Motor vehicles (four wheels or more)
	Motor-cycles	Pharmaceuticals
	Weaving (other than gunny sacks)	Motor vehicle components & accessories
	Other fertilisers	Textile fibre preparation
	Cooking spices	Rolled steel
	Cosmetics
	Sugar
	Petroleum refining
^aThe top 29 industries by value added are listed.
LIX: low import content and export oriented; LID: low import content and domestic oriented;
HIX: high import content and export oriented; HID: high import content and domestic oriented.
Demarcations between ‘high’ and ‘low’ are the relevant average values.
Sources: BPS (2008) and authors’ calculations.

The adverse impact of the GFC will be stronger for industries in the LIX and HIX categories because of their strong export orientation. Although these industries would benefit from a weakening rupiah, the sharp decline in demand from major trading partners is likely to be the more dominant force. Industries in these categories contributed around 38% of manufacturing value added, and employed around 39% of the manufacturing sector labour force. They include industries such as pulp (for paper manufacture); crumb rubber; cement; palm oil based cooking oil; wooden furniture; plywood; clothing and textiles; newsprint and printed writing paper; electronics; steel pipes; and sports shoes. For example, 40–50% of the output of the clothing, textiles and footwear industries was exported in 2006. Industries relying on locally produced raw materials also depend heavily on external demand. Close to 80% of the output of the rubber industry was destined for the export market, for example, together with over half the output of the pulp and paper and plywood industries.

The last quarter of 2008 saw the rupiah depreciate in real terms against major trading partners’ currencies, notwithstanding some recovery in December (Figure 1). We expect the nominal rupiah to remain weak and inflationary pressure to moderate in 2009, preventing any significant real appreciation this year. If the real exchange rate remains weak, then the HID industries, which contribute about 25% of value added and 19% of employment, will also bear the adverse consequences of the GFC, since rupiah weakness will drive up the production costs of these industries, making their products less affordable. Two of the industries in question are motor vehicles (four wheels or more), and motor vehicle components and accessories.

FIGURE 1. Selected Real Exchange Rates of the Rupiah^a (Dec 2007=100)

^a A decrease in the index implies a real depreciation.

Source: CEIC Asia Database.

The expected further slowdown of manufacturing output has prompted concern over likely job losses. The Indonesian Rattan Furniture and Craft Producers Association (AMKRI) estimated that this industry would have to lay off some 35,000 workers by the end of 2008, while some 700 textile firms had already ‘temporarily’ dismissed a total of 14,000 workers by mid-December (Adamrah 2008). Business leaders expect that up to 1.5 million people could be laid off in 2009, particularly from labour-intensive industries, as firms cut back on production (Kris-mantari 2008)–although the basis for such estimates is unclear. An additional concern is job losses and repatriation of Indonesian workers overseas, as the GFC slows economies elsewhere.

Balance of payments

Confirming the picture suggested by the latest national income accounts data, trade data for Q4 of 2008 show significant disruption to Indonesia's merchandise trade performance as the GFC deepened (Figure 2). In addition to the decline in the terms of trade as commodity prices fell,6 economic downturns in key export destinations had a strong negative impact. The very healthy 19.1% trend rate of annual growth in non-oil and gas exports established over the previous four years came to an abrupt end, with the value for December 2008 some 25% below the corresponding trend value. Although this triggered market concern about the strength of the balance of payments, its impact on the current account deficit has been relatively slight. Indonesia's imports tend to move hand in hand with exports because of the high import content of the latter. In particular, manufactured exports (which comprise over 80% of the total) such as electronics, clothing, textiles, footwear and cigarettes have import content levels of 35–85%.

FIGURE 2. Non-oil and Gas Exports and Imports^a ($ billion/month)

^a The trend rate of growth for non-oil and gas exports for the period December 2004 through September 2008 was 19.1% p.a. Imports shown here are those from outside the bonded economic zones.

Source: CEIC Asia Database.

The values of oil and gas exports and imports during 2008 and early 2009 were dominated by the unprecedented surge and subsequent decline in world oil prices. The price of light sweet crude oil at the New York Mercantile Exchange had risen to around $99 per barrel in early January 2008. It went on to peak at around $145 in July, only to fall to $34 by December. Again, the impact on the current account was relatively slight, however, because Indonesia imports roughly the same value of oil and gas products as it exports.

In this era of highly mobile capital, potential balance of payments pressures are more likely to come from the capital account than the current account. One indication of this is the massive sell-off by foreign investors of government bonds and Bank Indonesia Certificates (SBIs) that occurred in the second half of 2008 (Figure 3). At the end of July foreign investors held Rp 162 trillion in these government and central bank securities combined, but this had fallen to only Rp 97 trillion January–a decline equivalent to about $6 billion.7 By comparison, net merchandise exports actually grew by over $1 billion in Q4. Managing capital flows will be a critical aspect of economic policy making in 2009.

FIGURE 3.  Foreign Holdings of Government Bonds and SBIs^a (Rp trillion)

^a SBI = Bank Indonesia Certificate.

Sources: Bond data: Ministry of Finance <http://www.dmo.or.id/>; SBI data kindly supplied by Bank Indonesia.

