Survey of recent developments

SUMMARY

Sri Mulyani's resignation as finance minister in May disturbed markets and aroused concern about the government's commitment to reform. This concern was partly alleviated by the appointment of two well-respected individuals as finance minister and deputy finance minister. Further progress with reform will depend heavily on this new team and other key officials. Strong presidential support will also be needed to resist attempts by parliament to interfere excessively with the finance ministry's work.

The economy continued its steady recovery from the impact of the global financial crisis (GFC), but the recovery could still be jeopardised if sovereign debt concerns in Europe persist and block the rebound in global trade and commodity prices. Inflation continues to accelerate, suggesting little room for complacency on monetary policy. Fiscal policy, on the other hand, remains conservative. The higher deficit in the revised 2010 budget is not excessive, and is unlikely to be realised in any case. The real budget challenge is to spend budgeted amounts fully and well. The new five-year plan is also conservative and does little to clarify spending priorities, including for the president's ‘connectivity’ agenda.

Despite the GFC, poverty continued to decline, thanks largely to the uninterrupted expansion of GDP and to cash transfers to the poor. Unemployment also continued to fall, although particular groups suffered slight increases in unemployment (young workers 15–25 years old) and somewhat larger reductions in working hours (urban, non-poor, and male-headed households). Nevertheless the large and sustained deceleration of manufacturing growth and the closely related dramatic shift of employment from the formal to the informal sector provide cause for concern. Distortionary labour market policies may help to explain both.

A new mining law significantly alters the legal environment for firms in this industry, and also introduces long discredited policies intended to ‘increase value added’ by requiring the domestic processing of minerals. A new law on local government taxes attempts to reduce uncertainty for citizens and investors, but the nature of overall spending by local governments is of much greater importance for the investment climate. The central government has recently been seeking to restore the role of the ‘missing intermediate’ level of government and to boost the centre's indirect control over local governments through provincial governments and governors. This strategy is unlikely to succeed, but it highlights the conflicting requirements for provincial governors to act as agents of the central government while also being accountable to their provincial electorates.

POLITICAL DEVELOPMENTS

On 4 May 2010 the president of the World Bank, Robert Zoellick, announced the appointment of Sri Mulyani Indrawati, the then Indonesian Minister of Finance, as a managing director of the World Bank Group effective 1 June. Just hours before, Sri Mulyani had broken the news of her appointment and resignation as Minister of Finance to her senior ministry officials (Tempo, 12–18 May 2010: 33). They were as stunned as the markets, with both stock prices and, to a lesser extent, the exchange rate reacting negatively to the news (figure 1). When the dust had settled, questions turned to the reasons for her departure and the implications for economic policy and reform. Perhaps more than anyone, Sri Mulyani has been credited with maintaining Indonesia's reputation for sound economic management over the past five years and with successfully navigating the GFC. She has also championed the causes of good governance and bureaucratic reform, especially within the Ministry of Finance. Would her departure signal the end of an era? Or would others emerge to take up the reform mantle?

FIGURE 1  Composite Stock Price Index (CSPI) and Exchange Rate

Sources: Indonesia Stock Exchange; Pacific Exchange Rate Service.

There is no doubt that it had been a difficult few months for the minister. Along with Vice President Boediono, she had been targeted in a parliamentary investigation into the bail-out of the troubled Bank Century. They both argued that the bail-out was justified to sustain financial sector confidence and stability, and no evidence of wrong-doing in the decision-making process has emerged (Patunru and von Luebke 2010: 10–12). Yet the hearings, and the related walk-outs when Sri Mulyani appeared before parliament subsequently, took their toll. Just as things seemed to be settling down, another scandal erupted around accusations of corruption in the tax office. On 31 March, a tax auditor, Gayus Tambunan, was arrested in Singapore after police investigation of a suspicious Rp 28 billion bank deposit. This followed revelations by a former national police chief detective, Commander General Susno Duadji, who is also linked to the Bank Century case and attacks on the Anti-corruption Commission (KPK) (box 1). Gayus in turn threatened to expose other tax officials involved in corruption. This was undoubtedly an indication of the difficulty of cleaning up the tax office – one of the corner-stones of the minister's reform agenda. But it also provided an opportunity for Sri Mulyani to ‘up the tempo’, and she moved swiftly to re-assign several tax officials and push for greater disclosure of their financial assets.

BOX 1 The Susno Connection

On 12 March 2010, the Tangerang District Court acquitted Gayus Tambunan on charges of money laundering and embezzlement. However, the former national police chief detective, Commander General Susno Duadji, revealed details of tampering by police officers and prosecutors in the outcome of the trial. This then led to further investigations into Gayus's finances.

Susno Duadji has links to several recent legal cases, involving Bank Century, the Anti-corruption Commission (KPK) and tax corruption (for details on the first two cases, see Patunru and von Luebke 2010: 8–12). It was Susno who facilitated a meeting between Budi Sampoerna (the former owner of a cigarette conglomerate) and Bank Century management in order to assist Sampoerna to withdraw a deposit of $18 million when the bank was collapsing. It was Susno's phone that the KPK wire-tapped while investigating this case. Susno's name was mentioned several times in conversations between an Indonesian businessman and one of the state prosecutors when they were planning to frame two KPK deputy commissioners, Bibit Rianto and Chandra Hamzah. Susno was also allegedly involved in the suspected set-up of the KPK chief commissioner (Antasari Azhar); he later strongly denied this allegation, even becoming a witness for the defence in Antasari's trial.

After he was relieved of his position, and feeling that he had been made a scapegoat, Susno started to release information to the public about several corruption and tax fraud cases. He claims to possess much more such information, so this episode may not be over yet.

These events were no doubt trying, but not in themselves enough to discourage a staunch reformer such as Sri Mulyani. Perhaps more pertinent was the growing influence of Aburizal Bakrie, the current chair of the Golkar Party and the fourth-richest man in Indonesia, according to the latest Forbes Rich List (with a reported net worth of $2.5 billion). It is no secret that Sri Mulyani and Bakrie had crossed swords on several occasions (Patunru and von Luebke 2010: 12). These included Sri Mulyani's refusal in November 2008 to maintain a suspension of trading in Bakrie-controlled companies after they rapidly lost a large proportion of their market value the previous month; disagreements over Bakrie's responsibility for the Lapindo mudflow disaster and his plans to buy into one of the country's largest gold mines; and the tax office's active pursuit of allegedly overdue tax payments by his companies. The president's apparent reluctance to support Sri Mulyani openly in these disputes no doubt reflected his strategy of giving priority to political stability over economic reform, and it confirmed Bakrie's growing influence within the coalition government. Soon after Sri Mulyani's resignation, Bakrie was appointed executive chairman of a new joint secretariat to improve ‘coordination and communication’ among the coalition parties.

Sri Mulyani did not mince words in explaining her resignation. She commented in an interview (Cochrane 2010):

The (Indonesian) business community is not supportive of having the system co-opted for very personal, narrow interests … If they start to allow one party to hijack it, it is at the cost of everyone else … It is really a concern. It is a battle for Indonesia now.

Other commentators agreed. While noting that Indonesia's reputation for prudent economic management would probably remain intact, Hill (2010) expressed concern at the prospects for continued economic and bureaucratic reform. He warned that other reformers ‘may draw the conclusion: don't take on the most powerful in the land, especially where their business interests are at stake’.

Some of this initial concern was alleviated by the quick appointment of Agus Martowardojo as finance minister and Anny Ratnawati as deputy minister. Agus is a respected banker who has won plaudits for his professional management of the largest commercial bank in Indonesia, the largely state-owned Bank Mandiri. Anny is a respected finance ministry official (Director General for Budget). In the current political environment, the two may well turn out to be more effective than Sri Mulyani in proceeding with reform in a more measured and less confrontational manner.

Within the ministry of finance, much will depend on Agus's leadership and the commitment of key officials to sustaining bureaucratic reforms. Strong support will also be needed from the president to resist excessive parliamentary interference in the budget process and spending decisions. On the policy front, the new team will have to move quickly to demonstrate its credentials and capacity to handle a broad range of economic policy issues (as opposed to a more narrow focus on markets and budgets). In all of these areas, Sri Mulyani has left big shoes to fill.

