SURVEY OF RECENT DEVELOPMENTS

SUMMARY

The second half of 2008 is proving to be a time of unprecedented global volatility, and the sound performance of the Indonesian economy over the first half will be difficult to maintain. With growth for the year projected to remain around 6%, Indonesia is relatively well placed to face the challenges of the unfolding global financial crisis, but the risks to the outlook are increasing. The crisis has begun to impact directly, with trading on the Indonesian stock market suspended on 8 October after an alarming one-day fall of 10% in share prices. Sustained pressure on the currency since mid-August has also seen Bank Indonesia running down its sizable foreign exchange reserves in attempting to support the rupiah. The authorities are taking steps to relieve liquidity pressures in the financial system, but will also need to address medium-term issues of stability, especially in relation to inflation; interest rate increases have so far done little to contain prices. Although exports have remained surprisingly strong, rapid import growth has resulted in a small current account deficit. Growth of exports is likely to decelerate as demand in developed economies slows, putting further pressure on the balance of payments and the currency.

The 2009 budget reflects the government's positive outlook, but the underlying assumptions about growth, inflation and interest rates seem rather optimistic. Tax revenue has been increasing strongly, allowing the government to allocate significant new spending to education, in particular; however the budget remains hostage to global oil prices, with energy subsidies still very large despite the unpopular recent increases in domestic fuel prices. Other issues likely to affect voting in the 2009 elections include scheduled electricity blackouts in Jakarta in response to demand continuing to outstrip supply; the government's apparent indifference to the fate of the victims of the Sidoarjo mud disaster; and its failure to make much impact on the level of poverty.

Despite asking major donors for additional loans for budget support, the government has unveiled a new strategy for managing development partnerships. This will encourage smaller donors to operate through multi-donor arrangements and larger donors to use government systems for more of their programs—a signal that the government intends to shape its relationships with donors despite the global crisis.

INTRODUCTION

The domestic fuel price changes in May represent a significant win for policy over politics, although they may have harmed President Susilo Bambang Yudhoyono's (SBY's) popularity.1 The economy continued to grow strongly through the second quarter (Q2) of 2008, and Indonesia proved resilient in Q3 in the face of considerable uncertainty in global financial markets generated by the crisis in the US. The negative impact of the global turmoil became more noticeable in September, however, and by early October the financial markets were under considerable strain.

The difficulty for the government in the months remaining before the election in 2009 is how to manage the economy within a volatile global setting. Falling commodity prices are now leading to significant adjustments in stock markets worldwide, which have shed much of the commodity-driven gains of the last 1–2 years. Meanwhile, the continuing financial crisis in the US is destabilising the world economy, putting increasing pressure on global credit and capital markets. Balancing a reform agenda with the realities of the global economy and local pressures from domestic politics will require deft management. There is likely to be a concerted push from domestic constituencies to put growth first rather than try to reduce inflation. While falling commodity prices will help moderate inflation (as would somewhat tighter monetary policy), in the immediate term some price increases may still occur, since changes in international prices feed into local prices with a lag. In addition, significant financial problems in the US may lead to increased risk aversion in global credit markets, requiring Indonesia to be more mindful of its macroeconomic settings than ever.

Most macroeconomic indicators may remain positive, but if markets lose confidence in policy settings there is increasing risk of capital flight in the short run. Nervousness evident in the currency and stock markets in September and early October could turn into a more serious problem if Bank Indonesia (BI) is perceived to lack conviction in its monetary policy settings. The 2009 budget forecasts continued robust expansion of output, by around 6%, despite major trading partner (US, European and Japanese) economies contracting. Foreign exchange reserves remain substantial at almost $60 billion, providing the central bank with considerable means to manage these difficult conditions.

GROWTH

Second quarter national accounts for 2008 show the economy continuing to grow strongly, at 6.4% higher year-on-year (y-o-y) (Table 1), despite the prospect of a significant downturn in the world economy. Growth has now exceeded 6% for seven consecutive quarters, a pace that may prove difficult to maintain. Consensus Economics (2008): 12) predicts GDP growth for 2008 of 5.9%, implying that market economists expect the annualised growth rate for the second half to fall to around 5.6%. Likewise, the International Monetary Fund's World Economic Outlook, released on 7 October, revised its world growth forecast for 2009 down from 3.9% to 3.0%, and its estimate for Indonesia's GDP growth in 2009 from 6.3% to 5.5% (IMF 2008a).

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

	Mar-07	Jun-07	Sep-07	Dec-07	Mar-08	Jun-08
Gross domestic product	6.1	6.4	6.5	6.3	6.3	6.4
Non-oil & gas GDP	6.7	7.1	6.9	7.0	6.8	6.9
By expenditure
Household consumption	4.7	4.7	5.1	5.6	5.7	5.3
Government consumption	3.7	3.8	3.3	2.0	4.7	2.2
Investment	7.0	6.9	10.4	12.1	15.4	12.8
Building construction	8.4	7.7	8.3	9.9	7.9	8.0
Machinery & equipment	12.6	24.1	26.3	25.7	45.2	28.2
Transport	−25.8	−28.6	−1.1	13.5	53.7	39.9
Exports	8.1	9.8	6.9	7.3	15.5	16.1
Imports	8.5	6.5	7.0	13.6	17.8	16.7
By sector
Tradables	3.4	4.7	4.8	2.5	3.6	3.4
Agriculture, livestock, forestry	−1.7	4.7	7.6	3.1	6.1	4.6
& fisheries
Mining & quarrying	6.2	3.2	1.0	−2.1	−1.9	−0.9
Manufacturing	5.2	5.1	4.5	3.8	4.2	4.1
Excluding oil & gas	5.8	5.6	4.6	4.6	4.5	4.4
Non-tradables	9.0	8.2	8.3	10.0	9.1	9.5
Electricity, gas & water supply	8.2	10.2	11.3	11.8	12.6	11.2
Construction	8.4	7.7	8.3	9.9	7.9	8.0
Trade, hotels & restaurants	9.2	7.6	7.9	9.1	7.1	7.9
Transport	−0.0	0.8	4.4	5.6	9.4	3.5
Communications	31.0	28.8	26.6	31.7	31.7	36.7
Financial, rental & business	8.1	7.6	7.6	8.6	8.2	8.7
services
Other services	7.0	7.0	5.2	7.2	5.6	6.5
Source: CEIC Asia Database.

The growth of private consumption (which accounts for almost 60% of GDP) softened slightly from 5.7% y-o-y to 5.3%, presumably reflecting lower consumer purchasing power following the fuel price hikes in May 2008. Consumer confidence rebounded strongly in July from record lows (Danareksa Research Institute 2008); however, it may well fall again in the face of the global financial crisis. The growth of investment (comprising almost a quarter of GDP) fell only slightly from 15.4% in Q1 to 12.8% in Q2 despite tighter international credit conditions. Continued strong investment growth is reflected in rising investment in machinery and equipment (28%), construction (8%) and transport (40%). Tighter credit conditions both in Indonesia and offshore are likely to curb investment spending in the second half of 2008, and the increasingly severe disturbance to global markets from the US financial crisis intensifies the risk that GDP growth will moderate over the next 12 to 18 months.

Merchandise imports are growing more strongly than exports (and have been for some time), but exports continue to grow steadily (Figure 1). Indeed, export demand is showing surprising resilience despite slowing growth in most developed economies. Partly this is due to the fact that Indonesia is a large commodity exporter (around 60% of exports are commodities) and has seen a significant increase in income from exports related primarily to price effects (with supply remaining fairly steady). With the global oil price having fallen back well below $100/barrel, and other commodity prices also falling, export values may increase more slowly—if at all—over the next 12 months. The significant rise of imports is due largely to strong domestic demand coupled with higher prices. Like most of Asia (excluding Malaysia and India), Indonesia has suffered a negative terms-of-trade shock due to higher import prices since early 2007, despite record high commodity prices.

FIGURE 1.  Growth of Dollar Value of Trade^a (% p.a.)

