Country Report No. 07/272: Indonesia: 2007 Article IV Consultation - Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Indonesia

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Executive Summary

• Macroeconomic policies have been geared successfully towards promoting stability while supporting growth.
• The economy has been growing at about 6 percent over the past year, fuelled by a recovery in domestic demand and strong export performance. Bank and corporate balance sheets have strengthened while the public debt-to-GDP ratio continues to trend down. The current account remains in surplus and international reserves have risen.
• Growth is expected to continue at the same pace for the rest of the year and pick up modestly over the medium term, driven mainly by domestic demand. This assumes a significant increase in investment, especially in infrastructure.
• Inflation reached a six-month low in May allowing Bank Indonesia (BI) to continue its easing stance. The policy rate has been reduced by 425 basis points since the easing cycle began in May last year.
• Indonesia’s strengthening fundamentals and yield differentials have recently attracted significant, though volatile, portfolio inflows, resulting in appreciation pressures on the rupiah.

Policy Discussions
• On policies to address the portfolio inflows, staff and authorities agreed that allowing the rupiah to appreciate while intervening to avoid disruptive changes in the exchange rate would be the best way to deal with the capital influx. Moreover, appreciation would help to dampen inflation further and allow BI to cut interest rates, in turn helping to moderate capital inflows and ease concerns about a sudden reversal.
• Monetary policy discussions focused on the need to exercise caution in reducing interest rates to ensure that the inflation target for 2008 is met.
• Fiscal policy, targeting 1.7–1.8 percent of GDP deficits for 2007 and 2008, is appropriately geared to further reducing the public debt burden, while providing space for some additional spending on infrastructure, a major bottleneck to sustainable growth.
• Staff and authorities agreed on the need to strengthen the nonbank financial sector and long-term financing. Several prudential regulations have been eased in order to encourage banks to lend. BI believes strong risk management practices at banks will help to limit risks, but they plan to review the changes next year. Staff believe such measures send the wrong signals to banks and supervisors.
• Successful implementation of the new structural reform agenda, including reducing infrastructure bottlenecks, passage of the tax law currently in parliament and modification of labor regulations, would help attract investment, create jobs and raise productivity, thus accelerating growth, reducing poverty, and supporting stability.
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