FINANCIAL SECTOR

Capital, bond and foreign exchange markets

The meltdown in major financial markets in the US and Europe finally triggered a massive sell-out on the Indonesia Stock Exchange (IDX) early in the last quarter of 2008, bringing the market index back to its level in the first half of 2006. After peaking at 2,830 in early January 2008, the Composite Stock Price Index (CSPI) came under heavy pressure in March, before recovering to a lower peak of 2,511 in May. Following this there was a period of steady decline until the beginning of September. However, the collapse of the globally renowned Lehman Brothers in the US sparked consecutive weeks of corrections in the global financial markets in September and October, triggering a fall of almost 50% in the CSPI during those months (Figure 4).

FIGURE 4.  Composite Stock Price Index (CSPI) and Exchange Rate

Sources: Indonesia Stock Exchange; Pacific Exchange Rate Service.

This period was notable for the suspension of trading activities on the IDX from 9 to 13 October 2008, triggered by a 10% decline in the index on 8 October. This decline was in large part the consequence of uncertainty surrounding the fate of PT Bumi Resources, a company controlled by the family of the Coordinating Minister for People's Welfare, Aburizal Bakrie. With its ability to service and re-finance debt obligations of around $1.2 billion in September 2008 called into question, PT Bakrie & Brothers–the flagship holding company of the Bakrie family–was forced to sell many of its shares in various companies, including Bumi Resources, one of the world's largest thermal coal exporters. There was concern over the lack of transparency in share transactions involving Bumi Resources and these other companies, including the possibility that the government might be misusing state-owned enterprises to help out the Bakrie group. There were also strong rumours of a rift between the president and the finance minister over the suspension of trading in shares of Bumi Resources. The minister had called an end to the suspension on 5 November, but the IDX then announced that ‘after considering a request from the government, the Exchange decided to delay lifting the suspension until further notice’ (Wei 2008). Bakrie & Brothers stood to benefit from continued suspension, which would prevent further falls in the share price of Bumi Resources and other companies controlled by the group–falls that would have made it much more difficult for the group to obtain the new equity financing needed in order to reduce its high gearing ratios.

The 50% decline in IDX share prices translates to a corresponding 50% reduction in market capitalisation, equivalent to nearly 20% of Indonesia's 2008 GDP. Share price declines were felt in all major sectors, with the commodity sectors among the worst affected. Large falls in the prices of key commodities such as crude oil, crude palm oil, rubber, coal and steel were mainly responsible. The prices of some of these commodities in global markets had fallen back to their 2007 levels by the end of 2008, although they remained high relative to previous years–especially those of the energy commodities. It would appear that large declines in commodity prices, rather than the GFC, are mainly to blame for declining share prices in these industries. Agricultural stocks suffered a decline of almost 80% in market capitalisation for the full year, with over 85% of this loss occurring in the second half. Similarly, at its peak in early 2008, the market value of mining sector stocks was over Rp 400 trillion, but by the end of the year it was barely above Rp 100 trillion. Three other sectors–financial services, manufacturing and construction– have also been experiencing sharp downturns in demand that are likely to have significant medium-term implications for the economy. These sectors collectively accounted for about 65% of total IDX market capitalisation; on average, each lost at least 40% of its market value during 2008. Despite some recovery of stock prices in December and early January, the stock exchange remained fragile through to mid-February. Given the relatively weak outlook for the world economy–and, because of this, for the domestic economy–any substantial recovery in the IDX during the first semester of 2009 seems unlikely.

The government bond market also witnessed considerable volatility during the fourth quarter of 2008, as global risk aversion resulted in a credit crunch in the industrial countries. Bond prices fell dramatically, such that the yield on 5-year rupiah-denominated government bonds shot up to a peak of 22.2% on 28 October. Yields then fluctuated wildly during November before falling back quickly to 12.2% by the end of the year on expectations of declining inflation and interest rates. Rising bond prices early in 2009 mainly reflected increasing demand by domestic players, especially banks, while foreign investors remained on the sidelines.

Investors’ attempts to reduce their exposure to both private sector shares and government paper in Indonesia resulted in significant capital outflow and, eventually, in considerable depreciation of the rupiah. The currency came under pressure from about August, to which the central bank responded initially by running down its international reserves by about $10 billion–some $6.5 billion in October alone. But after the exchange rate was pushed beyond Rp 10,000/$ toward the end of October despite this intervention, Bank Indonesia (BI) chose to allow the market to determine a new level, and the rate went to well over Rp 12,000/$ within a month (Figure 4). The strong recovery evident in December was not sustained, and the rate had moved back to beyond Rp 11,700/$ by mid-February 2009, following the recent strengthening of the US dollar against other currencies.

Banking

At a time when several of the world's largest and most respected financial institutions have had to be closed down or recapitalised by national governments, it is important to assess the health of Indonesia's banking sector, even though it has had little direct exposure to the global sub-prime lending phenomenon. Despite the sharp global economic downturn, significant declines in asset values (in particular, of stocks, bonds and the rupiah) and substantial increases in interest rates since March 2008 (particularly in the second half of the year), the banking sector still appears on the surface to be in surprisingly good shape (Figure 5). The average capital adequacy ratio (CAR, the ratio of capital to risk-weighted assets) ended the year at 16.8%–over twice the regulatory minimum of 8.0%–while average non-performing loans (NPLs) continued their long-established downward trend, falling to 3.2% of total loans in December. The doubling of the average loans-to-deposits ratio (LDR) over the last several years is explained by the declining relative importance of recapitalisation bonds (injected by the government as new equity following the 1990s crisis) as the banks expanded their loan portfolios

FIGURE 5.  Banking Performance Indicators^a

^a CAR = capital adequacy ratio; NPLs = non-performing loans as a share of total loans; LDR = loans to deposits ratio.