The second quarter balance of payments revealed that Indonesia had posted a current account deficit (CAD) for the first time in three years.2 The CAD was small at around $1.4 billion, or a little over 1% of GDP, and in this case actually reflected the underlying strength of the economy, as growth of merchandise imports (51%) outpaced that of exports (28%). Further confirmation of this strength can be seen in Table 1, which shows investment in largely imported machinery and equipment, and in transport equipment, continuing to grow strongly.

From a sectoral perspective, non-tradables remain the principal drivers, with strong results in most sectors—led in particular by communications (Table 1).

Agriculture, mining (including oil and gas) and manufacturing continue to under-perform, despite high global commodity prices during the first half of 2008. Continuing contractual wrangling between the state oil and gas company Pertamina and Exxon Mobil over the management of the Cepu site in East Java, which contains significant oil reserves, constitutes a significant cost to the economy, as oil production for the country as a whole continues to decline (JP, 9/9/2008).

POLICY RESPONSES TO THE GLOBAL DOWNTURN AND VOLATILITY

While Indonesia is relatively well placed in the current difficult external economic environment, its vulnerability to external shocks should not be under-estimated. The global economy is facing the most challenging set of circumstances in recent memory, and a substantial slowdown in economic growth is occurring in the major advanced economies. The possibility of a crisis unrelated to domestic fundamentals is growing as financial market conditions in the US and Europe continue to deteriorate. Indonesia's vulnerability relates to both the financial (capital flow) and international trade channels.

Financial markets

The financial sector has been volatile in 2008 as a consequence of global financial problems. It reacted negatively to the announcement in September of a small current account deficit in the second quarter, despite the fact that the deficit simply reflected strong domestic demand and that most other macroeconomic indicators remained positive. The currency began to depreciate in August, and BI Governor Boediono was quick to issue a statement calling for calm, emphasising that ‘there [was] no issue with the underlying fundamentals’ (JP, 6/9/2008). But the episode underlined investors’ continuing risk-averse attitude towards Indonesia.

In the midst of big falls in global stock markets, on 8 October the Indonesia Stock Exchange (IDX) took the extraordinary step of suspending trade after the composite share price index fell by 10%. The index had by then fallen by a cumulative 40% in the previous four months (Figure 2). While IDX trends are not necessarily an accurate measure of investor confidence—since only a relatively small number of companies are listed on the exchange, many of them state owned—a fall of this magnitude was clearly of considerable concern to the authorities.

FIGURE 2.  Composite Share Price Index (CSPI) and Exchange Rate

The government responded quickly on 9 October at a joint press conference held by the ministers of finance and state enterprises, the chairman of the Capital Markets and Financial Institutions Supervisory Agency (Bapepam-LK) and the governor of BI. First, they announced plans to ease existing rules on share buybacks. The rule relaxations allow listed companies to buy back 20% of their issued shares (rather than 10% as previously) without first seeking shareholder approval, and scrap the previous limit on buybacks to 25% of the shares traded on a given day. Such buybacks may be undertaken only if the IDX experiences a ‘significant’ fall, or if trading is suspended, however. It was also announced that banks would be permitted to use approaches other than mark-to-market accounting for debt securities. Mirroring measures taken in various other countries, the government also announced its intention to raise the maximum size of bank deposits it would guarantee from Rp 100 million to Rp 2 billion (Ministry of Finance press release, 13/10/2008). BI further announced that it would unify the minimum reserve requirement (the percentage of total rupiah deposits that banks are required to hold as deposits at BI) at 7.5%, compared with ratios ranging from 5% to 13% previously (BI Regulation 7/29/PBI/2005) and averaging about 9.1%. In addition, it would change the rules for providing emergency support to banks facing liquidity problems, allowing them to use loans classified ‘current’ (lancar) as collateral for liquidity support where previously only government bonds or SBIs (Bank Indonesia Certificates) were acceptable for this purpose.

Softening bank regulations and making government and central bank support more readily available is intended to maintain liquidity and keep the banks lending, but it runs the risk of the government and BI accumulating significant new bad debts. Marking security values to market can certainly be unnerving to stakeholders in banks in times of financial upheaval, but it is by no means obvious that keeping them in the dark is the optimal policy, and it is worth recalling that the earlier guarantee of bank deposits proved extraordinarily costly to the Indonesian people (McLeod 2006). The government is presumably aware of the risks, given this history. It is reportedly working on a financial system safety net law aimed at improving coordination among authorities when dealing with financial crises (Suharmoko 2008). The law will set out the roles and responsibilities of BI and the Ministry of Finance (MOF), which were unclear during the Asian financial crisis of 1998.

Exchange rate

Despite the commodity boom of 2007 and early 2008 there was no nominal appreciation against the dollar during this period (in contrast with many other countries); this can probably be traced back to BI's unofficial targeting of the exchange rate. While not an explicit policy, it is obvious from the data that BI has been comfortable with the currency trading at around Rp 9,100/$, regardless of whether it was weakening relative to other regional currencies (throughout 2007) or strengthening against them (from February through September 2008) (Figure 3). The consequence of offering such an attractive price in return for dollars since early 2006 has been a considerable build-up in BI's foreign exchange reserves through most of this period. Although these can be used in the short run to offset pressure to depreciate, the policy also means that the rupiah starts from a relatively weak position in facing such pressure as investment slows and global commodity prices fall.

FIGURE 3.  Selected Currency Movements against the Dollar, 2007–08 (2 Jan 2007 = 100)

By early September BI found itself switching from preventing appreciation to supporting the currency (i.e. preventing depreciation). The sudden burst of speculation against the rupiah was, paradoxically, in response to the announcement of essentially positive economic data relating to the current account. This was interpreted by offshore investors as a weakening of the balance of payments—which, in the current risk-averse environment, was cause for selling the rupiah. Further speculation against the currency as the global financial crisis gathered steam throughout September and early October saw the rupiah depreciate by some 6% in the two months to early October, despite intervention in the foreign exchange market that saw BI's international reserves fall significantly, from their peak of $60.6 billion in July to $57.1 billion at the end of September. Some local market analysts such as Danamon Bank have noted that this depreciation has been fairly orderly and somewhat less than that of other regional currencies (such as the Korean won, the Thai baht and the Philippines peso) (Gunawan 2008); this presumably reflects intervention by BI. While support for the currency is designed to maintain confidence, preventing depreciation in a worsening external environment partly obstructs the important role the exchange rate can play as a shock absorber by supporting production of tradables (i.e. exports and import substitutes).

Financial volatility and crisis management

The effect on Indonesia's financial markets of the turmoil in major advanced economies was fairly limited through to September. This was largely a serendipitous result of relatively under-developed debt and money markets that mean direct exposure to collateralised debt obligations and sub-prime mortgages is low for Indonesian banks. Despite Indonesia's positive macroeconomic outlook, however, second-round effects from slowing global demand and tighter global credit conditions began to impact on the economy more forcefully in October (Figure 2), as global financial markets became increasingly unsettled. With a relatively open capital account—compared with countries such as Thailand and Malaysia—Indonesia will remain susceptible to a sudden outflow of capital should confidence disappear. Although this could be a consequence of factors unrelated to the domestic economy, monetary policy settings will also play a role in affecting investor perceptions (as discussed in more detail below).

In planning for the possibility of a financial crisis, the government has been proactive in addressing the key issue of coordination. Using the recommendations of the global Financial Stability Forum (FSF),3 it has established a Forum for Financial System Stability (Forum Stabilitas Sistem Keuangan, FSSK) to put in place a set of protocols for the authorities to follow in the case of a financial crisis. The primary objective is to address one of the main shortcomings of the current system—the lack of coordination between BI, the MOF and the Coordinating Ministry for Economic Affairs. The FSSK is a statutory agency separate from the other institutions, and it has taken some time to show any progress on these protocols. However, progress has accelerated in recent months, to the point where a ‘stress test’ of the system was scheduled for December 2008, involving a desktop simulation of a crisis. This would require the governor of BI, the Minister for Finance and all the relevant officials to respond to a regional crisis scenario. However, by early October a genuine crisis rather than a simulated one was looking increasingly likely to test the skills of these officials.

