indonesian economic outlook

Economic Research BureauDirectorate of Economic Research and Monetary Policy

2008-2012Indonesian Economic Outlook

ASEAN Economic Integration and the National Economic Outlook

January 2008

January 2008

Economic Research BureauEconomic Research BureauEconomic Research BureauEconomic Research BureauEconomic Research BureauDirectorate of Economic Research and Monetary PolicyDirectorate of Economic Research and Monetary PolicyDirectorate of Economic Research and Monetary PolicyDirectorate of Economic Research and Monetary PolicyDirectorate of Economic Research and Monetary Policy

Indonesian Economic Outlook

ASEAN Economic Integration andthe National Economic Outlook

Daftar Pustaka

ii Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Editors-in-Chief:Editors-in-Chief:Editors-in-Chief:Editors-in-Chief:Editors-in-Chief:

Made Sukada

Editorial Team:Editorial Team:Editorial Team:Editorial Team:Editorial Team:

Wijoyo Santoso

Endy Dwi Tjahjono

Harmanta

Hidayah Dhini Ari

Ferry Kurniawan

Haris Munandar

Oki Hermansyah

Myrnawati Savitri

The editorial team would like to thank the following members of the Focus Group Discussionsfor their participation, information and suggestions: Ministry of Finance, Ministry of Trade, Na-tional Development Planning Agency (BAPPENAS), Institute of Economic and Social Research ofthe University of Indonesia (LPEM-UI), Bogor Agricultural Institute (IPB), Indonesian Instituteof Sciences (LIPI), the Centre for Strategic and International Studies (CSIS), Indonesian Cham-ber of Commerce and Industry (KADIN), Indonesian Association of Automotive Manufacturers(GAIKINDO) and the Indonesian Textile Industries Association (API).This assessment is the result of analysis and research by the economic research team at theDirectorate of Economic Research and Monetary Policy (DKM). The assessment represents solelythe opinions of the team and does not necessary present or reflect the official opinions of BankIndonesia.

Daftar Pustaka

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition iii

TABLE OF CONTENTSTABLE OF CONTENTSTABLE OF CONTENTSTABLE OF CONTENTSTABLE OF CONTENTS

LIST OF TABLESLIST OF TABLESLIST OF TABLESLIST OF TABLESLIST OF TABLES ......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... vvvvv

LIST OF GRAPHSLIST OF GRAPHSLIST OF GRAPHSLIST OF GRAPHSLIST OF GRAPHS ......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... viiviiviiviivii

LIST OF DIAGRAMSLIST OF DIAGRAMSLIST OF DIAGRAMSLIST OF DIAGRAMSLIST OF DIAGRAMS ............................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... viiiviiiviiiviiiviii

CHAPTER 1 - GENERAL REVIEWCHAPTER 1 - GENERAL REVIEWCHAPTER 1 - GENERAL REVIEWCHAPTER 1 - GENERAL REVIEWCHAPTER 1 - GENERAL REVIEW ..................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... 11111

1.1 The World and Indonesian Economy ........................................................................ 1

1.2 Indonesian Economic Outlook, 2008-2012 .............................................................. 4

1.3 Implications for Macroeconomic and Sectoral Policy ................................................. 5

CHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMYCHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMYCHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMYCHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMYCHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMY ................................................................................................................................................................................................... 77777

2.1 Overview of the World Economy .............................................................................. 7

2.2 Overview of the Indonesian Economy ...................................................................... 10

2.2.1 Indonesian Economic Indicators ..................................................................... 10

2.2.2 Sectoral Developments in the National Economy ............................................ 14

2.2.3 Real Sector and Macroeconomic Policy .......................................................... 17

CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:

IMPLICATIONS FOR THE INDONESIAN ECONOMYIMPLICATIONS FOR THE INDONESIAN ECONOMYIMPLICATIONS FOR THE INDONESIAN ECONOMYIMPLICATIONS FOR THE INDONESIAN ECONOMYIMPLICATIONS FOR THE INDONESIAN ECONOMY .............................................................................................................................................................................................................................................................................................................................................................. 1919191919

3.1 Background to Establishment of the ASEAN Economic Community .......................... 20

3.2 Dynamics of the ASEAN Economy ............................................................................ 22

3.3 Conceptual Review of Economic Integration Theory ................................................. 25

3.4 AEC and Implications for Welfare ............................................................................. 28

3.4.1 Impact on Trade in Goods .............................................................................. 28

3.4.2 Impact on Investment, Growth and Poverty ................................................... 29

3.4.3 Impact on Labour Conditions ......................................................................... 30

3.5 AEC and Post-Integration Distribution of Output ...................................................... 32

3.6 AEC 2015 and the Monetary Authority Role ............................................................ 34

3.7 Policy Implications .................................................................................................... 35

3.7.1 Improvements to the Investment Climate and Institution Building .................. 35

3.7.2 Preparation at the Sectoral Level .................................................................... 36

CHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOKCHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOKCHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOKCHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOKCHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOK ............................................................................................................................................................................................................................................................................................................................................... 4141414141

4.1 Assumptions for the Global Economy, 2008-2012 .................................................... 41

a. World Economic Growth ...................................................................................... 41

b. World Commodity Prices ...................................................................................... 42

c. International Interest Rates ................................................................................... 43

d. Global FDI Inflows ................................................................................................ 43

4.2 Assumptions for the Indonesian Economy, 2008-2012 ............................................. 44

a. Government Financial Condition .......................................................................... 44

b. Domestic Interest Rates ........................................................................................ 44

c. FDI Inflows ........................................................................................................... 44

Table of Contents

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iv Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Table of Contents

4.3 Projection for the Indonesian Economy, 2008-2012 ................................................. 45

4.4 Policy Implications .................................................................................................... 47

4.4.1 Macroeconomic Policy (Monetary and Fiscal) .................................................. 47

4.4.2 Microeconomic (Structural) Policies ................................................................ 47

CHAPTER 5 - TOPICAL ISSUESCHAPTER 5 - TOPICAL ISSUESCHAPTER 5 - TOPICAL ISSUESCHAPTER 5 - TOPICAL ISSUESCHAPTER 5 - TOPICAL ISSUES ............................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... 4949494949

5.1 Mobility of Production Factors, Distribution and Regional Economic Integration ....... 49

5.1.1 Background and Motivation ........................................................................... 50

5.1.2 Economic Modelling ...................................................................................... 52

5.1.3 Policy Implications .......................................................................................... 53

5.1.4 Epilogue ........................................................................................................ 54

5.2 Regional Economic Integration, Investment and the Role of Monetary Authority ...... 54


5.2.2 Data and Analysis Method ............................................................................. 55

5.2.3 Short Run Analysis ......................................................................................... 57

5.2.4 Long Run Analysis .......................................................................................... 57

5.2.5 Conclusions ................................................................................................... 58

5.3 Impact of Proximity on Provincial Commodity Exports: Gravity Model Approach ....... 58

5.3.1 Overview of Exports by Indonesias Provinces ................................................. 60

5.3.2 Model and Estimates ..................................................................................... 60

5.3.3 Estimate Results ............................................................................................. 61

5.3.4 Conclusions ................................................................................................... 62

5.4 Human Capital Formation, Income Inequalities and Economic Integration:

A Meta-Analysis ....................................................................................................... 62


5.4.2 Education, Openness and Income Inequalities ................................................ 62

5.4.3 Overlapping Generation Economic Model, Heterogeneity and Economic

Integration ..................................................................................................... 64

5.4.4 Role of Human Capital in Conditions of Equilibrium ....................................... 65

BIBLIOGRAPHYBIBLIOGRAPHYBIBLIOGRAPHYBIBLIOGRAPHYBIBLIOGRAPHY ......................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................................... 6666666666

Daftar Pustaka

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition v

LIST OF TABLESLIST OF TABLESLIST OF TABLESLIST OF TABLESLIST OF TABLES

Table 1.1 Projections .............................................................................................................. 5

