VZCZCXRO8136
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #0653/01 0660826
ZNR UUUUU ZZH
R 070826Z MAR 07
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 3636
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHKO/AMEMBASSY TOKYO 0285
RUEHBJ/AMEMBASSY BEIJING 3872
RUEHBY/AMEMBASSY CANBERRA 0497
RUEHUL/AMEMBASSY SEOUL 3900
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 04 JAKARTA 000653 
 
SIPDIS 
 
SIPDIS 
SENSITIVE 
 
DEPT FOR EAP/MTS AND EB/IFD/OMA 
TREASURY FOR IA-SETH SEARLS 
COMMERCE FOR 4430/BERLINGUETTE 
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 MACROECONOMY - STRONG 2006 BUT CHALLENGES LOOM IN 
2007 
 
A) Jakarta 13326 B) Jakarta 00309 C) Jakarta 00031 
 
¶1. (SBU) Summary. The Government of Indonesia (GOI) successfully 
restored macroeconomic stability in 2006, implementing prudent 
monetary and fiscal policies and paving the way for a rebound in 
gross domestic product (GDP) growth.  These policies contributed to 
stable prices, a strong currency, lower public debt and increased 
investor confidence.  Real GDP growth rose to 6.1% on a year-on-year 
(YoY) basis during the final quarter of 2006, boosting GDP growth 
for the full year to 5.5% (YoY).  Although exports rose strongly 
during the year, employment growth lagged in large part due to 
limited growth in labor-intensive manufacturing.  Most analysts 
expect Indonesia's cyclical economic recovery to continue in 2007, 
with increases in domestic demand and investment, but risks to 
longer term stability and sustained growth have increased.  Growth 
in net exports, the primary driver of GDP growth in 2006, is likely 
to slow in 2007, in response to a likely flattening out of world 
commodity prices and increased demand for imports.  Despite a strong 
GOI budget position, very slow progress on the GOI's infrastructure 
policy initiatives make the outlook for a significant increase in 
infrastructure spending in 2007 poor.  The GOI's key medium term 
challenge will be finding ways to boost growth after the current 
cyclical upswing begins to wane or if the international economic 
environment turns less supportive. Ramping up anti-poverty spending 
in 2008-09 may be the GOI's best bet.  End summary. 
 
--------------------------------------------- ---------- 
Table 1:  2006 Real GDP Growth, Year-on-Year 
--------------------------------------------- ---------- 
                                                   Full 
                         Q1    Q2     Q3     Q4    Year 
--------------------------------------------- ---------- 
Private Consumption     3.2    3.0    3.0    3.8   3.2 
 
Government Consumption 14.2   31.6    1.8    2.2   9.6 
 
Fixed Capital 
         Formation      2.9   -1.0   -0.3    8.2   2.9 
 
Exports of Goods and 
         Services      10.8   11.3    12.1   6.1   9.2 
 
Imports of Goods and 
         Services       5.0    8.3     9.7   9.7   7.6 
--------------------------------------------- --------- 
GDP                     4.6    5.2     5.5   6.1   5.5 
--------------------------------------------- --------- 
Source: Central Bureau of Statistics 
 
Macroeconomic Stability Returns in 2006 
--------------------------------------- 
 
¶2. (SBU) 2006 was a good year for the Indonesian economy.  The GOI 
and BI took effective action to restore macroeconomic stability 
during the year by implementing prudent monetary and fiscal 
policies.  In addition to slowly easing rates in 2006 in line with 
lower inflationary expectations, BI issued a series of policy 
statements signaling an independent and prudent approach to monetary 
policy.  The GOI ran a cautious fiscal policy during the year, with 
the budget deficit remaining close to 1% of GDP. As Table 1 
indicates, YoY GDP growth rates accelerated in four consecutive 
quarters during the year largely in response to the stable 
macroeconomic environment. 
 
¶3. (U) Prudent GOI policies also contributed to stable prices, a 
strong rupiah, lower public debt and increased investor confidence. 
After climbing to 17.1% in 2005 due to the October 2005 fuel subsidy 
cuts, Indonesia's YoY headline inflation rate slowed again in 2006, 
ending the year at 6.6%.  The rupiah/USD exchange rate remained in 
the 9000-9200 range for most of 2006, recovering from a low of 
approximately Rp 11,000/USD in August 2005.  The public debt to GDP 
ratio continued to decline in 2006 to about 35%, down from 54% in 
¶2004.  Rating agencies also signaled renewed confidence in the 
Indonesian economy, with both Fitch and Moody's moving their 
sovereign debt outlook from stable to positive.  Portfolio 
investment continued to flow to Indonesia in 2006 driving the market 
capitalization of the Jakarta Stock Exchange up 55.6% (YoY) and the 
 
JAKARTA 00000653  002 OF 004 
 
 
risk premium on Indonesian debt down to roughly 100 basis points. 
Foreign exchange reserves grew by $7.4 billion during the year to 
$42.6 billion at the end of December, despite Indonesia's early 
repayment of $6.9 billion in IMF loans. 
 