In a very practical sense the protocols can be seen to be working already. Following the collapse of Lehman Bros, Merrill Lynch and American International Group in the US, worries over tightening global credit conditions, and a drop of 4.5% in the composite share price index of the IDX, the government and BI announced on 15 September that they would take steps jointly to ease liquidity pressures at the macroeconomic and microeconomic level (MOF 2008). The measures included accelerating government spending and the disbursement of funds to support such spending; reducing the issue of government bonds; speeding the implementation of tax facilities to stimulate investment and capital inflow; injecting liquidity to the banking system through BI's open market operations; and modifying the rules under which banks can obtain additional liquidity from the central bank. These measures were updated in the joint 9 October announcement by the MOF and BI, referred to above.

These are measures that are being implemented all over the world, and are therefore not remarkable in themselves, but they demonstrate a coordinated approach to macroeconomic policy making and crisis management that has been absent in the past. That said, increasing liquidity in the system runs the risk of boosting inflation, as occurred in the 1997–98 financial crisis, and the early responses to liquidity injections in the US, Europe and Australia have done little to suggest they hold the key to stabilising these economies.

Indonesia's banking system is another area that has performed well over the last two years, and it should be relatively well placed to manage current volatility owing largely to its low loan-to-deposit ratio, the predominance of floating- rather than fixed-rate securities, its small net open foreign exchange rate position, its strong recent profitability, and its high capital cushion (IMF 2008b: 21). However, the rapid expansion of lending in 2007 and into 2008—with loan growth over 30% per annum—is likely to be one of the main financial sector risks, and BI will need to ensure that its supervision remains proactive.

External exposure

Indonesia's second key vulnerability, trade, is broad-based, and the economy's exposure to external demand (as measured by the ratio of exports to GDP) is not as high (at around 48%) as that of some of its neighbours (Figure 4). This is important, as countries with high exposure to external demand and which, for example, are tightly linked into the global manufacturing cycle (i.e. are more affected by a downturn in developed economies) have recently announced contractions or significant slowdowns in their economies. These include the newly industrialised economies of Korea, Hong Kong, Taiwan and Singapore, plus the Philippines, and Thailand.

FIGURE 4.  External Exposure of Selected Asian Countries, 2007 (Exports:GDP,%)

However, Indonesia's share of exports to those developed countries that are facing a downturn is relatively high (Figure 5). Japan and some European countries (Germany, France and Italy) have recorded negative growth in their most recently reported quarters, while growth in the US and UK continues to be restrained by sharp downturns in their housing markets and associated disruptions in financial markets. This is counter-balanced to some extent by Indonesia's exposure to some fast-growing developing economies such as China and India.

FIGURE 5.  Indonesia's Exports by Major Destination, 2007 (% of total)

Ironically, Indonesia's current vulnerability has also been its recent strength: rising global commodity prices. While coal prices may remain high based on global supply side constraints and strong demand from China, lower oil prices will reduce the prices of palm oil and gas (two of Indonesia's other major exports). Other agricultural exports are also projected to soften somewhat as prices fall— although the potential for this situation to reverse remains, since global stocks are at very low levels (Mitchell 2008). Indonesian non-commodity exports, such as manufacturing, also face contractionary pressures, because Indonesia has not been able to diversify its manufacturing output significantly and thus take advantage of the opportunities presented by China's growth over the last decade (Athukorala 2006). On balance, external demand is now quite likely to fall, putting some pressure on the currency as markets re-assess Indonesia's ability to meet its short-term obligations.

Inflation

Volatility in the currency market (reflecting broader uncertainty in global markets) highlights the fact that inflation is now also a key risk. The CPI inflation rate has reached 12% y-o-y (Figure 6). Inflation has been rising since mid-2007, while the money supply has been expanding rapidly since late 2006 (McLeod 2008: 189). On the other hand, real interest rates (nominal interest rates adjusted for inflation) have been falling since November 2007, and are currently negative. Lending rates are significantly higher than the policy rate, but the settings of monetary policy have not been sufficiently tight to contain prices. This is one reason many investors remain sceptical about BI's interest rate policy: there does not seem to be sufficient resolve to bring inflation down to the target range (4–6%), making speculative attacks on the currency more likely.

FIGURE 6.  Inflation, Interest Rates and Money Growth^a (% p.a.)

Bank Indonesia, the Ministry of Finance and the Coordinating Ministry for Economic Affairs4 have changed their tone in recent months, and have been talking much more about price stability. Both BI governor Boediono and minister Sri Mul-yani have publicly emphasised inflation as a key threat to the near-term outlook, and underlined their intention to bring it back down to around 6.5% by the end of 2009.5 Earlier, however—ahead of the increase in the domestic fuel price in May—BI seemed to have accepted the inevitability of inflation rising well above its target range (IMF 2008b: 14). In addition, the minister stated publicly that the revised budget assumption of 6.5% inflation for 2008 was not realistic—that the outcome would almost certainly be higher. The problem with this apparent readiness to accept missed targets is that the markets are left with no credible medium-term target for inflation, almost certainly encouraging inflationary expectations to drift upwards.

This serves to highlight the need for conviction on the part of BI in handling domestic price pressures (OECD 2008). BI has raised rates by 25 basis points (0.25%) following each of its last six board of governors meetings, bringing the policy rate to 9.5%, but a number of senior BI figures have expressed the view that even raising interest rates more significantly would not bring inflation down—yet would have a detrimental impact on growth.

These internal doubts about the effectiveness of its monetary policy presumably explain why BI has been reluctant to raise rates more aggressively, and has instead opted for a combination of moderate rate rises and 'a more flexible exchange rate policy’ to combat ‘imported inflation’ (Goeltom 2008). In other words, BI intended to allow the exchange rate to appreciate to ease price rises for imports. However, in the context of increased uncertainty and heightened risk aversion in global markets, the strategy did not have the desired impact and, as noted, BI was in fact forced to support the currency instead.

BI maintains that inflation will return to around 6.5% by the end of 2009, and will be back within the 2008 target band of 4–6% in 2010, but has yet to articulate a clear strategy to show markets how it intends to achieve this medium-term target, given its obvious reluctance to increase interest rates. Indeed, evidence is emerging of investors losing confidence in the domestic bond market. For the first time this year the finance ministry was unable to attract bids for all bonds on offer at the auction on 10 September; in addition, the sustained pressure on the rupiah in the second week of October led to a depreciation to just under Rp 9,625/$. It might be argued that acting decisively now would reduce the ultimate cost in lost output, while also minimising Indonesia's vulnerability to future adverse supply shocks (IMF 2008b: 130).

THE 2009 BUDGET

The budget formulation process involves preliminary discussions between the government and the parliament (DPR), and culminates in the production of the Draft Budget and Financial Note—an extraordinarily lengthy document that this year extends to some 456 pages. Whereas in the past the budget typically was announced less than three months before commencement of the fiscal year, as of 2002 it began to make its appearance more than four months in advance, in the context of the president's State of the Nation address on or about Independence Day (Alisjahbana and Manning 2002: 285).

Managing the budget process in this manner has a number of drawbacks. First, key budget assumptions are seen as items for negotiation, rather than as realistic estimates of future levels of GDP growth, the price of oil and oil production, not to mention inflation, interest rates and the exchange rate—which are in any case the responsibility of the independent central bank, not the government. Second, the earlier the draft budget is finalised, the more likely it is that circumstances will have changed significantly by the time it has to be implemented, rendering it unrealistic. Third, the more voluminous the underlying documentation, the more impractical it will be to undertake revisions at the last moment.

These problems have come to the fore in the 2009 budget as a result of two important changes of circumstances. First, the budget had been prepared on the basis of an assumed world oil price of $130 per barrel but, after peaking at over $140 in July, the price had fallen to around $115 by early August. Acknowledging the high degree of uncertainty in relation to further movements in the price, the government decided that it would be more realistic to base its budget on an oil price of $100 rather than $130. Second, just days before the president's State of the Nation address the Constitutional Court found that the 2008 budget was unconstitutional: a 2002 constitutional amendment required that 20% of the budget be devoted to education, and the 2008 budget had fallen well short of this level.6 It was decided to revise the 2009 budget so as to increase spending on education to the 20% level and to change the oil price assumption, but it was not feasible to revise the entire document accordingly within such a short time-frame.