Source: CEIC Asia Database.

It is important, however, to treat these bank data with a degree of scepticism. For example, while the average CAR seems very healthy, there was a decline during 2008 of more than 4 percentage points from the average of about 21% that had been maintained from mid-2003. The decline in the average CAR during 2008 has at least two explanations: first, the switch from SBIs (safe assets) to loans (riskier assets) in that year, resulting in higher risk-weighted assets in the denominator of the CAR; and second, reductions in banks’ capital because they were required to ‘mark to market’ the value of bonds held in their trading portfolios when the prices of those bonds fell. In addition, it may be unwise to accept the NPL data at face value. In practice, banks have considerable discretion in classifying loans as non-performing–and are usually reluctant to do so. The steady decline in this measure may simply reflect the diminishing relative importance of bad loans left over from the 1997–98 crisis. A very large proportion of these had been classified as non-performing as part of the recapitalisation process at that time–because larger NPLs generated bigger capital injections by the government. Banks may have been reluctant subsequently to make realistic provisions against losses on newer loans; if so, this would imply commensurate over-statement of capital adequacy. It is important to appreciate that many highly reputed banks in the advanced economies failed abysmally to maintain adequate provisions against unexpected losses; it would be foolhardy to assume that this could not also happen in Indonesia.

Market players, of course, take published balance sheet data at face value at their peril. They are much more likely to be guided by ‘market intelligence’–which may amount to little more than speculation and rumours. Bad news travels fast, usually making its presence felt initially in the inter-bank market rather than in formal reports to the supervisory authorities. Banks that find themselves under a cloud face rapidly increasing borrowing costs, eventually being unable to borrow at all if they cannot dispel negative rumours. Indeed, one such case has already resulted in the take-over of a small bank, Bank Century, by the Indonesia Deposit Insurance Corporation (Lembaga Penjamin Simpanan, LPS).

There had been doubts for some years about Bank Century, and in 2005 BI had required its owner to put some funds in an escrow account as a guarantee because of concerns about the quality of some of its assets. By the time the authorities realised it was having difficulty obtaining inter-bank loans, Bank Century had already lost a significant proportion of its deposits. Its seemingly healthy capital adequacy ratio of 18% at the end of September 2008 fell abruptly to –2.3% in early November. Two weeks after Bank Century's take-over by the authorities, the Capital Market and Financial Institutions Supervisory Agency, Bapepam–LK, received complaints of payment defaults from investors in a closely affiliated securities company, PT Antaboga Delta Sekuritas Indonesia. Using Bank Century as its selling agent, Antaboga claimed to be operating a mutual fund, although Bapepam–LK has denied issuing it with a permit to do so. Investors who had naïvely put their savings with Antaboga in response to alleged promises of high returns eventually faced the prospect of being unable to retrieve even their initial investments (JP, 12/9/2008). The Antaboga–Century case demonstrates the danger of relying too heavily on published balance sheet data, and on banking and capital market regulators.

Banks’ declining confidence in each other is reflected in the shrinking volume of inter-bank borrowing and lending transactions–down by almost 60% to Rp 84 trillion in December 2008 from Rp 206 trillion in December 2007 (Guna-wan, Arman and Hendranata 2009). Declining confidence can also be seen among depositors. There is some evidence of a ‘flight to quality’–depositors shifting their savings to the larger private banks and state banks (although not to foreign banks as in the 1997–98 crisis), exacerbating the liquidity imbalance and segmentation of the banking system.

In mid-2007, rupiah-denominated loans and deposits had been growing by a little under 20% annually, as had base money (Figure 6). Base money and lending growth then accelerated until early 2008, at which stage the former levelled off at about 20%, while lending continued to accelerate, finally peaking at 38% in August. In contrast, the growth of deposits had declined throughout this period to a low of 8%. With system liquidity declining relative to bank lending, and with BI reluctant to allow yields on SBIs to increase, the banks began to replace their holdings of SBIs with loans to the private sector from January; by August, banks’ SBIs had fallen by almost two-thirds. As their holdings of SBIs fell towards zero, some banks began to compete more strongly for deposits. Deposit rates began to edge upwards from mid-year, and then to increase very rapidly in September and October: interest rates offered by some banks for large deposits (of the order of, say, Rp 1 billion) were as high as 16% by December.8 Lending rates followed a similar pattern, despite the fact that BI's policy rate peaked at around this time and then began to fall. As the GFC began to bite more strongly in December, the banks started to cut back on new lending (by 1.3% month-on-month), using the additional liquidity from accelerated government spending and a cut in the minimum reserves requirement (discussed below) to rebuild their investment in SBIs–holdings of which doubled by the end of the year–and government bonds.

