Indonesia Economic Quarterly Update Continuity amidst volatility

1. Indonesia Economic Quarterly Update Continuity amidst volatility ShubhamChaudhuri Lead Economist World Bank 23 June 2010 Jakarta Indonesia

2. What I’ll be talking about • CONTINUITY: Indonesia’s economy continues to perform well… • Quarterly GDP growth has continued in line with decade-averages • Inflation continues to be subdued • …and the fiscal position continues to be strong • …AMIDST VOLATILITY: • Financial markets have been more volatile because of developments in Europe • …and commodity prices have continued to be volatile • …AND THE CONTINUING CHALLENGES this implies • Indonesia is more exposed than many other economies to global financial market and commodity price volatility • Commodity price movements matter for Indonesia • Understanding Indonesia’s high lending rates, interest spreads and NIMs

3. Continuity…GDP growth remains robust… • Indonesia’s economy continued to grow at a trend rate in Q1, driven by strong investment growth • Economy expanded by 1.3% QoQ in Q1, or by 5.7% YoY • A record drop in government consumption was offset by strong investment and private demand growth • Indonesia’s major trading partners also continued to recover in Q1 Indonesian GDP growth Major Trading Partner GDP growth Sources: BPS via CEIC, World Bank

4. Continuity……and domestic indicators remain strong • Other economic indicators have remained stable at high levels • Consumer indicators are near record highs • Industrial indicators are strong Sources: CEIC, World Bank

5. Continuity……and mainly based on consumption and services • Private consumption and services continued to contribute the most to GDP growth… Sources: BPS via CEIC, World Bank

6. Continuity…...as has been the case over the last decade • …Private consumption and services continued to contribute the most to GDP growth Sources: BPS via CEIC, World Bank

7. Continuity…Inflation continues to track historic lows… • Though headline inflation picked up slightly in May to 4.2% YoY… • …core inflation remained near decade lows, at 3.8% in the year to May • The rise in headline inflation was mainly driven by food prices, which were the only component of CPI to grow above historical averages in the first 5 months of 2010… • …while core inflation remained low due to low capacity utilization levels and appreciation of the rupiah, which limited imported inflation • Inflation is expected to pick up in the 2nd half of 2010, as demand and credit growthcontinue to recover, and administered prices are moved closer to economic costs Source: BPS

8. Continuity……and the fiscal position remains strong • …with Indonesia continuing to set a global record pace in reducing its public debt-to-GDP ratio

9. Continuity……with continuing modest budget deficits… • The revised 2010 budget approved by the DPR targets a deficit of 2.1% of GDP Sources: BPS via CEIC, World Bank

10. Continuity……which may come in even lower than targeted… • Alternative projections of revenue and projected weaker disbursement suggest the budget deficit will be significantly smaller than current government projections, about 1.0% of GDP in 2010 and as low as 0.4% in 2011 • The pickup in commodity prices is likely to support slightly stronger government revenue growth in 2010 • The choice of price measure for nominal growth (deflator versus CPI) has a significant impact on revenue projections • By the end of Q1 2010, only 5 percent of allocated capital expenditure has been spent compared with 10 percent in 2009 Sources: BPS via CEIC, World Bank

11. Continuity……if we use the GDP deflator as a price gauge • Nominal GDP calculated using the GDP deflator instead of CPI leads to significant reductions in the budget deficit • The national accounts implicit price deflators offer a broader measure of prices than the CPI • The relationship between the CPI and economy-wide prices in Indonesia weakened after 2004, largely due to an acceleration in investment prices that was not captured by the CPI… • …but was captured by the GDP deflator, which as a result has a closer correlation with overall prices in Indonesia • As a result, using the GDP deflator rather than CPI improves the forecast of government tax revenues

12. Continuity….The outlook remains broadly positive • Outlook remains for gradual pick-up in growth • Continued strong private domestic demand and investment are expected to drive growth, offsetting any drag from imports outpacing exports • A slowdown in major trading partner growth should not impact Indonesia too much • Inflation is expected to accelerate in second half of 2010 on solid domestic demand, credit growth, a more stable exchange rate and rising commodity prices Sources: BPS, CEIC, World Bank. World Bank projections

13. …amidst volatilityDownside Risks have Increased • External factors have increased risks to the outlook… • Weak demand from OECD economies due to debt crisis could slow down recovery in Indonesia’s MTPs • Increased risk aversion due to debt crisis could increase financial market volatility and capital outflows • Ongoing commodity price volatility could affect real economy forecasts and the budget • …some of which call for the immediate attention of policy makers: • Addressing large capital inflows and outflows • Implementing policies to reduce vulnerability to commodity price shocks

14. …amidst volatilityCapital outflows pushed markets down in May • Indonesian equities and bonds weakened in May due to large capital outflows that also put the rupiah under pressure • Increased risk aversion due to European events triggered $5.7bn of net foreign capital outflows in May, 90% of this in SBI sales • The JCI fell by 5.5% on the month, yields on five year IDR sovereigns rose by 50 basis points, and Indonesian EMBI USD bond spreads widened by 100 basis points. • The rupiah weakened by 1.8% against the USD

15. …amidst volatilityFinancial markets vulnerable to capital outflows • After a record month of $4bn of net capital inflows in April, May’s $5.7bn in net capital outflows demonstrated Indonesia’s vulnerability to volatile capital flows • Compared to late 2008, Indonesia’s financial markets are more exposed now to a sudden reversal of capital flows due to the high percentage of foreign holdings of equities, bonds and SBIs • Reserves fell by $4bn in May as BI bought rupiah to smooth out exchange rate volatility caused by capital outflows • 90% of the outflows were SBI sales; new BI policies may help stem some of this going forward

16. …and some challenges this implies Indonesia particularly exposed to global volatility • Open capital account, relatively large presence of non-resident investors in local financial markets • Importance of commodity prices for Indonesia’s economy Share (%) of commodities in exports

17. …and some policy challenges Real economy, budget vulnerable to commodity price shocks • Volatility of commodity prices affects real economy and price forecasts in Indonesia as well as budget projections • consider 3 scenarios of commodity price shocks on the economy (+30%, +15% and -15%) • We found commodity price movements have a large impact on prices, and a more subdued impact on the real economy • The poverty rate declined slightly with an increase in commodity prices Sources: World Bank

18. …and some policy challengesHigh lending rates, NIMs may stifle investment • Indonesia has the highest NIMs in the region, driven by high lending rates • High deposit-side competition but low lending competition for banks in Indonesia leads to high deposit and lending rates, as well as NIMs • High and volatile historical inflation and bond yields increase the risk premium lenders charge on loans • Micro-level inefficiencies such as high operating costs combined with the non-competitive market structure may also contribute to higher NIMs • A deeper financial sector with a more competitive market structure, lower inflation volatility, improved corporate reporting, and higher bank-level efficiency could help reduce rates and NIMs going forward

19. Indonesia Economic Quarterly Update Continuity amidst volatility Shubham Chaudhuri Lead Economist World Bank 23 June 2010 Jakarta Indonesia