Accordingly, the approach has been to issue a supplementary budget document (‘Dokumen Tambahan Nota Keuangan dan RAPBN’) for 2009, based on the revised oil price assumption and the desire to increase spending on education significantly. Table 2 shows the projected budget outcomes for 2008, together with the 2009 revised budget amounts and ratios to GDP. The final column shows the change in each item relative to its projected 2008 outcome in terms of its ratio to GDP, to provide an idea of the likely stimulatory impact of the budget on economic growth. The column showing the original budget figures for 2009 is now mainly of historical interest, but the numbers are useful for showing the estimated impact of changes in the oil price on some of the key items.

TABLE 2. Projected Budget Outcome 2008 and Draft Budgets 2009^a (Rp trillion)

	2008		2009			Change^b
	Projected Actual	% of GDP	OriginalDraft	Revised Draft^c	% of GDP	(% of GDP)
REVENUE AND GRANTS	1,007.0	21.5	1,124.0	1,022.6	19.3	−2.2
Taxes	641.0	13.7	748.9	726.3	13.7	0.0
Income tax	325.7	7.0	384.3	364.4	6.9	−0.1
Oil & gas	70.4	1.5	85.6	65.7	1.2	−0.3
Non-oil & gas	255.3	5.5	298.7	298.7	5.6	0.1
Value added tax	199.5	4.3	245.4	245.4	4.6	0.3
Land & buildings tax	25.5	0.5	28.9	28.9	0.5	0.0
Taxes on property sales	5.5	0.1	7.3	7.3	0.1	0.0
Excise	46.7	1.0	47.5	47.5	0.9	−0.1
Other taxes	3.3	0.1	4.3	4.3	0.1	0.0
International trade taxes	34.7	0.7	31.3	28.5	0.5	−0.2
Non-tax revenues	363.1	7.8	374.1	295.4	5.6	−2.2
Natural resource revenues	264.8	5.7	288.4	212.6	4.0	−1.7
Oil & gas revenues	254.9	5.4	278.9	203.1	3.8	−1.6
Oil	209.9	4.5	221.4	159.3	3.0	−1.5
Natural gas	45.0	1.0	57.5	43.7	0.8	−0.2
Non-oil & gas revenues	9.9	0.2	9.5	9.5	0.2	0.0
State enterprise dividends	35.0	0.7	33.0	33.0	0.6	−0.1
Other non-tax revenues	58.1	1.2	46.8	44.0	0.8	−0.4
Income of public service agencies	5.1	0.1	5.8	5.8	0.1	0.0
Grants	3.0	0.1	0.9	0.9	0.0	−0.1
EXPENDITURES	1,097.6	23.4	1,203.3	1,122.2	21.2	−2.2
Central government	804.0	17.2	867.2	818.2	15.5	−1.7
Ministries & agencies	290.1	6.2	312.6	312.6	5.9	−0.3
Other	513.9	11.0	554.5	505.6	9.5	−1.5
Interest payments	97.0	2.1	109.3	110.3	2.1	0.0
Subsidies	327.8	7.0	323.3	227.2	4.3	−2.7
Energy	268.7	5.7	258.0	161.8	3.1	–2.6
Fuel	180.3	3.9	179.1	101.4	1.9	−2.0
Electricity	88.4	1.9	78.9	60.4	1.1	−0.8
Non-energy	59.1	1.3	65.4	65.4	1.2	−0.1
Other expenditure	43.4	0.9	54.3	100.4	1.9	1.0
Uncategorised^d	45.7	0.9	67.5	67.7	1.3	0.4
Transfers to regional	293.6	6.3	336.2	303.9	5.7	−0.6
governments
Equalisation funds	279.6	6.0	327.1	295.6	5.6	−0.4
Revenue sharing	78.9	1.7	102.8	89.9	1.7	0.0
General funds allocation	179.5	3.8	201.9	183.4	3.5	−0.3
Special funds allocation	21.2	0.5	22.3	22.3	0.4	−0.1
Special autonomy & adjustment	14.0	0.3	9.1	8.3	0.2	−0.1
funds
DEFICIT	−90.6	−1.9	−79.4	−99.6	−1.9	0.0
FINANCING	90.6	1.9	79.4	99.6	1.9	0.0
Domestic financing	105.6	2.3	93.0	110.7	2.1	−0.2
Domestic banks	−11.7	−0.2	9.8	9.8	0.2	0.4
Domestic non-bank	117.3	2.5	83.1	100.9	1.9	−0.6
Privatisation (net)	0.5	0.0	1.0	1.0	0.0	0.0
Asset sales	3.9	0.1	0.6	0.6	0.0	−0.1
Government bonds	115.8	2.5	94.7	112.5	2.1	−0.4
Government investment funds	−2.8	−0.1	−13.1	−13.1	−0.2	−0.1
Foreign financing (net)	−15.1	−0.3	−13.6	−11.1	−0.2	0.1
Foreign borrowing (gross)	47.2	1.0	46.0	48.5	0.9	−0.1
Program loans	25.4	0.5	21.2	23.7	0.4	−0.1
Project loans	21.8	0.5	24.9	24.9	0.5	0.0
Less amortisation	−62.3	−1.3	−59.6	-59.6	−1.1	0.2
	2008		2009
	Assumed	Projected Outcome	Original	Revised
ASSUMPTIONS
GDP (current prices) (Rp trillion)	4,484.4	4,681.9	5,295.3	5,295.3
Economic growth (%)	6.4	6.2	6.2	6.2
Average inflation (% p.a.)	6.5	11.4	6.5	6.5
Average exchange rate (Rp/$)	9,100	9,250	9,100	9,100
Average interest rate 3-month SBI (% p.a.)	7.5	9.1	8.5	8.5
Average oil price ($/barrel)	95.0	127.2	130.0	100.0
Average oil production (million barrels/day)	0.927	0.927	0.950	0.950
^a On 14 October 2008 the government again modified the budget assumptions for 2009 (see footnote 7). The new assumptions are: economic growth 5.5–6.1%; average infl ation 7.0%; average exchange rate Rp 9,500/$; average interest rate 8.5%; average oil price $85/barrel. However, this table and the accompanying analysis are based on the earlier assumptions.
^b ‘Change’ refers to the change from the projected 2008 outcome to the revised draft budget for 2009.
^c An explanation of revisions is contained in Departemen Keuangan (Ministry of Finance), ‘Dokumen Tambahan Nota Keuangan dan Rancangan Anggaran Pendapatan dan Belanja Negara Tahun Angga-ran 2009 [Supplementary Documents to the Financial Note and Draft Budget for 2009]’.
^d Row items listed in the original document under ‘Central government: Other’ do not sum to the total amount shown, apparently because not all items in this category are included.
Source: Departemen Keuangan (Ministry of Finance), Data Pokok APBN 2008–2009 [Basic Data for the 2008 and 2009 Budgets].

Note in particular that even large changes in the oil price have relatively little impact on the budget deficit. A reduction from $130 to $100 reduces 2009 oil and gas revenues by about Rp 76 trillion and income tax from the oil and gas sector by Rp 20 trillion, while energy subsidies decline by almost exactly the same total amount; revenues shared with regional governments also decline by about Rp 13 trillion. The overall impact is to increase the deficit by only about 0.2% of GDP. The problem posed by fuel subsidies is therefore not fiscal sustainability, but the opportunity cost of subsidising energy consumption at the expense of greater expenditure in areas such as education, health, law and order, and infrastructure. Notwithstanding the recent adjustment of domestic fuel prices, energy subsidies will still cost Rp 162 trillion ($18 billion) in 2009, equivalent to 3.1% of GDP—or 52% of the total spending by all ministries and other government agencies combined. Despite such considerations, and despite acknowledging that the subsidies benefit the wealthy relatively more than the poor, the president did not take the opportunity presented by the budget speech to argue for a further cut in fuel subsidies (although efforts to target the subsidies more carefully were mentioned as a possibility).

