Indonesia economic update & Country Partnership Strategy

1. Indonesia economic update & Country Partnership Strategy

2. Indonesia economic updateNear-term issues and looking ahead to 2012 ShubhamChaudhuri Indonesia Lead Economist World Bank March 2, 2011 World Bank, Washington DC

3. OutlineWhat I will be talking about • Near-term issues: managing risks, maximizing opportunities • The latest growth numbers: more of the same, floating along • Managing capital flows • Coping with food price increases • Improving budget disbursement • Looking ahead to 2012 • Strong investment driving economic growth • Exports strong but current account continues to narrow • High commodity prices are a double edged sword • Why isn’t higher investment resulting in even higher growth? • Emerging challenges for higher and broad-based growth • While jobs are picking up they aren’t growing in line with the economy • And inequality is rising • RPJM growth targets are going to need higher or more productive investment

4. Near-term issues Managing risks, maximizing opportunities

5. Maximizing opportunitiesFrom a strong near-term outlook • Building on strong GDP growth performance Sources: BPS and World Bank forecast for 2011

6. Maximizing opportunities...building on recent growth performance • … and the relative trend of stronger growth for “non-tradable” sectors continues Year-on-year growth Contributions to year-on-year GDP growth Source: CEIC, World Bank Note: “Tradables” defined as manufacturing, agriculture, mining and quarrying

7. Maximizing opportunities, managing risks…from capital inflows into Indonesia • The rise in net portfolio inflows has dominated the financial account since 2009 Source: BI, CEIC

8. Maximizing opportunities, managing risks…from capital inflows into Indonesia • With the majority of portfolio flows going into government securities

9. Maximizing opportunities, managing risks…from capital inflows into Indonesia • Portfolio capital inflows have contributed to a lowering of yields on government bonds… Local currency government bond yields (5-year) Source: CEIC, World Bank

10. Maximizing opportunities, managing risks…from capital inflows into Indonesia • …and a medium-term rise in domestic equity prices • The JCI is up 40% since 30 Dec 2009 (compared with an average of 12% for 10 benchmark global indices). Fall in equities in early 2011 but then recovery Source: CEIC, World Bank

11. Maximizing opportunities, managing risks…from capital inflows into Indonesia • … but the exchange rate has remained relatively stable • The rupiah strengthened by 3.6% in 2010 as a whole (with the REER appreciating by 5% over the year) Source: CEIC, World Bank

12. Managing risks......from capital inflows into Indonesia • Exposure to foreign ownership of financial assets has increased… • …but foreign reserves have kept pace Sources: BI, MoF and World Bank

13. Managing risks Inflation on the rise again Source: BPS, World Bank

14. Managing inflationRice prices in particular Source: BPS, World Bank, FAO

15. Managing food price inflationA regional priority • Regional food price inflation is also on the rise • Source: CEIC and World Bank

16. Poverty outlookPotential impact of rising food prices • National poverty rate (percent) • Sufficiently large food price shocks can raise the poverty rate, even in times of robust growth, such as in 2005-06, and potentially 2011 Source: Susenas and World Bank staff simulations

17. Managing inflationPotential impact of rising food prices • Sufficiently large food price shocks can raise the poverty rate, even in times of robust growth, such as in 2005-06, and potentially 2011 Note: Inflation rates are from March 2010 to March 2011. Source: Susenas and World Bank staff projections

18. Looking ahead Prospects for 2012 Indonesia growth is expected to accelerate over the next two years. High commodity prices will support growth off-Java and Bali. But Indonesia will need to address the challenges posed by these higher commodity prices, especially food and maybe oil prices.

19. Growth is expected to be driven by increasing investment levels • Investment should increase: stronger FDI flows and high commodity prices • Net exports should further boost growth in 2011 and 2012, consistent with solid growth in Indonesia’s major trading partners. • Higher inflation is a drag on private consumption expenditure Sources: BPS and World Bank forecast for 2011 and 2012

20. Transport, communications and retail trade especially strong • Higher commodity prices likely to result in more output from mining and agriculture sectors. • The manufacturing sector is picking up as investments pay off and exports to major trading partners rise. Sources: BPS and World Bank forecast for 2011 and 2012

21. Manufacturing exports are growing, while the current account surplus narrows • The current account surplus will continue to narrow despite export growth, as investment and domestic demand result in increased imports • Manufacturing continues to contribute to export growth aided by an increase in capital goods imports (which have risen from 28% to 37% of total imports over the last 5 years)

22. Inflation pressures will continue, particularly if oil price continues its upward trend Source: World Bank Source: BPS and World Bank estimates • Food price increases have resulted in high CPI and poverty basket inflation.

23. Investment levels are increasing, but not delivering the growth we would expect • Investment levels, at over 30 percent of GDP – are now at par with many countries in the region. • A far lower real investment to GDP ratio suggest supply side problems with investment

24. Outlook for 2011 and 2012

25. Thank you

26. Emerging challenges Growth has accelerated and 7 percent is in reach but only if there is progress on infrastructure and the investment climate. Growth will also need to be more inclusive.