Table 2.1 World Commodity Consumption ............................................................................ 8

Table 2.2 Global FDI Inflows, 1997-2006 ............................................................................... 9

Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006 ........................................ 10

Table 2.4 WEF Competitiveness Ratings ................................................................................. 11

Table 2.5 Competitiveness Ratings by IMD ............................................................................. 12

Table 2.6 Ranking of Competitiveness Components ............................................................... 12

Table 2.7 Findings of Survey on Doing Business ..................................................................... 13

Table 2.8 Progress, Implementation of Presidential Instruction No. 6 of 2007 ......................... 17

Table 3.1 Economic Indicators for ASEAN* ............................................................................ 23

Table 3.2 Labour Productivity in ASEAN ................................................................................. 23

Table 3.3 Intraregional Exports from Exporting Countries as Share of Total Exporting Country

Trade ...................................................................................................................... 24

Table 3.4 Total Exports from Exporting Countries to Export Destinations as Share of Total

Exporting Country Trade ......................................................................................... 24

Table 3.5 Export Commodities from Exporting Countries to Export Destinations as Share of

Total Exporting Country Trade ................................................................................. 24

Table 3.6 Intra-Industry Trade (IIT) Index for ASEAN-5 by Sector over 5 Years .......................... 25

Table 3.7 Intra-Industry Trade (IIT) Index for Indonesia by Sector over 5 Years ......................... 25

Table 3.8 Migrant Workers in ASEAN, 2006 (thousands) ........................................................ 31

Table 3.9 FDI Outcomes and Employment .............................................................................. 32

Table 3.10 Basic Indicators for ASEAN ...................................................................................... 33

Table 3.11 Human Development Indicators for ASEAN ............................................................. 33

Table 3.12 Competitiveness Components, Selected ASEAN Members ...................................... 33

Table 3.13 Condition of ASEAN Infrastructure ......................................................................... 34

Table 4.1 Projection of Global FDI Inflows, 2008-2011 ........................................................... 44

Table 4.2 Basic Domestic Assumptions ................................................................................... 45

Table 4.3 Projections .............................................................................................................. 47

Table 5.1 Investment Growth and Macroeconomic Performance in Thailand .......................... 56

Table 5.2 Investment Growth and Macroeconomic Performance in Indonesia ........................ 56

Table 5.3 Investment Growth and Macroeconomic Performance in Cambodia ....................... 56

Table 5.4 Investment Growth and Macroeconomic Performance in Singapore ........................ 56

List of Tables

Daftar Pustaka

vi Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

List of Tables

Table 5.5 Investment Growth and Macroeconomic Performance in Malaysia .......................... 56

Table 5.6 Investment Growth and Macroeconomic Performance in the Philippines ................. 56

Table 5.7 Investment Growth and Macroeconomic Performance in Vietnam .......................... 56

Table 5.8 Inward FDI and Macroeconomic Performance - 2006 Reference Year ...................... 57

Table 5.9 Inward FDI and Macroeconomic Performance 2002-2006 Reference Period ......... 57

Table 5.10 Contribution by Province to Non-Fuel Exports and Imports ...................................... 58

Table 5.11 Major Export Commodities and Exporting Regions .................................................. 59

Table 5.12 Gravity Model Estimates ......................................................................................... 61

Daftar Pustaka

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition vii

LIST OF GRAPHS

Graph 2.1 Contributions to World Growth .............................................................................. 7

Graph 2.2 Contributions to World Growth .............................................................................. 7

Graph 2.3 Oil Prices, Demand and Production Capacity ........................................................... 8

Graph 2.4 Non-Fuel Primary Commodity Prices ....................................................................... 8

Graph 2.5 World Commodity Supply ....................................................................................... 9

Graph 2.6 Global FDI Inflows and Mergers & Acquisitions ....................................................... 9

Graph 2.7 GDP Growth 1989-2007 ........................................................................................ 10

Graph 2.8 Inflation 1989 2007 ............................................................................................. 11

Graph 2.9 The Most Problematic Factors for Doing Business .................................................... 12

Graph 2.10 Time Required for Business Licensing (days) ............................................................ 13

Graph 2.11 Most Attractive Venues for FDI (number of responses) ............................................ 13

Graph 2.12 Risk Indices ............................................................................................................. 14

Graph 2.13 Criteria for Determination of FDI Venues (Percentage of Responses) ........................ 14

Graph 2.14 Sectoral Share of GDP ............................................................................................ 15

Graph 2.15 Sectoral Investment ................................................................................................ 15

Graph 2.16 Sectoral Dynamics of Capital Stock ......................................................................... 15

Graph 2.17 Sectoral Growth of Capital Stock ............................................................................ 15

Graph 2.18 BI Rate and Inflation ............................................................................................... 18

Graph 4.1 World Economic Growth and Volume of World Trade ............................................. 42

Graph 4.2 World Oil Price History and Projections .................................................................... 42

Graph 4.3 World Commodity Prices, 1906-2006 ..................................................................... 43

Graph 4.4 Trend in Fiscal policy ............................................................................................... 44

List of Graphs

Daftar Pustaka

viii Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

LIST OF DIAGRAMS

Diagram 4.1 Structural Reforms, Aggregate Supply and Performance of the Indonesian Economy 45

List of Diagrams

Daftar Pustaka

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition ix

F O R E W O R DDEPUTY GOVERNOR OF BANK INDONESIA FOR MONETARY POLICY

FOR PUBLICATION

OF THE INDONESIAN ECONOMIC OUTLOOK, JANUARY 2008 EDITION

The Directorate of Economic Research and Monetary Policy has completed an in-depth study on

the medium-term outlook for the Indonesian economy (2008-2012). The findings of this study have

been carefully organised for presentation in this January 2008 edition of the Indonesian Economic Outlook.

My congratulations for this achievement.

The Indonesian Economic Outlook is a regular semi-annual publication by Bank Indonesia forming

a vital component of a wide range of analyses by many units at Bank Indonesia. The description of the

constellation of the economy, the main study themes, projections and topical issues all serve as a strategic

window on the future condition of the Indonesian economy.

The main topic chosen for this edition is: ASEAN Economic Integration and the National Economic

Outlook. As the monetary authority in this republic, Bank Indonesia has the statutory obligation of

working consistently for low, stable inflation. This low, stable inflation will bring improvement to the

investment climate, which in turn will stimulate greater investment and bring significant expansion in

the stock of capital. This book describes how prudent monetary policy is proven to be a pro-investment

policy, particularly in gearing for the ASEAN Economic Community (AEC) in 2015.

However, investment is hampered by various issues that unfortunately still beset this nation. It is

essential that policy makers, including Bank Indonesia, make use of the dynamics of the global and

domestic economy in the creative design and earnest implementation of a range of policies for

improvement of the investment climate. In the medium-term, the most relevant and effective policy for

the Indonesian economy is a structural policy for strengthening aggregate supply.

The effects of structural flaws will undeniably have a negative impact on inflation and

macroeconomic stability, and therefore the design and implementation of structural policies is not

only the domain of the Government, but also represents a concern of Bank Indonesia. Significant

strengthening in aggregate supply is not only intended to create opportunities and build capacity

among the poor, but is also a prerequisite for high economic growth without sacrificing price stability.

To build the productivity and efficiency of the economy, determined, unswerving effort is necessary to

incorporate FDI-led investment growth, improvement in the quality of our nations human capital and

broader, more intensive transfer of technology into the spirit of each and every policy at the national,

regional and sectoral level.

Foreword

Daftar Pustaka

x Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Finally, on behalf of the Board of Governors of Bank Indonesia, I would like to express my sincere

appreciation to the Editorial Team. May the Almighty God always bestow His Blessing on our work and

lighten our steps on the journey to a better future.

