Indonesia 2012 Outlook: Sustaining the Structural Changes

Indonesia has seen at least 3 unprecedented changes over the past few years —
This refers to the broader-based composition of GDP growth, the gradual decline in the medium-term average rate of inflation and the historically low interest rates both in the short and long tenors.

 Question that comes to mind is whether or not these changes are sustainable —
Given the young population and growing middle class, domestic consumption will
remain a pillar of growth. And in the face of a changing global landscape, we expect
Indonesia to become a growing recipient of FDI. Hence to the extent that infrastructure
bottlenecks can be overcome, the revitalization of manufacturing, especially the
domestically oriented industries, is a momentum that could persist in the medium term.

 On inflation, are we really seeing a structural decline? — The average rate of
inflation has come down over the past 5 years. We attribute this to several factors, one
of which is the government’s rather gradual approach on energy subsidy reforms.
Going forward, it can still afford to do gradual adjustments given low spending in other posts. This can help avoid double-digit spikes in inflation over the medium term (although at the expense of forgone opportunities). But we must still look out for cyclical inflation risks, especially if capacity utilization rates rise further.

 Policy interest rates have been taken down to uncharted territory, how long will itlast and what risk does it bring for 2012? — BI’s policy interest rates will likely be kept down for as long as global interest rates are also low. In this regard, excessive credit growth is probably less of a concern near-term due to the expected softening of external demand (although there could be lagged effects later on). The more immediate risk appears more towards asset price inflation, as deposit rates decline and savers seek alternative placements to invest their funds.

 Low long-term bond yields have not been purely market-driven but also policydriven;
this latter aspect is prone to change — Central bank buying, for their stockbuilding
or stabilization objectives, has been virtually the only support for the bond
market during risk-off times. Yet the continuity of this policy is uncertain. If negotiations on the conversion of legacy bonds in BI’s balance sheet (into tradable bonds) are completed, BI may no longer need to accumulate bonds from the market, meaning long-end support during risk off environments could diminish significantly.

 Perceptions of “relative vulnerability” is still an issue, while policy complexities are growing — Indonesia’s reserve adequacy indicators have shown improvement;
however, it is still ranked lower to comparable Asian countries. Short-term money
market outflows are less of a risk now; but questions on the central bank’s dovish
interest rate policy stance could affect bond flows and the IDR when global concerns
are elevated. The country will likely see the current account tilt into deficit next year.
Economics
Indonesia has seen at least three unprecedented changes over the past few
years: its broader based growth structure, lower inflation and historically low
interest rates. The key issue for 2012 is whether or not these changes could
be sustained.

Broader based GDP growth and “re-industrialization”
Indonesia has seen a growing role of investments in supporting economic
growth. The country’s investment / GDP ratio has been on the rise over the past 5-
years, from 25% to around 30%. Indeed this figure is lower when constant price
GDP is used. But still, we have seen stronger capital goods imports in the form of
non transport machinery, relative to the transport equipment imports.
Over the past 2 years, increases in capacity have been seen in a number of
manufacturing sub-industries. As a result economic growth has become broaderbased,
marked by a rise in manufacturing sector growth to 7% YoY. This was
accompanied by a decline in the unemployment rate (down to 6.6% in Aug-11 from
7.1% in Aug-10) which was of better quality, i.e. marked by an increase in formal
sector employment and a decline in the informal sector employment.

Given Indonesia’s favorable demographics and less conducive conditions
globally, we believe the revitalization of Indonesia’s manufacturing sector,
especially the domestic oriented industries, is a momentum which could
persist in the medium term. But the continuity depends on how the many
challenges are overcome, e.g. with regard to infrastructure development. The power
generating capacity of PLN grew by just 5% YoY in 2010, and by 3.6% CAGR over
the past 5-years, which is below the rate of GDP growth. Furthermore the land
acquisition for public use bill, which many view necessary to accelerate the
development of road infrastructure, has not yet been passed due to resistance by
various interest groups.

For 2012, overall growth may slow towards 6.3% in 2012 (from 6.5%) amid a
slowdown in external demand; however the economy is still expected to see
relatively strong support from domestic demand. As of October, consumer
confidence still stands at elevated levels although inflation expectations are
relatively high. With over 60 percent of the population spending more than half of
their expenditures on food (data as of 2009), inflation (compared to export growth)
is a more important factor impacting household consumption. So far inflation has
been kept at bay, and although energy subsidy cuts next year may increase

Commodity exports are indeed important to the trade balance, but for the
economy, the contribution is not alarmingly high. Over the past 3 years,
Indonesia’s trade with emerging Asian economies has intensified and exports to
developed markets (US, Europe and Japan) have dwindled. This comes with a
growing portion of primary commodity exports, with the six key primary commodities
(oil, gas, coal, palm oil, rubber, iron ores) comprising around 56% of total exports as
of Aug-11, from just 49% in Aug-08. But although commodity exports look very
important to the trade balance, we should mind that compared to the size of the
economy it is much lower at around 12 percent of GDP.

What happens if commodity prices decline? The answer depends on which
commodity. Production of plantation commodities, e.g. rubber and palm oil, are
labor intensive and thus should have a stronger impact on rural purchasing power.
Meanwhile the more capital intensive industries, e.g. coal and iron ore mining, use
less labor cost as % of total cost. But demand for these will affect other industries,
e.g. heavy machinery. So far, the commodities which have seen severe drops in
prices are the industrial use commodities, e.g. copper, tins, rubber. Meanwhile, CPO

Generally though, a decline in commodity prices should impact the
commodity producing regions to a larger extent, while Java & Jakarta
economies may see milder impact. We deduce this from the experience in 2009:
the commodity producing regions of Sulawesi, North Sumatra & Riau saw a
relatively steeper percentage point decline in regional GDP growth compared to
Jakarta and the manufacturing bases in Java. Of course in 2009, Java was to some
extent helped by pre-election campaign spending. But we could also argue that
consumer confidence is at much higher levels now than it was back then, as the
inflation environment over the past year has been relatively benign.