Country Intelligence: Report

Indonesia

REPORT PRINTED ON 02 MAY 2012

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This information was last updated on 24 APR 2012, 1:49 PM EDT (17:49 GMT)

Outlook and Assumptions: Outlook

External headwinds will marginally soften growth momentum this year. Weaker external demand growth in 2012 will shave a few tenths of a percentage point off Indonesias growth, but the impact will be much less severe than in most other Asian economies. Thanks to stable macroeconomic conditions domestically, improved business conditions, and easier access to credit, both consumer and investment spending should hold up well in coming quarters. One downside risk to the outlook is that proposed energy price increases by the government could dampen consumer spending in the year ahead. In recent years, Indonesia has repeatedly impressed observers with its steady progress along the path of macroeconomic reforms and this is now bearing fruit in the form of record-high foreign-direct-investment inflows and improved sovereign credit ratings. These will help minimize downside risks from ongoing sovereign debt problems in Europe and should help keep overall GDP growth in the 6.2% range in 2012. The window has essentially closed on the latest monetary easing cycle. Since October 2011, Bank Indonesia has lowered interest rates by a total of 100 basis points (the last cut being delivered at the February 2012 meeting). This was driven by a combination of worsening external conditions and high degree of confidence that inflation targets would be met. However, we think the current easing cycle has run its course and unless external conditions deteriorate far more than currently expected, we expect no further rate cuts. In fact, there are reasons to believe that global economic activity and commodity prices will lift during the second half of the year, so the downshift in Indonesian inflation will similarly begin to reverse. Furthermore, the central bank will have to contend with the governments plans to reduce fuel subsidies from April 2012 and raise electricity tariffs over the remainder of 2012. The changes will cause inflation to spike from its current lows, and the central bank will have to monitor prices closely in coming months for evidence of second-round effects gaining too much momentum. The central bank will initially look through the policy-induced spike, and is expected to use monetary tools such as the deposit facility rate to help contain inflation before resorting to raising the policy interest rate. We nonetheless think that the February rate cut will be reversed before the year is over and that the policy rate is likely to end 2012 at 6%, the same rate at which it started the year. Reform efforts will pay off over the medium term via higher foreign direct investment (FDI). Quietly and without fanfare, Indonesia has taken important steps to improve its business climate over the last few years. Given reduced corporate tax rates, less red tape, and an improved reputation as a favorable investment destination, Indonesia is well positioned to grab a larger share of global FDI inflows in coming years. We anticipate a steady increase in FDI inflows to Indonesia over the medium term, particularly in areas such as mining and hydrocarbons, infrastructure development, and manufacturing.

Outlook and Assumptions: Domestic Assumptions

There is no double-dip recession in the United States and no hard landing in China. The Eurozone sovereign debt crisis is contained with considerable difficulty; Greece avoids a disorderly default on its foreign debts but remains within the common currency zone. European policymakers manage to ring-fence the other vulnerable economies. The strength and sustainability of the global economic recovery over the medium term remain in question given that underlying global imbalances are still in place. Past over-consumption in many developed economies and the associated household-debt accumulation will weigh heavily on these countries' ability to resume pre-crisis consumption levels and support Asia's export-oriented development model.

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Inflation is expected to spike temporarily owing to the governments planned changes to energy prices, but the increase does not destabilize the currency. Profit taking following two years of excellent stock market returns does not evolve into large-scale capital flight. Domestic political stability is maintained over the forecast horizon; there will be no major outbreak of ethnic or religious violence.

Outlook and Assumptions: Alternative Scenarios

The probability of a double-dip recession in the United States stands at 20% as of March 2012 (down from the JanuaryFebruary reading of 30% and 40%, respectively, in OctoberNovember 2011). Renewed panic in financial markets might not necessarily hit Indonesias growth particularly hard, but it could cause a massive sell-off in the stock market (which, after two years of strong returns is ripe for profit-taking) and in government bonds. The rupiah could depreciate sharply, although we think such weakness would be temporary. A global recession or a sharp downturn in China would lead to a decline in global commodity prices, including coal, metals, and hydrocarbons. Since a large share of foreign direct investment inflows into Indonesia target these very sectors, we would see investment flows from abroad as well as domestic investment spending weaken under such a scenario. A major terrorist incident in Bali, Jakarta, or in another economically sensitive center would undermine our growth forecast. Rising protectionism worldwide could undermine the speed and sustainability of the recovery phase, possibly leading to below-potential global growth over the medium term.

Economic Growth: Outlook

External headwinds will marginally soften growth momentum in 2012. Weak external demand growth in 2012 will shave a few tenths of a percentage point off Indonesias growth, but the impact will be modest. Thanks to stable macroeconomic conditions domestically, improved business conditions, and easier access to credit, both consumer and investment spending should hold up well in coming quarters. One risk to the consumer spending outlook is the governments proposed changes to fuel subsidies and electricity tariffs, since they would reduce disposable incomes. In recent years, Indonesia has repeatedly impressed observers with its steady progress along the path of macroeconomic reforms and this is now bearing fruit in the form of record-high foreign-direct-investment inflows and improved sovereign credit ratings. These will help minimize downside risks from ongoing sovereign debt problems in Europe and should help keep overall GDP growth in the 6.2% range this year.

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Economic Growth Indicators 2009 Real GDP (% change) Real Consumer Spending (% change) Real Government Consumption (% change) Real Fixed Capital Formation (% change) Real Exports of Goods and Services (% change) Real Imports of Goods and Services (% change) Nominal GDP (US$ bil.) Nominal GDP Per Capita (US$) 4.6 4.9 15.7 3.3 -9.7 -15.0 2010 6.1 4.6 0.3 8.5 14.9 17.3 2011 6.6 4.8 3.2 8.8 13.9 13.4 2012 6.2 5.2 2.8 9.8 7.6 7.6 2013 6.2 5.1 3.1 9.0 7.8 7.6 2014 6.3 5.3 3.1 8.6 7.7 7.1 2015 5.9 5.5 4.2 7.9 5.8 6.4 2016 5.7 5.4 4.5 7.3 5.6 6.2

539.4 706.6 846.9 917.3 1,067.6 1,229.4 1,358.7 1,477.6 2,272 2,946 3,495 3,748 4,319 4,926 5,394 5,814

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank.

