VZCZCXRO8381
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #2543/01 2861006
ZNR UUUUU ZZH
R 131006Z OCT 06
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 1245
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHKO/AMEMBASSY TOKYO 0045
RUEHBJ/AMEMBASSY BEIJING 3672
RUEHBY/AMEMBASSY CANBERRA 0005
RUEHUL/AMEMBASSY SEOUL 3769
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 04 JAKARTA 012543 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
DEPT FOR EAP/MTS AND EB/IFD/OMA 
TREASURY FOR IA-SETH SEARLS 
COMMERCE FOR 4430/GOLIKE 
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR FINEMAN 
DEPARTMENT PASS EXIM BANK 
 
E.O. 12598: N/A 
TAGS: EFIN EINV ECON PGOV ID
SUBJECT: INDONESIA'S ECONOMY ONE YEAR AFTER THE FUEL PRICE 
HIKES 
 
A) 05 Jakarta 11807; B) Jakarta 7013 
 
¶1. (SBU) Summary.  Indonesia successfully restored 
macroeconomic stability in the first half of 2006 after the 
August 2005 rupiah "mini-crisis" and the fuel price hikes 
and interest rate increases that followed.  After the 
Government of Indonesia (GOI) hiked fuel prices by an 
average of 126% in October 2005, high inflation resulted. 
Bank Indonesia (BI) raised interest rates by a total of 425 
basis points in response, curbing inflation expectations and 
sharply limiting the hoarding of consumer goods.  One year 
after the implementation of the fuel price hikes, the 
economy is on target to recover in the second half of 2006 
and the near-term downside risks to economic growth and 
stability are limited.  Delays in enacting labor, tax and 
investment reforms, however, may negatively impact the 
macroeconomic environment in the longer run.  End Summary. 
 
Economic Conditions Stabilize After the Mini-Crisis 
--------------------------------------------- ------ 
 
¶2. (U) The GOI introduced two important policy measures to 
address a bout of macroeconomic instability in the third 
quarter of 2005.  Most prominent was the 126% average hike 
in fuel prices on October 1, 2005, reducing increasingly 
costly government subsidies in an environment of rising 
global oil prices.  This policy, which amounted to a 
transfer from consumers to the GOI of an estimated 3-4% of 
gross domestic product (GDP) ($7.5-10 billion), put 
Indonesia's fiscal spending on a sustainable path.  In 
addition to the fuel subsidy reduction, BI raised its 
benchmark interest rate from 8.5% in August 2005 to 12.75% 
in December 2005 in an effort to curb the depreciation of 
the rupiah.  These policies were largely successful in 
restoring macroeconomic stability in Indonesia (Ref A). 
 
¶3. (U) After the two policies took hold, the rupiah 
appreciated steadily in response to tighter monetary policy 
and more prudent fiscal policy.  The Indonesian currency 
firmed from over 10,000 Rp/USD in September to less than 
9,000 Rp/USD by May 2006, and has remained in the 8,800/USD 
- 9,300/USD range since.  Higher interest rates also 
increased the interest rate differential between Indonesia 
and the rest of the world, particularly the United States, 
encouraging renewed interest among portfolio investors in 
Indonesia's capital markets.  According to BI, net portfolio 
investment liabilities jumped to $3.5 billion and $4.1 
billion in the fourth quarter (Q4) of 2005 and first quarter 
(Q1) of 2006, respectively.  Increased portfolio flows in 
turn contributed to a significant improvement in Indonesia's 
foreign exchange reserves, which moved from $30 million in 
September 2005 to over $44 million by May 2006.  The 
increase in reserves allowed Indonesia to repay its entire 
$6.94 billion debt to the International Monetary Fund in 
separate tranches in June and October 2006, well in advance 
of scheduled repayment.  In February 2006, Standard and 
Poor's changed the outlook for Indonesia's sovereign rating 
from stable to positive. 
 
Impact on Consumer Demand Slows Growth 
-------------------------------------- 
 
¶4. (U) The fuel price hikes and interest rate increases 
stabilized the economy, but also led to slower growth in 
late 2005 and early 2006.  Overall GDP growth slowed to less 
than 5% year-on-year (YoY) during the last quarter of 2005 
and the first quarter of 2006, but remained roughly at or 
above GDP growth rates recorded during the 2000-2004 period. 
Further, GDP growth increased during the second quarter of 
2006 to 5.2% (YoY).  Nevertheless, growth rates remain well 
below the Government's 6.6 average annual growth target for 
2005-09. 
 