27. Job creation remains a problem…especially good jobs… • Indonesia’s workforce is strong and growing. Today, there are almost 114 million workers in Indonesia. Over the next decade the working age population will grow by another 20 million people. • Economic growth is not matched by growth of higher-quality jobs (formal and non-agricultural): over 61 percent of workers are employed informally; over 40 percent are still working in agriculture. Source: BPS

28. While poverty levels are declining inequality is rising

29. Higher growth will take higher or more productive investment • A growth accounting exercise allows us to reflect on the growth targets in the RPJM and the implicit investment growth. • With L given and Q as a target, we solve for A or K respectively. With historical productivity gains of around 2.2, investment would need to grow at 11 percent to achieve economic growth of 7 percent. Annual investment growth in 2010 was 8.5%.

30. Achieving broad-based, inclusive growth Emerging ChallengesAchieving higher, and broad-based, growth • Raising the level of growth Enhancing fiscal space Subsidy reform Higher fiscal deficit Using Fiscal Space more effectively Managing bureaucracy reform Monitoring and evaluation Mobilizing fiscal resources

31. Addressing emerging challenges • Focus on: • Increasing growth through infrastructure investments and an improved business environment • Addressing inequality through social assistance and social protection programs as well as removing obstacles for job creation • Creating and using more effectively the necessary fiscal space to finance Indonesia’s priorities

32. Indonesia is lagging behind most ASEAN peers in infrastructure development Source: PT AngkasaPura II, other airports, media reports (Standard Chartered) Source: ASEAN Ports Association (Standard Chartered) Source: LPI 2010 (World Bank)

33. Infrastructure levels have not recovered to pre-crisis levels yet Public Infra Spending/ GDP Investment in infrastructure (% of GDP) Subnational Central Source: Philippine’s Transport for Growth, 2009 (World Bank), various years • Indonesia needs a big push on infrastructure with the government and public sector playing a lead catalytic role.Private sector participation is often around 20% of investment, PPP will need market friendly design. • Rationalize/ prioritize investments. See next slide for connectivity priorities. • Identifying and implementing financing, accountability and capacity-building mechanisms to incentivize and empower local governments to deliver on water, sanitation and roads • Creatively tackling tariff reform in the powersector

34. Connectivity is a prerequisite to developing National Economic Corridors • Priorities for Connectivity • Strengthening economic integration through National Connectivity is the best way to get both the benefits of the concentration of production and the long-term benefits of a convergence in living standards • Connectivity increases the gravityfoces of economic corridors by amplifying market forces that are already driving concentration of activities/production in certain areas

35. Strengthening the investment climate and creating jobsSome data and principles • Net FDI inflows-to-GDP (percent) • An Indonesia that takes dynamic steps at improving its investment climate will increase the competitiveness of domestic goods and exports. Present reform efforts are moving in the right direction but require a greater push to yield results. • Global Rank in Doing Business 2011 - selected countries in East Asia • Effective reform requires coordinated actions by different ministries, institutions and layers of government. Therefore, it needs to be led from the top. A single agency should be tasked with undertaking a multi-year national and subnational regulatory review and reform initiative.

36. Strengthening the investment climate and creating jobsA Regulatory Reform Commission Priority reforms: Draft regulatory reform law incorporating the need for Regulatory Impact Assessments and a 60-day public disclosure and feedback period prior to enactment of new regulations. Revise the Investment Negative List (DNI) maintaining the positive improvements in the 2007 revision while relaxing restrictions in key sectors. Push ahead on the National Single Window agenda by accelerating current work plan implementation, e.g. replacing paper copies for a single electronic document and single approval. Establish National Logistics Council to implement logistics reform blueprint. Easiest and fastest way to accomplish these reforms is to create a Regulatory Reform Commission with a broad mandate and authority to balance interests, address policy, coordination and implementation issues existing TimnasPEPI structure provides foundations for such a commission

37. Access to Finance remains a challengeParticularly for the poorer segments of the population • Mainstream financial inclusion into the planning process • Streamline existing individual ministry programs into coherent programs to maximize impact and increase effectiveness • Improve coordination among various government ministries and central and subnational governments.

38. Maximizing opportunitiesIndonesia’s remaining demographic dividend

39. Expand and target skills training to address Indonesia’s skills shortage • Skills shortage: Only one-fifth of workers have finished senior secondary school; only 6 percent have a tertiary degree. • Employers are looking for increasingly higher skill levels, resulting in high wage premiums for educated workers, • BLK revitalization and expansion is important, but not enough. The number of BLK is not enough to meet potential demand. • Pilot a complementary third approach to training using public-private partnerships. • Consider the Jovenes model from Latin America that provides comprehensive training (including soft skills), work opportunities, links with industries, and vouchers for vulnerable groups.