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Download this table in Microsoft Excel format

Economic Growth: Recent Developments

Economic growth hit a fifteen-year high in 2011. Newly released official data show Indonesia's economy expanded by 6.6% year-on-year (y/y) during the last quarter of 2011. Marginal upward revisions to the JanuarySeptember figures brought the annual 2011 average to a similar 6.6% ratethe highest since 1996. This is just the latest in a string of positive developments related to the Indonesian economy over the course of 2011. The country also recently regained its investment-grade status in sovereign credit markets, which it lost 14 years ago, thanks to an upgrade by Fitch in December 2011 and a similar move by Moody's in January 2012. Both were preceded by IHS Global Insight's similar upgrade in June 2011. Domestic demand was key to improved performance. During the fourth quarter and over the course of 2011 as a whole, the key to Indonesia's strong growth has been its resilient domestic demand. Consumer spending accelerated at the end of the year, up 5.4% from a year earlier, while fixed investment rose 11.5% y/y. These were the strongest expansion rates for these sectors since early 2009 and late 2008, respectively. Declining inflation and more affordable credit (Bank Indonesia cut interest rates twice in October and November) have buoyed households' purchasing power, while the prospect of a growing market, alongside improvements in the business environment, have supported the upturn in investment spending. Indeed, foreign direct investment (FDI) flows are estimated to have reached a new record high of about USD19 billion last year. Given the disproportionately high share of total investment that is financed via FDI flows, this upturn has been the critical force behind the recent pick-up in investment spending. The downside to strong domestic demand has been the relatively faster import growth in recent months: during the fourth quarter, real exports grew 8.3% y/y, but imports jumped 10.3% y/y. Performance was more balanced for the year as a whole, but net exports made a far smaller contribution to growth in 2011 than they did in 2010. This may actually prove to be a positive development at a time when prospects for external demand continue to dim under the shadow of the Eurozone sovereign crisis. Manufacturing competitiveness is improving. From a supply standpoint, it is worth noting that the manufacturing sector experienced a steady pick-up in growth over the course of 2011 and expanded by 7.1% y/y during OctoberDecember. This is highly encouraging. Between 2005 and 2010, Indonesia's manufacturing sector grew by an annual average of only 4.0%considerably below rates seen elsewhere in Southeast Asia. So the fact that growth in the sector quickened to the fastest pace since 1996 raises hopes that a steady, sustained improvement in Indonesia's manufacturing competitiveness is under way. This would facilitate the government's goal of raising the value-added profile of the export sector, which is currently still heavily skewed towards various agricultural and mineral resources.

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Economic Growth: Consumer Demand - Outlook

Consumer spending growth remains robust, but sharp acceleration is unlikely. Political stability, improving labor incomes, stable prices, and broadening access to consumer credit will support private consumption in Indonesia over the medium term. Some uncertainty has been introduced in the near-term outlook by worsening global economic conditions that have the potential to sap confidence, but the impact should be fairly modest. One additional risk to our outlook is the governments plans to reduce fuel subsidies from April 2012, which will negatively impact the countrys inflationary environment and weigh on household disposable incomes. Real private consumption is expected to grow by 5% during 2012, with high-ticket items such as car sales anticipated to remain strong and potentially reach new records.

Economic Growth: Consumer Demand - Recent Developments

Demand for consumer durables has surged in recent years. Over the past couple of years, consumer sentiment has been supported by improving economic conditions, stable inflation, and an appreciating currency. Demand for consumer durables, in particular, has been very strong. This momentum extended into 2011 as well, with vehicle sales up about 28%, despite poor sales in MarchMay (likely related to shortages of Japanese imports) and November (because of the Thai floods). This came after car sales surged some 61% to an all-time high of about 765,000 units in 2010. Despite the recession, household consumption continued to grow in 2009. Despite headwinds from the global recession, consumer spending in Indonesia held up remarkably well in 2009, growing 4.9%. Two main factors facilitated this performance. On one hand, consumer price inflation moderated rapidly over the course 2009, falling from 9.2% y/y in January to an average of 2.7% between July and December. This was in sharp contrast to 2008, when inflationary pressures were steadily intensifying in response to rising commodity prices. Another favorable factor has been the electoral cycle, with both legislative and presidential elections taking place smoothly and having outcomes perceived as favorable by the majority of the population. As a result, consumer confidence had shot up to multi-year highs before taking a slight step back during the second half of 2009.

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Economic Growth: Capital Investment - Outlook

Investment spending will accelerate over the medium term, thanks to better fundamentals and higher foreign direct investment (FDI) inflows. Stable domestic economic conditions and easier credit availability are boosting investment spending. Improved investor perceptions about the country's business climate, political stability, and lower corporate-tax rates should help maintain inflows of FDI, despite the lingering effects of the global recession. In late 2011, parliament approved a much-awaited land acquisition law that should substantially speed up and ease the process for land acquisition for public projects. This action should facilitate much-needed investment in transportation infrastructure through public-private partnerships in coming years. Nevertheless, implementation rules will likely take months to be finalized, so the beneficial impact of this piece of legislation may not really be felt until 2013. All in all, investment spending should grow at a robust 9.0%-plus pace annually in 201213.

Economic Growth: Capital Investment - Recent Developments

Investment spending grows at a solid pace. Fixed investment spending grew 8.8% in 2011, in line with upbeat business sentiment and increased foreign direct investment (FDI) inflows. Moreover, fixed investment growth accelerated to a three-year high of 11.5% y/y during the fourth quarter. FDI inflows hit a fresh record high of USD19.5 billion in 2011, up from the previous record of USD13.3 billion in 2010. Over the course of 2011, foreign direct investors primarily targeted the transport, storage, communications, and mining sectors. Other sectors attracting considerable amounts of FDI were utilities, metals, machinery, electronics, and chemicals and pharmaceuticals.

