Economic Assessment of Indonesia 2008: Growth performance and policy challenges

 

Contents |  How to obtain this publication | Additional information

 

The following provides a summary of chapter 1 of the Economic Assessment of Indonesia  published on 24 July 2008.

 

Contents                                                                                                                             

 

Growth is picking up, helping to close a still sizeable gap in living standards relative to the OECD area

Indonesia’s economic performance has improved markedly over the last few years. The economy has recovered in earnest from the 1997-98 financial crisis, and GDP growth has been around 5½ per cent per year since 2004. This rate is below that of some regional peers, but high enough to deliver broad based improvements in living standards. The contribution of private consumption has trended up, especially since 2004, on the back of robust credit creation. Investment also appears to be rebounding, although it remains lower than elsewhere in the region when measured in relation to GDP. Export growth has been supported by high commodity prices. The momentum of the current expansion is expected to be maintained in 2008-09, with GDP growth likely exceeding 6% per year. Yet, the current level of growth is insufficient to speed up the pace of reduction in poverty and unemployment. Therefore, raising the economy’s growth potential and sustaining it over the longer term is Indonesia’s foremost policy challenge. To achieve this, concerted efforts are required in several areas, especially if the goals set out in Vision 2030 – a well thought out initiative by a group of independent experts to achieve high growth – are to be fulfilled. Against this background, this Economic Assessment discusses a number of policy options for improving the business climate and making better use of labour inputs. Progress in these areas will contribute to enhancing economic efficiency further, so as to narrow the gap in relative living standards that currently exists between Indonesia and the more prosperous countries in the OECD area.


Indonesia’s long term growth performance and relative living standards
In per cent

 


Source: World Bank and OECD.


Fiscal performance is improving and should remain strong

Responsible conduct of fiscal policy in an increasingly decentralised setting has delivered low budget deficits and falling public indebtedness in relation to GDP. The budget has therefore benefitted from an “interest dividend”, which has allowed the authorities to begin to reallocate scarce resources towards meritorious programmes in the social and infrastructure development areas. Emphasis on human capital accumulation, and particularly on improvements in the quality of services, including labour training, would be particularly welcome, given that Indonesia’s educational attainment indicators fare particularly poorly in relation to some regional comparator countries and the OECD area. Efforts are also under way to strengthen tax administration, to alleviate the income tax burden on the business sector and to improve value added taxation. Decentralisation, which has put the local governments at the helm of service delivery since 2001, was implemented rapidly and yet without disruption. There is broad agreement that, based on its favourable public debt dynamics, Indonesia will in all likelihood continue to benefit from a relatively comfortable fiscal position in the years to come. Therefore, the time is now ripe for building on past achievements, which are commendable, and for strengthening the fiscal framework further.


There is room for further reducing price subsidies for fuel and electricity

Indonesia continues to subsidise fuel and electricity consumption by maintaining a sizeable gap between domestic and international oil prices. Subsidies are expected to make up about 20% of central government expenditure in 2008, with those on fuel taking up the lion’s share of the total. A few selected food items are also subsidised, but such outlays account for a small share of outlays on subsidies. Efforts to eliminate fuel price subsidisation have yielded mixed results. For example, a mechanism introduced in 2001-02 for automatically adjusting domestic prices so as to reduce the gap between domestic and international fuel prices was abolished not long after. These subsidies are an inefficient use of scarce budgetary resources at a time when resources are needed for human capital accumulation and infrastructure development, in addition to creating considerable fiscal stress when international fuel prices are high. First and foremost, a significant share of government spending on some subsidies (about two thirds in the case of fuel, according to official estimates) accrue to individuals in the top two quintiles of the income distribution, rather than benefitting vulnerable social groups. These subsidies also make it difficult for the oil and electricity companies to pursue their commercial objectives independently of the government’s social policies. Moreover, extensive subsidisation complicates the regulatory framework, because uncertainty in price setting discourages much needed private investment in these sectors. Finally, by keeping the price of fossil fuels artificially low, such price support encourages wasteful consumption and discourages a search for alternative sources of energy, with a detrimental impact on the environment. Therefore, the authorities’ efforts to gradually reduce the gap between domestic and international energy prices would be welcome, provided that targeted compensatory measures (discussed below) are taken to shield the needy from the attendant price rises. The increase in domestic fuel prices by nearly 30% in mid May was  a step in the right direction, but the introduction of a formula based mechanism for setting domestic fuel prices would have the advantage of making price changes transparent and removing them from the political arena.