MACROECONOMIC DEVELOPMENTS

Growth and investment

Despite the political turmoil resulting from the Bank Century case, and its impact on both the finance ministry and the central bank, the economy has continued to recover steadily from the effects of the GFC. GDP growth (year on year) returned to pre-GFC levels in the fourth quarter (Q4) of 2009 and rose further to 5.7% in Q1 2010 (table 1a). The quarter-on-quarter growth of 1.4% in Q1 2010 (table 1b) is consistent with projected growth rates for 2010 as a whole in the range of 5.5% to 6.0%. While China is expected to continue to grow more strongly (8.7%), Indonesia's performance should be in line with the average for other developing countries in East Asia (5.5%) during 2010 (World Bank 2010c: 18). However, some caution is needed, given current volatility in world financial markets due to concerns about Europe's emerging fiscal and debt problems. These concerns have the potential to slow the recovery in global trade and commodity prices.

TABLE 1a Components of GDP Growth (2000 prices;% year on year)

	Dec-08	Mar-09	Jun-09	Sep-09	Dec-09	Mar-10
Gross domestic product (GDP)	5.3	4.5	4.1	4.2	5.4	5.7
GDP excluding petroleum & gas	5.7	4.9	4.5	4.5	5.8	6.1
By expenditure
Private consumption	4.8	6.0	4.8	4.7	4.0	3.9
Government consumption	16.4	19.2	17.0	10.3	17.0	−8.8
Investment	9.4	3.5	2.4	3.2	4.2	7.9
Construction	5.9	6.2	6.1	7.7	8.0	7.3
Machinery & equipment	15.9	−8.6	−11.5	−12.7	−3.9	7.7
Transport	38.3	9.6	−0.6	−2.1	−14.6	20.8
Other	6.2	−4.2	−2.6	1.8	3.0	2.4
Exports	2.0	−18.7	−15.5	−7.8	3.7	19.6
Imports	−3.7	−24.4	−21.0	−14.7	1.6	22.6
By sector
Tradables	2.8	2.9	2.2	2.7	4.5	3.4
Agriculture, livestock, forestry & fisheries	5.1	5.9	2.9	3.3	4.6	2.9
Mining & quarrying	2.4	2.6	3.4	6.2	5.2	3.5
Manufacturing industries	1.8	1.5	1.5	1.3	4.2	3.6
Excluding petroleum & gas	2.1	1.9	1.8	1.5	4.9	4.0
Non-tradables	7.6	6.1	5.9	5.6	6.3	7.9
Electricity, gas & water supply	9.3	11.2	15.3	14.5	14.0	7.2
Construction	5.9	6.2	6.1	7.7	8.0	7.3
Trade, hotels & restaurants	5.5	0.6	−0.0	−0.2	4.2	9.3
Transport	−1.0	2.0	5.7	7.4	6.7	4.8
Communication	33.5	30.3	26.6	23.7	16.3	17.0
Financial, rental & business services	7.4	6.3	5.3	4.9	3.8	5.5
Services	5.9	6.7	7.2	6.0	5.7	4.6
Source: CEIC Asia Database.

TABLE 1b Components of GDP Growth (2000 prices; seasonally adjusted; % quarter on quarter)

	Dec-08	Mar-09	Jun-09	Sep-09	Dec-09	Mar-10
Gross domestic product (GDP)	0.9	1.1	1.2	1.2	1.5	1.4
GDP excluding petroleum & gas	0.9	1.1	1.3	1.4	1.7	1.5
By expenditure
Private consumption	1.3	1.6	0.6	1.1	0.7	1.3
Government consumption	2.8	7.2	0.6	0.3	1.3	−3.7
Not seasonally adjusted	25.6	−28.7	23.7	−0.4	33.2	−44.4
Investment	0.9	−1.1	0.6	2.8	1.8	2.4
Construction	1.7	1.7	1.7	2.1	1.8	1.5
Machinery & equipment	−7.8	−11.1	−1.4	8.1	1.4	−0.4
Transport	8.7	−16.0	4.2	6.4	−3.6	4.2
Other	−0.9	−2.8	2.5	3.2	0.2	−3.5
Exports	−4.7	−14.7	6.1	6.9	7.0	−1.5
Imports	−8.7	−14.4	4.4	4.6	8.2	3.7
By sector
Tradables	0.5	0.9	0.7	0.9	1.0	0.8
Agriculture, livestock, forestry & fisheries	0.9	1.3	0.5	0.9	1.0	0.7
Mining & quarrying	0.9	0.9	1.4	2.1	−0.2	−0.6
Manufacturing	−1.4	0.9	0.9	0.8	1.4	0.4
Excluding petroleum & gas	−1.7	1.2	1.1	1.1	1.1	1.0
Non-tradables	1.3	0.7	1.8	1.7	1.9	2.1
Electricity, gas & water supply	2.5	4.3	3.2	2.1	2.6	1.0
Construction	1.7	1.7	1.7	2.1	1.8	1.5
Trade, hotels & restaurants	−1.1	−3.4	2.1	2.3	3.3	1.3
Transport	1.3	2.0	2.3	1.4	0.8	0.2
Communication	7.4	4.0	5.0	5.5	1.0	4.6
Financial, rental & business services	2.0	0.8	0.6	1.4	0.9	2.5
Services	1.5	1.8	1.9	0.7	1.2	0.9
Source: CEIC Asia Database.

GDP growth in 2009 was held back somewhat by the rather modest increase in private consumption, but boosted by strong growth in government consumption (table 1a). According to World Bank estimates (2010b: 25–27), the government's February 2009 GFC stimulus package added about 1 percentage point to growth in 2009. Budget figures suggest that the main impact came from lower taxes than originally budgeted (see budget table below). While there was also spending on stimulus programs, this was offset by spending shortfalls elsewhere in the budget. The growth of government consumption became strongly negative in Q1 2010, but there are encouraging signs of some pick-up in investment. The year-on-year data show a huge improvement in export growth, but it remains to be seen whether this will be sustained, with seasonally adjusted quarter-on-quarter growth in Q1 2010 turning negative (table 1b). Moreover, whereas imports have generally been declining more rapidly, or growing more slowly, than exports in recent times, resulting in a positive impetus to GDP growth from net exports, this outcome was reversed in Q1 2010. Observers such as Basri and Rahardja (2010), who have argued that Indonesia's economy was to some extent protected from the GFC by its relatively low dependence on exports (compared, say, with Singapore, Malaysia and Thailand), appear to have overlooked the equally important impact of changes in import growth. Ironically, now that world trade is recovering, Indonesia is unlikely to benefit as much as other countries from export recovery, and if imports continue to grow even more rapidly than exports, GDP growth will suffer even further in the short run (although increased imports of capital goods will add to productive capacity in the medium term).

On the production side, GDP growth is still dominated by the non-tradable sectors (such as domestic trade and communications), which expanded collectively by 7.9% (year on year) in Q1 2010 (table 1a). The manufacturing sector (excluding oil and gas) is recovering more slowly, up by 4.0% in Q1 2010. According to Danamon (2010), manufacturing sector growth is also relatively narrowly based, being concentrated in a few sub-sectors such as vehicle manufacturing and chemicals. By contrast, the wood, paper and printing, basic metals and steel, and textiles and footwear sub-sectors are continuing to contract.

In early May 2010 the Investment Coordinating Board (Badan Koordinasi Penanaman Modal, BKPM) released new data on foreign and domestic investment realisation for the first quarter of 2010. Investment realisation totalled Rp 42 trillion for 574 projects, of which Rp 35 trillion ($3.8 billion) was foreign investment in 424 projects and Rp 7 trillion was domestic investment in 150 projects. While these numbers suggest a significant rise in foreign investment and fall in domestic investment compared with Q1 2009, they are not strictly comparable. BKPM now bases its investment data on investment activity reports rather than relying, as before, on data on the issue of permanent business licences. Over time, this change should provide more accurate estimates of realised investments. However, initial compliance with the new reporting requirements is incomplete, so the new data probably under-record actual investment activity.

