The Indonesian Economic Outlook William Wallace, Lead Economist World Bank, Indonesia March 2, 2005

Agenda The international environment The events of The Reform agenda Summary Conclusions

International Economic Environment GDP Growth (% change) World (PPP weights) OECD United States Japan Euro Area World Trade (% change Vol) CPI Inflation G7 (% change) Oil Price ($/bbl) Non-oil commodity prices (% change) Libor (US$, 6 mo) Source: World Bank DEC: Prospects Group (November, 2005)

Indonesia 2005

In 2005 Indonesian growth was strongest since the crisis but slowing rapidly Growth (real GDP): o Overall 5.6% o Non-oil GDP 6.5% o Investment 9.9% o Domestic cap gds -2.2% o Imported cap gds31.8% o Construction 6.2% Trade (USD) o Exports o Overall19.5% o Non-oil18.6% o Selected Manufacturing (Oct) o Electronics 31.3% o Textiles/cloth/shoes 12.5 % o Other 12.1% o Imports o Overall23.7% o Capital (Oct)30.2% o This masks a sharp slowdown in growth, investment although exports hold up o 4 th qtr growth 4.9% o 4 th qtr investment 1.8% o Import (Jan y-o-y) 3.6% o Non-oil export (Jan y-o-y) 16.1% Quarterly GDP and Investment Growth

Indonesian fuel prices remain low and risks remain In 2006 subsidies (fuel, electricity and other) (at international oil price US $57) are still 80 trillion (assume electricity prices are raised substantially) Risks –Most Indonesia fuel sold at administered prices, risking another cycle – and price adjustments remain political –If prices fall significantly, transfers to regional governments are locked in raising risks to central government finances Premium gasoline price, US$ per liter

Indonesia 2006

2006 The Story Line o Short-term a dip o The fuel price increase reallocates approx 4% of GDP (10 billion USD) from consumers to government. o This will force difficult adjustments: o Consumers: to lower disposable income, higher interest rates and changed relative prices. o Industry: to changing demand, the need for efficiency and an appropriate energy mix. o And put pressure on fiscal and monetary policy to respond appropriately o Fiscal: reallocating the savings on the subsidy to government spending quickly and effectively o Monetary: establish and deliver inflation of less than 10% by year end o But the longer-term is potentially positive o For efficiency and the environment with fuel prices closer to opportunity costs o For growth and poverty reduction o As resources shift from consumption to government investment and social programs o How positive depends on how effective the spending is Car and Motorcycle Sales

Growth reaccelerates Growth reaccelerates (year on year growth rates, percent)

Fiscal Consolidation The Name of the Game Post Crisis A strategic focus on getting debt down – Economic arguments Macro stability Ratings – Political arguments And they have been successful But the challenge in 2006 is different Government Deficit and Debt

Spending the Money o Expenditure o The key to a smooth economic transition in 2006 is the rapid recycling of resources by the Government: o Back into consumption o Cash transfers (approximately US $2 billion) o And Investment o An increase in central government programs o Capital spending (rebuilding schools, clinics, rural roads and social assistance 36 trillion) o And transfers to regional governments o Total transfers rise by 66.6 trillion rp. (US $ 6.6 billion) o In the longer run the Government (at all levels) needs to develop a pipeline of infrastructure projects (trunk roads, water systems, etc.) while taking heed of the fact that world oil prices remain volatile. Financing will get harder – The government will have to pay an additional 22 trillion in Amortization on foreign loans (end of Tsunami based Paris Club) and obtain an additional 13 trillion in commercial (domestic/foreign) borrowing. – Total gross financing needs (foreign and domestic amortization plus the budget deficit will be 116 trillion (or US $11.6 billion) up from US $8.5 billion this year – But net financing needs remain low (Budget deficit still in the 1% of GDP range)

Getting spending going early won’t be easy o Central government budget spending is typically limited in Q1 and Q2, most spending is in Q3 and especially in Q4. o Regional government’s (especially resource rich ones) are having a hard time absorbing the increases they received in 2005 o Regional government deposits in the banking system have increased by approximately 17 trillion rupiah and the increases in 2006 are much larger (we tentatively estimate that regional government’s might build up surpluses close to 50 trillion in 2006) o But there are mitigating factors o Delayed spending from early 2005 provided a boost in the 4 th quarter and we expect another boost in the 1 st quarter (a carry-over of trillion in government spending through April), a period when government spending is usually low and was exceptionally low in 2005 – this will provide a real boost when needed most o The transfers to regions, while quite large, are widely spread through the block grant as opposed to the revenue sharing last year o Bottom Line: o Government spending (recycling the subsidies) will not be in full swing till the end of 2006, when small scale construction may well be booming

Current account will likely move back to surplus but capital account flows are harder to predict Trade – With slowing growth imports are easing Consumers (and firms) will cut back and this will feed into lower imports And oil & gas imports will fall – They were US$ 17 billion in 2005 up close to 50% on 2004 and 30% of imports. – In the months of November, December and January they are 33% below the level in the previous three months. – Exports have remained reasonably strong Commodity prices are expected to slow but only slightly High investment in recent years has increased capacity which should be available for export as domestic demand softens – Net effect should be an easing of trade pressure on the rupiah. Capital flows are more problematic – Repayments on official debt restart (end of Paris Club), a turn around of approximately US $2.6 billion – But the question is what happens to private flows FDI – investor sentiment Portfolio – investor sentiment plus BI interest rate policy Thus far the net effect has been clearly positive, but could reverse as interest rates fall