The investment spending acceleration has been a multi-year phenomenon, reflecting the extreme declines in investment in the immediate post Asia-crisis period on one hand and the genuine improvement in Indonesias business environment in recent years on the other. As a result, the share of fixed investment to GDP reached a new historical high of 32% as of 2010 (prior peaks were in the 3031% range), having fallen to as low as 19% of GDP in 2002. We anticipate this ratio to continue rising, though at a much slower pace, over the next decade or so, as the drive to upgrade outdated infrastructure continues and multinational corporations establish more substantial manufacturing facilities in the country. Investment growth picked up considerably in 2010. Favorable base effects, improved business confidence, and easier access to credit steadily lifted investment spending over the course of 2010, resulting in an 8.5% expansion. Higher inflows of capital from abroad also supported investment spending as FDI inflows surged 173% in 2010 to reach USD13.3 billion.

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Recession slowed but did not stop investment spending. Real investment spending grew 3.3% in 2009a far cry from the double-digit rates recorded during the same period in 2008, but nonetheless impressive in the context of a severe global recession. In fact, Indonesia was almost an exception in Southeast Asia, as investment spending in many countries in the region plunged severely during 2009.

Labor Markets: Outlook

Unemployment is easing, but remains high by regional standards. High domestic unemployment will remain a significant challenge for Indonesian policymakers for some time to come. Although population and labor-force growth per se are not particularly rapid, job creation is constrained by fairly rigid labor laws. Many foreign and domestic investors often complain about worker "protectionism" and extremely generous termination packages. While such measures appear to be worker-friendly on the surface, they have in fact stymied new hiring across the board and encouraged companies to resort to under-the-table arrangements, which then leave the workers involved without any form of protection. Yet, given the growing political influence of organized labor (there are some 180 unions and five national labor confederations), this trend will be difficult to alter significantly in the future.

Labor Markets: Recent Developments

Recent declines in unemployment are encouraging but the pace of improvement remains too slow. Good economic performance in recent years has facilitated a steady decline in the unemployment rate from 8.4% in August 2008 to 6.6% in August 2011. While the trend is encouraging, the absolute level of unemployment remains very high and is festering social tensions. Moreover, official statistics also tend to underestimate the unemployment problem as large numbers of underemployed workers are not included in the unemployment definition. Indonesia's high unemployment can be attributed to stricter, less flexible labor laws implemented over the past several years. A recent World Bank study, for instance, showed Indonesia to be very poorly placed in relation to other Asian countries in terms of labor competitiveness. According to the report, Indonesia's cost of laying off workers is higher than that of China and about twice that of India, being equivalent to some 108 weeks of pay. There is abundant anecdotal information suggesting that small businesses often choose to close down rather than lay off workers and bear the associated severance costs. In addition, local governments have the ability to set minimum-wage rates, and populist tendencies mean that the mandated increases are often times quite large. Although other countries such as China and Vietnam have also experienced rising labor costs, so far productivity gains in Indonesia have lagged those elsewhere. As a result, foreign investors often cite Vietnam as the preferred manufacturing location alternative, especially for labor-intensive industries such as textiles and footwear. While this may now be changing thanks to Indonesia's more aggressive reform efforts, it will take the country many years before unemployment rates can be reduced in a meaningful fashion.

Inflation: Outlook
Inflation is under control, but changes to energy prices will cause inflation to rise again. Rising food and commodity prices lifted inflation during the early part of 2011, but the trend reversed during the last part of the year and moderated

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further in early 2012. Earlier plans to reduce fuel subsidies have been watered down so much recently that it is now unlikely they would be implemented until the last few months of 2012, if at all. Therefore, in the April forecast round, we have reverted to our 4.5% 2012 inflation forecast.

Inflation Indicators 2009 Consumer Price Index (% change) Wholesale-Producer Price Index (% change) 4.8 -1.8 2010 5.1 4.9 2011 5.4 7.5 2012 4.5 4.8 2013 5.3 5.1 2014 5.8 5.9 2015 4.0 2.4 2016 4.2 3.3

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Inflation: Recent Developments

A retreat in food prices allowed headline inflation to moderate over the course of 2011 and into early 2012. A strong disinflation trend continued from late 2011 into early 2012: the consumer price index (CPI) rate fell to 3.6% y/y in February 2012, thanks to favorable base effects from the previous years food price spike. Having peaked at 7.0% year-on-year (y/y) in January 2011 on account of high food prices, Indonesian inflation moderated steadily over the course of the year and retreated to 3.8% y/y in December 2011. For 2011 as a whole, inflation averaged 5.4%. Inflationary pressures were modest in 2010, but began rising during the fall. Both consumer and wholesale price inflation were pretty subdued during most of 2010, with CPI and wholesale price index (WPI) inflation averaging 4.8% and 4.6%, respectively, during JanuarySeptember. The appreciation of the local currency, as well as Indonesia's less-intense economic recovery and the persistent slack in the labor market contributed to keeping inflationary pressures in check. By year-end, however, a spike in food prices pushed headline inflation higherto 7.0% y/y by December 2010. For the year as a whole, CPI inflation averaged 5.1%.

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A strong disinflationary trend took hold in 2009. The year 2009 brought much improved news on the inflation front. If one were to look for a silver lining in the cloud of global recession, it would have to be the correction in commodity prices from overextended levels, which allowed inflationary pressures to diminish sharply, not just in Indonesia or Asia, but across the world. As a result, the CPI inflation rate fell to just 2.4% y/y in November 2009the lowest since 2000. This directly reflected trends in producer prices, which by July 2009, were experiencing double-digit declines from year-earlier levels. For 2009 as a whole, consumer price inflation averaged 4.6% (versus 10.1% in 2008), while producer prices actually declined 1.2% (having surged 26.2% the previous year).