Balance of payments and trade policy

Exports recovered during 2009 from their March lows (figure 2a), spurred by strong demand and higher prices for commodities, but they fell back slightly in Q1 2010. Meanwhile imports continued to rise (figure 2b), narrowing the merchandise trade surplus from $11.5 billion in Q4 2009 to $7.9 billion in Q1 2010 (table 2). However, strong portfolio investment inflows ($6.2 billion in Q1 2010, more than three times larger than a year earlier) continued to bolster the overall balance of payments. Foreign direct investment has been more subdued, although Danamon (2010: 10) reports some signs of a recovery in the manufacturing sector in Q1 2010. To offset the impact of portfolio flows on the exchange rate, Bank Indonesia (BI) has accumulated foreign reserves, which rose from $52 billion to $66 billion over 2009 and further to $79 billion by the end of April 2010. This means that Indonesia is effectively forgoing the opportunity to use available foreign savings to finance imports, in order to support investment and growth by instead lending these savings back to the rest of the world. However, this trend has moderated more recently, because foreign investor interest in Indonesia has been adversely affected by the impact of Europe's debt problems on risk appetite.

FIGURE 2a  Exports ($ values, 3-month rolling sum, July 2008 = 100)

Source: CEIC Asia Database.

FIGURE 2b  Imports ($ values, 3-month rolling sum, July 2008 = 100)

Source: CEIC Asia Database.

TABLE 2 Balance of Payments ($ billion per quarter)

	Mar-09	Jun-09	Sep-09	Dec-09	Mar-10
Current account	2.9	3.1	2.2	3.4	1.6
Exports	24.2	27.5	31.3	35.9	34.3
Non oil & gas	20.5	23.1	25.6	29.2	27.8
Oil & gas	3.7	4.5	5.7	6.8	6.5
Imports	17.2	18.8	22.8	24.5	26.4
Non oil & gas	15.2	16.5	19.0	20.7	22.0
Oil & gas	2.0	2.3	3.8	3.7	4.4
Merchandise trade balance	7.0	8.7	8.5	11.5	7.9
Non oil & gas	5.3	6.6	6.6	8.4	5.8
Oil & gas	1.6	2.1	1.8	3.0	2.1
Services	−2.5	−3.1	−3.5	−4.6	−3.6
Income	−2.7	−3.7	−4.1	−4.7	−4.0
Current transfers	1.1	1.2	1.2	1.3	1.2
Capital account	0.0	0.0	0.0	0.0	0.0
Financial account	1.7	−2.4	2.5	1.4	4.3
Direct investment	1.7	0.0	0.5	1.0	1.9
Portfolio investment	1.9	2.0	3.0	3.3	6.2
Other investment	−1.8	−4.5	−1.0	−2.9	−3.9
Errors & omissions	−0.7	0.4	−1.1	−0.9	0.8
Overall balance (change in reserves)	4.0	1.1	3.5	4.0	6.6
Sources: CEIC Asia Database; Bank Indonesia.

On the trade front, most attention in recent months has focused on the ASEAN–China Free Trade Agreement (ACFTA).2 As noted in the last survey (Patunru and von Luebke 2010: 27–30), there was considerable pressure from domestic producers and parliament for Indonesia to re-negotiate tariffs on 228 items in the steel products, textiles and footwear sectors. Following a meeting between Indonesian and Chinese officials in Yogyakarta on 3 April 2010, however, it was decided that the ACFTA would be implemented as planned. At the same time, both countries agreed that, if there is a bilateral trade imbalance, ‘the surplus country is obliged to implement steps to increase imports’ and to provide whatever ‘support is needed by the partner country’.3 This is a good outcome in terms of honouring Indonesia's international obligations, while also recognising the potential impact of factor market and exchange rate distortions in China. However, in practice, it remains to be seen how China would respond to a bilateral trade imbalance with Indonesia. And, in economic terms, the individual country components of Indonesia's overall trade balance with the rest of the world are of little consequence.

Inflation, monetary policy and financial markets

Consumer price inflation has been creeping up since November 2009, reaching an annual rate of 4.2% in May 2010 (figure 3). However, monthly inflation in May (0.3%) was relatively mild, and there is no evidence of a strong upward trend in core inflation or wholesale prices. This is due partly to the moderating influence of the rupiah's appreciation against the US dollar over the past year. This exchange rate effect may now unwind as the US dollar strengthens on world markets. There may also be some moderate inflationary pressure from rising prices in Indonesia's trading partners and the proposed 10% increase in electricity tariffs. The impact of the latter is expected to be small, however, because tariff rises for low-end consumers (who account for around 65% of household energy usage) will be excluded, and because electricity costs comprise just 3.5% of input costs for medium and large-scale manufacturing industries (Danamon 2010: 14). Inflationary expectations remain low and inflation is expected to stay well within BI's range of 4–6% during 2010.

FIGURE 3  Monetary Policy and Inflation ^a (% p.a.)

^aCPI = consumer price index; SBI = Sertifikat Bank Indonesa (Bank Indonesia Certifcate).

Source: CEIC Asia Database; Bank Indonesia.

That said, there is little room for complacency on monetary policy. While BI's policy rate has stayed at 6.5% since August 2009 (Figure 3), the 30-day SBI (Bank Indonesia Certificate) rate has tracked down in recent months (from 7.3% in May 2009 to 6.3% in May 2010). This downward trend is a better indication of BI's relaxed monetary stance than the fixed policy rate. Portfolio capital flows from overseas have influenced monetary conditions, because BI's open market operations have not been enough to sterilise the extra liquidity resulting from its accumulation of reserves (intended to moderate upward pressure on the rupiah) (World Bank 2010b: 32–5). The net effect of these developments has been a doubling in the rate of growth of currency in circulation since September 2009 (figure 3). It would be prudent for BI to moderate its ‘dovish’ position, and act if necessary, well before inflation reaches the top (6%) of its inflation band.

How this plays out over the next few months will depend a lot on developments in world financial markets and their impact on international prices and risk perceptions. As events in recent weeks have shown, Indonesian markets are very sensitive to changes in risk appetites (figure 1). A sustained crisis in Europe, for example, could cause foreign investors to pull back from Indonesia, with negative effects on the stock market and the exchange rate. While the government has had no difficulty so far in meeting its bond issue targets for 2010 (with more than half the total requirement fulfilled by mid-May), fund-raising could become more difficult with a deterioration in foreign investor sentiment.

The banking system appears to be in good health, with reported commercial bank non-performing loan ratios remaining at around 3.4% in Q1 2010 – slightly lower than the averages for 2009 and 2008, and well below the averages for 2007 (5.6%) and 2006 (8.0%) (World Bank 2010b: 9). However, as shown in the Bank Century case, official numbers do not always tell the whole story, and averages, dominated by the top 14 commercial banks, may conceal weaker performance in some smaller ones. For example, Bank Eksekutif revealed a non-performing loan ratio of 15.6% in September 2009 and has been placed under enhanced BI surveillance. Lending growth has also started to recover, after modest growth in 2009 (11.5%), and average rates for working capital loans have started to fall below 14%. However, bank net interest margins, at over 5.8% in March 2010, are still among the highest in the region (World Bank 2010b: 10–11), presumably reflecting the high perceived risks of doing business in Indonesia and the low efficiency of banking.

Fiscal policy

The revised budget for 2010 (table 3) was finally approved by parliament on 3 May 2010.4 The revised macro assumptions – especially the increase in the assumed oil price from $65 to $80 per barrel – are prudent given current volatility in world financial and commodity markets. The main question mark – other than the difficulty of predicting the volatile oil price – is over the assumed level of oil production (965,000 barrels per day), which may be on the high side. The revised budget also assumes that electricity tariffs will be raised on average by 10% in July, with proportionately higher increases for larger power consumers.5 Even so, most of the increase in spending is allocated to higher subsidies, with departmental spending close to original estimates.