The monetary policy regime can be strengthened further

Monetary policy has been conducted within a fully fledged inflation targeting regime since mid 2005, when monetary targeting was formally abandoned. Following an upsurge in 2005-06 as a result of fuel price hikes, inflation was reduced and kept within the end year target range of 5-7% in 2007. Increases in food and energy prices are nevertheless weighing on inflation outcomes yet again. Headline inflation and expectations have risen and are now well above the ceiling of the target range of 4-6% for 2008. The effect of high food prices on inflation is particularly strong in emerging market economies, where these items account for a comparatively high proportion of the consumer price index. To strengthen credibility in the policy regime, the central bank is advised to react pre emptively by tightening the monetary policy stance should the outlook for inflation and expectations deteriorate further. International experience shows that resolute, forward looking action is essential for anchoring expectations and enhancing policy credibility in countries that have a short track record with inflation targeting. Over the longer term, policy effort should also focus on lowering inflation towards the average of Indonesia’s main trading partners. The announcement of gradually decreasing targets for the coming years, from 4-6% in 2008 to 3-5% over the medium term, is therefore a welcome signal of commitment to inflation convergence, which will require a sustained effort to achieve those targets.


Inflation and monetary policy, 2000-08
In per cent, unless otherwise indicated

 

Source: Bank Indonesia and OECD.


The financial sector has recovered in earnest from the crisis

The steps taken to strengthen the financial sector since the financial crisis of 1997-98, including the most recent biennial Structural Reform Programme, have largely paid off: the banking system is sound, capital adequacy and liquidity indicators have improved over the years, and the quality of loan portfolios has been strengthened. Nevertheless, State owned banks have a large presence in the sector, in part due to the rescue of failing banks after the crisis, and the non bank sector is relatively small. Credit to GDP ratios are lower than in regional peers and Indonesia’s pre crisis level, despite a robust expansion over the last few years. As in other countries with a large informal sector, access to credit is particularly difficult for small and unregistered enterprises, which tend to rely on informal, costly sources of finance. Indonesia would therefore benefit from further financial deepening, including in particular the development of the non bank market segment and an expansion of credit to small businesses. Progress in this area could unleash opportunities for entrepreneurship, but policy action should continue to be guided by high standards of financial sector supervision and prudential regulations.


There is plenty of room for making product market regulations more pro competition

Pro competition product market regulations tend to be growth enhancing, because the reallocation of inputs towards higher productivity sectors is unencumbered. An assessment of Indonesia’s regulatory environment on the basis of the OECD methodology for gauging competitive pressures in product markets suggests considerable scope for improvement. In particular, despite recent deregulation efforts and reforms, Indonesia still fares particularly poorly in comparison with OECD countries in terms of the size and scope of government. For example, the government owns all or the majority of large firms in several sectors, including network industries. It is also involved in manufacturing and services, including banking and insurance. Sector specific restrictions on private sector involvement also remain, including in transport and retail distribution, as well as foreign ownership ceilings, as discussed below. Options are being put forward by the authorities for liberalising State owned monopolies in key network industries, which would contribute to opening up opportunities for the private sector. The experience of several countries in the OECD area and beyond suggests that, with appropriately designed regulatory frameworks, the withdrawal of the State from network industries has been accompanied by an expansion of supply and a reduction in service prices, as well as increases in productivity.


Product market regulations: Cross country comparisons
Low scores indicate less restriction
 


Source: OECD.
 

How to obtain this publication                                                                                   

The Policy Brief: Economic Assessment of Indonesia, 2008  can be downloaded in English. It summarises the OECD assessment. The complete edition of the Economic Assessment of Indonesia 2008 is available from:

 

 

Additional information                                                                                                  

 

For further information please contact the Indonesia Desk at the OECD Economics Department at eco.survey@oecd.org.  The OECD Secretariat's report was prepared by Luiz de Mello and Diego Moccero under the supervision of Peter Jarrett. Research assistance was provided by Anne Legendre.

 

 

 

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