Exchange Rates: Outlook

The rupiah is fundamentally well supported, but remains vulnerable to panic selling in the context of heightened risk aversion. Strong external balances, such as trade surpluses and higher inflows of foreign capital, offer fundamental support for the rupiah. Additionally, since interest rates in both the United States and Europe are likely to remain close to zero for an extended period, there is reason to believe that the carry trade will continue to lend support to Indonesia's rupiah over the medium term. Sovereign rating upgrades since late 2011 brought Indonesia back into the investment-grade club after a 14-year hiatus and represent another positive for the rupiah. Nevertheless, experience shows that fundamental factors tend to be overwhelmed by cyclical forces in determining the near-term performance for the rupiah. The rupiah remains quite vulnerable to sudden shifts in investor risk aversion; as long as worries about the stability of the global financial system remain in the background, episodes of sudden rupiah depreciation cannot be discounted. An additional issue to watch in the coming months is how much inflation accelerates in response to the governments planned fuel-subsidy reductions in April 2012. Investor concerns about inflation have weighed on the currency since the subsidy changes were first discussed.

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Exchange Rate Indicators 2009 Exchange Rate (LCU/US$, end of period) Exchange Rate (LCU/US$, period avg) Exchange Rate (LCU/Euro, end of period) Exchange Rate (LCU/Euro, period avg) 2010 2011 2012 2013 2014 2015 2016

9,400.00

8,991.00

9,068.00

8,850.73

8,629.07

8,455.81

8,633.07

8,719.92

10,389.90

9,090.43

8,770.43

9,041.80

8,719.85

8,542.41

8,588.45

8,677.69

13,540.77 12,013.63 11,732.44 11,328.94 10,872.64 11,077.09 11,827.25 12,469.49

14,438.44 12,038.71 12,194.71 11,769.95 11,010.47 10,953.49 11,506.49 12,146.82

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Exchange Rates: Recent Developments

Rupiah remained strong during the first half of 2011, but contagion caused it to weaken in SeptemberDecember. The rupiah's appreciation continued from 2010 into 2011, supported by strong economic growth, diminished risk aversion, moderate domestic inflation, and continuing support from carry trade. The appreciation was most powerful in the early months of 2011, and the exchange rate ended August 2011 near a seven-year high of IDR8,578/USD1. In September 2011, however, substantial portfolio capital outflows owing to increased foreign participation in the market in recent years induced a 4% depreciation of the rupiah versus the US dollar. Foreign ownership of local currency government bonds, for

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instance, fell from 35.7% of the total market on 9 September to 31.4% by 29 September. The large depreciation forced the central bank to intervene in the market and increase its own purchases of government bonds to the highest level since December 2010. Contagion from the Eurozone situation kicked up again in November, causing the exchange rate to end the month at IDR9,170/USD1the first close above 9,000 since January. It ended 2011 at IDR9,066/USD1 and stood at IDR9,180/USD1 at the end of March 2012. Improved risk appetite and carry trade lifted the rupiah since spring 2009. Despite favorable fundamentals, the rupiah was hard hit by the indiscriminate flight to safety that accompanied the onset of the global credit crisis in the fall of 2008. Within a few weeks, the rupiah lost more than 25% of its value against the dollar. Nevertheless, once it became evident that the world was, in fact, going to survive the recession, risk appetite began building anew. The exchange rate reached IDR9,433/USD1 at end-2009, compared with more than IDR12,000/USD1 at the height of the crisis. The rupiah remains among the most volatile emerging-market currencies. Despite improving macroeconomic fundamentals that should support the rupiah, trading in the currency is thin, and the rupiah is seen as one of the riskiest in Asia. As such, it tends to suffer more than others in periods of market turbulence and risk aversion. Nevertheless, just as it has historically experienced bouts of severe depreciation, it has also gone through several rapid appreciation runs. Generally, both the currency and the economy as a whole have become much more resilient to shocks, and we believe that although depreciation episodes are possible, they should be brief.

Economic Policy: Monetary Policy and Outlook

The window appears to have closed on the latest monetary easing cycle. Since October 2011, Bank Indonesia has lowered interest rates by a total of 100 basis points (the last cut being delivered at the February 2012 meeting). This was driven by a combination of worsening external conditions and a high degree of confidence that inflation targets will be met. However, we believe the current easing episode has run its course and unless external conditions deteriorate far more than currently expected, we expect no further rate cuts. In fact, there are reasons to believe that global economic activity and commodity prices will lift during the second half of 2012, so the downshift in Indonesian inflation will similarly begin to reverse. Furthermore, even though effectively postponed, government plans to reduce fuel subsidies remain a key risk to the inflation outlook. We therefore think that the February rate cut will be reversed before the year is over and that the policy rate is likely to end 2012 at 6%, the same rate at which it started the year.

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Monetary Policy Indicators 2009 Policy Interest Rate (%, end of period) Short-term Interest Rate (%, end of period) 6.50 9.28 2010 6.50 7.02 2011 6.00 6.93 2012 6.00 6.17 2013 6.25 6.04 2014 6.25 6.22 2015 6.22 6.38 2016 6.19 6.45

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Economic Policy: Monetary Policy - Recent Developments

Monetary easing was initiated in October 2011, but the cycle may have ended with the February 2012 cut. Bank Indonesia decided to hold its policy rate at 5.75% in March 2012, after kicking off its 100-basis-point loosening cycle in October 2011, owing to healthy domestic activity and concerns about future inflation. At its monthly policy meeting on 11 October, Indonesia's central bank surprised markets with a 25-basis-point interest-rate cut, bringing the policy rate back to 6.50% where it had stood between August 2009 and February 2011. The decision to initiate monetary easing rested on Bank Indonesia's conviction that 2011 inflation targets would be met (which they were). The benign inflation outlook then coupled with rising external risks to induce a further 50-basis-point cut at the November meeting. Having remained on hold in December and January, Bank Indonesia resumed its easing cycle in February 2012 with another 25-basis-point rate cut. The bank remained on hold at the March and April meetings. February 2011 brought the first rate hike since the 2009 downturn. The first signs of a shift in Bank Indonesia's stance came in late 2010. Reserve requirements for domestic currency loans were raised in November; shortly thereafter, the bank announced that higher reserve requirements for foreign currency deposits would be required beginning in March