Macroeconomic assumptions7

There are some noteworthy inconsistencies in the macroeconomic assumptions underlying the budget. Perhaps most obviously, a reduction of the oil price from $130/barrel to $100 is assumed to have no impact on nominal GDP, whereas in fact this would result in a decrease of about Rp 95 trillion. This in turn would slightly affect all the ratios to GDP for 2009, raising the question whether these might more usefully be calculated as ratios to non-oil and gas GDP. The assumed rate of economic growth for next year is 6.2%—the same as the projected outcome for 2008, but well above the IMF World Economic Outlook and Consensus Economics 2009 forecasts of 5.5% and 5.6%, respectively (IMF 2008a; Consensus Economics 2008: 12). The nominal GDP value (regardless of whether it is adjusted for the lower oil price or not), combined with assumed real growth of 6.2%, implies inflation of over 11%, whereas the budget assumes inflation of 6.5%.8 The assumed interest rate is just 8.5% compared with an October level of around 9.5%, yet further rate increases seem necessary if inflation is to be brought down so far from its current level of around 12%. Even with the impact of the domestic fuel price rises falling out of the calculation in May next year, these assumptions seem unduly optimistic. They imply a steep rise in rates followed by a very quick moderation of inflation, in order to allow BI to cut rates back to an average of around 8.5% for the year—with almost no impact on the real rate of GDP growth. BI has in fact indicated that it will use gradual and moderate rate rises and support the exchange rate in order to address inflation, further calling into question the plausibility of the budget assumptions.

Composition and economic impact

For the most part the composition of the budget—as reflected in changes in each item as a percentage of GDP—is little different from the expected outcome for 2008. The overall size of the government sector is expected to decline by 2.2% relative to GDP. On the revenue side, this is a consequence of relatively slow growth of non-tax oil revenues, given slow growth in production and an oil price significantly lower than the average for 2008 ($127/barrel). On the expenditure side, the central government's contribution to GDP is set to decline by 1.7% as a consequence of the decision in May 2008 to increase domestic fuel prices significantly and thus cut expenditure on fuel subsidies. This effect is partially offset by the last-minute huge increase in expenditure on education—rather confusingly located in the item ‘Other expenditure’ within central government expenditure's ‘Other’ category (expenditure other than that by ministries and other government agencies)—causing this item to increase by 1.0% of GDP. Transfers to regional governments also decline by an amount equivalent to 0.6% of GDP. This appears to be explained mainly by a decision the government made some time after formulating the original draft budget to change the basis for calculation of the general funds allocation, the total amount of which declines by about Rp 18.5 trillion in the revised version (Dokumen Tambahan Nota Keuangan dan RAPBN 2008: 12).

The budget deficit is estimated as 1.9% of GDP, the same as the likely outcome for 2008. The government asserts its intention to provide a fiscal stimulus to economic growth, pointing out that the 2009 deficit will be larger than deficits in the period 2004–07. Whether the budget imparts a stimulatory impact to the economy does not depend on whether it provides for a deficit, however: it is changes in levels of expenditure and revenue relative to GDP that matter. The budget in fact seems likely to be slightly contractionary rather than expansionary, because of the reduction in government sector expenditure in combination with no change in the collection of tax revenues (both items measured relative to GDP).9

Fuel subsidies versus more spending on education

The fact that it would be possible roughly to double expenditure on education without any blow-out in the budget deficit illustrates concretely the opportunity cost of continuing to subsidise energy consumption. Given that the reduction in energy subsidies made possible by the May fuel price adjustments yields savings that are more than twice the additional spending on education, a significant amount of ‘fiscal space’ remains that could be used to fund even higher transfers to the poor (in cash or in kind), and to increase spending on sorely needed infrastructure.

With the prospect of an additional Rp 57 trillion ($6 billion) per year for education (Table 3), Bappenas (the National Planning Agency) has set about designing a new five-year plan for that sector. The Ministry of Education has not signed up to the Bappenas process, however, and is understood to be working on its own plan for allocating the additional funds. The other major player, the Ministry of Finance, has very properly voiced its concern about the wisdom of attempting roughly to double the amount spent on education in a single year. It would prefer to see education funding raised gradually, as it has been over successive SBY budgets. All of this serves to highlight the lack of coordination in government policy making.

TABLE 3. Central Government Spending by Function, 2008–09 (Rp trillion)

	2008	2009	Change
	Projected actual	Revised draft	(%)
General services	625.2	565.0	−9.6
Education	58.0	115.2	98.7
Economy	57.2	58.9	2.9
Housing & public facilities	13.0	18.4	41.9
Health	16.0	17.5	9.3
Public order & security	12.3	15.7	27.3
Defence	10.5	13.8	31.3
Environment	6.4	7.8	22.6
Social security	3.3	3.4	1.6
Tourism & culture	1.4	1.6	15.7
Religion	0.8	1.0	28.3
Total	804.0	818.2	1.8
Source: As for table 2.

Statement of Fiscal Risks

At the request of the Minister for Finance, a joint IMF–World Bank team visited Jakarta in late 2006 and early 2007 to draft a Statement of Fiscal Risks (SOFR). The IMF‘s original recommendation was that the government construct a statement covering budget sensitivity to macroeconomic risks, public debt management, civil service pensions, central government contingent expenditures, state-owned enterprises (SOEs), public–private partnerships and sub-national governments. A SOFR was first introduced as a section of the 2008 budget, to allow readers to assess the overall risks to the government's financial position. The 2009 budget again contains such a statement, which discusses the sensitivity of budget outcomes to shocks and divergences of the underlying parameters from their assumed values, and examines the risks associated with large projects (such as the planned 10,000 megawatt expansion of electricity generation capacity) and SOEs.

The first SOFR focused primarily on macroeconomic sensitivity analysis, debt management, and selected SOEs and projects for which the MOF had reasonably accurate data. In principle this was a very positive step toward improved transparency. However, when assumptions are compared with outcomes it is clear that there is a long way to go in making the SOFR an effective tool for quantifying the risks in the budget. The topical issue at the time of the 2008 budget, as now, was the volatile global oil price and its potential impact on the budget and the economy. The 2008 SOFR proved relatively ineffective at portraying the sensitivity of the budget estimates to changes in the price and production assumptions for oil. When the oil price sky-rocketed, it turned out that the impact on the total amount of energy subsidies had been significantly under-estimated.10 The SOFR sensitivity analysis had suggested that the impact of a higher than assumed oil price (at least for prices below $100/barrel) would be to decrease the budget deficit rather than increase it, as was the case in the first half of 2008, because additional revenue from crude oil exports was expected to exceed increased spending on energy subsidies and increased oil-related transfers to regional governments.

The SOFR for 2009 still does not address risk comprehensively. It provides considerable information about the sensitivity of the budget to shocks, including interest rate changes and increases in the obligations of SOEs—especially those with particularly expensive public service obligations (PSOs)—but it does not explain how, precisely, these arrangements represent a risk to the budget or what the government intends to do to reduce or respond to those risks.

The MOF has been reluctant to make significant changes to the SOFR it introduced last year, which was generally well received. Capacity within the ministry to model shocks remains limited and, while the first SOFR was viewed by most as a work in progress, the ministry has settled for a simple update of the numbers together with some minor cosmetic changes.11 Thus although the new SOFR again contains very useful information, much of it merely duplicates other parts of the budget (the section on debt, for example) or other publicly available sources (as with much of the data on SOEs).

TAX

Tax revenue continues to grow very strongly, with recent data showing very large year-on-year increases for the fourth year in a row. Collections for the year to May 2008 far surpassed expectations, with 48% growth in realised tax revenue (JP, 9/6/2008), compared to an already high annual growth average of around 18% over the last five years. The dramatic increase in tax revenue is a consequence of continuing strong economic growth and arguably a better performing Directorate General of Taxation (DGT).

Improved performance of the DGT has been achieved through a reform agenda encompassing what it describes as ‘modernisation’, ‘extensification’ and ‘inten-sification’.12 The modernisation or administrative reform began with the introduction of large taxpayer offices in around 2004 (McLeod 2008: 197); a program of opening modernised medium and small taxpayer offices is due for completion by the end of 2008. This has been supported by reorganisation of the DGT head office, significant changes to governance (internal and external to DGT), and strong leadership of the DGT executive in coordinating with the increasing number of donors providing technical assistance.