DEPUTY GOVERNOR OF BANK INDONESIADEPUTY GOVERNOR OF BANK INDONESIADEPUTY GOVERNOR OF BANK INDONESIADEPUTY GOVERNOR OF BANK INDONESIADEPUTY GOVERNOR OF BANK INDONESIA

Hartadi A. SarwonoHartadi A. SarwonoHartadi A. SarwonoHartadi A. SarwonoHartadi A. Sarwono

Foreword

Outlook Ekonomi Indonesia 2008 - 2012, Edisi Januari 2008 xi

PREFACE

Let us offer our praise and thanksgiving to the Almighty God, by Whose pleasure the book on the

Indonesian Economic Outlook 2008-2012, edition IV January 2008, has successfully reached completion.

In departure from past publications of the Outlook, this edition examines opportunities and challenges

as Indonesia gears for the ASEAN Economic Community (AEC) in 2015 and the relevant implications for

the Indonesian economy. The issue of economic integration has been given special focus in view of the

agreement reached by Indonesia and nine other ASEAN members in November 2007 on the blue print

for establishment of the ASEAN Economic Community in 2015. This represents a joint commitment to

building a stable, prosperous and highly competitive region with balanced economic growth and reduction

in poverty and socio-economic disparities. There is a growing need for assessment of Indonesias economic

fundamentals and the economic integration of ASEAN to support medium to long-term analyses and

projections on the direction of the economy over the coming five years. For this reason, the Indonesian

Economic Outlook has been developed as a regular product of the Economic Research Office of the

Directorate of Economic Research and Monetary Policy at Bank Indonesia.

The economic projections in this Edition IV of the Indonesian Economic Outlook are intended for

use as internal reference for the units at Bank Indonesia in their medium-term analyses and projections,

including assessments and formulation of Destination Statements in the Strategic Forum (FORSTRA) held

each year, and as a source of information for Bank Indonesia stakeholders. Information and data in these

projections is updated on an ongoing basis. The publication of the Indonesian Economic Outlook is the

culmination of a sincere desire to help place the Indonesian economy on a better course for the benefit

of all who call this country their home.

Jakarta, January 2008

Directorate of Economic Research and Monetary Policy

MADE SUKADAMADE SUKADAMADE SUKADAMADE SUKADAMADE SUKADA

Director

Preface

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Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

1

In the last five years, the world economy has

been marked by a high growth above the historical

average (more than 4%), steadily expanding global

FDI inflows and soaring prices for oil and non-oil

commodities, all leading to added world

inflationary pressure. During the same period, the

Indonesian economy has also seen accelerated

growth, albeit at a moderate level, a low

investment-to-GDP ratio in comparison to the pre-

crisis period despite rising net FDI inflows, and

average inflation slightly above that of the pre-crisis

years triggered mainly by the fuel price hikes in

2005.

In 2008-2012, growth in the world economy

and volume of world trade is predicted to remain

strong, while oil and gas and non-oil commodity

prices will hold above their historical averages. In

the domestic economy, macroeconomic stability

is forecasted to continue with Indonesias fiscal

condition within safe limits accompanied by

steadily rising inflows of FDI. Based on these

assumptions for the world and domestic economic

conditions, the Indonesian economy is predicted

to see further improvement in 2008-2012, with

more vigorous, higher quality economic growth

and falling inflation. This economic outlook is

based on optimism for policy synergy between

Government and Bank Indonesia in maintaining

macroeconomic stabil ity and steady

improvements in the investment climate,

infrastructure, employment and business certainty

through real sector policies. Indonesias

macroeconomic stability and vast market potential

represent two major attractions for international

investors, and for this reason, FDI is predicted to


keep pouring into Indonesia and support strong

investment growth. With investment on the rise,

the economy is expected to chart higher, better

quality growth alongside reduced inflation. A

further benefit will be improvement in real public

purchasing power, which augurs for continued

high growth in consumption. At the same time,

conducive external conditions reflected in the

sustained high volume of world trade is predicted

to strengthen the performance of Indonesias

exports. Growing exports and flourishing

investment activity will be followed by a surge of

imports of goods and services that in turn will

diminish the current account surplus. However,

mounting global FDI inflows will provide a safety

valve for the downward pressure on the balance

of payments, thus maintaining relative exchange

rate stability.

For Indonesia to achieve 7.4%-8.0%

economic growth in 2012, stable macroeconomic

conditions will require support from robust

sectoral policies, such as improvement in the

investment climate (including construction of

infrastructure), greater competitiveness and

productivity, and improvements in the quality of

human resources. These conditions are key to

overcoming supply-side l imitations and

stimulating global FDI inflows in support of high,

better quality economic growth.

1.1 The World and Indonesian Economy

The dynamics of the Indonesian economy areThe dynamics of the Indonesian economy areThe dynamics of the Indonesian economy areThe dynamics of the Indonesian economy areThe dynamics of the Indonesian economy are

very closely interlinked with the global and regionalvery closely interlinked with the global and regionalvery closely interlinked with the global and regionalvery closely interlinked with the global and regionalvery closely interlinked with the global and regional

economy and influenced by progress improvementseconomy and influenced by progress improvementseconomy and influenced by progress improvementseconomy and influenced by progress improvementseconomy and influenced by progress improvements

in the investment climate, infrastructure,in the investment climate, infrastructure,in the investment climate, infrastructure,in the investment climate, infrastructure,in the investment climate, infrastructure,

2 Indonesian Economic Outlook 2008 - 2012, January 2008 Edition


productivity, competitiveness and domestic supplyproductivity, competitiveness and domestic supplyproductivity, competitiveness and domestic supplyproductivity, competitiveness and domestic supplyproductivity, competitiveness and domestic supply

constraints. constraints. constraints. constraints. constraints. The world economy has maintained

above 4% growth during the past five years,

surpassing the historical average.1 Key to this

performance is the brisk pace of economic growth

in developing countries (led by China and India)

and Europe. This vigorous growth in the world

economy has been accompanied by surging

volume of world trade volume beyond the long-

term trend.2 Consistent with these developments,

global inflows of foreign direct investment (FDI)

flows have seen rapid expansion. However, this

impressive performance is daunted by burgeoning

world prices for oil and non-oil commodities. The

combination of soaring commodity prices amid

continued strong world economic growth has

fuelled world inflationary pressures.

Central banks have responded in varyingCentral banks have responded in varyingCentral banks have responded in varyingCentral banks have responded in varyingCentral banks have responded in varying

ways to mounting world inflationary pressure asways to mounting world inflationary pressure asways to mounting world inflationary pressure asways to mounting world inflationary pressure asways to mounting world inflationary pressure as

commodity prices remain stubbornly high.commodity prices remain stubbornly high.commodity prices remain stubbornly high.commodity prices remain stubbornly high.commodity prices remain stubbornly high. This is

explained by the move by some central banks to

consider financial market stability and the outlook

for their domestic economies, in addition to

inflationary pressures. The United States Federal

Reserve has given high priority to recovery from

the financial market crisis and stimulus for the

domestic economy, as demonstrated by aggressive

cuts in the Fed Funds Rate to 3.00% in January

2008. On the other hand, the European Central

Bank (ECB) and Bank of Japan (BOJ) appear to give

greater priority to control of domestic inflationary

pressures and have therefore kept interest rates

on hold.