TABLE 3 Budgets for 2009 and 2010 (Rp trillion)

	2009			2010
	Original	Revised	Preliminary Actual	Original^a	Revised
REVENUES & GRANTS	985.7	871.0	866.8	949.7	992.4
Tax revenues	725.8	652.0	641.2	742.7	743.3
Non-tax revenues	258.9	218.0	224.5	205.4	247.2
Grants	0.9	1.0	1.1	1.5	1.9
EXPENDITURES	1,037.1	1,000.8	954.0	1,047.7	1,126.2
Interest payments	101.7	109.6	93.8	115.6	105.7
Subsidies	166.7	158.1	159.5	157.8	201.3
Transfers to regional governments	320.7	309.3	308.6	322.4	344.6
Other^b	448.0	423.8	392.1	451.8	474.6
DEFICIT	−51.3	−129.8	−87.2	−98.0	−133.8
% of GDP	−1.0	−2.5	−1.6	−1.6	−2.1
FINANCING ^c	51.3	129.8	125.2	98.0	133.8
Domestic financing (net)	60.8	142.6	142.6	107.9	133.9
Foreign financing (net)	−9.5	−12.7	−17.4	−9.9	−0.2
Gross drawings	52.2	56.3		57.6	54.0
Amortisation	−61.6	−69.0		−67.5	−54.1
UNSPENT FUNDS	0.0	0.0	38.0	0.0	0.0
MACRO ASSUMPTIONS & OUTCOMES
GDP (Rp trillion)	5,134	5,194	5,613	6,126	6,369
GDP growth (%)	6.0	4.3	4.5	5.5	5.8
Inflation (% p.a.)	6.2	5.0	2.8	5.0	5.3
Exchange rate (average, Rp/$)	9,400	10,600	9,408	10,000	9,200
3-month SBI rate (average% p.a.)	7.5	7.5	7.6	6.5	6.5
Oil price (average, $/barrel)	80.0	61.0	61.6	65.0	80.0
Oil production (‘000 barrels/day)	960	960	952	965	965
^a Data in this column reflect the budget approved by the DPR. Some amounts differ from those originally proposed, which were reported in the previous survey.
^b ‘Other’ includes departmental spending on personnel, material, capital, social and other items.
^c Foreign financing is from official sources only. All bonds (including those denominated in foreign currencies and those held by foreigners) are included in the domestic financing figures.
Sources: 2009 macro outcomes: World Bank; all other data: Ministry of Finance.

The overall deficit is raised from Rp 98 trillion (1.6% of GDP) in the original 2010 budget to Rp 134 trillion (2.1% of GDP) in the revised budget. The increase will be funded largely by drawing on unspent funds of Rp 38 trillion from the previous year. However, if past experience is any guide, budget spending and the deficit are likely to fall well short of planned levels. Last year, for example, the revised deficit after the stimulus package was projected to be 2.5% of GDP, but the actual deficit was only 1.6% of GDP. For this year, the World Bank (2010b) is projecting a deficit closer to 1.3% of GDP, owing to higher GDP and revenue estimates and lower spending than in the revised budget.

This pattern of spending shortfalls raises more fundamental issues about the appropriate fiscal stance. Indonesia has jealously guarded its reputation for fiscal prudence over the past 30 years (box 2), even though there have been lapses along the way (as during the Asian financial crisis) and even though the means of financing the deficit have changed over time (with a significant shift from official loans to sovereign bond issues during the past decade). Trends in budget financing and public debt are summarised in figure 4a and 4b.6 Now that public debt has been brought back down below 30% of GDP, it is appropriate to ask whether a larger deficit may be justified to boost economic growth (through infrastructure investment, for example) or to expand coverage of anti-poverty programs.

BOX 2 A Brief History of Deficits and Debt in Indonesia

Indonesia has earned a reputation for sound fiscal management over the past 30 years. During the Soeharto era, the economic team (often referred to as the ‘technocrats’) maintained fiscal discipline through the ‘balanced budget rule’, which kept spending roughly equal to domestic revenues plus official external assistance. The level, allocation and implementation of development spending were largely determined by loans mobilised from the international community. These were on concessional terms and were considered to be more ‘development-oriented’ than commercial credits. Windfalls in oil revenues were often ‘hidden’ and used to cushion spending cuts when oil prices fell (and also to fund ‘off-budget’ programs). Additional program loans were also sought from donors in times of crisis (such as when oil prices collapsed in 1986).

This model broke down during the AFC. Although public debt was only 23% of GDP in 1996/97, this was quickly inflated by the impact of the rupiah depreciation on external debt, and by the issuing of new domestic debt to recapitalise banks and compensate BI for the non-repayment of last-resort loans issued during the early months of the crisis. Initial attempts under the IMF program to run budget surpluses proved counter-productive, as output fell sharply. Subsequent efforts to operate deficits ran into financing constraints, because conditions for promised program lending were not met. Although the budget situation was eventually brought under control, public debt had risen to almost 100% of GDP by 2000.

Over the past decade the government has worked hard to restore the credibility of budget institutions, by passing new laws on public financial management and reforming the Ministry of Finance (especially the tax and customs directorates). It has also kept tight control over the budget deficit to lower the burden of public debt. By 2009 public debt had been reduced to less than 30% of GDP. More than 60% of public debt is now in the form of government bonds (denominated in both rupiah and foreign currencies), while net borrowing (that is, new borrowing less repayments of outstanding loans) from official sources is negative. The decision to abolish the Consultative Group on Indonesia (CGI) in January 2007 symbolised the end of Indonesia's ‘aid dependence’, and ushered in a new era of bilateral ‘partnerships’ with major creditors and donors.

In response to the GFC, the government implemented a modest stimulus package of tax and spending measures to raise the budget deficit to 2.5% of GDP in 2009. This higher deficit was to be funded by additional bond issues, while various stand-by facilities were also put in place in case market conditions deteriorated. But spending fell well short of plans, and the actual deficit was only 1.6% of GDP. Similar outcomes are expected in 2010. For the medium term, the policy debate has shifted back to the scope for running larger deficits to boost economic growth and anti-poverty programs, while still safeguarding Indonesia's hard-earned reputation for fiscal prudence.

FIGURE 4a  Budget Financing ^a (% of GDP)

^aData for the years 1996–99 refer to fiscal years ending in March the following year.

Source: Ministry of Finance.

FIGURE 4b  Public Debt ^a (% of GDP)

Source: Ministry of Finance (foreign currency denominated debt converted to rupiah using International Monetary Fund International Financial Statistics end-of-year exchange rates). The figure for 1996 is a World Bank estimate.

From a financing point of view, deficits of around 2% of GDP should be manageable without risking Indonesia's credit rating. Deficits in this range have already been projected for 2009 and 2010 without upsetting the domestic bond markets. Additional financing from official creditors and donors could also be tapped for worthwhile development programs, or to provide stand-by financing in case market conditions deteriorate.7 That said, the recent experience of countries such as Greece is indicative of the dangers of relaxing the discipline of limits on budget deficits. Small deficits can expand significantly in just a few years as politicians respond to the pressures of populism, producing an unsustainable public debt burden. One of the great achievements of the balanced budget rule during the Soeharto era was to prevent this from happening. Nevertheless, the real issues in Indonesia today lie on the spending side. Two challenges stand out.

The first challenge is to fix the mechanics of budget spending. Past surveys (for example, Kuncoro, Widodo and McLeod 2009: 159) have highlighted the problem of bunched spending in the last quarter of the fiscal year. According to the latest analysis from the World Bank (2010b), while there has been some improvement in the spending performance of line ministries, more than 40% of spending still occurred in the last quarter of 2009. This pattern leads to wasteful spending and budget shortfalls for the year as a whole. International experience suggests that the solution lies in better advance planning before the start of the fiscal year, greater flexibility in spending during the fiscal year and more scope to carry over funding at the end of the fiscal year.8 While Indonesia's new budget laws provide for some flexibility, officials rarely exploit this, for fear of violating budget rules and being accused of corruption. Major changes are needed in the ‘control and compliance’ mindset of officials in both the Ministry of Finance and line ministries.

