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Cablegate: Indonesia: Strong First Quarter Growth but Risks Mount

VZCZCXRO0502
RR RUEHCHI RUEHCN RUEHDT RUEHHM
DE RUEHJA #1007/01 1430511
ZNR UUUUU ZZH
R 220511Z MAY 08
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 9071
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEHKO/AMEMBASSY TOKYO 1998
RUEHBJ/AMEMBASSY BEIJING 5062
RUEHBY/AMEMBASSY CANBERRA 2533
RUEHUL/AMEMBASSY SEOUL 4611
RUEAIIA/CIA WASHDC

UNCLAS SECTION 01 OF 02 JAKARTA 001007

SIPDIS
SENSITIVE

DEPT FOR EAP/MTS AND EB/IFD/OMA
TREASURY FOR IA-SETH SEARLS
COMMERCE FOR 4430/KELLY
DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN
DEPARTMENT PASS EXIM BANK
SINGAPORE FOR SBAKER
TOKYO FOR MGREWE
USDA/FAS/OA YOST, MILLER, JACKSON
USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER
USDA/FAS/OGA CHAUDRY, DWYER
USTR WEISEL, EHLERS

E.O. 12598: N/A
TAGS: EFIN EINV ECON EAGR ID
SUBJECT: INDONESIA: STRONG FIRST QUARTER GROWTH BUT RISKS MOUNT

REF: A) Jakarta 848 B) Jakarta 871

1. (U) Summary. Indonesia's economy grew 6.3% (y-o-y) in response
to strong internal and external demand as well as an increase in the
rate of investment. Analysts attributed the strong performance in
part to the lagged impact of looser monetary policy in 2007. The
manufacturing sector recorded modest growth, while the
transportation/communication and utilities sectors expanded rapidly.
Economists expect inflationary pressure to prompt tighter monetary
policy and reduce GDP growth later this year. The outlook for job
creation and poverty reduction in 2008 also remains poor. End
Summary.

Strong Investment and Exports Support Growth
--------------------------------------------

2. (U) Indonesia's first quarter 2008 growth rate was 6.3% (y-o-y),
due to strong expansion of exports, investment and domestic demand.
After slowing in late 2007, Indonesia's exports rebounded during the
first three months of the year due to strong performance in the
commodity sector. Exports as a whole rose 15.0% in the first
quarter. Palm oil, rubber, and coal exports rose 17.1%, 7.1%, and
7.0% respectively (y-o-y) during the same period. Growth in exports
to the European Union, Japan, and the US outpaced other
destinations. Investment growth was also strong, surging 13.3%
(y-o-y) during the quarter. Analysts attributed the strong
investment performance to the lagged effect of looser monetary
policy in 2007. Domestic demand remained healthy, increasing 5.5%
(y-o-y) over the period and accounting for roughly half of the
overall expansion in GDP. Imports continued to increase rapidly,
with strong growth in electrical and other mechanical tools. The
weakest component of GDP was government spending, which grew only
3.6% (y-o-y) during the quarter.

3. (U) Growth across sectors varied widely, with transportation,
communication and utilities (electricity, gas, and water) expanding
much more rapidly than other sectors. However, utilities
contributed little to overall growth, given the limited size of the
sector. Agriculture growth expanded rapidly during the first
quarter, jumping 6.0% (y-o-y), due to better weather and rising crop
prices. Growth in the manufacturing sector improved modestly, at
4.3% (y-o-y), after slowing to 3.8% (y-o-y) in the final quarter of
2007. The poorest performing sector was mining, which contracted
2.3% over the previous year.

Inflation Risk Rising
---------------------

4. (U) External sources of inflation are the biggest risks to growth
and stability this year. Soaring food prices have already pushed
CPI inflation to 9.0% (y-o-y) as of the end of April. The expected
continued strength of global prices for imported agricultural
commodities, such as soybeans, wheat and rice (imports of rice are
forecast toward the end of the year; ref A), will put additional
pressure on the CPI. The price of flour in Indonesia continues to
soar, rising 13.1% since early January. Rice prices have also begun
to climb, increasing 8.3% since the beginning of the year. Market
analysts and government officials expect Indonesia's inflation rate
to rise above 11% if the government implements its proposed fuel
price increase (ref B). HSBC economists predict CPI inflation will
soar in the next few months and could hit 15% before the end of the
year.

5. (SBU) Most market analysts expect the central bank - Bank
Indonesia (BI) - to raise interest rates further before the end of
the year to control domestic inflation. Government officials have
stated that they expect BI to increase rates by at least 250 basis
points if the government moves ahead with plans to reduce fuel
subsidies. Higher rates are likely to curb investment and domestic
demand. Yet, experts do not agree on the extent to which BI should
raise rates. Given that a large portion of food and fuel inflation
is imported, higher domestic interest rates may not be an effective

JAKARTA 00001007 002 OF 002


tool in fighting inflation in Indonesia. If higher interest rates
slow domestic demand and economic growth but fail to control
inflation, pressure on poor household budgets will likely mount.

6. (U) Other economic analysts argue the food and fuel prices will
quickly spread to the broader basket of consumer goods and prompt
rapid increases across the board if BI does not act decisively to
control inflation. In addition, an increasing number of investors
in the region are taking a more cautious approach to Indonesia in
advance of the 2009 election, according to market analysts. If the
government fails to secure the budget by reducing fuel subsidies, or
is slow to fight inflation, investors may begin to lose confidence
in Indonesian assets. A reverse in capital flows would weaken the
currency and exacerbate imported inflation.

Outlook for Job Creation Weak
-----------------------------
7. (U) Slower growth and structural inefficiencies mean the outlook
for job creation this year remains poor. The open rate of
unemployment is roughly 9 percent and Indonesia faces a lingering
underemployment problem, particularly in the rural sector.
Although the prices of many Indonesian crops have reached historic
highs, structural inefficiencies in the agriculture sector impede
most farmers from taking advantage of higher food prices. The vast
majority of Indonesian small-scale farmers remain net purchasers of
food. Other industries are also unlikely to net significant
additional jobs this year. High commodity prices rather than higher
export volumes drove Indonesia's commodity export performance in
recent quarters, due to limited investment in new productive
capacity, according to analysts. The value of imports grew 13.2% in
2007, while the volume increased only 4.8%, according to the Central
Bureau of Statistics. As a result, potential job creation in the
natural resources sector remains limited in the near term, even if
commodity prices remain high. Analysts also predict that the
labor-intensive manufacturing sector will slow later this year in
response to reduced demand from the U.S. and Japan.

HEFFERN

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