On the domestic front, while Indonesia is ableOn the domestic front, while Indonesia is ableOn the domestic front, while Indonesia is ableOn the domestic front, while Indonesia is ableOn the domestic front, while Indonesia is able

to maintain macroeconomic stability, higher, betterto maintain macroeconomic stability, higher, betterto maintain macroeconomic stability, higher, betterto maintain macroeconomic stability, higher, betterto maintain macroeconomic stability, higher, better

quality growth continues to be hampered by thequality growth continues to be hampered by thequality growth continues to be hampered by thequality growth continues to be hampered by thequality growth continues to be hampered by the

array of structural problems such as the investmentarray of structural problems such as the investmentarray of structural problems such as the investmentarray of structural problems such as the investmentarray of structural problems such as the investment

climate, infrastructure, productivity andclimate, infrastructure, productivity andclimate, infrastructure, productivity andclimate, infrastructure, productivity andclimate, infrastructure, productivity and

competitiveness (supply side). competitiveness (supply side). competitiveness (supply side). competitiveness (supply side). competitiveness (supply side). Part of this is

explained by the post-crisis structure of the

Indonesian economy, supported more by

consumption and exports while investment has had

a much less significant role. The lack of recovery in

investment is demonstrated by the diminishing

share of investment to GDP, particularly in key

sectors of the Indonesian economy such as

manufacturing, agriculture and mining. In all of

this, inflation behaved differently before and after

the crisis with considerably increased volatility in

the post-crisis period. This condition of lower post-

crisis economic growth alongside slightly higher

inflation is an indication of supply-side constraints

impacting aggregate supply,3 rendering the

Indonesian economy more sensitive to price

pressures.

In spite of the problems described above,In spite of the problems described above,In spite of the problems described above,In spite of the problems described above,In spite of the problems described above,

international investors generally see promise ininternational investors generally see promise ininternational investors generally see promise ininternational investors generally see promise ininternational investors generally see promise in

the business outlook and Indonesia is stillthe business outlook and Indonesia is stillthe business outlook and Indonesia is stillthe business outlook and Indonesia is stillthe business outlook and Indonesia is still

regarded an attractive venue for FDI.regarded an attractive venue for FDI.regarded an attractive venue for FDI.regarded an attractive venue for FDI.regarded an attractive venue for FDI. In an

UNCTAD survey in 2007, Indonesia ranked

among the top 15 most attractive countries for

FDI. In addition, Indonesias rating on FDI

performance and potential has seen steady

improvement.4 This is consistent with the

progressive improvement in perceptions of risks

in Indonesia over the years, as show in the

International Country Risk Guide (ICRG).

1 In 1970-2006, world economic growth averaged 3.7%.

2 Average growth in volume of world trade during the 1970-

2006 period came to 6.1%.

3 BIs analysis using the SVAR Blanchard-Quah approach

indicates a steeper post-crisis supply curve compared to the

pre-crisis period. For further analysis, see Nugroho (2007):

Review of the Pre and Post-Crisis Aggregate Supply Curve,

Indonesian Economic Outlook, July 2007 edition.

4 World Investment Report 2007.



3

Furthermore, Indonesia is seen as having a large

potential market and healthy business climate.

In the constellation of the Indonesian andIn the constellation of the Indonesian andIn the constellation of the Indonesian andIn the constellation of the Indonesian andIn the constellation of the Indonesian and

world economy over the past five years, externalworld economy over the past five years, externalworld economy over the past five years, externalworld economy over the past five years, externalworld economy over the past five years, external

factors have contributed in increasingly significantfactors have contributed in increasingly significantfactors have contributed in increasingly significantfactors have contributed in increasingly significantfactors have contributed in increasingly significant

ways to economic developments in Indonesia.ways to economic developments in Indonesia.ways to economic developments in Indonesia.ways to economic developments in Indonesia.ways to economic developments in Indonesia. This

is related to Indonesias growing openness to both

the world economy and the region. A noteworthy

development of significance at the regional level is

the plan to move forward the establishment of the

ASEAN Economic Community (AEC) from 2020 to

2015 with the objective of creating a stable,

prosperous and highly competitive zone with

balanced economic growth and reduction of

poverty and socioeconomic disparities. This is

because economic integration promises greater

prosperity for participating nations through

increased market access and incentives for higher

levels of efficiency and economic competitiveness,

including opportunities for more extensive

absorption of labour.

As a region in its own right, ASEAN offersAs a region in its own right, ASEAN offersAs a region in its own right, ASEAN offersAs a region in its own right, ASEAN offersAs a region in its own right, ASEAN offers

vast economic potential. vast economic potential. vast economic potential. vast economic potential. vast economic potential. In analysis of intra-

ASEAN trade, the Intra-Industry Trade (IIT) index

calculations point to linkages among the various

ASEAN industries that offer strong support for the

ASEAN economic integration process. Using

gravity model applied for five ASEAN nations over

the 1989-2006 period found that the AFTA

agreement is one factor spurring intra-ASEAN

trade.5 In all of this, liberalisation of trade, services

and investment and mobility of labour will affect

labour conditions. For Indonesia, the opportunity

for labour migration is potentially advantageous

in view of the relatively high rate of

unemployment in Indonesia compared to other

ASEAN nations.6 However, the FDI trend in

Indonesia over the past five years indicates a shift

in FDI industry orientation from the secondary to

the tertiary sector. Concerning absorption of

labour, this shift in orientation calls for close

monitoring given that the secondary sector

(manufacturing) has traditionally been the largest

provider of employment.

To optimise the benefits of economicTo optimise the benefits of economicTo optimise the benefits of economicTo optimise the benefits of economicTo optimise the benefits of economic

integration, each country is demanded to expandintegration, each country is demanded to expandintegration, each country is demanded to expandintegration, each country is demanded to expandintegration, each country is demanded to expand

production capacity.production capacity.production capacity.production capacity.production capacity. In this regard, the central bank

has a significant role through monetary policy in

promoting higher levels of investment in order to

accumulate physical capital. Empirical evidence

from data from Thailand, Indonesia, Cambodia,

Singapore, Malaysia, the Philippines and Thailand

(ASEAN-7) for the 1992-2006 period points to a

strong relationship between inflation and

investment in those countries.7 A positive

correlation was also identified between

macroeconomic stability and investment growth.

Both findings indicate that a country with low

inflation and stable macroeconomic conditions will

tend to attract high levels of investment. Central

bank policy aimed at achieving and maintaining

low inflation and stable macroeconomic conditions

can be fittingly described as pro-investment

monetary policy.

5 More complete information on the study findings is

presented in the Box titled Impact of AFTA on ASEAN-5

Export Performance: A Gravity Model Approach in

Chapter 3.

6 According to statistical data taken in 2006, Indonesia and

Myanmar are the two largest labour exporting nations,

accounting for 23% and 27% of total migrant workers in

ASEAN.

7 More complete study findings are presented in Chapter V,

Topical Issue 2 under the title, Regional Economic

Integration, Investment and the Monetary Authority Role.



1.2 Indonesian Economic Outlook, 2008-2012

The overall forecast is for further improvementThe overall forecast is for further improvementThe overall forecast is for further improvementThe overall forecast is for further improvementThe overall forecast is for further improvement

in the Indonesian economy in the coming five yearsin the Indonesian economy in the coming five yearsin the Indonesian economy in the coming five yearsin the Indonesian economy in the coming five yearsin the Indonesian economy in the coming five years

with growth in the range of 7.4%-8.0%. Thiswith growth in the range of 7.4%-8.0%. Thiswith growth in the range of 7.4%-8.0%. Thiswith growth in the range of 7.4%-8.0%. Thiswith growth in the range of 7.4%-8.0%. This

projection assumes that world economic growth andprojection assumes that world economic growth andprojection assumes that world economic growth andprojection assumes that world economic growth andprojection assumes that world economic growth and

volume of world trade remain strong alongsidevolume of world trade remain strong alongsidevolume of world trade remain strong alongsidevolume of world trade remain strong alongsidevolume of world trade remain strong alongside

sustained high prices for oil and natural gas andsustained high prices for oil and natural gas andsustained high prices for oil and natural gas andsustained high prices for oil and natural gas andsustained high prices for oil and natural gas and

non-oil commodities, relative stability in world andnon-oil commodities, relative stability in world andnon-oil commodities, relative stability in world andnon-oil commodities, relative stability in world andnon-oil commodities, relative stability in world and

Indonesian monetary policy, robust fiscal conditionsIndonesian monetary policy, robust fiscal conditionsIndonesian monetary policy, robust fiscal conditionsIndonesian monetary policy, robust fiscal conditionsIndonesian monetary policy, robust fiscal conditions

in Indonesia and rising inflows of FDI in Indonesia.in Indonesia and rising inflows of FDI in Indonesia.in Indonesia and rising inflows of FDI in Indonesia.in Indonesia and rising inflows of FDI in Indonesia.in Indonesia and rising inflows of FDI in Indonesia.

