Extracted from East Asia Update report from World Bank http://siteresources.worldbank.org/INTEA...ate-Nov2007.pdf

Indonesian Investment Climate

The last six months have witnessed a pick-up in the
momentum of growth. After a moderate slowdown in 2005,
economic growth in Indonesia has increased appreciably.

By 2Q 2007, year-on-year growth was up to 6.3 percent
compared with 5 percent in early 2006. Most monthly
indicators signal a further rise in the third quarter of 2007,
despite recent turbulence in international financial and oil

The main drivers of recent growth have been
investment and net exports. Investment growth has been
running around 7-8 percent per annum since 2Q 2006 with
indications of a further pick-up in the near-term. For their
part, net exports were neutral or a slight drag on growth in
the second half of 2006. In the first half of 2007, they added
more than 1 percent to growth in GDP. In nominal terms,
exports have surged to record levels, owing only in part to
the world commodity price boom. Exports of agricultural
and mining and mineral commodities (accounting for about
1/3 of merchandise exports) increased by 18 and 42 percent
in US$ terms respectively earlier this year. Exports of
manufactured products (which account for almost half of the
total) also increased at a robust rate of 15 percent; with
forestry products up by 24 percent.

Reflecting the strength in exports, the current
account surplus is projected to widen further to US$10.8
billion in 2007 (some 2 1/2 percent of GDP) versus virtual
balance in 2005. Some of these recent gains have been
offset by the capital account, which is currently projected to
record a narrower surplus in 2007 than the year before. Net
international reserves have climbed steadily during this
period, to almost US$53 billion in late September,
compared with US$42.6 billion at end-2006.

Financial markets quickly absorbed the recent
turbulence in international markets with what appears to be
minimal disruption of overall economic performance to
date. As examples, the Jakarta Stock Exchange, after
plunging by 20 percent in the 3 weeks between late July and
mid-August, rebounded quickly and was back at record
highs by mid-October. The rupiah exchange rate, which
was around 9000/US$ in the months prior to the turmoil,
slid to 9500, before recovering to 9100 by early October.

Medium- and long-term interest rates rose by some 200
basis points across the yield spectrum during the crisis. As
of early September, the yield curve had reversed about half
of the rise, and there was a further moderate improvement
(especially at the shorter end of the spectrum) through early

Inflation has been a growing concern recently. It
fell dramatically in the wake of the major 2005 fuel price
increases from a high of 18.4 percent (y-o-y) to 5.3 percent
in November 2006. However since then inflation has been
creeping higher, reaching 6.9 percent by October, very near
the upper end of Bank Indonesia’s target band of 5-7
percent by end-2007. Foodstuffs, which account for almost
25 percent of the CPI in Indonesia, have been the main
source of inflation in the past several months; they have
outpaced general inflation since early 2006, often by several
percentage points. By contrast, administered prices (fuel,
transportation and electricity among others) have been
holding down inflation during the past year, running at less
than 2 percent (measured on a 12-month basis).

Reflecting concerns about inflation, Bank
Indonesia held its key policy rate steady at 8.25 percent
since early July. This shift in stance followed a series of
cuts in steps of 25-50 basis points from a peak of 12.75
percent in April 2006. Reflecting the stronger economy,
including investment, credit growth has accelerated in 2007,
reaching 22 ½ percent (y-o-y) by August.

Fiscal deficits have narrowed significantly in
recent years, from above 4 percent of GDP in 1998 to 0.5
percent in 2005. However, the deficit widened a little to 0.9
percent of GDP in 2006, and it looks likely to widen further
in 2007, to 1.5 percent of GDP. This wider deficit stems, in
part, from temporary factors (e.g., large, once-only
settlements of arrears in payment of VAT refunds and
spending for disaster relief). But it also reflects more lasting
factors, e.g., increased spending on priorities, including
health, education and infrastructure. Notwithstanding these
wider deficits, the ratio of government debt to GDP is
projected to continue to decline, from 39 percent at end-
2006 to less than 35 percent by end-2007, owing to
continued strong growth.

The incidence of poverty dropped in 2007, to 16.6
percent from 17.8 percent in 2006. This reverses about 75
percent of the deterioration in 2006. Analysis of this latest
data is underway but it appears that strong economic
growth, falling inflation and targeted cash transfers
contributed to the decline in 2007. Nevertheless, a large
proportion of the population remains vulnerable with many
households tightly clustered around the poverty line.

Viewed in relation to the eight Millennium Development
Goals (MDGs), poverty alleviation (as measured by the
percentage of the population living on US$1/day) is one of
Indonesia’s successes. Other MDG successes include:
enrollment in primary schools; child mortality; and access to
improved water facilities. Other indicators are less positive, but overall the majority of Indonesia’s indicators are ontrack
to achieve the MDGs Reform momentum continues, especially in
budgeting and investment climate reforms. The Government
is using increased fiscal space to scale up spending on
poverty alleviation through a large National Community
Empowerment Program and two conditional cash transfer
pilots, one directed at households and the other at
communities. The 2008 budget proposes a substantial
reallocation of spending to priority areas, including
infrastructure, education and social assistance. In July 2007
the Government issued an integrated economic policy
package aimed at improving the investment climate and
building upon a series of individual policy packages issued
in 2006 covering investment policy, infrastructure, financial
sector reform and SME policy. The Government has
established teams to monitor progress on each part of the
package and has designated a minister responsible for each
item. There have been a number of specific reform
initiatives as well, including passage of an investment law
and associated regulations on the negative list designed to
improve transparency. There was also a new tax
administration law that addresses business concerns about
arbitrary treatment and a Government Regulation in lieu of
Law that clarifies the status of Batam (Indonesia’s largest
and most active free trade zone).

Looking ahead, growth is expected to reach 6.3
percent for 2007 as a whole and to rise a bit further, to 6.4
percent in 2008. Investment is expected to remain strong,
but exports are expected to slow modestly, due to the
projected slowdown in the world economy. A mild fiscal
stimulus will help growth prospects with the slight widening
of the budget deficit to 1.8 percent of GDP. Spending on
pro-poor programs and key priority areas such as
infrastructure and social programs (poverty reduction) while
increase (in part through a reallocation from fuel subsidies),
while achieving reductions in government debt (measured as
share of GDP).
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