The second challenge is to ensure that money is well spent. During the Soeharto era, the technocrats used the planning process and the budget constraint to weed out ‘white elephant’ projects. However, as discussed below, the planning process is no longer as strong or as well linked to the budget as in the past. Therefore, in the current political environment, there is a risk that ‘pet’ projects will get funded without adequate vetting for economic and social returns. The recent, ultimately unsuccessful, proposal from Golkar – initially with the support of other parties – to allocate Rp 15 billion for each DPR law maker in the 2011 budget (Jakarta Post, 4/6/2010) is a case in point. Close scrutiny of the budget by the Ministry of Finance provides some insurance against poor spending decisions.9 It is also important to monitor the results of budget spending. The proposed move to performance-based budgeting next year will help shift the focus of accountability from ex ante controls to ex post results. But, as with the mechanics of spending, a lot will depend on how the new system is used and how it feeds back into spending decisions. If it just becomes another layer in the spending management system, without any simplification of ex ante controls, it could further reduce budget flexibility.

THE NEW FIVE-YEAR PLAN

The five-year National Medium-term Development Plan (Rencana Pembangunan Jangka Menengah Nasional, RPJMN) for 2010–14 was launched in early February 2010. It is a very large document, in three volumes. The first volume outlines the government's development strategy for the next five years to realise the president's vision of a ‘prosperous, democratic and just’ Indonesia. The other two volumes expand on the sectoral and regional development plans. It is easy to dismiss the plan as excessive rhetoric, having little impact on budget or policy decisions. Nonetheless, a lot of time and effort will now be spent translating the RPJMN into the strategic plans of line ministries (Rencana Strategis Kementerian Lembaga, Renstra–KL) and the development plans of provincial and district governments. In April the president held a two-day retreat in Bali with his full cabinet and all provincial governors to prepare a ‘roadmap’ to achieve the plan's goals. So it is worth examining what the plan says and the main development challenges it identifies for the next five years.

The plan projects an average annual economic growth rate of 6.3–6.8% for 2010–14. Provided the global economy stabilises and there are no further major economic crises, the growth rate is expected to reach 7% or more by 2014 (table 4). Along with various pro-poor programs, this growth is expected to reduce the poverty rate from 14.2% in 2008–09 to 8–10% in 2014, and the open unemployment rate from 7.9% to 5–6% over the same period. Eleven national priorities are identified to achieve these outcomes: bureaucracy and governance reform; education; health; poverty reduction; food security; infrastructure; investment and business climate; energy; environment and disaster management; least developed, frontier, outer and post-conflict areas; and culture, creativity and technological innovation.

TABLE 4 National Medium-term Development Plan 2010–14, Selected Macroeconomic Targets

	2010	2011	2012	2013	2014
GDP growth (%)	5.5–6.0	6.0–6.3	6.4–6.9	6.7–7.4	7.0–7.7
Inflation (CPI) (% p.a.)	4.0–6.0	4.0–6.0	4.0–6.0	3.5–5.5	3.5–5.5
Tax revenues/GDP (%)	12.4	12.6	13.0	13.6	14.2
Budget deficit/GDP (%)	−1.6	−1.9	−1.6	−1.4	−1.2
Public debt/GDP (%)	29.0	28.0	27.0	25.0	24.0
Source: Bappenas (2010).

The overall tone of the plan is consistent with the vision laid out in the president's Independence Day address in August 2009 (Yudhoyono 2009). There is a heavy emphasis on building a strong, stable, unified country, based on self-reliance and a well-connected domestic economy. Issues of economic efficiency and international competitiveness are mentioned, but take a back seat to concerns about domestic equity and connectivity. This is perhaps understandable, especially in the aftermath of the GFC. But it is also a missed opportunity to set more ambitious growth targets, needed to make significant inroads on poverty over the next five years.

The macroeconomic framework for the plan is also conservative. The budget deficit is projected to fall to 1.2% of GDP, and public debt to 24% of GDP, by 2014 (table 4). Higher tax revenues and lower subsidies apparently provide more than enough resources to finance the proposed public investment program (although numerical values are not specified in the plan). As discussed above, there is scope on the financing side for considering a more expansionary fiscal policy to support economic growth and anti-poverty programs. However, this can only be justified and realised if current spending constraints are addressed.

Unfortunately, the plan does little to clarify spending priorities. The 11 priorities outlined above are very comprehensive, and provide little guidance for the preparation of the national budget, sectoral programs and regional plans. While the program for the first 100 days of the president's second term has been rightly criticised for its vagueness and limited scope (Patunru and von Luebke 2010: 24–27), it did at least initiate a process for monitoring progress on priority actions. The same approach has now been carried over into Inpres (Presidential Instruction) No. 1 for 2010, which outlines the government's priorities for 2010. It has only 155 priority activities, compared with 1,167 in the five-year plan. The Presidential Unit for Development Supervision and Control (Unit Kerja Presiden untuk Pengawasan dan Pengendalian Pembangunan, UKP4), under Kuntoro Mangkusubroto, is responsible for monitoring progress and identifying possible bottlenecks. Although this process brings some much-needed discipline to the government's program, it depends on the right priorities being identified at the outset. This is where a close working relationship between the national planning agency, Bappenas, and UKP4 is essential.

Connectivity

One of the recurring themes10 of the plan is the importance of ‘connecting Indonesia’ so as to unify the country and ensure that the benefits of economic growth are widely shared.11 This is reflected in the plan's national priorities, infrastructure targets and regional development strategy. But what is less clear is what ‘connectivity’ means in terms of investment and policy choices. One framework for thinking about these issues is provided in the 2009 World Development Report on Reshaping Economic Geography (World Bank 2008a).12 This stresses that as economies progress from low to high income, production becomes more concentrated spatially. For Indonesia the concentration is on Java, especially around the Greater Jakarta area, and in smaller regional centres in the outer islands. This is not a trend that can or should be reversed. Rather, the need is to find ways to share the benefits of concentrated production across regions and income groups, while recognising that almost 60% of the poor live on Java.

For Indonesia, the challenge of connectivity can be broken down into three dimensions: intra-island, inter-island and international connectivity. Intra-island connectivity is important to link poorer rural areas to urban growth poles and to link growth poles to each other. Differential strategies are required, with ‘back-bone’ infrastructure on the more densely populated islands of Java and Sumatra; ‘special-purpose’ infrastructure connecting major resource-based industries with their ports on Sumatra and Kalimantan; and ‘ink-spot’ development around smaller growth poles on the more remote and less densely populated islands of eastern Indonesia. Much of the infrastructure in both urban and rural areas will come from local governments. The private sector can contribute to financing infrastructure projects – including, for example, toll roads on Java and those serving resource-based industries on the outer islands. But the central government also has a role to play in providing a sound regulatory framework, including for land acquisition, local borrowing and pricing and subsidy decisions.

Inter-island connectivity is especially important in a far-flung archipelago like Indonesia. At the Asia Pacific infrastructure conference in Jakarta on 14 April 2010, the president reiterated his commitment to building the Sunda bridge to connect Java and Sumatra. At an estimated cost of at least $10 billion, this would be a major investment that warrants careful economic and financial analysis.13 A much smaller investment in better ferry services might well generate similar benefits. More generally, something needs to be done to improve the reliability and reduce the cost of inter-island shipping services. As documented in Dick (2008), current restrictions protect domestic ship-builders and shipping companies, but thereby penalise the outlying regions that depend on their services. The recent booms in telecommunications and domestic airways, following the deregulation that opened up opportunities for competition from new firms, provide a telling counter-point to the situation in inter-island shipping. There may also be a case for subsidising pioneer shipping services in eastern Indonesia, so long as the subsidies are provided in a way that is transparent and encourages competition. Similar arguments for transparent and targeted subsidies may apply to the development of regional ports, although the investment requirements can be substantially reduced through the development of roll-on, roll-off services (as in the Philippines), and the extension of telecommunication services to Papua and West Papua provinces.