FIGURE 6.  Growth of Money and Banking Aggregates (% p.a.)

Source: CEIC Asia Database.

POLICY RESPONSES

In his New Year press conference, President Susilo Bambang Yudhoyono pledged a fiscal stimulus to achieve several priority targets in 2009, and specifically to minimise the impact of the GFC. The main objectives were to maintain economic growth at no less than 4.5% annually and minimise any increase in unemployment; to protect those below the poverty line; to maintain food and energy sufficiency; and to bring inflation down to the targeted range of 5–7%. To meet these objectives, a number of response packages have been announced, including fiscal, monetary and trade policies.

The government's capacity to implement these packages remains to be seen, however. In their annual survey of governance, Kaufmann, Kraay and Mastruzzi (2008) provide the latest estimates of six indices of governance, one of which focuses on government effectiveness (GE). This encompasses the quality of public services; the quality of the civil service and the degree of its independence from political pressures; the quality of policy formulation and implementation; and the credibility of the government's commitment to its stated policies. The index ranges from –2.5 (least effective) to 2.5 (most effective). In spite of a notable improvement since 2003, Indonesia's GE index for 2007 remained clearly the lowest among those for the five major ASEAN countries, much the same as for Vietnam, and significantly higher only than those for the newly emerging Southeast Asian nations of Myanmar, Cambodia and Laos (Figure 7).

FIGURE 7.  Effectiveness Index for Governments in Asia

Source: Kaufmann, Kraay and Mastruzzi (2008).

Financial sector safety net policies

In October 2008, the administration introduced three government regulations in lieu of law (peraturan pemerintah pengganti undang-undang, Perpu) to protect the financial system from a potential crisis. The first was Perpu 2/2008 to further amend the Central Bank Law of 1999 so as to expand the range of types of collateral acceptable for gaining access to BI's short-term lending and emergency financing facilities. The second was Perpu 3/2008 to expand the coverage of the LPS guarantee of bank deposits from Rp 100 million to Rp 2 billion. The third was Perpu 4/2008, which would allow the government and the central bank jointly to inject emergency liquidity into financial institutions–not just banks–in the event of a potential systemic collapse, without first obtaining approval of the DPR. In relation to Perpu 4/2008, the finance minister stipulated three criteria that could indicate a major problem in the financial system: a shortage of bank liquidity; potential insolvencies among the banks; and signs of liquidity or solvency problems in non-bank financial institutions. The regulations could be implemented only if the liquidity and solvency problems of financial institutions were deemed to be ‘systemic’. A ‘systemic’ problem was defined as a condition requiring such intervention in order to maintain confidence in the financial system and the national economy; this, in turn, would be at the discretion of the government in consultation with BI.

During a DPR hearing in December 2008, Commission XI (which deals with matters related to the finance sector) approved the first of these two regulations, but rejected the third on liquidity injections. Legislators from seven of the 10 parties represented on the commission opposed the regulation, voicing concern that it could be misused, and that the authority it conferred on BI would limit scope for public oversight of potential bail-outs of the financial system. There was particular concern with a provision stating that the finance minister and the central bank governor could not be prosecuted in relation to liquidity injections intended to prevent collapse of the financial system. Both proponents and opponents of this provision presumably had in mind the crisis of 1997–98, in which the authorities succeeded in preventing a collapse of the banking system only by virtue of massive last-resort lending (BLBI) by the central bank, followed by the introduction of a blanket guarantee of bank liabilities by the government. Only a small proportion of the BLBI was repaid, and top officials of the central bank who had approved it were subsequently accused of improper behaviour–a number of them ending up in prison–so it is not surprising that their successors would want to avoid a similar fate. On the other hand, these policies ended up costing the general public at least $50 billion (Frécaut 2004; McLeod 2004), so the legislators had good reason to insist that similar policy choices could not be taken too lightly in the future.

As in some other countries, the political bottleneck over the financial institution bail-out regulation highlights the difficulty of implementing appropriate safety net policies rapidly at times of incipient severe economic downturn. Ideally these policies should be designed when conditions are normal rather than when crisis conditions are already emerging, but in normal conditions there is little interest in such matters. Evidently the law that established the LPS following the last crisis is now seen as inadequate for dealing with a threatened sudden and unexpected loss of confidence in the banking system–hence the move to make borrowing from BI easier, and the dramatic expansion in coverage of the deposit guarantee.

Aside from the political difficulties involved in responding to this threat, however, there are also a number of potential shortcomings in the financial sector safety net policies implemented so far. Perhaps most significant is the possibility that the Rp 2 billion maximum guarantee on bank deposits may not be effective in preventing a bank run. The government has emphasised that this guarantee will cover almost all depositors. Indeed it does, but in terms of the value of deposits, only around 54% of the total amount (as of December 2008) would be protected by the guarantee (Table 5). Moreover, interest rates offered for large deposits are now significantly higher than the latest maximum guarantee rate of 9.0% set by the LPS; this also reduces the extent to which the deposit guarantee can be relied on to prevent bank runs.9 In our day-to-day discussions with market analysts, private bankers and regional economists in Singapore, we found that there had already been outflows of deposits from Indonesia to Singapore, where all local and foreign currency deposits of individuals (including foreign residents) and non-bank customers at banks and finance companies are fully guaranteed until the end of 2010. Elsewhere in the region, Hong Kong and Malaysia have adopted similar measures. In these circumstances, Indonesia's newly expanded guarantee alone cannot be relied upon to prevent a run on the banks.

