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Indonesia put to test

Asia Times - October 20, 2012

Richard Javad Heydarian With the world's third-largest democracy and Asia's fifth-largest economy, Indonesia has emerged as a regional bastion of political stability and economic dynamism, assuming a place of pride among developing nations. But with global economic clouds on the horizon, the country looks increasingly vulnerable to losing some of its newfound luster.

Unlike China's fast growth, Indonesia's economic boom has relied more on commodity exports than shipments of high-value-added manufactured products. About half of Indonesia's exports are basic commodities, including coal, coffee, copper, natural gas, nickel, oil, rubber, tea and tin, making its economy highly vulnerable to volatility in global commodity markets.

Exports have fallen for five straight months, with August registering a worse-than-expected contraction of 24.3% from a year earlier. Fitch Ratings, a sovereign-risk credit-rating agency, recently categorized the country as "highly vulnerable to systemic stress", alongside China, Mongolia and Sri Lanka in Asia. As China shows signs of a slowdown, demand for Indonesian commodities is expected to fall further in the months ahead. About 15% of Indonesia's exports are shipped to China.

A domestic consumer and investment boom, meanwhile, has buoyed growth but also placed heavy pressure on the current account. For the first time in four decades, Indonesia registered a current-account deficit for two months in a row in April and May. The trend has sparked market speculation that the country could register a record trade deficit in 2012. International reserves have dwindled in the process, falling 15% from August 2011 to July this year.

Before these statistical dips, Indonesia was viewed widely as a reservoir of countercyclical resilience. Three years after the 2008 global recession, Indonesia outpaced its pre-crisis (2003-07) average growth clip with a robust 6.5% expansion in gross domestic product, bucking the slower post-recession trend seen in many developing countries. To sustain that resilience during the impending slowdown, however, Indonesia will need to address two structural challenges: lagging infrastructure and over-reliance on commodity exports.

Rising star

Indonesia's economic emergence has shone against the gloomy backdrop of its recent past. It was arguably the worst-hit country during the 1997-98 Asian financial crisis, with its economy contracting by a staggering 20% and the value of the local currency plunging by 80%. The economic catastrophe ignited a major political upheaval, culminating in the demise of Suharto's three-plus decades of authoritarian rule and a transition toward democratic rule.

Jakarta has clearly learned lessons from that tumultuous economic past. Where local banks collapsed under the weight of poor lending decisions in 1997-98, their current gross ratio non-performing assets is among the region's lowest at around 2%, according to Fitch.

Indonesian banks' return on average assets of 2.6% is currently more than twice as high as comparable financial institutions in India, Malaysia and Vietnam, and substantially higher than Philippine and Thai banks, Fitch reports. This month, Indonesian monetary authorities maintained the benchmark interest rate at 5.75%, a record low it has maintained for eight consecutive months.

While the International Monetary Fund recently narrowed its 2012 economic-growth forecast for Asia, Indonesia is still expected to expand by more than 6% this year. GDP grew by 6.3% and 6.4% year on year in the first and second quarters respectively, the fastest rate of any large global economy outside China. Despite fears of overheating, inflation actually fell month on month in September and is viewed as manageable at 4.3% on an annualized basis.

Strong flows of foreign direct investment have contributed to the resilience. FDI flows rose from US$10.8 billion in 2009 to $18.9 billion in 2011. In the first half of this year, Indonesia attracted $12 billion in FDI, raising government hopes of a record $25 billion inflow for the full calendar year. The inflows have gathered pace despite rising resource nationalism and protectionism, lingering concerns about the country's inefficient and perceived-as-corrupt courts and bureaucracy, and creaky infrastructure.

Better balance

Political devolution spearheaded by President Susilo Bambang Yudhoyono's administration has allowed for a more balanced and equitable distribution of investment, public spending and economic growth across the sprawling archipelago of 250 million people. As structural inflation the inevitable rise in labor and related costs in rapidly growing economies erodes China's competitiveness, lower-cost Indonesia has benefited from a recent inflow of investment relocations from mainland China.

Based on a recent International Labor Organization report, Indonesian workers earn about $148 per month against $190 for average workers in Chinese manufacturing hubs such as Shenzhen, a substantial wage differential for multinational manufacturers. Chinese entrepreneurs from the Aigo Entrepreneurs Alliance expressed plans last year to relocate their textile factories to Indonesia. In August 2011, Chinese companies signed $10 billion worth of investment projects in cement, infrastructure, agriculture, and real estate in Indonesia.