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2011. With supply limitations pushing consumer price index inflation to 7.0% in January 2011, Bank Indonesia finally tapped the brakes and announced a 25-basis-point interest-rate hike in early Februaryjust as we had anticipated, but then remained on hold through August. The 200809 financial crisis necessitated a quick shift to easing. As it became clear that the global economy was entering a serious recession, the central bank (Bank Indonesia) quickly changed course and responded to the new reality by initiating a moderately aggressive easing cycle. The extent of the rate cuts was initially limited by still high inflation (11.4% in the fourth quarter of 2008), but this was subsequently compensated by a longer easing cycle than elsewhere in the region. Thus, between December 2008 and August 2009, the policy interest rate was lowered nine times by a total of 300 basis points. It then remained at 6.50% between August 2009 and January 2011. Inflation-targeting framework improves policy transparency. In July 2005, Bank Indonesia moved to an explicit inflation-targeting framework, replacing base money with interest rates as its operational targets. The new policy framework is believed to allow for a more transparent and effective conduct of monetary policy. With the country's banking and financial system becoming more complex, base-money growth had become a less effective way of guiding overall credit or money-supply growth, making inflation targeting difficult. The new monetary policy framework has been launched concomitantly with a new plan to further consolidate the banking sector and improve its efficiency.

Economic Policy: Fiscal Policy and Outlook

A favorable deficit picture will likely be maintained over the medium term. Generally speaking, the main problem with Indonesia's public finances is not really that of a chronic deficit, such as in India, but rather the fact that resource allocation is very inefficient. Although the debt burden has eased considerably in recent years, a big chunk of scarce resources continues to be diverted into debt repayment, leaving little available for much-needed social, education, and infrastructure spending. Nonetheless, purely from a deficit point of view, Indonesia is not a problem country. More often than not, it is in a position where the actual deficit falls below budget projections on account of weak spending implementation. Therefore, although the budget calls for a deficit of 1.5% in 2012, we believe that the actual shortfall will be closer to 1.1% of GDP. High oil prices (which tend to greatly increase subsidy costs in the budget) represent a considerable risk to this otherwise benign fiscal picture. This is why the government is seeking to reduce fuel subsidies starting on 1 April 2012, and is hoping to also boost electricity tariffs.

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Economic Policy: Fiscal Situation - Recent Developments

The 2011 fiscal deficit is estimated at 1.3% of GDP, below the 2.1% budgetary target. The favorable reading was facilitated by stronger-than-expected revenues on one hand and lower-than-anticipated capital expenditures on the other. Total revenues came in at 1,199.5 trillion Indonesian rupiah (USD13 billion), above the budgetary target of IDR1,169 trillion. On the expenditure side, subsidy costs greatly exceeded targets (by over 30%) because of high prices of oil and energy, but capital expenditures were lower than anticipated because of perennial delays in project implementation. Indonesia does not have large deficits, but it does face several structural fiscal challenges. From a purely numerical standpoint, Indonesia's fiscal performance compares well with regional peers. In fact, its fiscal deficits are among the lowest in all of Asia, and are certainly far smaller than neighboring Malaysia's, whose fiscal shortfalls averaged 4.8% during 200610. Rather, Indonesia's fiscal challenges are of a different nature and have to do with a low level of tax penetration, inefficient spending distribution, and poor implementation of capital spending projects. The first issue of low tax penetration, which means that only a fraction of those supposed to pay taxes actually do so, has been on the government's radar for years. Several steps to fight tax evasion have been undertaken in recent years. The latest onea nationwide tax censuswas announced in September 2011. The program, which will see tax data collected door-to-door until the end of 2012, is hoped to boost the number of taxpaying residents by over 25% by 2013, as well as improve compliance in submitting tax reports. In 2010, only 20 million of 237 million Indonesians had registered as paying tax and only 9 million people submitted their income statements. The second key issue deals with wasteful spending in the form of costly subsidies. In fact, subsidy costs have become a far larger drag on the budget in recent years than interest payments. The revised 2011 budget, for instance, allotted 18% of total expenditures toward subsidies and the 2012 budget calls for a similarly large 15%. Subsidy costs also dwarf the country's health and education budgets. Once again, the government has tried to gradually correct the problem through periodic increases in fuel prices, but it has now been a while since a substantial adjustment has been implemented (in 2008). Considerable public opposition makes such moves politically difficult to push through, although ultimately these steps will need to be taken. Finally, another structural weakness in Indonesia's fiscal process are perennial delays in capital spending implementation. Oddly enough, these tend to improve the budgetary outcome by constraining expenditure growth, but have had a detrimental impact on infrastructure expansion in recent years. The recent passage of a new land acquisition law is hoped to speed up project implementation going forward.

External Sector: Outlook

External balances will benefit from expected productivity and competitiveness improvements. We expect Indonesia to maintain trade and current-account surpluses over the next few years. A narrowing of both surpluses is expected, and temporary reversals in the trade balance are possible. We anticipate, for instance, that stronger foreign direct investment inflows will be accompanied by increased demand for imported investment goods. In such a scenario, however, the narrowing of trade surpluses would not be a problematic development because higher imports would be not only financed through these investment inflows, but would also contribute to boosting productive capacity and competitiveness. Recognizing the inherent volatility associated with global trade and capital flows, we believe that steady improvements in competitiveness will allow Indonesia to retain a moderate trade surplus over the next few years.