TABLE 5. Size Distribution of Customer Deposits (December 2008)

Size Range (Rp million)	Number of Accounts		Total Value
	(‘000)	Cumulative Share (%)	(Rp trillion)	Cumulative Share (%)
0–100	80,766	97.7	331	18.7
100–200	882	98.7	120	25.5
200–1,000	846	99.8	355	45.5
1,000–2,000	108	99.9	152	54.1
2,000–5,000	50	100.0	160	63.2
>5,000	30	100.0	652	100.0
All	82,682		1,769
Source: Indonesia Deposit Insurance Corporation (LPS).

In late October 2008, in an attempt to prevent a potentially massive exodus of domestic residents’ capital, BI introduced a new administrative control on foreign exchange transactions (BI Regulation 10/28/PBI/2008). This measure requires any entity wanting to purchase foreign currency exceeding the equivalent of $100,000 a month in either the spot or the forward market to provide a statement justifying the need for the transaction. The objective of the control was to minimise speculative transactions in the foreign exchange market. But the penalty for banks involved in such transactions if they fail to comply is merely an administrative reprimand and a trivially small fine of Rp 10 million (less than $1,000). Given the light penalty and the lack of clarity as to what are considered to be justifiable underlying motives, this policy is unlikely to have any significant impact.

Rather than making it difficult for people to shift their assets offshore, or trying to persuade them not to do so by offering a government guarantee that is potentially extremely expensive to the general public, it would seem desirable for the authorities to address the underlying problem of fragile confidence in Indonesia's financial institutions. Official assertions that there have been considerable improvements in the effectiveness of prudential supervision since Indonesia's last crisis are beginning to sound hollow with the collapse of Bank Century and the alleged embezzlement by Antaboga.10 These cases invite urgent reconsideration of the desirability of establishing an independent supervisory agency for the entire financial sector, which was strongly debated in 2002–04 without any conclusive decision or follow-up action (Siregar and James 2006)–even though chapter 34 of Law 3/2004 on Changes to Law 23/1999 on Bank Indonesia requires that this should be achieved by the end of 2010.

The GFC lends urgency to the need to re-assess the regulations on banks’ capital adequacy. Work is already under way to modify the Basel II capital adequacy regulations11 in such a way as to ensure greater sensitivity of capital requirements to the different risks to which banks are exposed (Turner 2009). There is a strong perception that, under the present regulations, the capital requirement has been too low relative to the risks being taken on by banks. Indeed, in his speech to the Annual Bankers Dinner on 30 January 2009, BI Governor Boediono mentioned the need for banks to strengthen their CARs (Boediono 2009)–although just a few days earlier BI had moved in the other direction by delaying the full inclusion of operational risks into the CAR measurement until January 2011.12 While the authorities are waiting for a new internationally accepted minimum CAR, it might be a good time to announce a significant increase in Indonesia's own requirement. Ensuring that bank share-holders had much more to lose should their bank fail would lessen the severe moral hazard inherent in the recently expanded government guarantee of bank deposits. Since Indonesia's banks had an average CAR of more than twice the minimum requirement at the end of 2008, increasing the minimum CAR would require no further action on the part of many of them. Individual banks with relatively low CARs would have to cut back on lending if they were unwilling or unable to increase their capital, but this would be entirely appropriate in current circumstances, given that confidence in banks is absolutely essential. It is important that bank lending continues to expand, but it would be counter-productive to rely too heavily for this on banks with inadequate capital.

The difficulty of forecasting the severity of the economic downturn means that any budget is likely to miss its targets. It is important, therefore, to have as much flexibility as possible in responding to rapidly changing circumstances. Faced with considerable uncertainty about the near-term future, the government sought parliamentary approval for urgent adjustments to the 2009 budget in mid-January 2009. Article 23 of Law 41/2008 on the Budget for 2009 stipulates that, in an emergency, the government can propose budget revisions if the following three conditions apply: first, if deviations from key macroeconomic assumptions will result in a significant reduction in revenue or increase in expenditure; second, if there is a dramatic rise in the yield on government bonds; and third if there is a crisis in the banking and finance system requiring additional funds to guarantee bank and non-bank institutions.

On the grounds that Indonesia was now–or might soon be–facing most if not all of these circumstances, the finance minister unveiled a fiscal stimulus package that would have the effect of increasing the 2009 budget deficit by around Rp 71 trillion, or 1.4% of GDP (Table 6). The package has four major categories: income tax cuts; waivers of various taxes and import duties; additional energy subsidies for firms; and additional government spending. It aims to stimulate aggregate demand mainly through the business sector. Additional government spending accounts for only a small part of the total amount, and there is little by way of stimulus to the household sector: more than 60% of the package is devoted to income tax cuts, but most income tax is derived from businesses rather than individuals. Moreover, the rate cuts will tend to be offset by ongoing efforts to encourage more individuals and firms to register as taxpayers.