¶4. (SBU) After falling below 5.0% during the first quarter of 2006, 
real GDP growth rebounded to 6.1% (YoY) during the final quarter of 
the year, boosting GDP growth for all of 2006 to 5.5% (YoY).  A 
strong expansion in commodity exports was the primary driver of 
growth during the year (Ref B).  A moderate increase in domestic 
demand and the almost 10% growth (YoY) in government spending also 
supported GDP expansion.  Although the pace of domestic investment 
growth improved in the fourth quarter of 2004, expanding 8.3%(YoY), 
investment growth remained below 3.0% (YoY) during the full year 
2006, in contrast to 14.1% (YoY) and 9.9% growth (YoY) in 2004 and 
2005, respectively.  (Note:  Indonesia's official investment 
statistics may understate investment growth due to difficulties in 
compiling statistics.  Actual investment growth in 2006 may have 
been closer to the rate of growth of GDP. End note.) 
 
--------------------------------------------- ---------- 
Table 2: 2006 GDP Growth by Industry (percent) 
--------------------------------------------- ---------- 
                                  Growth       Share 
                                   Rate       GDP Grow. 
 
Agriculture/Livestock/Forestry 
        and Fishery                 3.0         7.3 
Mining and Quarrying                2.2         3.6 
Manufacturing                       4.6        23.6 
Electricity/Gas/Water               5.9         1.8 
Construction                        9.0         9.1 
Trade/Hotel/Restaurant              6.1        18.2 
Transport/Communication            13.6        16.4 
Financial/Bus. Service              5.7         9.1 
Services                            6.2        10.9 
--------------------------------------------- ---------- 
GDP                                 5.5       100.0 
--------------------------------------------- ---------- 
Note:  Share of GDP Growth (Share GDP Grow.) 
Source:  Central Bureau of Statistics 
 
¶5. (SBU) The most vibrant industries in the economy in 2006 were 
transportation/communications and construction, which grew 13.6% and 
9.0% (YoY), respectively.  Growth in these sectors comprised a 
combined 25% of overall GDP growth.  Manufacturing growth, which 
comprises the largest single industrial component of the GDP, 
expanded a modest 4.6 percent in 2006, contributing slightly less to 
growth than transportation/communications and construction combined. 
 Growth in financial and business services as well as trade, hotel 
and restaurant services was moderate, but growth in those industries 
contributed a combined 35% of overall GDP growth. 
 
¶6.  (SBU) Despite accelerating growth during the year, Indonesia's 
open unemployment rate barely budged, remaining at about 10.3%. 
Most analysts believe lagging growth in labor-intensive agriculture 
and manufacturing industries is to blame for Indonesia's stubborn 
unemployment problem.  Despite several policy packages designed to 
improve the climate for investment, excessive red tape (especially 
relating to customs clearance and taxation), corruption, and limited 
access to capital continue to hold back growth in the manufacturing 
sector. 
 
Investment and Household Demand to Rise in 2007 
--------------------------------------------- -- 
 
¶7. (SBU) Most analysts expect a modest increase in domestic demand 
and investment during 2007, in line with Indonesia's current 
cyclical economic recovery.  Indicators of strengthening domestic 
demand include rising non-oil imports, faster expansion of domestic 
credit, and improved auto sales.  Non-oil imports grew almost 20% 
YoY in January 2007.  After growing less than 3% during the first 
half of the year, domestic credit expansion accelerated during the 
fourth quarter of 2006, bringing the YoY growth in credit for 2006 
to 10.7% on a nominal basis.  After rising to a record 50,000 a 
month in August 2005, monthly auto sales plummeted to an average of 
roughly 25,000 a month from November 2005 to October 2006.  However, 
 
JAKARTA 00000653  003 OF 004 
 
 
beginning in November 2006, auto sales began to slowly recover, 
averaging 32,200 a month during the final two months of 2006.  Yet 
not all indicators of domestic demand point to stronger growth. 
BI's consumer confidence index declined in January 2007 for the 
second consecutive month due to increased pessimism over job 
availability and decreased optimism about the future direction of 
economic conditions and wage rates. 
 
¶8. (U) Observers expect overall investment to continue to recover 
during at least the first half of 2007, again in line with 
Indonesia's cyclical recovery.  In line with this expectation, 
capital goods imports doubled from October to November 2006, jumping 
from $500 million to $1 billion.  Capital goods imports were roughly 
$700 million per month in December and January 2006.  Moreover, BI's 
fourth quarter 2006 Business Survey, 27.5% of respondents plan to 
increase investment in the first half of 2007, compared to 26.6% 
during the latter half of 2006. 
 
