Cablegate: Indonesia's Economic Recovery Remains On Track

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E.O. 12598: N/A
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: INDONESIA'S ECONOMIC RECOVERY REMAINS ON TRACK

A) Jakarta 12775 B) Jakarta 13236 C) Jakarta 12543

1. (SBU) Summary. Indonesia's economy continues to recover
from the impact of August 2005 rupiah "mini-crisis," with
growth in gross domestic product (GDP) reaching 5.5% year-on-
year (YoY) in the third quarter. Strong external demand for
Indonesian commodities and increased household consumption
supported the more robust growth rate. In contrast to the
previous quarter, however, growth in government expenditures
slowed significantly during the July to September period,
due in part to decentralization which continues to disrupt
the dispersal of government funds. While the investment
outlook in Indonesia has improved somewhat, fixed capital
investment remained stalled in the third quarter,
contracting over the same period last year. Analysts expect
domestic demand to continue to accelerate through the end of
2006 and through the first half of 2007 supporting more
robust GDP growth. Indonesia's overall macroeconomic
outlook continues to improve with lower inflation
expectations, rising foreign exchange reserves, and a less
volatile exchange rate. A significant contraction in global
demand, a sudden change in foreign short-term investor
sentiment, slow progress on pro-investment reforms, and the
failure to reduce unemployment levels are the key risks to
economic growth and stability over the short-to-medium term.
End summary.

--------------------------------------------- -----
Table 1: Real GDP Growth, 2005-2006, Year-on-Year
--------------------------------------------- -----
2005 2006 2006 2006
Q4 Q1 Q2 Q3
--------------------------------------------- -----
Private Consumption 4.2 3.2 3.0 3.0

Government Consumption 30.0 14.2 31.6 1.8

Fixed Capital Formation 1.8 2.9 -1.0 -0.3

Exports of Goods and
Services 7.4 10.8 11.3 12.1

Imports of Goods and
Services 3.7 5.0 8.3 9.7
--------------------------------------------- -----
GDP 4.9 4.6 5.2 5.5
--------------------------------------------- -----
Source: Central Bureau of Statistics

Indonesia Reports Higher GDP Growth in Third Quarter
--------------------------------------------- ---------

2. (U) Private consumption, which comprises the largest
component of GDP at over 60%, continued to recover modestly
in third quarter of 2006, growing 3.0% YoY as the affects of
lower inflation and reduced interest rates began to take
hold among individual consumers. Headline inflation dropped
to 6.3% YoY in October, due to the significant increase in
the inflation base caused by the October 2005 fuel price
hikes. In response to lower price levels, Bank Indonesia
(BI) loosened monetary policy further in November, reducing
the BI policy rate (reference interest rate) by 50 basis
points on November 7 to 10.25%. According to BI, demand for
loans began to improve significantly during the third
quarter, with domestic credit increasing by Rp 18.5 trillion
(US$ 2.0 billion) during the month of September, the highest
monthly increase this year. Observers expect private
domestic demand to improve further in the near term, as more
stable price levels and lower interest rates encourage
private sector spending and the Government of Indonesia
(GOI) implements planned wage increases for civil servants
(Ref A).

3. (U) Strong external demand for Indonesian commodities
resulted in robust net export growth during the third
quarter. Exports of goods and services rose 12.1% YoY,
continuing the trend of strong growth during the first half
of 2006. Indonesia's commodity exports have been very

JAKARTA 00013326 002 OF 003

strong during the first nine months of 2006, with exports of
coal, rubber and rubber goods, and crude palm oil growing
44, 71, and 17 percent respectively YoY. Growth in imported
goods and services failed to keep pace, increasing only 9.7%
YoY in the July to September period. Looking ahead, most
observers expect local demand for imports to increase in
subsequent quarters in line with resurging private demand,
and global demand for Indonesian commodities to decline in
proportion to slower world growth. While most analysts
expect the economic impact of these trends to be moderate, a
sharper than anticipated contraction in net exports would
slow growth and put pressure on Indonesia's balance of
payments.