TABLE 6. January 2009 Fiscal Stimulus Package

Policy Measure	Rp trillion	%
Income tax cuts for individuals & businesses, including increase in individuals’ non-taxable income threshold	43.0	60.3
Waivers of taxes & import duties (mainly for businesses)	13.3	18.7
VAT on oil & gas exploration, cooking oil	3.5	4.9
Import duties on raw materials & capital goods	2.5	3.5
Income taxes of employees	6.5	9.1
Income taxes of geo-thermal energy producers	0.8	1.1
Energy subsidies & government spending for businesses	4.2	5.9
Price reduction of Rp 300/litre for diesel fuel	2.8	3.9
Discounted peak load electricity tariff for manufacturers	1.4	2.0
Additional government spending	10.8	15.1
Infrastructure	10.2	14.3
Expansion of National Program for Empowerment of Society	0.6	0.8
Total	71.3	100.0
Source: Abimanyu (2009).

Simply put, the most immediate problem facing policy makers is a rapid decline in demand for Indonesian exports, together with generalised reductions in spending by both firms and individuals in response to a highly uncertain outlook. In light of this, it seems preferable to introduce measures intended to encourage as many individuals and firms as possible to increase their spending. While the stimulus package will certainly help to improve business sector cash flows, neither improved cash flow nor ready availability of bank loans will suffice to keep production near capacity and thus avoid large-scale lay-offs of workers if there is a lack of demand.

Given the urgency of increasing spending on infrastructure, it is disappointing that only a relatively small amount is allocated to it. It is true that there are significant lags involved in spending on new infrastructure, but there is surely plenty of scope for doing much more almost immediately by way of small-scale, labour-intensive maintenance work, since this requires no new land acquisition and no new design work. Its own spending aside, the government already has at its disposal a mechanism for putting additional income and spending power in the hands of vast numbers of consumers, through the existing direct cash transfer program introduced to compensate the poor for fuel price rises in 2005 and 2008. The program connects directly with about 20 million families, or perhaps 100 million individuals–by contrast with only about 6 million mainly wealthy, urban-based individuals who might benefit from income tax reductions–and it would be a simple matter to increase the value of monthly transfers to them. Unfortunately, many members of the DPR are strongly opposed to this idea, fearing (with some justification) that the president and his party would use it as a means of gaining electoral advantage. This policy–which would contribute to the stated objective of poverty alleviation as well as stimulating the economy–is a notable omission from the stimulus package.

The pattern of spending in previous budgets also underlies concern about the capacity of the government to pursue counter-cyclical fiscal measures. In principle, to offset the decline in export demand and predictable cutbacks in private sector spending, the stance of fiscal policy would need to be increasingly expansionary during the first semester of 2009. By contrast, the 2008 budget outcome was in fact somewhat contractionary. In particular only about 90% of funds allocated to ministries and government agencies was actually spent, with spending concentrated in the second half. Successful implementation of broad-based expansionary fiscal policy requires a strong policy commitment across the various ministries, agencies and regional governments. Public sector reforms carried out at the Ministry of Finance (McLeod 2008) seem to be having a commendable impact on tax revenue collection, and should be a model for other ministries to follow. Ironically, however, what is needed at present is more spending, not more tax revenue, and as yet there has been little progress in bureaucratic reform on the expenditure side of the budget. The finance minister has spoken of the need to accelerate the project tender process, and possibly to increase the maximum value of projects that can be implemented without a call for tenders. Her ministry has little control over spending at the regional government level, however, or over that of other ministries and government agencies.

The lack of capacity to spend at regional government level is one of the greatest challenges to the counter-cyclical policy agenda in 2009. By July and December 2008, for example, the government of the capital city, Jakarta, had managed to disburse only 17% and 64%, respectively, of its annual budget. Two factors were blamed for this: late budget approval, and the fear of being accused of improperly disbursing funds following the Supreme Audit Agency's discovery of irregularities in the 2007 budget. Despite considerable improvement during the last two years in the timeliness of submission of local government budgets to the central government–which is a prerequisite for the disbursement of fiscal equalisation funds–by the end of January 2009, only around two-thirds of all regional governments had submitted their final 2009 budgets (Figure 8).

FIGURE 8.  Timing of Regional Government Budget Submissions to Central Government^a (cumulative number of governments)

^a Position as of 28 July 2008 for 2007 and 2008, and 30 January 2009 for 2009. The number of regional governments has increased significantly during this period, mainly because of increases in the number of local governments from about 473 in early 2007 to 489 in 2008 and 510 in 2009.

Sources: Ministry of Finance (2008); Kompas Team (2009).

