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Cablegate: Indonesia's Economy One Year After the Fuel Price

DE RUEHJA #2543/01 2861006
R 131006Z OCT 06





E.O. 12598: N/A

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.

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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

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

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.


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