¶5. (U) The sharp reduction in fuel subsidies in October 2005 
introduced a significant price shock to the domestic economy 
across a wide range of products.  Headline inflation jumped 
from 9.1% in September 2005 to 17.9% in October 2005. 
 
JAKARTA 00012543  002 OF 004 
 
 
Fortunately, there was no hoarding of consumer goods.  As 
illustrated in Table 1, real growth in household 
consumption, which accounts for almost 60% of gross domestic 
product (GDP), slowed in response to the price increases, 
dropping from 4.2% YoY in Q4 of 2005 to 3.2% YoY in the Q1 
of 2006.  The decline in household spending growth continued 
in the second quarter of 2006, increasing by only 3% YoY. 
 
--------------------------------------------- ----- 
Table 1:  Real GDP Growth, 2005-2006, Year-on-Year 
--------------------------------------------- ----- 
                         2005      2005      2006     2006 
                         Q3        Q4        Q1        Q2 
--------------------------------------------- -------------- 
Household Consumption    4.4       4.2        3.2       3.0 
 
Government Consumption  14.7      30.0       14.2      31.6 
 
Fixed Capital Formation  9.4       1.8        2.9      -1.0 
 
Exports of Goods and 
          Services       4.8       7.4       10.8      11.3 
 
Imports of Goods and 
          Services      10.6       3.7        5.0       8.3 
--------------------------------------------- -------------- 
GDP                      5.6       4.9        4.6       5.2 
--------------------------------------------- -------------- 
Source: Central Bureau of Statistics 
 
¶6. (U) In addition to slowing household demand, the fuel 
price hikes coupled with delays in implementing investment 
climate reforms weakened already soft investment growth in 
Indonesia.  Fixed capital investment grew at an anemic 1.8% 
YoY in Q4 of 2005, and increased only slightly to 2.9% YoY 
in Q1 of 2006, before contracting 1.0% YoY in Q2.  More 
positively, fiscal stimulus and gains from trade prevented a 
more significant slowdown in GDP growth.  Strong growth in 
government spending linked to compensation programs for the 
fuel price hikes supported overall GDP expansion in the 
fourth quarter of 2005.  However, growth in government 
spending weakened in 2006 as bureaucratic inefficiencies 
reemerged and local governments failed to spend funds. 
Nonetheless, the government was able to significantly 
increase spending in the second quarter of 2006.  As shown 
in table 1, growth in government spending slowed to 14.2% 
YoY in the first quarter of 2006, before rebounding in the 
second quarter to 31.6% YoY. 
 
¶7. (U) Indonesia's exports of goods and services grew 
robustly in the first half of 2006.  The strong growth was 
centered on non-oil exports and supported by robust global 
demand and an increase in global prices for Indonesia 
commodities, such as rubber, palm oil, coal, and cooper. 
This improvement coupled with a slowdown in import growth 
resulted in a strong trade surplus.  Import growth slowed in 
response to weaker domestic demand.  Import growth fell to 
5% YoY and 8.3% YoY, respectively, in the first and second 
quarters of 2006, with a slowdown in oil imports responsible 
for most of the decline.  Growth of consumer goods imports 
remained strong, growing almost 17% YoY over the January to 
May 2006 period, but growth in imports of intermediate goods 
dropped 5.2% YoY during the same period, signaling a 
slowdown in manufacturing. 
 
Signs of Increased Growth in Second Half of 2006 
--------------------------------------------- --- 
 
¶8. (U) In May 2006, BI began lowering interest rates in 
response to lower inflation expectations and an improved 
balance of payments position.  Headline CPI inflation slowed 
to 14.55% YoY in September, down from 14.9% YoY and 15.15% 
YoY in the two previous months.  The YoY inflation rate will 
decline significantly in October with the elimination of the 
base effect from the fuel subsidy reduction.  The IMF 
estimates that the full year 2006 headline inflation rate 
will be roughly 7%, in line with Indonesia's historical 
 
JAKARTA 00012543  003 OF 004 
 
 
performance.  The recent fall in world oil prices is having 
some impact on the inflation rate, as the GOI reduces non- 
subsidized domestic oil prices in the line with global 
trends.  While portfolio capital outflows exceeded inflows 
in the second quarter of 2006, a strong trade surplus led to 
an overall balance of payments surplus during the same 
quarter.  After pausing in June, BI continued to ease 
interest rates in the July to October period, moving the 
Bank Indonesia rate from 12.50% in June 2006 to 10.75% by 
early October 2006.  BI is expected to cut rates further in 
November and December 2006 if moderate inflation and a 
positive balance of payments outlook continue, as expected. 
 