Infrastructure Spending Still Very Slow 
--------------------------------------- 
 
¶9. (SBU) Despite a strong GOI budget position and several ongoing 
infrastructure policy initiatives, the outlook for a significant 
increase in infrastructure spending in 2007 appears poor. 
Increasing infrastructure investment is important to relieve 
transportation bottlenecks that are raising the cost of producing 
goods in Indonesia, and also because of the positive impact on 
aggregate demand of large infrastructure projects.  World Bank and 
Asian Development Bank infrastructure experts are growing 
increasingly pessimistic about the pace of infrastructure projects 
in the GOI pipeline.  They cite extremely poor coordination among 
GOI infrastructure ministries, complicated legal processes necessary 
to implement infrastructure projects, political interference, and 
continuing corruption as critical problems impeding progress on 
infrastructure investment.  They note that under the current system, 
the time required to move from tendering to financial closing for 
most projects is roughly two years. 
 
¶10. (SBU) The continuing slowness in infrastructure development is 
leading the World Bank, ADB, and other institutions to rethink the 
GOI's heavy reliance on private-public partnerships to attract 
capital to the infrastructure sector.  Instead, they are 
recommending the GOI consider financing more infrastructure projects 
directly from the budget or through consortia of state-owned 
companies and state-owned banks. 
 
Slowing Export Growth Raises Risks 
---------------------------------- 
 
¶11. (U) Most economists in the region expect growth in global 
commodity prices to moderate in 2007, in line with slower growth 
across the United States and other developed countries.  In 
addition, capital goods imports are likely to increase in 2007 in 
line with Indonesia's cyclical recovery.  As a result, growth in net 
exports, the primary driver of GDP growth in 2006, is likely to slow 
in 2007.  While few predict a major slowdown in commodity exports 
over the next twelve months, a significant decline in commodity 
prices could have a destabilizing effect on the economy, 
particularly in the context of weak manufactured goods exports.  A 
significant contraction in net exports could put pressure on 
Indonesia's currency and balance of payments, with a possible 
negative impact on Indonesia's risk premium. 
 
¶12. (SBU) Perhaps chastened by the August 2005 rupiah "mini-crisis," 
BI has signaled it will move cautiously on monetary policy in 2007. 
In its most recent press release on monetary policy, BI stated that 
it intends to "proceed more carefully in the timing and magnitude of 
changes in the BI rate to maintain existing price and exchange rate 
stability."  According to BI staff, concerns that excessive domestic 
demand could reignite inflation and possibly macroeconomic 
instability in light of the significant supply side constraints 
facing Indonesia are driving this cautious stance.  As a result, BI 
is likely to slow the rate of interest rate cuts in the absence of 
significant efforts on the part of the government to improve 
Indonesia's infrastructure and investment climate and/or significant 
growth in fixed capital investment in Indonesia. 
 
 
JAKARTA 00000653  004 OF 004 
 
 
Budget Deficit to Rise Modestly 
------------------------------- 
 
¶13. (SBU) The GOI's October 2005 fuel subsidy cuts, which trimmed 
subsidy spending that had reached over 3% of GDP in 2005, have 
provided an estimate $10-15 billion of fiscal space for the GOI to 
spend on other priorities.  Education and health has already 
increased dramatically, but as noted above, spending on large scale 
infrastructure projects has yet to accelerate.  The central 
government now distributes approximately one third of the national 
budget to local governments.  However, according to World Bank 
staff, only 40% of local governments actually have a quantified 
budget, while even fewer have the resources necessary to manage 
public spending programs.  As a result, a large number of local 
governments have been slow to spend their newly expanded resources, 
opting instead to deposit the funds in local banks.  While most 
observers expect central and local spending to rise in 2007, many 
doubt that the government will be able to overcome the significant 
bureaucratic hurdles needed to ramp up infrastructure spending. 
 
 
Comment: What About 2008? 
------------------------- 
 
¶14. (SBU) The SBY administration and BI are unlikely to depart from 
their prudent monetary and fiscal policy stance in 2007, and most 
analysts expect a very good year in 2007, with growth possibly 
approaching seven percent.  But given the important role of export 
growth as a driver of Indonesia's recent economic performance, 
Indonesia's medium term growth prospects are cloudier, especially if 
the external economic environment turns less supportive.  In this 
case, to maintain high growth rates, Indonesia would need to expand 
government consumption and investment, neither of which is an easy 
task.  Inducing more private investment would require finding a way 
to advance stalled reforms on important investment climate issues 
like corruption, tax, customs, and labor issues.  And with few large 
infrastructure projects yet out of the gate, it is difficult to see 
much infrastructure-led growth occurring before 2009.  The GOI's 
best hope to deliver more growth after 2007 may be to expand 
aggressively several anti-poverty programs it is scheduled to roll 
out in 2008-09.  If the GOI can channel enough funds through these 
programs to villages and poorer Indonesians, it could make for a 
much more supportive macroeconomic (and political) environment for 
the next election cycle in 2009. 
 
PASCOE