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Trade and External Accounts Indicators 2009 Exports of Goods (US$ bil.) Imports of Goods (US$ bil.) Trade Balance (US$ bil.) Trade Balance (% of GDP) Current Account Balance (US$ bil.) Current Account Balance (% of GDP) 119.6 88.7 30.9 5.7 12.4 2.3 2010 158.1 127.4 30.6 4.3 7.5 1.1 2011 201.4 172.6 28.9 3.4 3.1 0.4 2012 216.4 192.7 23.7 2.6 2.7 0.3 2013 251.4 222.8 28.6 2.7 6.6 0.6 2014 298.8 268.2 30.6 2.5 7.2 0.6 2015 319.3 290.6 28.7 2.1 2.6 0.2 2016 340.8 314.8 26.0 1.8 -1.3 -0.1

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

External Sector: Recent Developments

Trade balances drive the current-account position, but the income account is increasingly weighing on the balance. Over the course of 2011, preliminary data indicates that the current-account surplus progressively narrowed, particularly between the first and the second quarters. Early data also hints at the country recording a deficit for the fourth quarter. The surplus narrowed in 2011 not as much in response to a narrowing merchandise trade deficit as much as rising deficits on the services and income accounts, as growth in services imports and income outflows was stronger than growth of inflows. Rising income-account deficits are one risk to the countrys increased investor interest as profit-remitting by foreigners could become a larger drag on the current account going forward. The current-account balance remained in surplus in 2010, but the size of the surpluses moderated with each passing quarter. The first-quarter surplus stood at USD1.9 billion, but fell to USD1.1 billion by the fourth quarter. This happened despite the trade balance remaining steady over the period, and reflected a larger deficit on the income side. The external debt to GDP ratio is estimated at 29%, having registered steady improvement from 82% a decade ago.

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The current-account surplus vanished in 2008, but revived in 2009. Surging import costs, particularly for food and energy, led to Indonesia's current-account surplus to effectively disappear over the course of 2008. A roughly USD10-billion decline in the merchandise-trade surplus from USD32 billion to USD22 billion was translated essentially dollar-to-dollar into the current account. The current-account surplus fell from USD10.5 billion in 2007 to a mere USD300 million in 2008. In 2009, the situation improved considerably as import demand took a dive and terms of trade improved, with the current account back into surplus of USD10.7 billion, or 1.9% of GDP. Trade surpluses widened after the 1997 Asian financial crisis. Export-oriented policies and bountiful natural resources have allowed Indonesia to maintain healthy trade surpluses (of about 45% of GDP) for most of the past 20 years. The magnitude of these surpluses expanded greatly following the 1997 crisis, as the massive depreciation of the rupiah inhibited demand for imported capital and consumer goods. Even after the economic situation stabilized, import growth continued to lag exports, so the trade surplus widened from USD10 billion in 1997 to USD25 billion in 2000equivalent to 15% of GDP. Trade surpluses remained very high relative to GDP for several years thereafter, averaging 13% of GDP during 200003. Growing import demand in more recent years, as domestic demand recovered, has led to a smaller trade surplus, but it has still averaged 6.8% of GDP between 2004 and 2008.

Economic Structure and Context: Development and Strategy

Improving the investment and business environment tops the governments agenda. With macroeconomic stability restored following the crushing experience of the 1997/98 Asian financial crisis, the policy agenda is now focused on improving the investment and business environment. Corruption, red tape, and contradictory legislation are among the most troublesome issues facing investors and are placing Indonesia at a disadvantage compared with regional competitors such as China, India, or Malaysia. Thankfully, the government has made substantial progress on the path to reform in recent years. It has substantially widened the tax base, lowered corporate tax rates, reduced red tape, introduced critical new legislation, and clarified the regulatory environment. As a result, Indonesia has gradually inched higher in global competitiveness rankings and was recently named the most active Asian reformer in 2008/09 by the World Bank. Its impressive performance during the great recession of 2009 (when it managed to grow 4.5%) has further boosted its international profile and investor interest.

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From import substitution to export-led manufacturing. Indonesia began an industrialization process in the 1960s under the centralized planning of Suharto's New Order. As with many developing countries at the time, policy was initially focused on economic self-sufficiency through the development of import substitution industries. A wave of reform began in the second half of the 1980s after oil receipts, which had dominated export earnings and government revenues, fell dramatically. Indonesia then joined other Asian countries in encouraging export-led manufacturing sectors while domestic industry was fostered by the state under a protective regulatory shield. Liberal investment laws were enacted, bureaucratic red tape reduced, and duty-free zones established. Foreign investment rose sharply in the late 1980s, focused mostly on labor-intensive light manufacturing processing sectors, and Indonesia became one of the successful "tiger" economies. Structural problems persist despite rapid economic growth. Although socioeconomic indicators improved dramatically through the 1980s and early 1990s, the model was riddled with structural problems. Control over key corporations and industries remained concentrated in a handful of politically influential families, encouraging corruption and moral hazard. State interventionism was also high (a legacy of the command economics of the New Order) undermining efficient resource allocation. Lack of an independent central bank resulted in weak oversight of the banking system, politically motivated landing, and a gradual deterioration of the banking sector's balance sheet. Descent into crisis and policy reaction. Liberalization of capital flows resulted in sharply higher exposure to foreign debt in the early to mid-1990s. Encouraged by the exchange-rate peg, domestic corporations financed investments by borrowing abroad in hard currencies. This currency mismatch had steadily worsened as weak banking-sector supervision and moral hazard exacerbated systemic risk. Once the rupiah was devalued, most of these loans soured and the financial house of cards crumpled. In the event, recourse was made to the IMF, which responded with a USD4.3-billion bailout program. The strategy involved stringent austerity measures to curb inflation, stabilize the exchange rate, and redress fiscal and external imbalances. Recapitalization of the banking sector, disposal of non-performing loans, and foreign debt forgiveness were key elements of the program.