The major sources of this growth will be significant

inflows of FDI stimulated by improvements in the

investment climate with FDI reaching 1.5% of GDP

in 2012, bringing the share of investment to about

30% of GDP that year. In addition, intraregional

trade in the ASEAN and Asia-Pacific is predicted to

become a significant source of economic growth in

the medium-term. On the domestic front, disciplined

monetary policy aimed at safeguarding

macroeconomic stability and a continued fiscal

stimulus will have a vital role in bolstering Indonesias

medium-term economic prospects. The above

economic growth forecast is clearly contingent on

robust structural policies such as improvement in

the investment climate, empowerment of MSMEs,

financial sector reform and improvement in

infrastructure.

These conducive external and domesticThese conducive external and domesticThese conducive external and domesticThese conducive external and domesticThese conducive external and domestic

conditions are expected to generate higherconditions are expected to generate higherconditions are expected to generate higherconditions are expected to generate higherconditions are expected to generate higher

economic growth accompanied by subduedeconomic growth accompanied by subduedeconomic growth accompanied by subduedeconomic growth accompanied by subduedeconomic growth accompanied by subdued

inflation.inflation.inflation.inflation.inflation. Macroeconomic stability in combination

with vast market potential represents a vital draw

card for international investors to keep investing in

Indonesia.8 Steadily expanding inflows of FDI will

be followed by buoyant investment growth, set to

climb from about 9.3% in 2008 to 13.0%-15.0%

in 2012. The brisk investment growth will build

greater economic capacity (read: improvements in

production and distribution) on the supply side,

paving the way for improvement in economic

growth from 6.2% in 2008 to 7.4%-8.0% in 2012

alongside reduced inflation. Low inflation

accompanied by the planned increases in minimum

wage levels will strengthen public purchasing power,

with private consumption predicted to maintain

vigorous growth reaching 5.6%-6.0% in 2012.

With external conditions still conducive,With external conditions still conducive,With external conditions still conducive,With external conditions still conducive,With external conditions still conducive,

Indonesias exports are predicted to improve furtherIndonesias exports are predicted to improve furtherIndonesias exports are predicted to improve furtherIndonesias exports are predicted to improve furtherIndonesias exports are predicted to improve further

alongside mounting global FDI inflows to Indonesia.alongside mounting global FDI inflows to Indonesia.alongside mounting global FDI inflows to Indonesia.alongside mounting global FDI inflows to Indonesia.alongside mounting global FDI inflows to Indonesia.

This will keep the balance of payments in strongThis will keep the balance of payments in strongThis will keep the balance of payments in strongThis will keep the balance of payments in strongThis will keep the balance of payments in strong

shape with a stable trend in the exchange rate.shape with a stable trend in the exchange rate.shape with a stable trend in the exchange rate.shape with a stable trend in the exchange rate.shape with a stable trend in the exchange rate.

The various structural improvements launched by

the Government, dealing with areas such as

infrastructure, licensing, customs and taxation, will

provide significant support for Indonesias export

competitiveness. In addition, the high volume of

FDI will be accompanied by technological

advancements benefiting productivity and

efficiency. However, export growth and flourishing

investment activity will be followed by increased

imports of goods and services, which in turn will

diminish the current account surplus. However,

mounting global FDI inflows will provide a safety

valve for the pressure bearing down on the balance

of payments. The relatively secure condition of the

balance of payments, supported by improving

economic fundamentals, is forecasted to keep the

exchange rate stable.9

8 UNCTAD survey findings state that market size and growth

alongside the quality of the business environment are the

major determining factors in decisions on venues for FDI.

9 This is borne out in survey findings published by UNCTAD

and the Economist Intelligence Unit (EIU) at The Economist,

stating that FDI inflows in Indonesia will remain positive,

particularly because of the size of the domestic market and

considerable potential for expansion seen as adequately

compensating for risks.



5

Higher economic growth, subdued inflation,Higher economic growth, subdued inflation,Higher economic growth, subdued inflation,Higher economic growth, subdued inflation,Higher economic growth, subdued inflation,

a stable exchange rate trend and supply-sidea stable exchange rate trend and supply-sidea stable exchange rate trend and supply-sidea stable exchange rate trend and supply-sidea stable exchange rate trend and supply-side

improvements are predicted to contribute to higherimprovements are predicted to contribute to higherimprovements are predicted to contribute to higherimprovements are predicted to contribute to higherimprovements are predicted to contribute to higher

levels of public prosperity.levels of public prosperity.levels of public prosperity.levels of public prosperity.levels of public prosperity. Robust economic growth

driven by expanding production capacity will

generate employment for the growing workforce,

with unemployment projected to ease to 7.5%-

8.5% in 2012. The increased employment of the

workforce accompanied by falling inflation will also

reduce poverty levels. These medium-term

improvements in the economic outlook will in turn

boost prosperity levels with per capita income

expected to climb from USD 1,980 in 2008 to USD

2,950-3,000 in 2012.

1.3 Implications for Macroeconomic and Sectoral

Policy

The envisaged 7.4%-8.0% economic growth

calls for strong support from macro and sectoral

policies as follows:

a. Monetary policy must maintain a prudent

stance, guiding public expectations of

inflation towards the inflation target while

carefully taking account of the dynamics of

the world and domestic economy.

b. Continuation of the fiscal stimulus for the

economy at the central and regional level over

the next five years without sacrificing long-

term fiscal sustainability. The fiscal stimulus

must be targeted at improving infrastructure,

promoting industry capable of generating high

levels of employment, maintaining public

purchasing power, alleviating poverty and

improving income distribution. A steady

reduction is predicted in the fiscal deficit to

1.4% of GDP at end-2012.

c. Given the importance of physical investment

and human resources to long-term economic

growth, creation of a conducive climate for

investment, infrastructure development,

improved competitiveness and improvement

in human capital will be crucial to building

quality, sustainable economic growth and

readiness for the launching of AEC in 2015.

Concerning this, Presidential Instruction

(Inpres) No. 6 of 2007 concerning Policy for

Accelerated Development of the Real Sector

and Empowerment of Micro, Small and

Medium Enterprises (MSMEs), which covers:

1) Improvements in the Investment Climate,

2) Financial Sector Reform, 3) Accelerated

Construction of Infrastructure and 4)

Empowerment of MSMEs, needs to be fast-

tracked for optimum implementation.

Projections 2007 2008 2009 2010 2011 2012

Table 1.1 ProjectionsTable 1.1 ProjectionsTable 1.1 ProjectionsTable 1.1 ProjectionsTable 1.1 Projections

Component Growth (%)Gross Domestic ProductGross Domestic ProductGross Domestic ProductGross Domestic ProductGross Domestic Product 6.3 6.2 6.2-6.8 6.8-7.4 7.2-7.8 7.4-8.0 - Private Consumption 5.0 5.4 5.6-5.9 5.6-6.0 5.6-6.0 5.6-6.0 - Government Consumption 3.9 3.8 4.0-5.0 7.0-9.0 8.0-10.0 8.0-10.0 - Investment 9.2 9.3 10.5-10.8 11.0-13.0 12.0-13.0 13.0-15.0 - Export on Goods and Services 8.0 7.9 8.1-9.1 10.5-11.5 11.5-12.5 12.5-13.5 - Import on Goods and Services 8.9 9.4 10.4-10.7 12.5-13.5 13.5-14.5 14.5-15.5OthersOthersOthersOthersOthers Income per Capita (USD) 1.947.1 1980 2145-2180 2375-2410 2650-2685 2950-3000 Unemployment (%) 9.1 9.0 9.0-10.0 8.5-9.5 8.0-9.0 7.5-8.5 Inflation taget (%)* 6.01% 5.01% 4.51% 4.01%

*) Pursuant to Decree of the Minister of Finance No. 1 of 2008.