Japanese investors have also poured in capital. After major disruptions in their Thailand-based production facilities last year, just months after the Fukushima tsunami and nuclear disaster, leading Japanese car manufacturers including Toyota, Nissan and Daihatsu pledged $1.8 billion worth of investments to improve and expand their Indonesia-based production facilities. Annual car sales in Indonesia have risen rapidly and are expected to reach about a million new vehicles this year.

Indonesia's expanding and increasingly sophisticated domestic market is part of the attraction. It is now among the world's largest markets for consumer products and electronics and among the world's top four biggest subscribers to social-networking giant Facebook.

Indonesia now has a 50-million-strong "bourgeoisie" market, which is projected to reach around 150 million by 2014, according to the Japanese bank Nomura. Consulting firm McKinsey, meanwhile, estimates Indonesia will become the world's third-largest consumer market trailing only China and India by 2030. Riding that optimism, Yudhoyono has announced his goal of setting the country on course to become one of the world's 10 largest economies by 2025.

Persistent weakness

Yet all these positive assessments and predictions mask persistent structural weaknesses. In particular, Indonesia's competitiveness is undercut by its weak infrastructure and corrupt bureaucracy. Experts believe that without a fast and major upgrade of both, the dual inefficiencies will be an increasingly substantial drag on growth, crucially at a time when the global and regional economy is expected to slow.

Decades of corruption, legal uncertainty and misappropriation of public funds have all conspired to retard Indonesia's infrastructure development. In the 2010 Logistics Performance Index a World Bank measure of overall infrastructural competitiveness and efficiency Indonesia ranked 75th, well below regional peers in Malaysia, Thailand and even the laggard Philippines.

Indonesia's "ease of doing business" ranking in the World Bank's annual survey slipped from 126th in 2011 to 129th this year. It also scored poorly in global comparative indicators such as electricity supply (161st), starting a business (155th), and contract enforcement (156th). It also slid by four spots in the 2012-13 Global Competitiveness report, from 46th in 2011 to 50th this year. The independent report characterized Indonesia's infrastructure as "largely underdeveloped", while the institutional framework is undermined by "corruption and bribery".

To improve the situation, the government pushed through a new land-acquisition bill, approved in December 2011, to hasten infrastructure development. Officials say they plan to double spending on roads, railways, airports and ports to $140 billion within the next five years. Total infrastructure spending is scheduled to hit $250 billion from 2011 to 2015. If actually realized, Indonesia's investment-to-GDP ratio would jump from 3.9% in 2009 to 5.9% in 2015, according to Morgan Stanley, an investment bank. The accelerated spending would supplement a larger, longer-term $600 billion infrastructure spending plan to be implemented between 2011 and 2025.

Diversity dilemma

Where all that money will come from, however, is still unclear. Indonesia has a major tax-collection problem: 80% of state revenues are currently derived from a narrow tax base, amounting to only 12.7% of GDP. That's well below the regional average, which ranges between 14% and 22%. Inefficient energy-subsidy schemes also eat into the state's budget and raise wider concerns about the quality of current and planned public spending.

Better infrastructure is crucial to diversifying the economy away from raw commodity exports toward more value-added manufacturing. While Indonesia has registered significant gains in labor productivity, representing by some measures a 60% rise from the previous decade, its overall manufacturing sector suffers from anemic annual growth compared with other economic sectors.

Recent nationalistic efforts to shift investments into manufacturing by raising restrictions on the mining sector, which currently accounts for 12% of GDP, have backfired badly. New rules requiring special licenses for mineral exports have led to a major decline in outward shipments and fueled complaints from piqued multinationals about the rising costs of government corruption. New laws and regulations have also aimed to limit foreign ownership in mining and banking ventures.

Despite these challenges, Indonesia's strong macroeconomic fundamentals, robust domestic demand and relatively healthy corporate and financial sectors provide room to maneuver amid rising global economic uncertainties. The government also has considerable room for fiscal stimulus and other schemes such as direct cash transfers. But without efforts to overcome structural weaknesses and endemic corruption, Indonesia's resilience will be tested by any sudden shift in market and investor sentiment.

[Richard Javad Heydarian is a foreign affairs analyst based in Manila. He can be reached at jrheydarian@gmail.com.]

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