A necessary consequence of the stimulus package is a significantly larger deficit of around 2.5% of GDP in 2009, which raises the question of how this can be financed.13 The GFC began to result in substantially higher borrowing costs for the government in the second half of 2008. In September, the market was looking for bond yields of 13-13.5% p.a., or around 300 basis points higher than the government was willing to pay, given its considerable success in boosting tax revenues. Thus the government effectively ceased issuing bonds during Q4 2008. In view of the need to finance the new stimulus package, however, the finance ministry re-entered the market via two auctions in January 2009, obtaining around Rp 9.25 trillion from the sale of bonds of 1–10 years maturity, at yields of 11.20–12.24%. With the yield on US treasury bills hovering close to 0% at the time, this implied a very large yield differential for Indonesian government bonds, yet there was little interest on the part of foreign investors. Domestic investors, mainly banks with excess liquidity on the lookout for safe earning assets, were the primary buyers. Although this helps the government to finance the planned fiscal stimulus, from another point of view it is an undesirable outcome: recent easing of monetary policy has been intended to encourage banks to lend to the private sector–not to the government. In this sense, another cause for concern is that the stimulus package might simply crowd out private sector spending–although any additional loans the finance ministry can obtain from bilateral and multilateral donors and institutions will reduce that concern. Another way to finance the stimulus package is to encourage local governments and their regional development banks (BPDs) to put their excess funds with the central government rather than the central bank. In December 2008 the BPDs were holding some Rp 26.3 trillion of SBIs, and in early February 2009 the finance ministry began to tap these funds by selling Rp 0.5 trillion of non-tradable short-term bonds to local governments.

Inflation, the exchange rate and growth

Consumer prices increased by about 11% in 2008, with the year-on-year inflation rate falling to 9.2% in January 2009 (Table 7). Inflationary pressure has continued to subside, with the monthly rate of change in the consumer price index (CPI) falling from 0.45% in October to –0.07% in January. The small declines in December and January were almost entirely accounted for by significant price reductions in the transport, communication and finance group, following the reduction in administered prices for gasoline and diesel in these months; the prices of kerosene and LPG also declined in January, resulting in a slight fall in the housing component. For the year as a whole, the groups that experienced the most rapid price increases were food; processed food, beverages, cigarettes and tobacco; and housing, water, electricity, gas and fuel.

TABLE 7. Consumer Price Inflation (%)

	Month on month			Year on year
	Oct-08	Nov-08	Dec-08	Jan-09	Dec-08	Jan-09
Consumer price index	0.45	0.12	−0.04	−0.07	11.1	9.2
Food	0.71	−0.67	0.57	0.76	16.4	14.1
Processed food, beverages, cigarettes & tobacco	0.77	1.13	0.52	0.95	12.5	11.5
Housing, water, electricity, gas & fuel	0.24	0.23	0.52	−0.06	10.9	9.0
Clothing	0.71	0.72	1.13	0.55	7.3	5.9
Health	0.52	0.37	0.21	0.37	8.0	7.5
Education, recreation & sports	0.39	0.26	0.16	0.12	6.7	6.3
Transport, communication & finance	0.10	−0.31	−2.74	−2.53	7.5	4.3
Source: CEIC Asia Database.

With inflation (overall and for each component group) well outside its 4–6% target range, BI increased its policy interest rate by 25 basis points (bps) six times between May and October 2008 (Figure 9), while other central banks around the globe–including in Southeast Asia–began cutting interest rates aggressively. Many observers, including government officials, questioned BI's reluctance to pursue an expansionary macroeconomic policy, and it responded by cutting the banks’ required reserves ratio to 5% from about 9% previously, thus freeing up system liquidity. Not until December, however, did the central bank begin to break with previous policy on interest rates, cutting its policy rate at first by a moderate 25 bps to 9.25%. Then, with the slowdown in the world economy becoming increasingly ominous and expected inflation on the wane, the policy rate was reduced by 50 bps in both January and February 2009, bringing it down to 8.25%.

FIGURE 9. Bank Indonesia Policy Rate and Bank Lending Rates^a (% P.a)

^a Bank lending rates are for working capital loans.

Sources: CEIC Asia Database; Bank Indonesia.

As an ‘inflation targeting’ (IT) central bank, BI faces the dilemma of whether to commit to its inflation target or pursue an expansionary monetary stance to stimulate economic growth and mitigate the impact of the GFC.14 The term ‘inflation targeting’ may seem unambiguous, but in reality there are two different interpretations (Bernanke and Mishkin 2007). The first is literal: if a central bank follows an IT rule, it concerns itself only with managing inflation. The second–more common in practice–is that the central bank works within an IT framework, in which it also concerns itself with other matters, such as exchange rate stability and trying to keep the economy operating near full capacity–trading one objective off against the others if necessary. In other words, under an IT framework the central bank exercises discretion as to the relative weights it gives to stimulating output growth, stabilising the exchange rate and stabilising prices. Siregar and Goo (2008) found that when economic conditions have been relatively stable, inflation expectations have been the only significant factor explaining fluctuations of BI's policy rate–suggesting that the central bank followed an IT rule at such times. But during turbulent periods it switched to the more ambitious IT framework, adjusting its policy rate in an attempt to influence inflation and output growth simultaneously.

Siregar and Goo's findings appear to confirm statements by senior officials of BI that the central bank adopted an IT framework rather than following a strict IT rule in 2008. During the early part of the first semester, BI emphasised inflation as the key threat. But rather than tightening monetary policy when domestic fuel prices were increased in May, it began to accept the inevitability of double-digit inflation–well above its target range (Ashcroft and Cavanough 2008: 345). Our discussions with BI officials and market analysts confirm that more recently BI has placed a higher weight on fighting depreciation pressure as investors have dumped Indonesian stocks and bonds in favour of overseas assets. The exchange rate exhibited considerable volatility during the last quarter of 2008. Even though BI resisted the urge to reduce its policy rate and sold off a considerable portion of its international reserves, the rupiah depreciated by as much as 28% against the dollar during the first two months of Q4, before strengthening again by 10% by year-end.