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Chapter 2: Update of the World and Indonesian Economy

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition 7

The long-term outlook for the world

economy remains positive, despite the turbulent

dynamics of recent months. Reinforcing this is high

world economic growth accompanied by

expanding volume of world trade and growing

international capital flows. Nevertheless, these

positive developments are clouded by persistently

high levels of world commodity prices (fuel and

non-fuel) and the ongoing turmoil on world

financial markets. Domestically, the Indonesian

economy has shown steady progress even though

daunted by weak supply-side response, low

investment role and still inadequate quality of

economic growth reflected in high rates of

unemployment and poverty.

2.1 Overview of the World Economy

In the last five years, world economic growthIn the last five years, world economic growthIn the last five years, world economic growthIn the last five years, world economic growthIn the last five years, world economic growth

has forged ahead at more than 4% per annum,has forged ahead at more than 4% per annum,has forged ahead at more than 4% per annum,has forged ahead at more than 4% per annum,has forged ahead at more than 4% per annum,

surpassing the historical average (3.7% for 1970-surpassing the historical average (3.7% for 1970-surpassing the historical average (3.7% for 1970-surpassing the historical average (3.7% for 1970-surpassing the historical average (3.7% for 1970-

2006).2006).2006).2006).2006). This impressive performance has been driven

by buoyant growth in developing countries and

Europe (unprecedented levels in the last five years).

Rapid economic growth in developing economies,

led by China, India and Russia, has filled the gap

created by the US economic slowdown in the wake

of financial market woes triggered by the subprime

mortgage crisis. For the first time, China and India

have become engines of world growth, as shown

in Graphs 2.1 and 2.2.1 These impressive

developments in the world economy have also

been accompanied by steady expansion in world


trade, with volume growing at an average of 9.2%

in the past three years, ahead of the long-term

trend.2

Graph 2.2 Contributions to World GrowthGraph 2.2 Contributions to World GrowthGraph 2.2 Contributions to World GrowthGraph 2.2 Contributions to World GrowthGraph 2.2 Contributions to World Growth

Graph 2.1 Contributions to World GrowthGraph 2.1 Contributions to World GrowthGraph 2.1 Contributions to World GrowthGraph 2.1 Contributions to World GrowthGraph 2.1 Contributions to World Growth

However, these impressive developments areimpressive developments areimpressive developments areimpressive developments areimpressive developments are

overshadowed by spiralling oil pricesovershadowed by spiralling oil pricesovershadowed by spiralling oil pricesovershadowed by spiralling oil pricesovershadowed by spiralling oil prices.

Fundamentally, the surging prices are the result of

pressing world demand amid tight supply (see

Graph 2.3). Soaring world oil consumption,

especially in emerging markets like China

2 In 1970-2006, growth in volume of world trade averaged

6.1%.

Source: IMF: Survey Magazine-IMF Research

35

30

25

20

15

10

5

0China India United

StatesEuro area Russia Japan Brazil

2006

2007

(Based on PPP weights, percent of world growth)

Contributions to Real GDP Growth

Source: IMF: Survey Magazine-IMF Research

35

20

15

10

5

0UnitedStates

Euro area China Japan India UnitedKingdom

Russia

2006

2007

(Based on PPP weights, percent of world growth)

Contributions to Real GDP Growth

1 In 2006, contributions of growth from China (11.5%), India

(9%) and Russia (8%) accounted for half of world economic

growth.



accounting for more than one third of growth in

world oil consumption, has not been matched by

adequate supply. In fact, since 2003, spare

production capacity among world oil producers

tend to decline. This has led to an upward spiral in

oil prices beginning in 2003, with prices reaching

a record high of USD100 per barrel in early January

2008. Furthermore, non-fundamental factors, such

as geopolitical conditions in oil-producing

countries, climatic factors and expectations also

influence movement in oil prices.

Graph 2.3 Oil Prices, Demand andGraph 2.3 Oil Prices, Demand andGraph 2.3 Oil Prices, Demand andGraph 2.3 Oil Prices, Demand andGraph 2.3 Oil Prices, Demand andProduction CapacityProduction CapacityProduction CapacityProduction CapacityProduction Capacity

Source: Energy International Agency (EIA)

Oil Demand - Million Barrel per Day (left)

Oil Price WTI - $ per Barrel (left)Spare Capacity - Million Barrel per Day (right)

100

80

60

40

20

02000 2001 2002 2003 2004 2005 2006 2007

77 77 78 8082 84 85 86

6

5

4

3

2

1

0

3.1 4.1

5.6

1.9

1.3 1.01.5

2.1

6769

57

43

332829

34

Non-oil and gas primary commodities haveNon-oil and gas primary commodities haveNon-oil and gas primary commodities haveNon-oil and gas primary commodities haveNon-oil and gas primary commodities have

also shown a steady upward trend.also shown a steady upward trend.also shown a steady upward trend.also shown a steady upward trend.also shown a steady upward trend. Before 2000,

these commodity prices were relatively stable (see

Graph 2.4). However, after 2003, primary

commodity prices mounted significantly, with price

escalation reaching as much as 28% in 2006. Prices

have spiralled mainly in response to high world

demand amid tight supply. Table 2.1 below shows

the size of Chinas contribution to consumption of

some non-fuel commodities, such as aluminium

and copper. Supply has tightened because of low

levels of investment in basic metal production and

lack of new discoveries of reserves. Since 2004,

metal inventories have remained below their

historical average (see Graph 2.5). Soaring prices

for metal commodities have also been followed

by mounting food prices. This has resulted not only

from supply constraints, due to harvest failures for

example, but has also been spurred by growing

demand for foodstuffs in biofuel production. The

combination of spiralling commodity prices and

robust world economic growth has fuelled world

inflationary pressures. In the second half of 2007,

inflation surged ahead in industrialised nations and

developing nations alike.

Graph 2.4 Non-Fuel Primary Commodity PricesGraph 2.4 Non-Fuel Primary Commodity PricesGraph 2.4 Non-Fuel Primary Commodity PricesGraph 2.4 Non-Fuel Primary Commodity PricesGraph 2.4 Non-Fuel Primary Commodity Prices

Source: IMF Database

Non Fuel Primary Commodity Growth Non-Fuel Primary Commodity Price Index - RHS

%30

25

20

15

10

5

0

-5

-10

-15

-201981 19831985 1987 1989 1991 19931995 1997 19992001 2003 2005 2007

%160

140

120

100

80

60

40

20

0

Table 2.1 World Commodity ConsumptionTable 2.1 World Commodity ConsumptionTable 2.1 World Commodity ConsumptionTable 2.1 World Commodity ConsumptionTable 2.1 World Commodity Consumption(% Growth)(% Growth)(% Growth)(% Growth)(% Growth)

Source: Bank of England, Inflation Report November 2007

United UnitedWorld States China World States China

Oil 1.7 0.3 0.6 1.4 0.1 0.5Alumunium 5.2 -0.4 2.8 6.6 0.2 5.5MetalsMetalsMetalsMetalsMetalsCopper 3.4 -0.9 2.5 2.7 -0.8 3.1Zinc 4.4 -0.5 3.3 2.4 -0.4 2.4Agriculture food (c)

Wheat 0.5 -0.1 -0.2 1.2 -0.1 -0.1Maize 2.5 1.0 0.5 3.5 1.4 0.8Soya beans 4.4 0.0 1.9 5.0 0.9 1.6Memo:Memo:Memo:Memo:Memo:Share of wprld GDP (percent) (d) - 20.8 12.3 - 19.6 15.1

Projections2008-2012

2000 - 04 2005 - 07 (a)

Contribution of (b) Contribution of (b)



In keeping with the impressive performanceIn keeping with the impressive performanceIn keeping with the impressive performanceIn keeping with the impressive performanceIn keeping with the impressive performance

in the world economy over the past 4 years, globalin the world economy over the past 4 years, globalin the world economy over the past 4 years, globalin the world economy over the past 4 years, globalin the world economy over the past 4 years, global

inflows of foreign direct investment (FDI) haveinflows of foreign direct investment (FDI) haveinflows of foreign direct investment (FDI) haveinflows of foreign direct investment (FDI) haveinflows of foreign direct investment (FDI) have

seen rapid expansion.seen rapid expansion.seen rapid expansion.seen rapid expansion.seen rapid expansion. Following a period of

substantial negative growth, global FDI charted

significant gains in 2004-2006. The negative

growth in 2001-2003 resulted mainly from

slowing world economic growth and the end of

the previous boom in mergers and acquisitions

(M&A). However, with the improving condition

of the world economy, FDI inflows climbed sharply

with growth in 2004, 2005 and 2006 at 26.6%,

33.1% and 37.4%. In 2006, FDI inflows almost

touched the previous high in 2000 at about USD

1.3 billion (as shown in Table 2.2 below). In 2007,

FDI inflows remained strong although not as high

as in the 2004-2006 period.

