Commentary: Indonesia needs investment to head off stagflation
By Andy Mukherjee Bloomberg News

TUESDAY, MARCH 7, 2006

The Indonesian authorities are faced with the unenviable task of fighting inflation in a slowing economy. Ever since the Indonesian government cut its pernicious fuel subsidies in October, more expensive gasoline and diesel have pushed up the inflation rate to more than 17 percent, compared with an average of 8 percent in the first nine months of 2005.

In three aggressive moves in the fourth quarter, the central bank increased its benchmark one-month interest rate, which was 10 percent before the spike in energy prices, to 12.75 percent. The increase in borrowing costs had a dual objective of stabilizing the rupiah, which had crashed to a four-year low in August, and arresting the relentless surge in consumer prices.

The first objective has been met successfully - too successfully, some would say - even as the second goal eludes: The Indonesian rupiah is now 10.7 percent dearer against the U.S. dollar than it was on Sept. 30. Inflation, however, still hovers close to 18 percent.

The International Monetary Fund in Washington is advising Bank Indonesia to "maintain a tightening bias" in monetary policy until "inflation shows clear signs of abating."

The central bank left its benchmark interest rate unchanged for the third straight month Tuesday, a decision most private-sector economists had been expecting because investment growth has collapsed even as a rising currency threatens to hurt exports.

Indonesia's gross domestic product expanded 4.9 percent in the final three months of 2005 from a year earlier, the slowest pace of growth in six quarters. According to an International Monetary Fund assessment, released last week, gross domestic product will expand between 4.5 percent and 5 percent this year.

That may be unacceptable to the new economic team of Coordinating Minister Boediono and Finance Minister Sri Mulyani Indrawati, who were appointed in December. President Susilo Bambang Yudhoyono gave them the task of restoring investor confidence and raising annual growth to at least 6 percent, the minimum pace required to create jobs and reduce poverty.

At least for the first half of the year, the ministers should not hope for much accommodation from the central bank, whose immediate priority must be to tackle inflation.

Most of the current year's rice crop is set to be harvested in March and April. That may ease food prices. At the same time, an expected increase in electricity tariffs could push up the overall inflation rate by one percentage point or more. What is not known is how soon that might be.

Until there is more clarity on the future path of inflation, it may be suicidal for Bank Indonesia to start easing rates to support growth. Its priority should be to establish the credibility of its inflation-targeting mechanism.

Stoking economic growth should be squarely the responsibility of the Finance Ministry. The budget deficit last year was less than 1 percent of GDP. That offers the government some leeway to spend more on public works.

Finance Minister Sri Mulyani is quite correct to "frontload" into the first quarter of this year about $1.4 billion of investment plans carried over from last year.

Fiscal pump-priming by itself will not be enough. A lot is riding on a long-awaited policy on improving the business climate.

From unfriendly taxation policies and cumbersome customs procedures to rigid labor laws and a legal system that refuses to recognize precedent, much in Indonesia needs to be fixed before the $276 billion economy can at least double the $8.9 billion in foreign direct investment it received last year.

A January survey by PricewaterhouseCoopers said that Indonesia was the third-most-difficult country for miners.

Exxon Mobil and the Indonesian state-owned oil company Pertamina have quarreled for more than four years over control of Cepu, the nation's biggest untapped oil field, even as oil production and exports decline.

Retrenchment costs in Indonesia amount to 145 weeks of wages, the sixth-highest in the world.

Boediono has made it clear that Indonesia's economic growth over the medium term should be supported by investment, which rose less than 2 percent from a year earlier in the fourth quarter of 2005.

A revival in investment is vital because consumer demand, which was buoyant in the fourth quarter despite rising fuel prices, may not be sustained while inflation remains a threat.

Automobile sales dropped 41 percent in January, the biggest decline in almost seven years.

A hawkish monetary policy coupled with a somewhat relaxed fiscal stance and an aggressive plan for improving the investment climate might be the only prudent course open to the Indonesian authorities while the U.S. Federal Reserve is still in a tightening mode.

Such a strategy might not lead to spectacular economic growth, though an inflation rate at or below the central bank's target of 9 percent this year will put Indonesia on track for a better 2007.