International connectivity is vital to ensure that Indonesia remains competitive within the region and to realise the full benefits of better market access. Jakarta's Tanjung Priok port handles 70% of Indonesia's general cargo and container exports and imports, and the logistics of accessing and using the port are key components in Indonesia's trade costs. The latest Logistics Performance Index compiled by the World Bank (2010a) shows that Indonesia's ranking has fallen from 43^rd in 2007 to 75^th in 2010. While this does not put it out of line with other lower middle-income countries, Indonesia lags well behind its competitors in the region: Singapore ranks 2^nd, Malaysia 29^th, Thailand 35^th, the Philippines 44^th and Vietnam 53^rd.14 The private sector is especially critical of border management, including customs procedures. Recent progress on the Logistics Blueprint – including around-the-clock port operations, a national single window for border clearances, and a dry port at Cikarang – is encouraging. But more needs to be done to improve efficiency at Tanjung Priok (including the rail link from Cikarang) and to develop a new deep water port as quickly as possible.

These are not new issues. Given the strong vested interests involved, high-level commitment from the president and vice president will be needed to make progress. A substantial commitment of public and private resources will also be required. Fortunately, the government can now afford to spend more on priority infrastructure projects, and has the budget mechanisms to work with the private sector.15 While private participation in infrastructure has recovered from the lows of 2005, it has been concentrated in telecommunications and energy. Private investment can be attracted into major transport projects such as a new Jakarta port and the Trans-Java Expressway, but only if there is clarity on the regulatory framework and confidence that the project will be profitable (through tariffs and/or subsidies). A high-level and well-coordinated push on the connectivity agenda is therefore urgently needed – both to support stronger economic growth and to share its benefits across the country.

POVERTY AND EMPLOYMENT

The impact of the GFC on poverty

According to estimates by the central statistics agency (BPS), the poverty rate fell from 16.6% in 2007 to 15.4% in 2008 and 14.2% in 2009.16 This is despite the impact of higher food prices in mid-2008 and the subsequent impact of the GFC on commodity prices (figure 5) and GDP growth later in 2008 and early 2009. Overall, the impact of the GFC on the real economy was much milder than that of the 1997–98 Asian financial crisis (AFC), and the impact on the poor was further mitigated by direct cash transfers (bantuan langsung tunai, BLT) in July 2008, October 2008 and April 2009; by election campaign spending from July 2008 to July 2009; and by the fiscal stimulus package in late 2009.

FIGURE 5  Key Commodity Prices ^a (Jan-2007 = 100)

^aPalm oil: Malaysia Palm Oil Futures (first contract forward) 4–5% FFA; rubber: No. 1 Rubber Smoked Sheet, fob Malaysia/Singapore; coal: Australian thermal coal, 12,000-btu/pound, less than 1% sulphur, 14% ash, fob Newcastle/Port Kembla; rice: 5% broken milled white rice, Thailand nominal price quote.

Source: IndexMundi, <http://indexmundi.com/commodities/>.

The mild effect of the crisis on poverty is consistent with the findings of Resosudarmo and Yusuf (2009), and is confirmed by recent quantitative and qualitative studies (McCulloch and Grover 2010; World Bank 2010b; SMERU Research Institute 2009). However, these studies also point to a number of differences in impact across population sub-groups. The results of qualitative and quantitative research by McCulloch and Grover (2010) for the year to February 2009 are summarised in table 5. The most significant employment effects seem to be on young workers. For 18–25-year-olds, unemployment rose from 19.8% in February 2008 to 21.6% in August 2008, before falling slightly to 21.4% in February 2009. Comparable figures for 15–17-year-olds are slightly higher: 21.1% in February 2008, 24.9% in August 2008 and 22.3% in February 2009.17 The qualitative study also shows a more noticeable impact of the crisis on contract and migrant workers in the commodity (rubber and coal) and manufacturing (automotive, electronics and consumer products) sectors.

TABLE 5 Impact of the Crisis: February 2008 to February 2009

	Qualitative Study (Feb-2009)	Quantitative Study (Feb-2008, Aug-2008, Feb-2009)
School enrolment and attendance	No change, but some arrears in payment	Generally no change or continued improvement for 13–14-year-olds, but some seasonal withdrawal in August for girls and 17-year-olds
Female labour participation	No change	No change
Child labour participation	No change	Significant falls in labour force participation of 12–17-year-olds
Unemployment	Increase for young, migrant industrial workers and workers in rubber and coal industries	Rising for 15–17 and 18–25-year-olds, falling for 25–55-year-olds
Hours of work	Reduced for contract workers	No significant changes
Informal employment	Some suggestion of a shift to informal employment	Some increases in own business and casual non-agricultural work in 2008, but little overall change
Wages and income	Large falls in take-home pay for contract workers; reduction in income for local businesses	Significant increases in real wages for formal sector employees, but little change in incomes in the informal sector^a
^a McCulloch and Grover (2010) argue that inflation in mid-2008 might have caused the increase in nominal wages in the formal sector after August 2008 and before the onset of the GFC in October 2008. The subsequent collapse of commodity and food prices resulted in reduced inflation, increasing real wages significantly.
Source: McCulloch and Grover (2010).

The impact of the crisis was also monitored by the government's Crisis Monitoring and Response System (CMRS) (World Bank 2010b) from February 2009 through February 2010.18 Workers in general experienced a reduction in working hours and, although there had been some recovery by November 2009, the national average was still 0.8 hours per week lower than in May 2009. From February to August 2009, weekly working hours declined on average nationally, with greater declines in urban than in rural areas (after adjustment to account for seasonality).19 From May to August 2009, however, weekly working hours in rural areas declined more than those in urban areas (–1.5 hours versus –1.1 hours) (these figures do not account for seasonality) (table 6). This may indicate that the crisis might have affected the urban areas first, which seems plausible. Overall, from May to November 2009, urban, non-poor20 and male-headed households had relatively greater reductions in working hours than rural, poor and female-headed households, although rural and poor households experienced greater reductions between May and August 2009.

TABLE 6 Changes in Weekly Hours Worked (hours)

	Location		Income Group		Household Head
	Urban	Rural	Non-poor	Poor	Male	Female
May–August 2009	−1.1	−1.5	−1.3	−1.5	−1.4	−1.1
May–November 2009	−1.1	−0.5	−1.0	0.3	−1.0	1.2
Source: World Bank (2010b)

Households coped in part by buying lower-quality non-staple food. The proportion of households reporting difficulty in meeting consumption needs rose by about 4 percentage points from April to July 2009 (World Bank 2010b). The increase was higher among the poor and in rural areas. However, by October 2009, the proportion of households reporting difficulty in meeting consumption needs had fallen back to about 3 percentage points below the April level.

Household expenditures on health care and education remained constant. There was no evidence of households coping with economic hardship by sending their children into the labour force. One qualitative study (SMERU Research Institute 2009) shows that few school-age children dropped out of school at any level, even though there were cases where children at high-school level moved to cheaper schools. Some changes in attitudes towards expenditure on health care were noted in this study, including a shift to cheaper medical treatment in certain case studies.21 There was no evidence of non-working females being forced to enter the labour force.

In summary, the impact of the GFC on poverty was mild (compared with that of the 1997 AFC), but it was not uniform among sub-groups of the population. Commodity prices and export volumes have now picked up, easing employment concerns in the export sector. But the crisis may still be prolonged for those hardest hit, because of missed opportunities for receiving proper education or good health care, for example. Fortunately, the direct cash transfers and election campaign spending cushioned the impact of this crisis on the poor. Given that different crises have very different impacts, more targeted interventions would require regular and up-to-date monitoring of poverty levels and social conditions. It would not seem too difficult to institutionalise the CMRS surveys to play this role in the future, although the feasibility of undertaking targeted interventions, tailored on an ad hoc basis to the particular effects of each new crisis, should not be taken for granted.

The impact of the 2003 Manpower Law on employment

Like poverty rates, unemployment rates have steadily declined from a peak of 11.2% in 2005 to 8.4% in 2008, 7.9% in 2009 and 7.4% in February 2010 (BPS, National Labour Force Survey). However, there is continuing concern about the quality of employment, as more and more people have been seeking work in the low-productivity informal sector since the AFC. The formal sector accounted for 44% of employment in 1996 (World Bank 2008b), but this proportion has fallen dramatically during the last several years to only 31% – compared with an average of 43% in East Asia and a global average of 47% (Asher 2010: 7).