Economic Structure and Context: Demographics and Labor Markets

With a population of 240 million people, Indonesia enjoys a large labor-force pool. Although this has traditionally been one of the country's competitive advantages, its lead has been eroded by a relatively low skill level and growing labor protectionism. Indonesia continues to export labor to more affluent Asian countries (plantation workers to Malaysia and maids to Singapore, for instance), but has generally failed to find a niche in higher-skill industries. Even manufacturing jobs are stagnating because of stronger competition from China and Vietnam. Domestic unemployment remains high, which is why the number of Indonesians working abroad has grown steadily since the Asia crisis. Often times these workers are undocumented, however, at times straining relations between Indonesia and the destination countries. Labor activism has intensified notably over the past decade. Labor laws have become much more protective of workers. Worker benefits and severance packages are quite generous, to the point where they have become a deterrent to new investment.

Economic Structure and Context: Monetary System

Having been subject to recurrent political interference prior to the Asia Crisis, the Bank of Indonesia (BI) is nowadays an independent institution whose reputation has improved greatly in recent years. Corruption scandals, recurrent in the years immediately following the Asia crisis, have now become quite rare. The latest debacle over the bailout of Bank Century during the global financial crisis appeared to be little more than a politically motivated move to discredit a highly competent

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central bank governor (who has since left to join the World Bank as a managing director). The quality of monetary policy has also increased greatly, particularly since 200607, as the central bank has increasingly focused on strengthening the regulatory framework to minimize exposure to sudden shifts in capital flows.

Economic Structure and Context: Financial System

The Jakarta Stock Exchange (JSE) is a medium-sized exchange that lists about 300 companies. It became a private entity in 1991. Securities trading began to take off in the mid-1990s, following the adoption of a new capital market law in 1996 and the listing of several formerly state-owned firms. Market capitalization dried up in the aftermath of the Asian crisis, but trading has picked up greatly in recent years, with the market repeatedly reaching new historical highs since 2005. 2009 and 2010, in particular, were banner years for stock market returns in Indonesia, as the country's ability to avoid recession during the global economic convulsions of 200809 brought renewed attention to investment opportunities in Southeast Asia's largest economy. The OCT marketthe Surabaya Stock Exchangewas created in 1995 through the merger of two earlier exchanges.

Economic Structure and Context: Key Sectors

Oil and gas: This is by far Indonesia's single-largest industry, accounting for a fifth of merchandise exports. Nevertheless, it has been plagued in recent years by insufficient investments, a situation aggravated by the poor regulatory/legal environment. Tourism: Despite multiple shocks in recent years, this remains one of Indonesia's more vibrant industries, with significant potential for future expansion. It remains vulnerable, though, to terrorist attacks and natural disasters. Logging: Environmental concerns have reduced export volumes in recent years, but timber remains one of Indonesia's greatest natural resources. Indonesia: Top-10 Sectors Ranked by Value Added 2011 Level (Bil. US$) 1. Agriculture 2. Oil and Gas Mining 3. Construction 4. Wholesale Trade 5. Public Admin. and Defense 6. Retail Trade - Total 7. Communication Services 8. Hotels and Restaurants 9. Food Products 10. Health and Social Services Top-10 Total 147.4 95.4 87.6 51.9 46.2 42.0 25.9 23.2 20.0 18.1 557.6 2012 Percent Change (Real terms) 3.3 3.0 6.4 6.8 4.7 6.5 8.3 5.3 7.1 5.9 Percent Share in GDP (2011) (Nominal terms) 16.7 10.8 9.9 5.9 5.2 4.8 2.9 2.6 2.3 2.1 63.3

Source: World Industry Service, IHS Global Insight, Inc. Updated: 18 Apr 2012

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Economic Structure and Context: Natural Resources

Indonesia is a country well-endowed with natural resources, including natural gas, petroleum, tin, nickel, timber, bauxite, and copper, as well as precious metals like gold and silver. Indonesia also exports agricultural products, such as palm oil. Indonesia used to be OPEC's only Asian member, but declining production meant the country became a net oil importer in 2005. In 2008, it officially withdrew from OPEC. The country's main strength, however, lies in natural gas exports, which are directed mainly to regional powerhouses like Japan and Singapore. Despite abundant mineral resources, however, the mining and oil industries have languished in the period immediately following the Asia crisis. For several years, new investments had been delayed by opaque and contradictory legislation. The situation has gradually improved under the Yudhoyono administration, but Indonesia is still a long way away from fully exploring its natural endowments.

Economic Structure and Context: Trade Profile

Indonesia enjoys a fairly open trade regime and few barriers to trade, being a member of both the World Trade Organization (WTO) and the Association of Southeast Asian Nations (ASEAN). About one-fifth of Indonesia's roughly US$50-billion annual merchandise export earnings come from petroleum and natural gas. Manufactured goods make up the bulk of exports, however, led by textiles, electronics, and machinery and equipment. Indonesia also exports significant quantities of timber (volumes have declined in recent years because of environmental concerns), cocoa, and coffee, as well as tin, copper, and nickel. Service exports, mostly tourism, bring in about US$5 billion per year. Japan remains, by far, Indonesia's largest market, accounting for around a fifth of its exports, yet its share has almost halved since the early 1990s. The United States is another major export market, while China has gained prominence in recent years as a destination for raw materials. Indonesia's main export destinations also tend to be its largest sources of imports. Indonesia: Major Trading Partners, 2010

EXPORTS

IMPORTS

Country

Billions of USD Percent Share

Country

Billions of USD Percent Share

Japan China United States Singapore South Korea India

25.8 15.7 14.3 13.7 12.6 9.9

16.3 9.9 9.1 8.7 8.0 6.3

China Singapore Japan United States Malaysia South Korea

20.4 20.2 17.0 9.4 8.6 7.7

15.1 14.9 12.5 6.9 6.4 5.7

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Malaysia Thailand Australia Netherlands

Source: IMF, Direction of Trade

9.4 4.6 4.2 3.7

5.9 2.9 2.7 2.4

Thailand Saudi Arabia Australia India

7.5 4.4 4.1 3.3

5.5 3.2 3.0 2.4

Indonesia: Major Trading Partners, 2000

EXPORTS

IMPORTS

Country

Billions of USD Percent Share

Country

Billions of USD Percent Share

Japan United States Singapore South Korea China Malaysia Netherlands Hong Kong Australia United Kingdom
Source: IMF, Direction of Trade