The Indonesian authorities are faced with the unenviable task of fighting inflation in a slowing economy. Ever since the Indonesian government cut its pernicious fuel subsidies in October, more expensive gasoline and diesel have pushed up the inflation rate to more than 17 percent, compared with an average of 8 percent in the first nine months of 2005.

In three aggressive moves in the fourth quarter, the central bank increased its benchmark one-month interest rate, which was 10 percent before the spike in energy prices, to 12.75 percent. The increase in borrowing costs had a dual objective of stabilizing the rupiah, which had crashed to a four-year low in August, and arresting the relentless surge in consumer prices.

The first objective has been met successfully - too successfully, some would say - even as the second goal eludes: The Indonesian rupiah is now 10.7 percent dearer against the U.S. dollar than it was on Sept. 30. Inflation, however, still hovers close to 18 percent.

The International Monetary Fund in Washington is advising Bank Indonesia to "maintain a tightening bias" in monetary policy until "inflation shows clear signs of abating."

The central bank left its benchmark interest rate unchanged for the third straight month Tuesday, a decision most private-sector economists had been expecting because investment growth has collapsed even as a rising currency threatens to hurt exports.

Indonesia's gross domestic product expanded 4.9 percent in the final three months of 2005 from a year earlier, the slowest pace of growth in six quarters. According to an International Monetary Fund assessment, released last week, gross domestic product will expand between 4.5 percent and 5 percent this year.

That may be unacceptable to the new economic team of Coordinating Minister Boediono and Finance Minister Sri Mulyani Indrawati, who were appointed in December. President Susilo Bambang Yudhoyono gave them the task of restoring investor confidence and raising annual growth to at least 6 percent, the minimum pace required to create jobs and reduce poverty.

At least for the first half of the year, the ministers should not hope for much accommodation from the central bank, whose immediate priority must be to tackle inflation.

Most of the current year's rice crop is set to be harvested in March and April. That may ease food prices. At the same time, an expected increase in electricity tariffs could push up the overall inflation rate by one percentage point or more. What is not known is how soon that might be.

Until there is more clarity on the future path of inflation, it may be suicidal for Bank Indonesia to start easing rates to support growth. Its priority should be to establish the credibility of its inflation-targeting mechanism.

Stoking economic growth should be squarely the responsibility of the Finance Ministry. The budget deficit last year was less than 1 percent of GDP. That offers the government some leeway to spend more on public works.

Finance Minister Sri Mulyani is quite correct to "frontload" into the first quarter of this year about $1.4 billion of investment plans carried over from last year.

Fiscal pump-priming by itself will not be enough. A lot is riding on a long-awaited policy on improving the business climate.

From unfriendly taxation policies and cumbersome customs procedures to rigid labor laws and a legal system that refuses to recognize precedent, much in Indonesia needs to be fixed before the $276 billion economy can at least double the $8.9 billion in foreign direct investment it received last year.

A January survey by PricewaterhouseCoopers said that Indonesia was the third-most-difficult country for miners.

Exxon Mobil and the Indonesian state-owned oil company Pertamina have quarreled for more than four years over control of Cepu, the nation's biggest untapped oil field, even as oil production and exports decline.

Retrenchment costs in Indonesia amount to 145 weeks of wages, the sixth-highest in the world.

Boediono has made it clear that Indonesia's economic growth over the medium term should be supported by investment, which rose less than 2 percent from a year earlier in the fourth quarter of 2005.

A revival in investment is vital because consumer demand, which was buoyant in the fourth quarter despite rising fuel prices, may not be sustained while inflation remains a threat.

Automobile sales dropped 41 percent in January, the biggest decline in almost seven years.

A hawkish monetary policy coupled with a somewhat relaxed fiscal stance and an aggressive plan for improving the investment climate might be the only prudent course open to the Indonesian authorities while the U.S. Federal Reserve is still in a tightening mode.

Such a strategy might not lead to spectacular economic growth, though an inflation rate at or below the central bank's target of 9 percent this year will put Indonesia on track for a better 2007.
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