Given recent reduced inflationary pressure as world commodity prices decline, and our belief that BI's interest rate policy has a limited impact on the exchange rate,15 we consider that BI should take the opportunity to pursue even more expansionary monetary policy in 2009. The counter-cyclical fiscal policy discussed earlier should have a higher chance of success if it is supported by expansionary monetary policy (Mohanty and Scatigna 2003; Taylor 2000). Recent reductions in the policy rate are steps in the right direction, signalling to the market that BI has shifted its policy focus to align with the government's overall macroeconomic policy agenda of supporting growth.

Such a policy recommendation is not uncontroversial, however. Banks currently are wary of extending new loans because of fears that the downturn will result in a high level of defaults, not to mention their own need (especially that of the foreign banks) to strengthen their capital relative to assets; for this reason, and because of the increasing cost of funds, lending rates have continued to increase, even as BI has been reducing its policy rate (Figure 9). Moreover, many potential borrowers are themselves reluctant to undertake new investments given the uncertain economic outlook. As we have seen, several of the banks recently preferred to use available liquidity to purchase safe government bonds rather than lend to the private sector, and it is entirely possible that they, and the investor community more generally, could extend this strategy to purchasing relatively safe assets offshore, such as US government paper. Thus, although BI may be tempted, or pressured, to reduce its policy rate further in the hope of lowering the prevailing high lending rates of the commercial banks, it may be recalled that the effect of expansionary monetary policy in 1997–98 was simply to provide the finance necessary for firms and individuals to speculate against the rupiah, provoking a severe burst of inflation and enormous depreciation of the currency.

Indeed, it is important that BI should be thinking about how to respond if there is a sudden and sustained loss of confidence resulting in high capital outflow. Its complete unpreparedness for this in 1997 led to a series of policy changes that succeeded only in destabilising the markets. One view is that BI should be prepared to back its judgment against that of the market, selling off its international reserves in order to defend the rupiah near its current level. On the other hand, this is precisely the policy followed by the central bank in Thailand during 1996 and 1997–a strategy whose failure led to a sudden and unexpected large depreciation of the baht, and precipitated the 1997–98 Asian financial crisis.

19 February 2009

Notes

¹This includes six local parties in Nanggroe Aceh Darussalam province, where the usual eligibility requirement for parties to have a wide national presence does not apply.

²These include elections of parliaments at national, provincial and local government levels, and of government leaders ranging from the president to village heads.

³Investors have been waiting for years for the enactment of a new mining bill. Although this was at last approved by the DPR in December 2008, the implementing regulations are not yet ready.

⁴Employees without taxpayer registration numbers are now subject to a withholding tax on their salaries 20% higher than the income tax rate that would otherwise apply, and to much higher fiskal withholding taxes if they go overseas.

⁵Our analysis is restricted to the larger firms (ranked by value added) that together account for 80% of total value added.

⁶For example, the price of crude palm oil increased by over 40% during the first two months of 2008 to $1,315 per tonne, before plummeting to just $386 in late October 2008. Exports of palm oil account for around 9% of total exports.

⁷It is possible that other domestic assets were substituted for these securities, but it seems more likely that a large part of the funds generated by this divestment was repatriated.

⁸The sudden contraction of base money in October 2008 mainly reflects the reduction in the minimum reserve requirement. Although this freed up liquidity, adding to the impact of accelerated government spending, these effects were offset by issues of SBIs and sales of foreign exchange by BI.

⁹The guarantee applies only if the interest rate on deposits does not exceed the LPS guarantee rate. This is to reduce moral hazard by preventing banks from offering excessively high deposit rates in order to finance very risky assets.

¹⁰January 2009 saw the emergence of another embezzlement case involving a securities company, PT Sarijaya Permana Sekuritas, that reportedly has cost investors billions of rupiah (Krismantari 2009).

¹¹The International Convergence of Capital Measurement and Capital Standards: A Revised Framework–known as ‘Basel II’–stipulates that banks need to take into account a wider set of risks, especially their operational risks, when calculating their CARs.

¹²The inclusion of an allowance for operational risks in the CAR was to commence from 1 January 2009, but it is now to be phased in gradually over two semesters, starting from 1 January 2010 (BI Circular 11/3/DPNP, dated 27 January 2009).

¹³Only a week after the finance ministry forecast the new budget deficit at 2.5% of GDP, Vice President Jusuf Kalla announced that the government would review the budget with a view to reducing the deficit (Oktaveri 2009). Contrasting views on the desirability of running a larger deficit in 2009 point to a lack of coordination among key policy makers.

¹⁴By contrast, its own website proclaims that ‘Bank Indonesia has one single overarching objective: to establish and maintain rupiah stability’ (<http://www.bi.go.id>).

¹⁵Despite continued increases in the BI rate through October, the rupiah continued to experience pressure from capital outflow, weakening to over Rp 12,000/$ in November from around Rp 9,300–9,400/$ in September (figure 4). It would appear that capital flows are much more sensitive to risk than to interest rate differentials in turbulent times.