14.4 8.5 6.6 4.3 2.8 2.0 1.8 1.6 1.5 1.5

23.2 13.7 10.6 6.9 4.5 3.2 3.0 2.5 2.4 2.4

Japan Singapore United States South Korea China Australia Saudi Arabia Germany Malaysia Thailand

5.4 3.8 3.4 2.1 2.0 1.7 1.6 1.2 1.1 1.1

16.1 11.3 10.1 6.2 6.0 5.1 4.8 3.7 3.4 3.3

Medium- and Long-Term: Outlook

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Indonesias economy is expected to grow by 4.8% annually over the long term (201241). This would be about two and a half percentage points lower than the average growth rate prior to the Asian crisis, but still a respectable performance by any standard, especially since the economy has become much larger since then. Our projection rests on several assumptions, of which continued economic openness and relatively stable politics are perhaps the most crucial. The country's positive outlook is supported by superior factor endowment, including abundant natural resources and favorable demographics. Proximity to Asia's largest sources of capital (Japan, China, and Singapore) and to the region's fast-growing markets is another valuable asset. Finally, economic openness has been one of the main reasons for strong growth in the past and should remain an important advantage in the future, especially as the regulatory and legal environment gradually improves. Indonesia is rich in natural wealth and has significant deposits of oil and gas, minerals, and agricultural resources. As OPEC's only Asian member, it produces about 1.0 million barrels per day of crude oil, but proven reserves have fallen by half over the past two decades. The country's main strength lies in natural gas exports (reserves are the sixth-largest among OPEC members), which are directed mainly to regional powerhouses like Japan and Singapore. Indonesia is also actively seeking to secure long-term contracts to supply liquid natural gas to China's growing market. Other exports include tin, nickel, timber, bauxite, and copper, as well as precious metals like gold and silver. The country is also among the top three exporters of cocoa and natural rubber in the world. Indonesia's insular structure (there are over 15,000 islands forming the largest archipelago in the world) means that most urban and manufacturing centers have easy access to ports. This tends to lower transport costs and improve export competitiveness. Moreover, fish stocks and some of the largest coral reefs in the world add to the country's natural resources. Many small islands are currently uninhabited, but hold tremendous tourism potential, and niche tourism could become a growing industry in the future. With the world's fourth-largest population, Indonesia has an abundant labor supply. In fact, it has been exporting labor to countries like Malaysia and Singapore for many years. This could become an even greater advantage in the future, given graying populations in some regional economic powerhouses. At the same time, however, recent developments highlight new risks. After decades of little labor-market regulation and union activism under former dictator Suharto, labor has become increasingly organized and vocal. Sometimes violent protests over the past few years have helped push through substantial wage increases and generous severance packages, which are among the highest in Asia. With a general shift toward more direct political participation, organized labor's political influence will probably increase over time. This could result in excessive regulation and diminished competitiveness. One characteristic setting Indonesia apart from other developing countries is the presence of a large and highly entrepreneurial Chinese community within its borders. Despite a period of heightened anti-Chinese sentiment and even violence in the second half of the 1960s, relations have improved greatly since then. Indonesia's Chinese community has historically been a source of innovation and entrepreneurship, and has acted as a bridge to China's business community. This has made Indonesia a preferred destination for Chinese investment, with highly beneficial effects on economic growth. Yet, it was economic reform and liberalization in the aftermath of the second oil crisis that set the stage for two decades of rapid economic growth. Under International Monetary Fund/World Bank supervision, the government decided to diversify the economic base, open up most sectors to foreign participation, and limit the state's economic role. These policies have helped Indonesia avoid the fate of other OPEC countries and instead grow into one of Southeast Asia's largest and most dynamic economies. The ability to retain openness in trade, further deregulate its markets, engender savings growth, and provide a suitable environment for technology transfer and investment will determine Indonesia's future advancement. Some medium- and long-term constraints to growth include Islamic militancy and terrorism as well as the potential for ethnic violence and political instability. Although considerable progress has been made in recent years, Indonesia still remains in the bottom half of countries rated by the World Bank's Doing Business Surveys. The shaky legal

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system and still-opaque regulatory environment constrain growth by stymieing foreign investment and threatening international competitiveness. The country's shaky transition to democracy, after more than three decades of authoritarian rule, will also shape its long-term potential. So far, developments on this front have exceeded expectations in that elections have been deemed fair and free of violence. Nonetheless, there is no room for complacency, as the risk of reforms falling victim to entrenched vested interests remains ever present.

Analyst Contact Details:

Simona Mocuta, Bree Neff

Indonesia: Country Reports - Recent Analysis

Economic 1. Visitor Arrivals Continue to Rise in Indonesia During Q1 02 MAY 2012

Economic 2. April Data Suggest Indonesian Inflation Has Bottomed 02 MAY 2012

Economic - Sovereign Risk 3. High Imports Result in Another Low Trade Surplus in Indonesia During March 02 MAY 2012

Economic 4. FDI Inflows Near Record Highs in Indonesia During Q1 24 APR 2012

Economic 5. Bank Indonesia Leaves Interest Rate Unchanged, Eyes Fuel Prices and Global Growth 13 APR 2012

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Economic 6. Jump in Indonesia's IP Growth During February Overestimates Sector's Strength 12 APR 2012

Economic 7. Indonesian Inflation Accelerates But Outlook Improves Without April Fuel Price Rise 03 APR 2012

Country - Economic 8. Fuel Hike Protests Hit Indonesia and More Expected 22 MAR 2012

Economic 9. Indonesia Maintains Interest Rates, Points to Inflation Risk from Reduced Fuel Subsidies 09 MAR 2012

Economic 10. Inflation Continues to Ease in Indonesia As Trade Surplus Improves 02 MAR 2012

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