Extensification—the effort to broaden the tax base by increasing the number of taxpayers—should help to ensure that the strong revenue growth achieved so far continues (albeit at slower rates as the pool of non-taxpayers diminishes). Inten-sification—the mapping, profiling and benchmarking of the largest tax payers with a view to extracting larger payments from them—has ensured that many companies can no longer hide behind false financial accounts to evade their tax obligations. In the future, continued growth in their businesses will result in corresponding increases in tax payments. This is particularly pertinent to booming sectors such as crude palm oil.

Importantly, the increased flow of tax revenue to date has been broad-based, and seems to be accompanied by increased confidence in the tax system on the part of businesses. If there is a cloud on the horizon in this overwhelmingly positive story, it relates to the 2009 elections, since the huge advances made in reforming the tax administration have without doubt reflected the strength of current leadership at all levels of the central government. Continuity in the reform process up to and beyond the presidential election is particularly important for a number of initiatives that are still in their early stages.13 Similarly, the considerable progress hitherto in gaining the trust of taxpayers could be quickly dissipated if a new government were less resolute in its attitude to reform of the tax system.

Box 1 Tax Law Amendments

1. Law 28/2007 on General Provisions and Administration of Taxation a provides for: extensions of time for filing small taxpayer and corporate income tax returns; a sunset policy, providing an opportunity to revise earlier tax returns without penalty until the end of 2008; a shortening of the statutory limitation for assessment from 10 to 5 years; improved dispute settlement arrangements, with taxpayers no longer obliged to pay the disputed amount up front; regulation of audit procedures; and measures to ensure the integrity of tax officials, such as channels for reporting misconduct, and the establishment of a tax supervisor commission.

2. The Law on Income Tax (enacted in early September 2008, but not yet signed by the president) encompasses reductions in tax rates while seeking to encourage entry into the tax system, thus increasing tax revenue over time. More specifically, the law provides for reductions in taxes for individuals: those earning Rp 25–50 million will be subject to a tax rate of 5% (previously 10%), while the maximum rate will be lowered from 35% to 33% in 2009 and 30% in 2010, and dividend payments will be taxed at 15% (compared with up to 35% previously). For businesses, the corporate income tax will be lowered from 30% to 28% in 2009, and to 25% in 2010. The law also assists certain activities, such as education and research and development (such that non-profit organisations in these fields will not be subject to income tax), charities (which will not be taxable), and small enterprises (which will now be able to reduce their tax liability by claiming new deductions). It also allows tax deductions for contributions to scholarships, natural disaster relief, social infrastructure, research and development, and education.

3. A draft Law on Value Added Tax (VAT) has been presented to parliament, but is yet to be debated. The draft law provides that: mergers, exports of services and intangible goods, syariah-compliant financial products and agriculture will not be subject to VAT; tourists can receive VAT refunds; VAT can be exempted for certain electricity and water supply customers; and services provided by secondary mortgage companies and special purpose vehicles for securitised assets will not be subject to VAT. The latter amendment is designed to assist with the development of secondary capital markets, where transactions often incur VAT on both the sale and purchase, and offsets cannot be claimed, making them relatively expensive.

^a Undang-Undang Nomor 28 Tahun 2007 tentang Perubahan Ketiga atas Undang- Undang Nomor 6 Tahun 1983 tentang Ketentuan Umum dan Tata Cara Perpajakan [Law 28/2007 on the Third Amendment to Law 6/1983 on General Provisions and Administration of Taxation].

Major tax reforms are at various stages of implementation (box 1). Business groups have been active in lobbying the government for measures that go beyond administrative reforms to address the issue of Indonesia's international tax competitiveness.14 Meanwhile, the proposed reductions in tax rates may have a positive impact on overall tax collection. The prevalence of non-filing of tax returns and under-stating of income by taxpayers means that lowering tax rates (while at the same time trying harder to put an end to informal ‘facilitation payments’) will encourage more firms and individuals to pay, or pay more, tax15—especially if the audit function can be refined to better target entities that should be paying more tax. This approach is already paying dividends: anecdotal evidence from DGT suggests that a number of large taxpayers that filed for the first time in 2006 or 2007 are likely to remit as much as six times more tax in 2008.

ELECTRICITY SHORTAGES16

The difficulties for the government in matching growing demand for electricity with a secure supply are well documented (Narjoko and Jotzo 2007: 161–4). In recent months the problem has been highlighted by the government's announcement that over the second half of 2008 Jakarta would experience scheduled blackouts, staggered in different parts of the city and lasting 3–5 hours. The rationale for these ‘brown-outs’ was that they result from the need to undertake significant maintenance on existing plants. The government promised that emergency services would not be affected but, in an almost comical twist, acknowledged that the power outages would affect traffic lights, so that some traffic disruption could be expected. It has also taken steps to force factories and businesses to re-program some of their operations to weekends to reduce peak load demand. The more plausible reason for the scheduled brown-outs is simply that the state electricity company, PLN, has failed to ensure an expansion of capacity in line with the increasing demand for electricity, so few accept the government's explanation. Voter inconvenience due to continuing brown-outs seems likely to become a sig-nificant issue in the run-up to the 2009 elections.

The root cause of the problem is the PSO under which the government requires PLN to provide electricity at fixed rates to its customers, passing on any cost in excess of revenue generated to the government. Introduced in 2003, this policy saw the annual subsidy cost increase more than three-fold, from Rp 3.3 trillion to Rp 12.5 trillion. The basic tariffs charged to users have not changed since 2003, while costs—high to begin with because of excessive dependence on oil (including at plants optimally designed to run on gas)—have been rising sharply owing to rising oil prices. Pending completion of new plants and new gas supplies coming on stream, high demand—driven by strong economic growth and boosted by increasingly large subsidies—must be met from high-cost plants. Thus the more PLN's customer base grows, the bigger its losses become.

An assessment in 2006 of the cost of the PSO arrangement found that Java and Bali accounted for 80% of energy sales and 61% of the total subsidy amount. The average subsidy was Rp 310 per kilowatt hour (kWh), given average revenue of Rp 622/kWh and an average supply cost of Rp 932/kWh. This means the subsidy is equivalent to one-third of the total supply cost. The variable cost of electricity generated by a plant run on diesel fuel can be up to 12 times that for plants relying on alternative sources such as gas or coal, both of which Indonesia has in abundance (Table 4). Despite this, oil-based fuels such as high-speed distillate (HSD) and marine fuel oil (MFO) are now estimated to account for around half of all electricity generation.

TABLE 4. Indicative Variable Costs for Various Plant Types, Java, 2007

Plant Type	Fuel Type	Variable Cost
		Rp/kWh^a	Cents/kWh^a
Thermal	Coal	185	2.03
Gas turbine (combined cycle)	Gas	225	2.47
Gas turbine (open cycle)	Gas	290	3.19
Geothermal	Geothermal	520	5.71
Thermal	MFO^a	1,115	12.25
Gas turbine (combined cycle)	HSD^b	1,430	15.71
Gas turbine (open cycle)	HSD^b	2,420	26.60
a kWh = kilowatt hours.
^b MFO = marine fuel oil.
^c HSD = high-speed distillate (diesel fuel).
Source: Ministry of Finance and authors’ calculations using an assumed exchange rate of Rp 9,100/$.

In May 2006 the government announced its intention to address the supply issue by securing investment in an additional 10,000 megawatts of generation capacity. However, progress has been slow, with only half the proposed projects so far even funded, let alone completed. The plan is for most of the new supply to come from coal-fired power stations. However, according to a senior official from the Ministry of Mining and Energy speaking to an industry function in Jakarta in July 2008, the coal supplies are yet to be fully identified, and in the short run they might have to be diverted from exports. If this were to occur it is not clear whether PLN would pay market prices for this coal, and whether it would be permitted to increase tariffs to bring them into line with costs.

PLN has begun to take measures to reduce the overall cost of the electricity subsidies, working within the existing tariff framework. During 2008 it began to re-classify power users in various parts of Jakarta to ensure that what it deems to be wealthier households will not be able to access the more heavily subsidised power supplies. This is no more than a second-best measure until PLN can persuade the government to allow it to change the tariff structure, but for now residential electricity bills in wealthy suburbs such as Kuningan and Menteng have more than doubled since March—at the same time that black-outs have become more frequent.