40. Address unemployment and pension rights at the same time as severance Redundancy Costs (weeks of salary) • Hiring and firing regulations are among the region’s most rigid but compliance is low creating a “lose-lose” situation for employers and most workers: High de jure rates discourage entrepreneurs and stunts creation of “good” jobs. Low de facto pay (as reported by workers) leaving the majority of employees unprotected. Source: Doing Business, 2010 • Negotiate to: • Introduce an SJSN pension program for workers. • Adjust severance rates downward in-line with regional standards. • Reform severance system to improve real protection and boost job creation.

41. More can be spent on Social Assistance, but funds should be spent effectively… • Recommendations • Prepare white papers and operationalize reform roadmaps for each SA program.. • Clarify institutional arrangements and begin performance-based budgeting • Unified database of potential beneficiaries can improve targeting outcomes. • Monitoring and Evaluation needs to be made permanent and regular. • Constraints: • Fragmentation • Gaps in coverage • Targeting errors • Monitoring and Evaluation

42. Future social protectionStrategic vision • Vision of the SJSN laid out in White Paper and government regulation • SJSN programs: cover the whole population, with the same benefits to all and base benefits only • Health: Basic health services • Pension: Lifetime old-age annuity, disability and survivor benefits (20% replacement ratio) • Old-age Savings: Modest lump-sum at retirement (3% contribution rate) • Death: Lump-sum on death of worker (10 mill Rp.) • Worker accident • Achieving the vision • Building and reforming legal structures, institutions and infrastructure • SJSN program design, governance, financing and sequence of introduction • Harmonization with existing programs • Budget impact

43. Mobilizing fiscal resourcesEnhancing fiscal space – fuel subsidy reform • Indonesia’s fuel subsidies are very regressive, costly, and continue to create uncertainty for public finances • The number of vehicles in Indonesia is rapidly growing leading to a steady increase in the consumption of subsidized gasoline and diesel • The gap between subsidized and economic fuel prices is on the rise resulting in a large increase in subsidy spending in coming years (current oil price above any of the assumptions below)

44. Fuel subsidy reform Alternative reform options • Reform options • Current proposal (subsidies removed for private cars) • The ESDM Road Map (January 2010) • Convertible fuel vouchers • Indexation of regulated fuel prices to the economic cost of fuel • Full deregulation of fuel prices with compensating BLT program • International experience shows that it is difficult to target fuel subsidies well, and instead that many countries are moving to eliminate universal fuel subsidies by reducing the price gap while compensating the poor directly • Indonesia can do the same, as it has successfully done on an ad hoc basis before, but to go further and imbed sustainable reforms • Building broad-based political support will be critical to achieve reform as will socializing reforms with wider public (e.g. media campaigns)

45. Fuel subsidy reformThe potential impact of reforms • Reductions in fuel subsidies will impact three key variables – fiscal spending, inflation and the povertyrate. The poverty impact can be offset through BLT.

46. Looking ahead: the potential wage bill by 2014 with BR • Driven by: (1) high annual civil service pay rises; (2) increasing numbers of civil servants at sub-national level; (3) new performance allowances for pilot BR agencies at the central level

47. Bureaucracy reformPolicy options to manage fiscal risks • Range of policy options to help contain wage bill and fiscal risks from bureaucracy reform • Short-term measures include: • Carefully screen/audit BR plans and sequence payment of performance allowances • Offset new performance allowances by streamlining/abolishing old allowances • Decompress performance allowances • Consider setting wage ceilings as share of expenditure or revenue • Temporary freeze or capping of annual pay increases • Partial or selected hiring freeze, accelerated early retirement • Longer-term response may include undertaking functional reviews and rationalizing size and structure of government

48. Mobilizing Fiscal ResourcesIndonesia can afford higher budget deficits Public Debt to GDP ratios Interest payments (% of revenue) Sources: IMF Public Debt Database, IMF Fiscal Monitor, Ministry of Finance, BPS Note: Figures for 2010 are projections with exception of Indonesia Interest payment (% revenuie) • Higher budget deficits, combined with a renewed focus on efficiency of spending, would allow Indonesia to undertake the necessary investments

49. Better use of fiscal resourcesImproving subnational spending Status of district road by condition • Some initial thoughts on improving subnational spending: • Develop financing instruments that allow urban districts to finance necessary infrastructure investments; • Develop performance based transfers, with more rigorous assessment of performance and recognition of success; • Improved information system for transparency and planning purposes;

50. Better use of fiscal resourcesImproving Indonesia’s M&E System • Three characteristics of successful M&E systems • Intensive utilization of the M&E information in one or more stages of the policy cycle; • Information meets standards for data quality and evaluation reliability; • Sustainability: the system will survive a change in administration, government ministers, or top officials. • Increase utilization through relevant information, enhance skills to use information and provide incentives for use of information. • Improve availability and quality of relevant M&E information for planning and budgeting purposes. Quality assurance needed. • Ensure sustainability through powerful champion, stewardship by capable ministry and incentives in agencies to use M&E information. • Changing culture: impose accountability on line ministries and agencies, prepare guidelines of M&E role on results based budgeting.