To some extent the shift to informal sector employment may reflect Indonesia's changing industrial structure (Manning 2008),22 with manufacturing growth falling from double digits before the AFC to low single digits after the crisis, and below 2% during the GFC. However, there are other factors, including regulatory distortions, which at best discourage movement from the informal to the formal sector, and at worst encourage movement in the opposite direction. In particular, the post-AFC Manpower Law (13/2003) discourages formal sector employment and encourages a proliferation of contract and casual work. According to a study by five Indonesian universities (Naskah Akademik 2006) commissioned by the president in 2006, there are two major distortions that need to be addressed.

The first is the minimum wage, which is now based on the concept of kebutuhan hidup layak (KHL, reasonable living needs) instead of kebutuhan hidup minimum (KHM, minimum living needs). It has become a ‘political football’ in local elections, as candidates compete by offering larger increases. The average minimum wage of 26 provinces rose sharply from 2000 to 2002 (with the advent of decentralisation, and under a strong manpower minister from a trade union background), and it has subsequently been adjusted to provide for increases above the rate of inflation.

The second major distortion relates to terminations of employment. These require employers to engage in complex procedures involving the relevant labour union and, if necessary, an arbitrator, and to make large severance payments. Moreover, when terminations are based on efficiency considerations (rather than bankruptcy or force majeure), the payment is doubled. In this environment, businesses have to think twice before hiring workers.

Those who suffer because of these legal distortions are the less educated, low-skilled and therefore low-productivity workers – precisely those who are most vulnerable – and the businesses that otherwise could profitably employ such workers, but that now struggle to expand. Seen in this light, both the reversal of the trend to formal sector employment and the severe deceleration in the growth of low-skill labour-intensive manufacturing can be interpreted as unintended consequences of the new law. Analysis of this important empirical issue is beyond the scope of this survey, however.

Another independent study is now being conducted by the Indonesian Institute of Sciences (LIPI) – at the initiative of the national tripartite industrial relations forum (Badan Pekerja Lembaga Kerja Sama Tripartit Nasional), consisting of representatives of the government, labour unions and business associations, and the DPR – on possible revisions to the 2003 Manpower Law. This is expected to endorse the Naskah Akademik (2006) recommendation to return to a ‘safety net’ minimum wage related to the poverty line, rather than a minimum wage determined by political considerations. This recommendation has not yet been acted on because of strong pressure from NGOs, student activists and trade unions. In the absence of political leadership and commitment, it is unlikely that the expected LIPI recommendation will be any more effective.

In the meantime, unpublished World Bank estimates (based on a survey of workers’ perceptions) suggest that only 7% of firms are complying with the employment termination requirements in the law, while 27% are partially complying and 66% are not complying. Compliance is likely to be greater among larger employers, especially foreign firms, given the reality of economies of scale in enforcement. Revision of the law so as to simplify the terminations process and to make severance payments more reasonable would increase compliance among smaller firms and help to reverse the trend away from formal sector employment.

DECENTRALISATION

Local governments increasingly determine Indonesia's development trajectory following the decentralisation that commenced in 2001. The original decentralisation laws have been modified, and recently enacted laws on mining and local taxes have also changed the incentives facing regional governments. There has also been debate recently about the appropriate role for provincial governors.

Mining issues

The most significant changes under the new Law on Mining of Coal and Minerals (Law 4/2009) are:

• a new system of licences and permits issued by central, provincial and local governments to replace the old system of contracts (article 35);

• authorisation of regional governments to issue licences for mining coal and some types of minerals that were previously under the central government's sole authority (articles 6–8);

• requirements for miners to ‘increase value added’ by conducting ore processing and refining activities domestically (articles 102–103);

• a requirement for coal and metal minerals mining licences to be issued only on the basis of tenders (articles 51 and 60).

Under the old contract system there were three types of contract: Contracts of Work (Kontrak Karya, KK), Mining Concessions (Kuasa Pertambangan, KP), and Coal Contracts of Work (Perjanjian Karya Pengusahaan Pertambangan Batu Bara, PKP2B). Under the licence system, there will be three types of licence: Mining Business Permits (Izin Usaha Pertambangan, IUP), People's Mining Permits (Izin Pertambangan Rakyat, IPR), and Special Mining Permits (Izin Usaha Pertambangan Khusus, IUPK). The criteria for each type of permit include the area of the mine, the type of mineral, the ownership type (individual, private or public company, community) and the permissible duration of mining activity.

Under the new law, the issuing authority for a mining licence depends on the geographic location of the mine and on whether it crosses provincial or local government boundaries. This is a significant change. Coal mining, for example, was previously classified as involving a ‘strategic’ natural resource, and therefore was regulated by the central government,23 but now it is regulated by local government if it does not straddle any local government boundary, and by the provincial government if it straddles a local government boundary but no province boundary.

There are 42 KK and 76 PKP2B mining operations that need to adjust to the new law by extending their activities to include domestic processing and refining activities (although there will have to be exceptions for minerals such as coal, which are not highly processed). This provision is not as onerous as it sounds, however, as operators are allowed to sub-contract processing and refining activities to other companies. That said, it should be noted that forcing the domestic processing of minerals has an effect opposite to that intended. Although value added in the minerals sector will increase with the addition of a manufacturing component, this will be at the expense of a decline in the value of national income generated from a given amount of ore, which is the value of refined product (at world prices) less its cost of production. The overall cost of production increases if processing and refining is undertaken domestically rather than overseas, because domestic processing is less efficient: if it were not, firms would choose domestic processing and refining voluntarily. The increment in national income is therefore less than its potential. The policy is analogous to the long discredited minimum local content requirements for the production of import substitutes.

The transition for existing operations under KK and PKP2B arrangements is regulated in article 169, but that for KPs is not regulated in the new law; a new Presidential Regulation on this is still to be issued. If the transition (from KP to IUP, for example) is automatic, it is not clear whether the substance of the KP would automatically carry over to the substance of the new licence. This could be problematic if, for example, the land area of the KP exceeded that allowed by the IUP (Jaweng 2009).

There is also some inconsistency in Law 4/2009, relating to the transition from KKs and PKP2Bs to licences. While article 169b states that existing KKs and PKP2Bs have to adapt to the new law within one year, article 169a states that mines established before the enactment of the law can continue to operate until the associated contracts run their course. This inconsistency would seem to reflect the difficulty of reaching complete agreement among the political parties and between the central government and regional governments. In these circumstances the application of the new law will be determined by the central government, if necessary through implementing regulations. In any case, no KK or PKP2B has been terminated so far.

There is also concern about the duration of the new licences. IUPs, for example, allow for exploration periods of 3–8 years and for production periods of 5–20 years. These are shorter than the time horizons of the previous contracts, and are perhaps unreasonably short given the long-term nature of typical mining activities. This creates considerable uncertainty about whether a reasonable return can be earned on the large initial investment.

Since the enactment of the new law the number of KPs has grown rapidly, from 2,000 to 8,400 (Kompas, 30/01/2010). However, it is not clear whether the increase represents new mining activities or previously illegal activities that have now been registered. Whether there will be any benefit from the formal registration of previously illegal mining activities, however, will depend crucially on the capacity of the central and regional governments to provide proper oversight and control of mining activities, and of their impact on the environment.

Local taxes

Law 28/2009, a revision of Law 34/2000, regulates what regional governments can collect from their citizens in taxes and user charges. Provinces are restricted to a closed list of five taxes, including a new tax on cigarettes, while local governments are restricted to 11 taxes (article 2). Maximum or specific tax rates for each tax category are specified, and in a few cases there are even minimum rates as well. For example, the new cigarette tax rate is set at 10%, while the automotive fuel tax has a maximum rate of 10%; the rate for personal motor vehicles must be between 1% and 2%.24

Law 28/2009 also regulates the percentage of provincial tax revenues going to local governments within the province (article 94). For example, 70% of cigarette tax revenues must be given to local governments within the province in question (although there is no clear guidance as to how the total amount is to be allocated among the individual local governments). There is some earmarking of tax revenues. For example, 50% of cigarette tax revenues must be allocated to finance community health services and law enforcement at both provincial and local government levels. Given the fungibility of money, however, this is unlikely to have much impact on the total budgets allocated to these functions.

