Indonesia

Highlights and Key Issues

* The economy grew 6.3% last year, the strongest result since before the Asian crisis. While economic activity eased in Q4 2007, up 6.3% from a year earlier, domestic demand remained the driver of activity, with net exports detracting from growth.

* The economic momentum is set to continue this year, with growth forecast at 6.4%. Domestic demand will remain the driving force with net exports remaining subdued.

* But there are a number of downside risks to the forecast. Higher than expected oil prices and more widespread inflation could weaken consumer and business spending.

* Headline inflation in March rose to 8.2% from 7.4% in February, even further above the top of the central bank’s target band of 4-6% +/-1%. Core inflation also accelerated, up to 8.1%.

* Inflation is expected to remain high during 2008, not returning to under 6% until next year, as high food and oil prices continue to exert upward pressure.

* Despite the unfavourable inflation outlook, Bank Indonesia is likely to keep interest rates on hold until 2009 given the downside risks to the economy and an upcoming election in early-2009.

Overview

Domestic demand driving economy…

* In 2007, the economy grew 6.3%, the strongest performance since the Asian crisis. While year-on-year growth eased to 6.3% in Q4 2007, domestic demand remained the impetus of activity, with net exports detracting from growth.

* Household spending in Q4 was 5.6% stronger than a year earlier, the strongest since Q1 2004. The strong consumption outcome implies that the 450-basis point lowering of interest rates since mid-2006 has filtered through to the economy. Despite some weakening in consumer confidence, early indicators such as motorcycle sales suggest that low interest rates and strong wage increases last year will continue to support consumption in 2008.

* However, consumption is not expected to surge as wage growth is expected to moderate and higher inflation will dampen households’ real disposable incomes.

…as low interest rates lift investment

* As with household consumption, domestic investment will continue to benefit from low interest rates as indicated by a 15% increase in domestic investment applications in 2007. Furthermore, foreign direct investment continues to improve, with actual FDI totalling US$10.3bn last year, nearly double the 2006 level. This momentum is expected to continue, as foreign investment applications were at a record US$40bn last year, almost triple those in 2006.

* While domestic demand will continue to accelerate, the positive contribution from real net exports to GDP growth will soften further in 2008. Imports are expected to grow firmly, in line with strong domestic demand, while export growth will moderate given the weaker world economy. A current account surplus of around 2% of GDP is expected in 2008.

* Government policy is also expected to remain expansionary, which will see the budget deficit deteriorate for the third year in a row. The extent of this deterioration will in part be determined by the level of oil prices, as petrol subsidies remain a major fiscal burden and may detract from other spending if oil prices remain at current levels.

Oil and inflation are key risks…

* With concerns over global oil supplies continuing into 2008, higher oil prices are not only a risk to the government’s fiscal position but also to the recovery in domestic demand.

* Sustained high oil prices will increase input costs and squeeze margins and could hurt business sentiment, lowering business investment. High oil prices have already seen business input costs accelerate, with wholesale prices up over 20% year-on-year since November 2007.

* While households are partially protected by fuel subsidies, producers are better placed to pass on the increase in wholesale prices to consumers. Higher than expected inflation would not only erode households’ real disposable income but could exacerbate evidence that households are becoming more cautious, dampening consumer spending.

…with inflation to stay high in 2008…

* Inflation accelerated to 8.2% in March, the highest since September 2006, even further above the ceiling of the central bank target range of 4-6% +/-1%. Moreover, core inflation accelerated to 8.1%, suggesting that higher wholesale prices are already being passed on to consumers.

* Inflation has now been near the top of or above the central bank’s target range for the past seven months. Inflationary pressures have been gathering with food and oil prices, directly and indirectly, impacting on Indonesia as in other countries in the region. Against a backdrop of rising demand, the risks to the inflation outlook remain on the upside.

* As a result, inflation is expected to remain high in 2008, not returning to within the central bank target range until Q1 2009.

BI to remain cautious…

* Despite the recent rise in inflation, Bank Indonesia is not expected to raise interest rates, at least not until late-2008, as there are a number of risks that could dampen domestic demand. Political considerations may also help to keep rates unchanged until after elections due in early-2009. Thereafter, it is possible that rates may begin to rise unless inflation has subsided sharply.

Copyright Oxford Economic Forecasting Spring 2008

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