Monetary policy is constrained Monetary policy will need to bring inflation below 10 percent by end – This goal has been clearly stated by Ministers and President – BI will have to set and change the interest rate to deliver this credibly Foreign and domestic investors have had different takes: – Foreigners view yields as high relative to other countries and fx risk -- inflows are appreciating the currency and easing inflation pressure. – Indonesian investors had seen yields as low relative to inflation But the consensus is now a view based on forward inflation, a positive development for exchange rate stability if inflation continues to ease February inflation of.54% if annualized would be close to 7% or on target Inflation Monetary Policy

Market confidence appears to be coming back Market confidence appears to be coming back (Exchange rates and stock index)

Macroeconomic Projection 2003 (A) 2004 (A) 2005 (A) 2006 (P) GDP growth (%) ~5.6 o/w investment growth (%) o/w investment growth (%) ~12.0 Inflation (CPI, end year, %) Budget balance (% GDP) Gov’t debt to GDP (%) Current account (% GDP) Note: Currently being revised for East Asia Pacific Update (Forthcoming April)

The Reform Agenda The key to stability and higher growth in the medium and longer term is crowding in private investment (using government spending wisely by improving the investment climate. There is work to do World Bank Cost of Doing Business 2006 – Selected Indicators – Note: Indonesia is 115 th out of 155 countries with Thailand 20, Malaysia 21, Vietnam 99, and Philippines 113. But the government does appear to be developing a more coherent strategy with three reform packages in the works – Investment, Infrastructure and Financial CountryStart Business (days) Firing costs (week of salary) Time to pay taxes (hrs a year) Enforce a contract (days) Indonesia Thailand Malaysia3065…300 Vietnam Philippines

Investment climate 1. Draft Investment Law 1. Draft Investment Law to be sent to Parliament by end-March, (i) creating a unified national law for both domestic and foreign investment, (ii) stating the principle of equal treatment regardless of national origin, (iii) stipulating a clear non-discretionary investment negative list, (iv) removing the limited duration of investments and (v) abolishing forced divestment. 2. Investment Climate Policy Package: Streamline procedures to establish and license a business, with an eventual target to establish a company and obtain business licenses of 30 days. Resolve overlapping authority between central and local governments by issuing a new Government Regulation in place of PP 25/2000.

Investment climate Investment climate (continued) Cancel local/regional taxes and fees unfriendly to business, through an accelerated review process under a new team at MoF Accelerate customs clearance by reducing the percentage of import shipments subject to physical inspection to 20% by mid-2006, and to 10% by end Issue a Keppres to revitalize and strengthen PEPI (Presidential Trade and Investment Team) by end March Submit revisions to the Labor Law (Law 13/2003) to Parliament by April 2006, addressing problems in (i) severance pay, (ii) fixed term contracts, (iii) outsourcing, and (iv) expatriate employment. Reduce street lighting taxes for industry and resolve regional taxes/levies relating to weigh stations, interregional trade and telecommunication towers. Clarify environmental assessment (AMDAL) requirements. Cut the corporate income tax from 30% currently to 25% by 2010.

Infrastructure Infrastructure The 91 projects on offer at Infrastructure summit have not progressed well Initial toll road tendering has been poorly received. But efforts to facilitate private infrastructure provision are picking up – A national committee to accelerate infrastructure has been established and is being staffed out. – New regulations have been signed: Presidential regulation (67) establishes the rules for tendering PPP projects, responsibility for execution and the potential for government guarantees Finance decree (518) establishes a committee for risk management at the Ministry of Finance to develop an institution and procedures to assess the overall risk the government is willing to take on and allocate specific guarantees – The government appears committed to move ahead with the provision of government support but the exact mechanism needs to be developed – Distinguish guarantee funds (e.g. Guarantees Fund, Land Fund, Private Infra Fund) Until well designed and internationally tendered projects in various sectors are successfully underway uncertainty will persist and this requires strong Public Private Partnership units at each line ministry (and good coordination by the KKPPI) Bottom line: Indonesia needs a robust pipeline of major infrastructure projects to meet long-term growth objectives.

Financial Sector The Economic Coordinating Minister has also announced that a FS package is also being prepared Potential areas for reform include: – Addressing the weaknesses at state banks - Mandiri, BNI, and BTN Possible additional privatization and Special Purpose Vehicle to deal with NPLs – Steps to develop Government bond markets – (Improve transparency, Primary Dealers, a high level committee to resolve coordination issues, etc.) – Resolve the standoff over the Government’s assets and liabilities at Bank Indonesia (Currently the Government has non-interest bearing deposits and BI has virtually non-interest bearing Government bonds. The introduction of a Treasury Single Account is making this situation untenable

Summary 2006 a mirror image of – Growth slows early then picks up as firms and consumers adjust and central and regional spending rises. If expectations remain positive private investment (portfolio and FDI) will be crowded in early and the slow down will be shallow and growth higher, Key risks – Budget spending does not recycle subsidy spending quickly enough and the economic contraction is worse than estimated Mitigation – roll-over of 2005, faster execution in 2006 and faster regional spending – Inflationary momentum rises feeding into the exchange rate and market sentiment – forcing a stronger monetary response and further contraction The strengthening exchange rate is reducing the probability of this Mitigation – clear signals and action from BI to head this off – Other risks – (not factored in) Avian influenza Serious security/terror event

Conclusion The Government and BI will have to navigate a complicated short-run monetary and fiscal situation But in the medium term stability should be enhanced and economic growth and poverty reduction improve in the aftermath of the fuel price increases The key to success is – an effective use of resources shifted from the fuel subsidies (at all levels of government) to address government services and public infrastructure – And crowding in private investment through an improved investment climate and infrastructure development. However, sustaining higher growth is going to take more than policy packages as constraints are more often the result of implementation failures – This is going to require another round of reforms aimed at transforming the civil service

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