Public Information Notice No. 07/91

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Indonesia

July 31, 2007

On July 18, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the 2007 Article IV consultation with Indonesia.¹

Background

Indonesia's economic performance has been strong since the last Article IV consultation. Supported by sound policies and a favorable external environment, output has grown strongly, inflation has stabilized, and international reserves have risen to an all time high. The government, banking, and corporate sectors continued to reduce balance sheet vulnerabilities. Indonesia's financial markets have rallied in line with global trends and perceptions that risks have been reduced. A strong external position enabled Indonesia to complete the early repayment of its remaining obligations to the Fund in October last year.

This robust economic performance is starting to be reflected in unemployment and poverty indicators, where progress to date had been sluggish. The official unemployment rate dipped below 10 percent in 2007, although formal sector employment opportunities remain limited. Meanwhile, the poverty rate fell back to 16.6 percent in March 2007, having increased sharply to 17.8 percent a year earlier on the back of increased prices for some household staples. However, despite this recent progress, the authorities' focus remains on further accelerating economic growth to improve social conditions and ensure that the benefits of growth are felt across society.

Economic growth reached 5½ percent in 2006 as the dip in activity following the late 2005 fuel price and interest rate hikes proved shallow. Strong exports compensated for weak domestic demand. Staff projects growth at 6 percent in 2007—the pace maintained since the third quarter in 2006—with some shift from external to domestic demand. Inflation has stabilized at around 6 percent, allowing Bank Indonesia (BI) to lower its policy rate more than 400 basis points since May 2006 as the inflation rate remains on track to end 2007 inside its target range of 5-7 percent. The external current account surplus is projected to decline from 2¾ percent of GDP to 2 percent in 2007 as lower global growth and commodity prices reduce export values. The central government deficit increased modestly to 1.0 percent of GDP in 2006. For 2007, staff projects a somewhat higher deficit at about 1.8 percent of GDP, a level consistent with further reductions in the debt burden.

Equity and bond markets remain buoyant. In addition to increased global risk appetite, the rise in asset prices also reflected Indonesia-specific factors, such as lower domestic interest rates and perceptions of reduced vulnerability. Portfolio capital flows mirrored these developments as foreign investors have been increasing their positions in Indonesian securities. After considerable prior volatility, the exchange rate remained broadly stable during July 2006-April 2007, but appreciated by 3 percent in May vis-à-vis the U.S. dollar, in response to portfolio inflows, although most of this appreciation was reversed in June. Banking sector indicators have also strengthened recently. Banks' profitability has improved, while the system is well capitalized and nonperforming loans remain low for private banks, after falling sharply at the end of 2006 for state banks.

However, volatile portfolio flows are posing additional challenges for the authorities. These include avoiding new external vulnerabilities (e.g., to a sudden reversal of inflows) and minimizing the erosion of competitiveness in labor-intensive manufacturing resulting from real exchange rate appreciation. Meanwhile, a slowdown in domestic credit growth in 2006 has triggered pressure on the central bank and state-owned banks to ensure accelerated lending.

The government continues to implement its comprehensive reform agenda to boost growth over the medium term. Key elements of the strategy include policies to strengthen financial intermediation, improve the business climate, and increase infrastructure investment. While substantial progress has been achieved, including passing of a new investment law and several fiscal reforms, other measures, particularly with respect to the labor market, have encountered resistance.

Executive Board Assessment

The Executive Directors commended the authorities on Indonesia's strong growth, as well as success in reducing inflation and balance sheet vulnerabilities. Further progress has also been made in institution-building, especially in the fiscal area. Improved fundamentals, including lower debt and higher reserves, have increased the resilience of Indonesia's economy. The banking system is well capitalized, profitability has improved, and stress tests suggest it is capable of withstanding reasonable adverse shocks. The recent decline in poverty and unemployment is encouraging, but continued economic growth will be needed to improve social conditions.

Looking forward, Directors noted that Indonesia is well positioned to take advantage of continued favorable global conditions. With stronger financial intermediation, especially better availability of long-term financing, additional investment in infrastructure, and an improved investment climate, growth could be sustained in at least the 6-7 percent range needed to alleviate poverty and unemployment.

Directors noted that capital inflows have moderated recently, but acknowledged the authorities' concern about volatile portfolio capital flows and the challenges they pose to macroeconomic management. They emphasized that possible future surges in inflows should be addressed through allowing further rupiah appreciation, intervention to limit excessive exchange rate movements, and additional interest rate cuts, provided that exchange rate appreciation improves the inflation outlook. Directors welcomed a modest further increase in reserves.

Directors recognized that, while some estimates of equilibrium exchange rates suggest a modest undervaluation and although the performance of manufacturing exports has been moderate relative to many competitors, the real effective exchange rate is broadly in line with fundamentals. On balance, Directors endorsed the flexible exchange rate policy and current macroeconomic policy mix. Directors emphasized that continued focus on structural reforms would help to enhance external competitiveness.

Directors commended Bank Indonesia (BI) for its cautious monetary stance and emphasized that convergence of inflation and interest rates with major trading partners would help to reduce capital account volatility. With the 2007 inflation target well within reach, monetary policy should now focus on achieving the 2008 target. While the rupiah appreciation and moderating core inflation have opened room for limited interest rate cuts, the BI needs to exercise caution, keeping in mind the lags in monetary policy transmission.

Directors felt that the recent relaxation in prudential regulations to encourage lending is not likely to have much of an impact, as demand constraints are mostly at play, but were concerned that the departure from international standards could risk sending an adverse signal to supervisors and banks alike. They, therefore, encouraged BI to reconsider the measures as soon as possible. Directors also noted that moral suasion to encourage banks to lend to specific sectors could result in credit misallocation. Instead, steps to promote the development of capital markets and longer-term financing instruments would be more effective in expanding lending while helping to preserve the soundness of the financial sector. In addition, a strategy on the future role of state banks is needed. Directors encouraged the authorities to undertake a Financial Sector Assessment Program.

Directors supported the authorities' fiscal stance and felt that the modest relaxation in deficit targets for 2007 and 2008 would give the authorities some room for additional development spending. However, they viewed that the authorities should not go beyond the deficit levels currently envisaged for 2007-08, given the potential negative consequences of higher debt financing. Further improvements in tax administration, some new tax measures, and the streamlining of expenditures, including through greater flexibility of energy prices, could create additional space for priority spending. Enhancing the implementation capacity of local government would also contribute to this effort.

Directors commended the authorities on the good progress made in fiscal reform. They welcomed the completion of the restructuring of the tax agency and the recent adoption of a key tax reform bill. Directors welcomed the planned introduction of a fiscal risk statement and the medium-term fiscal framework in the 2008 budget and urged early passage of tax bills still in Parliament.

Directors commended the authorities on the passage of the investment law. They encouraged the authorities to focus on increased infrastructure spending, both through direct budget spending to the extent possible and by facilitating public-private partnerships in infrastructure. The authorities should also alleviate the burden of severance payments on employment generation.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.