¶9. (U) GDP will likely expand at a faster pace in the second 
half of 2006 due mainly to increased household spending, 
spurred by the lower interest rate environment, and higher 
government consumption.  A number of trends in recent months 
point to a rise in household consumption.  September 2006 
car sales increased over 15% from the previous month, after 
declining through the first half of the year.  Stronger 
cement sales and an increase in credit growth also point to 
a recovery in domestic demand.  In addition, non-oil imports 
increased in August in response to more solid demand for 
foreign raw materials and capital goods.  More negatively, 
BI's consumer confidence index slipped in August, revealing 
some renewed pessimism among households.  Nevertheless, most 
observers expect to see somewhat stronger household 
consumption through the end of the year. 
 
Government Spending a Question 
------------------------------ 
 
¶10. (U) The GOI expects to increase expenditures 
dramatically in the second half of 2006.  However, as in 
previous years, few observers expect the Government's end- 
year fiscal outtake to reach the target deficit of 1.3% of 
GDP, as bureaucratic obstacles and limited capacity at the 
local level continue to limit the government's ability to 
disperse funds.  While slower execution of planned spending 
will limit the ability of the government to spur growth in 
the second half of the year, it will keep public debt levels 
from rapidly rising.  In addition, lower world oil prices 
have reduced the cost of remaining fuel subsidies, 
contributing to a more stable fiscal outlook. 
 
¶11. (SBU) Most observers expect the current account surplus 
to shrink but stay positive during the second half of 2006. 
Stronger domestic demand will support growth, but may 
negatively impact the trade balance, as import demand rises. 
In addition, softer world oil prices will reduce the value 
of crude oil exports in the near term.  Nevertheless, 
observers expect the value of Indonesia's non-oil-and-gas 
exports to continue to grow as a result of high global 
prices and strong demand for a variety of Indonesian 
commodities. 
 
¶12. (SBU) Most analysts expect limited increases in 
investment during the second half of 2006, limiting the 
short-term growth outlook.  While the increase in capital 
goods imports points to some increase in infrastructure 
spending for ongoing projects, there is little evidence of 
significant new greenfield investment outside of the 
property sector.  The return of macroeconomic stability has 
piqued some interest from foreign investors, but potential 
investors still face major obstacles, limiting the amount of 
realized foreign direct investment.  Delays in implementing 
the GOI's investment climate improvement package coupled 
with the relatively rapid speed of similar reforms in other 
countries in the region continue to limit the number and 
size of investment projects. 
 
Risks to Sustained Growth and Macroeconomic Stability 
--------------------------------------------- -------- 
 
¶13. (SBU) In the near term, Indonesia faces few significant 
risks to macroeconomic stability.  While domestic demand 
will likely accelerate in the second half of 2006, most 
 
JAKARTA 00012543  004 OF 004 
 
 
observers believe it is unlikely to create significant new 
inflationary pressures.  In addition, BI would likely limit 
monetary easing if considerable inflationary pressures 
resurface.  World oil prices have been trending downward, 
limiting the pressure on the budget and Indonesia's balance 
of payments.  Portfolio inflows should remain stable given 
the significant interest rate differential between the 
United States and Indonesia and the relative political 
stability of Indonesia in recent years.  While profit taking 
has resulted in some outflows of "hot money" in recent 
months, these episodes have not resulted in major 
macroeconomic disturbances in 2006.  Furthermore, Indonesia 
well diversified export base limits the balance of payments 
risk from a major correction in commodity prices. 
 
¶14. (SBU) Indonesia's medium-term growth rates will continue 
to depend on the GOI's success in implementing large-scale 
reforms to the investment climate and successfully boosting 
infrastructure spending.  Delays in passing new tax, 
investment, and labor laws continue to undermine investor 
confidence in Indonesia, and the GOI's infrastructure 
development program has not yet produced a significant 
number of projects.  Given serious and growing 
infrastructure bottlenecks and a relatively low 
investment/GDP ratio, without large new capital investment, 
Indonesia will have difficulty achieving growth rates above 
the 6% level projected for 2007. 
 
PASCOE