Different taxes have different effective starting dates. While some will take effect on 1 January 2011, cigarette taxes will be effective only from 1 January 2014, for example. The short transition period for adjusting to the new law is problematic, however. The law mandates withdrawal, by way of Presidential Decrees, of distortive local tax regulations that do not pass scrutiny by the Ministry of Finance and are therefore recommended for withdrawal by the Ministry of Home Affairs. Previously some 3,000 local regulations did not pass scrutiny, yet 1,300 have yet to be cancelled. Withdrawal of inappropriate local regulations is often politically sensitive but, aside from this, for logistical reasons it will not be feasible for the presidential office to make a speedy examination of thousands of distortive local regulations. The previous practice of handling the annulment or withdrawal of problematic local regulations at the ministerial level seemed more sensible in this regard. In any case, it seems unlikely that any distortive regulations will be withdrawn before the end of 2010, by which time all regulations, distortive or not, that are not in accord with the law are supposed to be cancelled.

Before the law was enacted, local governments faced no legal limit on what could be taxed and by how much, provided there was approval from the finance and home affairs ministries. The new closed-list system has been formulated in order to provide greater certainty to citizens and investors in relation to local taxes. Nevertheless, some investors fear that local governments will attempt to maximise their own-source revenues by imposing the highest permitted tax rates, and differentiation of tax rates and user charges may therefore become one form of competition between local governments.25 Of much greater importance, however, is how well own-source revenues and the much larger transfers from the central government are used to improve the investment climate – for example, by spending on local infrastructure.

The role of provincial governors and governments

The powers of provincial governors were substantially reduced by decentralisation in 2001. The central government has come to see this as a source of frustration, not least because of its lack of control over local governments. Accordingly, Government Regulation 19/2010 was issued in January 2010 to clarify, and potentially restore, the position of governors as representatives of the central government. The president also symbolically reinforced their position by inviting them all to a two-day retreat in Bali in April 2010 to discuss the government's economic goals and strategy (Jakarta Post, 20/04/2010) – but perhaps also in the hope of winning their political support.26 Nevertheless, it is highly unlikely that the current constitutional requirement for governors to be popularly elected will be overturned. This seems to leave very little scope for the central government to influence these appointments, and correspondingly little scope to influence governors’ actions in office.

Past efforts to implement central government programs through provincial governments (‘deconcentrated’ activities) have not been particularly successful. Funds for deconcentrated activities are supposed to come from the central government's budget but in reality this does not occur. In other words, provincial government manpower is diverted from the province's responsibilities to work instead on other tasks requested by the central government. The problem reflects the vagueness of the decentralisation legislation, which puts province governors in the difficult position of being constitutionally accountable to the province electorate, yet also required to act as representatives of the central government. Not only must they serve two masters, but in practice they are required to serve one of those masters without the benefit of sufficient additional fiscal resources. Government Regulation 19/2010 attempts to overcome this problem by establishing a special secretariat in each province to carry out deconcentrated functions, but it remains to be seen whether this limited change will have much impact.

Acknowledgments

The authors gratefully acknowledge the contribution of Sunny Tanuwidjaja (Centre for Strategic and International Studies, Jakarta) to this section.

Notes

²For an analysis of the implementation and impact of ACFTA on the Indonesian economy, see World Bank (2010b): 27–32.

³Press briefing by the trade minister, Mari Pangestu, Jakarta, 5 April 2010.

⁴Two parties, PDI–P (the Indonesian Democratic Party of Struggle) and Hanura (the People's Conscience Party) walked out of the parliament (DPR) during Sri Mulyani's address on the budget, in protest at her role in the bail-out of Bank Century (Jakarta Post, 5/5/2010).

⁵Vice President Boediono recently announced that the government would also raise the price of gas sold on the domestic market to levels on par with international prices, to encourage producers to sell gas to local buyers (Jakarta Post, 19/5/2010). However, the timing and the scale of these adjustments are not yet clear.

⁶The official financing data shown in figure 4a exclude grants, which are recorded above the line in the budget (or not recorded at all). A significant growth of grants in recent years is due in large part to the expansion of the Australian aid program. Australia will provide over A$450 million to Indonesia in 2010/11, of which about A$325 million will be in grants.

⁷In an innovative response to the GFC, Indonesia's major creditors provided $5.5 billion in stand-by facilities and bond guarantees during 2009. While some of the guarantees from Japan have been used to guarantee samurai bonds issued by the Government of Indonesia, none of the stand-by facilities from the World Bank, the Asian Development Bank (ADB) and Australia have been drawn down to date.

⁸For international experience with budget carry-overs, including discussion of some of the risks in developing countries, see Lienert and Ljungman (2009). For a detailed discussion of budget spending constraints and solutions in Indonesia, see World Bank (2009).

⁹A 2002 constitutional amendment stipulating that 20% of the central government budget must be spent on education also distorts the allocation and undermines the efficiency of additional spending (World Bank 2010b: 35–9).

¹⁰This section draws on work done by Mark Baird for the World Bank during the first half of 2010 and summarised in World Bank (2010d). A more complete analysis will be published by the Bank in its next Country Economic Memorandum.

¹¹The term ‘connectivity’ covers all aspects of infrastructure and logistics that improve the movement of people and goods, as well as related policy issues.

¹²For applications to Indonesia, see Hill, Resosudarmo and Vidyattama (2008) and Deichmann et al. (2005).

¹³ Ex-post evaluations of the (English) Channel Tunnel suggest reasons for caution. Anguera (2005) concludes that ‘overall the British economy would have been better off had the tunnel never been constructed’.

¹⁴Indonesia received slightly better news in the latest International Institute for Management Development competitiveness ratings, where it jumped from 42^nd in 2009 to 35^th in 2010 (Jakarta Post, 22/5/2010).

¹⁵Mechanisms established by the Ministry of Finance to support private investment in infrastructure include the Indonesia Infrastructure Facility, the Indonesia Guarantee Fund and the Project Development Facility.

¹⁶Poverty rates are sensitive to the choice of poverty line. For 2009, the $1.25 PPP (purchasing power parity) head-count index is 16.8%, while the $2 PPP head-count index is 50%. This result reflects the large number of people living just above the official poverty line who are vulnerable to negative income shocks.

¹⁷The pattern for this age group may partly be due to seasonal factors: many young people finish school around May–June; hence youth employment can be expected to be higher in August.

¹⁸The results of the third round of CMRS monitoring (in February 2010) were not available at the time of writing.

¹⁹Weekly working hours usually increase by about 1 hour from February to August, but in 2009 the increase was not significant during this period (less than 0.5 hours).

²⁰Households identified here as ‘poor’ are those that received both BLT and Community Health Insurance Services (Jamkesmas); these would fall into the ‘very poor’, ‘poor’ and ‘almost poor’ categories in the Ministry of Social Welfare's Program for Documenting Social Services (Program Pendataan Layanan Sosial) – or, roughly, any household living below 1.2 times the poverty line.

²¹Although this shift was not systematic in the SMERU Research Institute findings, it provides some contrast with the World Bank (2010b) finding that household expenditures on health remained constant.

²²Manning (2008) also notes declining employment elasticities (with respect to economic growth) in almost all sectors after the AFC, which resulted in slower employment growth through 2006.

²³Government Regulation 27/1980 categorised coal and various types of minerals as type A (‘strategic’), B (‘vital’) or C (‘other’).

²⁴Law 28/2009 also specifies a ‘semi-open’ list of local user charges.

²⁵Some studies, however, show weak evidence of competition between local governments (see, for example, Pepinski and Wihardja 2010).

²⁶Also present at the retreat were the vice president, the full cabinet, chairs of regional parliaments, and invited business leaders and academics.