Graph 2.5 World Commodity SupplyGraph 2.5 World Commodity SupplyGraph 2.5 World Commodity SupplyGraph 2.5 World Commodity SupplyGraph 2.5 World Commodity Supply

Source: BoE, Energy Infromation Agency, London Metal Exchange, The Economist, ThompsonData Stream and US Department of Agriculture

Wheat. maize andsoya beans (b)

1997 1999 2001 2003 2005 2007

(number of standard deviations)

Oil (d)

Metals ( c )

2.0

1.5

1.0

0.5+

0.0

0.5

1.0

1.5

2.0

The sharp rise in global FDI is explained inThe sharp rise in global FDI is explained inThe sharp rise in global FDI is explained inThe sharp rise in global FDI is explained inThe sharp rise in global FDI is explained in

part by higher corporate profits worldwide, whichpart by higher corporate profits worldwide, whichpart by higher corporate profits worldwide, whichpart by higher corporate profits worldwide, whichpart by higher corporate profits worldwide, which

have driven up share prices and fuelled a wave ofhave driven up share prices and fuelled a wave ofhave driven up share prices and fuelled a wave ofhave driven up share prices and fuelled a wave ofhave driven up share prices and fuelled a wave of

cross-border mergers and acquisitions.cross-border mergers and acquisitions.cross-border mergers and acquisitions.cross-border mergers and acquisitions.cross-border mergers and acquisitions. The close

link between global FDI inflows and cross-border

M&A is depicted in Graph 2.6 below. This rise in

corporate earnings has caused reinvested earnings

to be an important component in FDI inflows,

accounting for 30% of global FDI inflows in 2006.

In developing nations, this ratio can reach as much

as 50% of total FDI inflows. Government policy in

FDI destination countries has played a role in the

upward trend in global FDI inflows. In 2006, a total

of 147 policies were launched to make FDI host

nations more attractive and conducive venues for

investment. Significant examples include corporate

tax cuts in Brazil and India.

Source: National Statistics, Economist Intelligence Unit, IMF, UNCTAD

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Word totalWord totalWord totalWord totalWord total 491,8491,8491,8491,8491,8 712,9712,9712,9712,9712,9 1.113,81.113,81.113,81.113,81.113,8 1.408,31.408,31.408,31.408,31.408,3 851,1851,1851,1851,1851,1 618,1618,1618,1618,1618,1 563,4563,4563,4563,4563,4 730,2730,2730,2730,2730,2 971,7971,7971,7971,7971,7 1.335,11.335,11.335,11.335,11.335,1

Developed countriesDeveloped countriesDeveloped countriesDeveloped countriesDeveloped countries 279,0279,0279,0279,0279,0 493,8493,8493,8493,8493,8 853,0853,0853,0853,0853,0 1.125,01.125,01.125,01.125,01.125,0 563,4563,4563,4563,4563,4 421,1421,1421,1421,1421,1 354,6354,6354,6354,6354,6 379,5379,5379,5379,5379,5 546,8546,8546,8546,8546,8 824,4824,4824,4824,4824,4

% of world total 56,7 69,3 76,6 79,9 66,2 68,1 62,9 52,0 56,3 61,7

Emerging markets 212,8 219,1 260,9 283,3 287,8 197,0 208,9 350,7 424,9 510,7

% of world total 43,3 20,7 23,4 20,1 33,8 31,9 37,1 48,0 43,7 38,8

Table 2.2 Global FDI Inflows, 1997-2006Table 2.2 Global FDI Inflows, 1997-2006Table 2.2 Global FDI Inflows, 1997-2006Table 2.2 Global FDI Inflows, 1997-2006Table 2.2 Global FDI Inflows, 1997-2006(USD billions)(USD billions)(USD billions)(USD billions)(USD billions)

Graph 2.6 Global FDI Inflows and Mergers &Graph 2.6 Global FDI Inflows and Mergers &Graph 2.6 Global FDI Inflows and Mergers &Graph 2.6 Global FDI Inflows and Mergers &Graph 2.6 Global FDI Inflows and Mergers &AcquisitionsAcquisitionsAcquisitionsAcquisitionsAcquisitions

Source: National Statistics, Economist Intelligence Unit, IMF, UNCTAD

1,600

1,400

1,200

1,000

800

600

400

200

0

(US$ bn)

1992 93 94 95 96 97 98 99 2000 01 02 03 04 05

FDI inflowsM & As



2.2 Overview of the Indonesian Economy

From long-term perspective, the constellation

of world economic developments, marked by

sustained high economic growth and volume of

world trade, substantial global FDI inflows and

unabated high commodity prices, will continue to

influence the dynamics of the Indonesian economy.

2.2.1 Indonesian Economic Indicators

Domestic economic indicators showDomestic economic indicators showDomestic economic indicators showDomestic economic indicators showDomestic economic indicators show

improvement, although still overshadowed by aimprovement, although still overshadowed by aimprovement, although still overshadowed by aimprovement, although still overshadowed by aimprovement, although still overshadowed by a

range of structural problems that could preventrange of structural problems that could preventrange of structural problems that could preventrange of structural problems that could preventrange of structural problems that could prevent

Indonesia from achieving faster economic growth.Indonesia from achieving faster economic growth.Indonesia from achieving faster economic growth.Indonesia from achieving faster economic growth.Indonesia from achieving faster economic growth.

Macroeconomic stability, a prerequisite for

sustainable economic growth, can be maintained

through collaboration by the Government and the

monetary authority in their various policies.

However, in the drive for faster, higher quality

economic growth, Indonesia remains beset by a

range of structural problems.

Since 2002, Indonesias economic growthSince 2002, Indonesias economic growthSince 2002, Indonesias economic growthSince 2002, Indonesias economic growthSince 2002, Indonesias economic growth

has gathered momentum, albeit slowly, withhas gathered momentum, albeit slowly, withhas gathered momentum, albeit slowly, withhas gathered momentum, albeit slowly, withhas gathered momentum, albeit slowly, with

growth still below the pre-crisis levelgrowth still below the pre-crisis levelgrowth still below the pre-crisis levelgrowth still below the pre-crisis levelgrowth still below the pre-crisis level (see Graph

2.7).3 Economic growth in the post-crisis period

has averaged about 5% per annum, well short of

that in the pre-crisis period indicate a weakening

Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006

Source: UNCTAD, World Investment Report 2007

Item 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Number of Countries that

Introduced Changes 43 56 49 63 66 76 60 65 70 71 72 82 103 93 93

Number of Regulatory Change 77 100 110 112 114 150 145 139 150 207 246 242 270 205 184

More Favorable to FDI 77 99 108 106 98 134 136 130 147 193 234 218 234 164 147

Less Favorable to FDI 0 1 2 6 16 16 9 9 3 14 12 24 36 41 37

3 The analysis is based on the following periodisation: 1989-

1996 for pre-crisis; 2000-2007 for the post-crisis period.

in aggregate demand.4 This has been accompanied

by structural change in the economy, with

investment, once representing 30% of GDP,

hovering at only about 20% of GDP in the post-

crisis period. Private consumption has experienced

the reverse, increasing from the pre-crisis share at

less than 60% of GDP to a consistent post-crisis

level at more than 60% of GDP.