POVERTY

The president's budget speech highlighted the fact that poverty remains a big issue in the context of the parliamentary and presidential elections scheduled for 2009. Despite SBY's rather extravagant promise to reduce poverty from around 16% to 8% by 2009, poverty actually rose to 17.7% in 2006. And in 2007 nearly half of Indonesia's population was either poor or highly vulnerable to falling into poverty, by virtue of having per capita consumption levels less than one-third above the national poverty line.17 Poverty has fallen only slightly subsequently, to 15.4% (as of March 2008), despite sustained GDP growth of more than 6% per annum over the last two years; accordingly, the government has had to revise its 2009 poverty target significantly, to between 12% and 14% (Figure 7). The failure to reduce poverty more significantly is partly explained by the impact of higher energy and food prices, but the data also reflect the lack of meaningful structural reforms in important areas like labour markets, where such reforms would result in an expansion of employment opportunities for low-skilled (poorer) workers.

FIGURE 7.  Poverty Incidence (% of population below poverty line)

Rather than undertaking structural reforms, the government's primary approach to alleviating poverty has been to introduce a large number of both nationally and locally targeted schemes to assist the poor directly. The 2009 budget addresses the issue by outlining a ‘three-cluster strategy’ (SBY 2008). The first cluster, described as ‘giving fish to the poor’, involves the government continuing to provide direct assistance, including through the Raskin (Rice for the Poor) program and through unconditional cash transfers intended to compensate the poor for the May 2008 fuel price hike (McLeod 2008: 194). A long-term pilot for a conditional cash transfer program, which was supposed to follow on from its unconditional cousin introduced in 2005 after the previous large increase in domestic fuel prices (World Bank 2006), has not been implemented. This conditional pilot program, targeting seven provinces, was originally to be designed and introduced in 2006. It was intended to link cash transfers to outcomes such as school attendance, child health and ante-natal health checks, and was envisaged as replacing the unconditional cash transfer scheme when it finished in 2006. However, the pilot was not ready for implementation at that time, and SBY was reluctant to keep the unconditional transfers going until the conditional pilot could be rolled out. Many expressed concern at the time that keeping the transfers would create a degree of dependency among the poor that had the potential to create a future welfare burden on the budget to rival the fuel subsidies—an argument the president seemed to accept. The fact that the budget savings from the reduction in fuel subsidies were considerably larger than the cash outlays for the transfers does not support this premise for ceasing the payments, however. It remains to be seen what happens after this second round of unconditional transfers comes to an end in 2009 if preparations for the conditional scheme are still incomplete.

The second cluster of support, described as ‘giving a fishing rod’, involves the government providing community-based assistance under the National Self-Reliant Community Empowerment Program. This program has had heavy donor support, and anecdotal evidence suggests that it is very well supported by both the central and regional governments. It addresses very localised infrastructure issues, however, rather than more broadly based nationwide reforms. For the third cluster, SBY wants to ‘provide the boat’, by putting measures in place for the provision of microcredit to almost 1 million small businesses.

The merit of these programs is by no means universally accepted, but it is argued that they are capable of helping alleviate the impact of short-run economic shocks on the very large number of vulnerable poor living just above the poverty line (World Bank 2006). (The government seems far more committed to these poverty alleviation programs than to helping the tens of thousands of individuals currently suffering through one of the most severe negative shocks to their livelihoods imaginable, as a consequence of the volcanic mudflow in East Java: box 2). But significant long-run reductions in poverty require sustained long-term growth and job creation—issues not addressed by the government's poverty alleviation strategy.

INDONESIA AND THE DONOR COMMUNITY

The change in global credit conditions in 2008 highlighted the evolving relationships between the government and the donor community. In the first half of 2008 the government asked major donors for additional loans for budget support, and at the same time unveiled a new strategy regarding future development partnerships that pushes smaller donors towards working through multi-donor arrangements and encourages larger donors increasingly to use government systems. For donors this is a clear signal that, despite difficult global economic conditions, the government intends to dictate the terms of the relationships, both financial and strategic.

Box 2 The Lapindo Mudflow: An Unnatural Disaster

The Lapindo mudflow in East Java shows no sign of abating, and the scale of the ecological, social and economic impacts continues to grow. A US Geological Service report has found that arsenic is present in the mud in concentrations that exceed US government environmental guidelines (Plumlee et al. 2008: 8-9). A worrying new development is the appearance of a damaging gas fissure three kilometres from the original mud vent (BPLS 2008). This suggests the possibility of further subterranean volatility.

Efforts to staunch the mudflow (Narjoko and Jotzo 2007: 144–5) have been unsuccessful, and attention has turned to long-term management of the problem. A UN Environment Programme report published in June recommended several options: continued pumping into the Porong River; channelling mud into mangrove wetlands on the coast; and, most expensively, constructing an open channel to convey the mud directly to the sea (UNEP 2008: 3). The likelihood of heavy wet season rains increases the risk that mud-induced siltation of the Porong River will upset the natural drainage of the Brantas River basin and create serious flooding in Surabaya (Rumiati 2007: 41–2).

Compensation for the victims (Lindblad and Thee 2007: 8-9) has stalled. A presiden tial decree in July provided for compensation for another three villages in the affected area, bringing the total number of families to receive assistance to nearly 13,000. The decree ordered PT Lapindo Brantas to pay compensation in two phases: 20% in the first phase and 80% in the second phase to cover lease payments on new houses for the vic tims. The Minister for Public Works said the government would allocate Rp 1.19 trillion ($130 million) in the 2009 state budget to deal with the mudflow, including compensation for the victims, but a finance ministry spokeswoman declared that government funding would only be disbursed once Lapindo had discharged its compensation obligations in full (JP, 12/9/2008). So far, Lapindo has spent Rp 5.4 trillion ($590 million) on environmental works and social compensation (JP, 1/9/2008).

An analysis of the mudflow's economic impact by the Surabaya Institute of Technology (ITS) suggests the East Java economy may have contracted by 4.2% between May 2006 and August 2007. ITS estimates the total cost of the mudflow through August 2007 at Rp 28.3 trillion, comprising Rp 8.3 trillion in infrastructure asset losses, Rp 5.8 trillion in lost production in Sidoarjo District and Rp 14.2 trillion in indirect losses to the provincial economy as a whole, especially in food and leather processing, transport and hospitality (Rumiati 2007: 46–7). These figures are likely to have risen substantially in the last 12 months. The region suffering the biggest economic loss is the central corridor from Surabaya south to Malang, which constitutes East Java's manufacturing heartland (Santosa and McMichael 2004: 14). Regions to the west and east have been less affected by transport and logistical constraints imposed by the mudflow.

Lapindo's relationship to the Bakrie Group (Basri and Putunru 2006: 311–13) is a major political headache for the government, given that Aburizal Bakrie is a senior member of President Yudhoyono's cabinet. Despite scientific analysis proving the initial mud eruption was caused by Lapindo drilling (AFR, 15/9/2008), the company does not accept responsibility and the government appears unable to force it to expedite compensation to the victims. Until the question of liability and responsibility for compensation is settled in the courts, any national rehabilitation effort appears to be on hold. Lapindo, meanwhile, continues to attempt to influence public opinion to its view. The company has bought the Surabaya Post daily and installed its spokesperson as the chief editor. Candidates in the East Java gubernatorial election campaign allegedly have been bribed to avoid public references to Lapindo's liability.

Whether it is ultimately deemed an industrial accident or a natural disaster, this very unnatural phenomenon with its serious social and economic impacts, particularly for the victims and the business sector in East Java, exposes the failure of the national government to deal adequately with a crisis of national proportions.

Heath McMichael

Department of Foreign Affairs and Trade, Canberra

It might be argued that 2008 provides a window into the future for donor– government relationships. With the marked improvement in Indonesia's fis-cal position over the last few years, many donors now channel their assistance through multilateral arrangements managed by others, rather than having their own bilateral activities; at least one donor, the UK, has chosen to wind down its operations as Indonesia moves into (low) middle-income status. The World Bank and the Asian Development Bank (ADB) are significant lenders to Indonesia, but are viewed by some within government as offering loans that the authorities should in fact be prepared to pay a premium to avoid. Others see benefits in both cheap loans from, and strategic engagement with, both organisations. For large bilateral donors such as Japan and Australia, the government is cultivating relationships that are very broad ranging, encompassing central government and sub-national government policy responsibilities.