Government Spending and Investment Flat
---------------------------------------

4. (SBU) Surprisingly, given that government expenditures
traditionally increase during the second half of the year,
YoY growth in government expenditures stagnated in the third
quarter, rising only 1.8%. Analysts attributed the slowdown
in spending to the more rapid than expected disbursement of
funds in the second quarter as well as ongoing difficulties
facing the disbursement of funds at at the local level. The
GOI plans to significantly increase spending in the fourth
quarter of 2006, likely boosting growth through the end of
the year. However, the GOI has announced a reduction in
overall spending in 2007 as a share of GDP (Ref A), and
observers expect problems associated with disbursement at
the local government level to persist over the short-to-
medium term, limiting the government's ability to stimulate
economic growth.

5. (SBU) Indonesia's economy continues to suffer from very
low levels of investment, with fixed capital formation
contracting 0.3% YoY in the third quarter. The low
investment numbers reveal that GOI policies aimed at
encouraging investment have so far failed to produce
tangible results. Looking ahead, however, analysts believe
the anticipated pick up in domestic private consumption will
provide some stimulus to investment over the next six to
nine months. According to data collect by BI, domestic
investment approvals have almost tripled during the first 8
months of 2006 compared to the same period a year earlier,
and foreign investment approvals are up 20% over the same
period. In addition, Indonesia's recent infrastructure has
helped reignite investor interest in large-scale
infrastructure projects in Indonesia, particularly in the
power sector. However, there are questions about when the
GOI will tender any of the 10 priority projects highlighted
at the forum. Important legislation impacting on the
investment climate, including draft investment, tax, and
labor laws, remain stuck in the GOI or Parliament, leaving
many investors skeptical of the GOI's ability to maintain a
competitive investment climate compared to Indonesia's
competitors in the region.

6. (U) Indonesia's cumulative GDP growth rate for the first
three quarters of 2006 was 5.1%, a rate generally in line
with economists' forecasts. Although the economy grew at a
more robust pace in the third quarter, it is still unlikely
to meet the GOI's target 5.8% growth rate for the full year.
The transportation and telecommunications sector, growing at
a cumulative rate of 12.8% during the first three quarters
of 2006, continues to outperform other segments of the
economy. Manufacturing growth slightly accelerated in the
third quarter but the sector's growth rate, at 4.1% year to
date in 2006, is still below that of the economy as a whole.
Growth in the agriculture and mining sectors remain
lackluster. Agriculture and mining production have expanded
3.4% and 2.3% year to date in 2006, respectively.

Prudent Macro Policies Expected, But Risks Remain
--------------------------------------------- ----

7. (SBU) Most economic observers expect the GOI and BI to
continue to pursue prudent monetary and fiscal policies over
the next several quarters. These policies have stabilized

JAKARTA 00013326 003 OF 003

the rupiah, lowered inflation expectations, and contributed
to the significant accumulation of foreign exchange reserves
in 2006. The GOI has limited spending in 2006 and expects
to further reduce spending levels during 2007 in order to
reduce Indonesia's external debt level and enhance investor
confidence. In its November 7 statement announcing the
lowering of the BI rate to 10.25%, BI cited "economic
concerns calling for vigilance in the months ahead"
including continued inflationary pressure in 2007. BI added
that "the Board of Governors...sees the need for more
measured, cautious operation of monetary policy to maintain
macroeconomic stability in the medium and long-term and
consolidate the momentum for sustainable economic recovery."
Despite these cautious words, there is some concern in the
financial sector that in its efforts to support growth, BI
will lower interest rates too quickly or too far, leading to
renewed inflation and/or rupiah volatility.

8. (SBU) The biggest risks to continued economic growth and
stability in Indonesia in the short term are negative
external developments. A sharp drop in global demand for
Indonesian products, especially commodities that have
provided significant support for GDP growth in recent
months, or a shift in foreign portfolio investor sentiment
away from Indonesia could put renewed pressure on
Indonesia's balance of payments and undermine Indonesia's
hard-won macroeconomic stability. However, continued strong
growth in the region, particularly in China, is expect to at
least partially offset an anticipated slowdown in the
economic growth in the United States. Longer term risks to
Indonesia's economic outlook include the slow pace of
infrastructure investment and the relatively slow growth in
labor intensive sectors like garments, footwear, and
electronics. New investment in infrastructure projects is
particularly important given that much of country's
electricity grid, road system, and ports are already
operating at maximum capacity and the quality of those
facilities has eroded substantially over time.

PASCOE

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