Bappenas remains the focal point for donors, but retains little of the authority it carried when it was responsible for development (capital) expenditure in the budget. Nevertheless Bappenas continues to coordinate the donors, and has recently produced a paper entitled ‘Aid for Development Effectiveness—Indonesia's Road Map to 2014’. This five-year development assistance plan is built on three pillars: strengthening country ownership over development; delivering and accounting for development results; and building more effective and inclusive partnerships for development.18 Encouraging smaller donors to provide support through multi-donor trust fund arrangements will lower the necessary government investment of resources and time in negotiations—not unlike the approach taken by India (Indian Ministry of Finance 2005). The main consequence for the large bilateral donors is that development assistance will increasingly move towards using government systems, bringing donor funds onto the government's budget. Government systems will improve with time, but at present they are often bureaucratic and inefficient, and in some cases involve higher levels of corruption or greater misallocation of funds than would be the case if donors dealt directly with contractors.

Financing and the donors

With debt levels now as low as 30% of GDP—low by global standards19—Indo-nesia can afford to borrow more and, as demonstrated earlier in 2008, it has a number of options for diversifying this borrowing. It has been able, until recently, to sell bonds domestically, to issue bonds globally (in both US dollars and euros), and to front-load its borrowing to ease pressure on later bond auctions and provide some flexibility in meeting the budget financing requirement for 2008.

The donor community no longer fills any significant gap in financing the budget.20 Donor funding covers less than 5% of total government expenditure, equivalent to around 0.5% of GDP. In other words, a decrease in the deficit of just 0.5% of GDP would obviate any need for donor funding. From another perspective, the increase in tax revenue in the first half of 2008 noted earlier is around four times the total amount of projected donor funding for that period.21

Despite the government's improving fiscal position and recent preference for borrowing from the market, it faces a more difficult task in financing the budget in 2008 and 2009 than the headline deficit amount indicates. Bonds maturing in amount to around Rp 60 trillion, which means that while the headline deficit is estimated on present projections to be around Rp 90 trillion, the total financ-ing requirement is close to Rp 150 trillion (MOF 2007). Under normal circumstances it would not be difficult to roll over the maturing debt, but in the face of deteriorating global credit conditions and volatile global commodity prices, the government made some requests in March 2008 for additional funds from the international financial institutions (IFIs). It reputedly requested over $1 billion in loans for budget support from both the World Bank and the ADB in 2008 and (not all of which could be provided). World Bank lending for budget support increased from around $700 million in 2007 to around $900 million in 2008, and is projected to go from $900 million in 2009 to over $1.5 billion in 2010 (World Bank 2008). According to ADB sources in Jakarta, the ADB will provide somewhere between $600 and $900 million in 2008, but because its total lending is limited to 100% of its total capital, it may not be able to provide the additional loans requested by the government. The ADB is looking to raise additional capital by 2010, which implies that this problem seems likely to persist through 2009.

In relation to project financing there are now new players from China, often government linked, which seem less risk-averse than other donors and offer competitive loans with fewer restrictions. With the government's need to increase investment in infrastructure it is no wonder the Chinese are becoming important players in areas such as the energy sector, where the MOF reports that Chinese institutions will finance around half of the proposed 10,000 megawatt expansion of Indonesia's electricity generation capacity.

It is clear from the events of this year that the government does not need donor funding even during difficult times, but it will continue to borrow from the IFIs to the extent that they represent a low-cost source of budget funding. In turn, the IFIs, whose core objective is to support long-term developmental progress, will have to work harder to ensure they are not seen merely as a funding source, so as to maintain their strategic engagement with the authorities on policy issues and key infrastructure projects. It appears that relationships with more traditional donors will be drawn up on Indonesia's terms, even though the term ‘partnership’ now represents the public face of the new style of engagement. Large bilateral donors like Australia may also find issues of trade, rather than aid, taking precedence at central government level, as has occurred in the ASEAN–Australia and New Zealand Free Trade Agreement talks, in which Indonesia has repeatedly described training and investment as key outcomes in ‘selling’ free trade agreements at home.

14 October 2008

Additional information

Notes on contributors

David Cavanough*

*The views expressed in this article, including those in box 2, are those of the authors and do not reflect the views of the Australian government or of the departments to which the authors belong

Notes

¹Recent polling by Jakarta's Centre for Strategic and International Studies showed Megawati Soekarnoputri as the candidate likely to get the most votes in a first presidential election round, polling some 8% ahead of the president (JP, 15/7/2008).

²See <http://www.bi.go.id/SDDS/series/bop/index_bop.htm>

³The FSF, based at the Bank of International Settlements, is a group of treasuries, central banks and supervisors from important financial centres, as well as some international financial institutions <http://www.fsforum.org > ).

⁴Both ministries are now headed by Sri Mulyani Indrawati.

⁵Infl ation target ranges are set each year.

⁶As, indeed, had the three previous budgets (JP, 18/8/2008).

On 14 October, after consultations with the parliament, the government announced a second round of modified assumptions for the 2009 budget in response to the worsening global crisis. These revised assumptions appear as note ‘a’ to table 2, but were announced too late for them to be analysed in detail for this survey. The analysis in this section and the data in table 2 are based on the assumptions in the supplementary budget document (‘Dokumen Tambahan Nota Keuangan dan RAPBN’) of August 2008 (table 2, note ‘c’).

⁸The first of these figures is based on the implicit GDP defl ator, while the second is based on CPI infl ation.

⁹The decline in non-tax revenues relative to GDP would not have an expansionary impact because the decreases do not benefit the domestic private sector: the main items here are decreases in the government's oil and gas revenues, its dividends from the SOEs, and other non-tax revenues.

¹⁰In the revised 2008 budget the estimated cost of fuel subsidies was increased from Rp 46 trillion to Rp 127 trillion, but the projected outcome is Rp 180 trillion.

¹¹Again at the request of the finance minister, the IMF sent a follow-up team to Jakarta in early 2008 to assist the MOF in analysing data from SOEs. The assistance comprised spreadsheet-based modelling tools, but little training was provided.

¹²The term ‘modernisation’ was adopted to capture the process of reforming each tax office to include new, integrated business processes and a commitment to giving up corrupt practices. Staff received large additional allowances as an incentive to sign up to a new code of conduct.

¹³For example, the World Bank's $150 million Project for Indonesian Tax Administration Reform (PINTAR) to modernise the systems and processes of DGT.

¹⁴It is widely held that Kadin (the Indonesian Chamber of Commerce and Industry) played a central role in persuading the DPR to pass the 2007 Tax Administration Law, and that it has been pushing for both the income and VAT bills to be passed in 2008.

¹⁵Revenue responses to a tax rate change depend upon the tax system in place, the period being considered, the extent of informal sector economic activities, the existing level of tax rates, the prevalence of legal and accounting-driven tax loopholes, and the ability to substitute productive factors in response to changes in tax arrangements (Laffer 2004).

Figures quoted in this section are drawn from internal working documents supplied to the authors by the MOF.

¹⁷Several regions, especially in Eastern Indonesia, are well behind the all-Indonesia average (Hill, Resosudarmo and Vidyattama 2008, in this issue). Indonesia is doing particularly poorly in relation to a number of health indicators and, as a result, may fail to reach several of its Millennium Development Goal targets (World Bank 2008).

¹⁸These correspond to the pillars set out in the OECD's Paris Declaration on Development Effectiveness, widely considered world's best practice for development assistance.

¹⁹For example the OECD average for general government net financial liabilities in 2008 is 42.4% of GDP; see <http://www.oecd.org/dataoecd/5/51/2483816.xls>, accessed 10 October 2008.

²⁰Dissolution in early 2007 of the Consultative Group on Indonesia, the official mechanism for managing donor ‘pledges’, can be interpreted partly as a refl ection of the greatly diminished importance of aid in Indonesia.

²¹Authors’ calculations based on figures from table 2.