Graph 2.7 GDP Growth 1989-2007Graph 2.7 GDP Growth 1989-2007Graph 2.7 GDP Growth 1989-2007Graph 2.7 GDP Growth 1989-2007Graph 2.7 GDP Growth 1989-2007

Source: CEIC

Economic Growth Average 1989-1996 Average 2000-2007

-5

-3

-1

1

3

5

7

9

2007*)200520032001199919971995199319911989

Average 1989 - 1996 7.3%

Average 2000 - 2007 5.0%

Inflation has behaved with differentInflation has behaved with differentInflation has behaved with differentInflation has behaved with differentInflation has behaved with different

characteristics in the pre-crisis and post-crisischaracteristics in the pre-crisis and post-crisischaracteristics in the pre-crisis and post-crisischaracteristics in the pre-crisis and post-crisischaracteristics in the pre-crisis and post-crisis

periods. While the inflation rate in the two periodsperiods. While the inflation rate in the two periodsperiods. While the inflation rate in the two periodsperiods. While the inflation rate in the two periodsperiods. While the inflation rate in the two periods

only slightly different, its volatility has soared inonly slightly different, its volatility has soared inonly slightly different, its volatility has soared inonly slightly different, its volatility has soared inonly slightly different, its volatility has soared in

4 According to research by BI, the long-term trend in

Indonesias economic growth during the 1981-2007 period

came to 4.9%. This long-term trend is a constant in the

GDP equation derived from macroeconomic models.



the post-crisis periodthe post-crisis periodthe post-crisis periodthe post-crisis periodthe post-crisis period (see Graph 2.8). Post-crisis

economic growth is below that of the previous

period, but despite this, the average post-crisis

inflation is slightly higher than it was in the pre-

crisis period. Theoretically, this occurs only when

aggregate demand softens alongside a

commensurate slowing in aggregate supply. This

interaction in supply and demand is indicative of

supply constraints.5 Accordingly, resolution of

various structural issues, which will bring

improvement to the investment climate and the

supply side, in conjunction with stimulation of

demand will be key to creating sustainable, quality

growth.

Graph 2.8 Inflation 1989 2007Graph 2.8 Inflation 1989 2007Graph 2.8 Inflation 1989 2007Graph 2.8 Inflation 1989 2007Graph 2.8 Inflation 1989 2007

Average 1989-1996 = 8.2% Average 2000-2007 = 8.7%

%

-5

0

5

10

15

20

2007200520032001199919971995199319911989

Source : CEIC

Various indicators and survey findings pointVarious indicators and survey findings pointVarious indicators and survey findings pointVarious indicators and survey findings pointVarious indicators and survey findings point

to the continued slow pace of improvement into the continued slow pace of improvement into the continued slow pace of improvement into the continued slow pace of improvement into the continued slow pace of improvement in

economic conditions in Indonesia. economic conditions in Indonesia. economic conditions in Indonesia. economic conditions in Indonesia. economic conditions in Indonesia. According to the

Global Competitiveness Report 2007-2008,

Indonesias economic competitiveness is still ranked

in the 54th position out of 131 countries, following

the significant improvement achieved in 2006

5 Using the Blanchard-Quah SVAR, a research by Bank

Indonesia indicates a steeper post-crisis supply curve

compared to the pre-crisis period. For further analysis, see

Nugroho (2007): Review of the Pre and Post-Crisis

Aggregate Supply Curve, in Indonesian Economic Outlook,

July 2007 edition.

compared to 2005 (see Table 2.4).6 A similar

situation was identified in the International Institute

for Management Development (IMD) survey

published in the World Competitiveness Yearbook

for 2007, which states that Indonesias economic

competitiveness has not improved (Table 2.5). In

2007, Indonesias competitiveness slipped from

52nd spot in 2006 to 54 out of 55 countries.7

Indonesias position was only one notch above

Venezuela and right below that of below

Argentina, Poland and Croatia. When compared

with other ASEAN countries, such as Singapore,

Malaysia, Thailand and the Philippines, Indonesia

lags far behind.

6 Publication by the World Economic Forum (WEF), based on

survey findings.

7 The IMD criteria in evaluating a countrys competitiveness

include indicators such as economic performance,

government efficiency, business legitimacy, business

efficiency and infrastructure.

Source: World Economic Forum, Global Competitiveness Report 2006 & 2007

NegaraPeringkat

2005 2006 2007

Indonesia 69 54 54Singapore 5 8 7Malaysia 25 19 21Thailand 33 28 28Phillippines 73 75 71Vietnam 74 64 68Kamboja 111 106 110Timor-Leste 113 120 127

Table 2.4 WEF Competitiveness RatingsTable 2.4 WEF Competitiveness RatingsTable 2.4 WEF Competitiveness RatingsTable 2.4 WEF Competitiveness RatingsTable 2.4 WEF Competitiveness Ratings

The poor condition of IndonesiasThe poor condition of IndonesiasThe poor condition of IndonesiasThe poor condition of IndonesiasThe poor condition of Indonesias

infrastructure, institutions and basic education hasinfrastructure, institutions and basic education hasinfrastructure, institutions and basic education hasinfrastructure, institutions and basic education hasinfrastructure, institutions and basic education has

contributed to the lack of improvement incontributed to the lack of improvement incontributed to the lack of improvement incontributed to the lack of improvement incontributed to the lack of improvement in

economic competitiveness.economic competitiveness.economic competitiveness.economic competitiveness.economic competitiveness. The 2007 WEF (World

Economic Forum) survey also states that the most

important factor hampering business in Indonesia



is poor infrastructure, followed by inefficient

government bureaucracy, as shown in Table 2.6 and

Graph 2.9. The quality of Indonesias institutions is

also rated low based on the Transparency

International survey on perceptions of corruption,

in which Indonesia is rated 134th on the list of

corrupt countries worldwide (out of 163 countries).

Meanwhile, a World Bank survey has identifiedMeanwhile, a World Bank survey has identifiedMeanwhile, a World Bank survey has identifiedMeanwhile, a World Bank survey has identifiedMeanwhile, a World Bank survey has identified

a number of barriers to commencing business ina number of barriers to commencing business ina number of barriers to commencing business ina number of barriers to commencing business ina number of barriers to commencing business in

Indonesia, which include the number of proceduresIndonesia, which include the number of proceduresIndonesia, which include the number of proceduresIndonesia, which include the number of proceduresIndonesia, which include the number of procedures

to be completed and the costs involved in businessto be completed and the costs involved in businessto be completed and the costs involved in businessto be completed and the costs involved in businessto be completed and the costs involved in business

startupstartupstartupstartupstartup. In general, Indonesias ranking by ease of

starting business ventures improved from 133 in

2006 to 123 in 2007 (see Table 2.7). However,

Indonesias ranking also suffers badly when

compared to other ASEAN countries. Indonesias

position in the 123rd spot is ahead only of countries

like Lesotho, Algeria and Egypt. The most important

barrier to doing business in Indonesia is the process

for starting a business venture, which normally

requires 105 days. This is far longer than the time

Negara 2007 2006 2005 2004 2003

USA 1 1 1 1 1Singapore 2 3 3 2 4Hongkong 3 2 2 6 40China 15 18 31 24 29Taiwan 18 17 11 12 17Malaysia 23 22 28 16 21India 27 27 39 34 50Korea 29 32 29 35 37Thailand 33 29 27 29 30Philippines 45 42 49 52 49Brazil 49 44 51 53 52South Africa 50 44 46 49 47Argentina 51 47 58 59 58Poland 52 58 57 57 55Croatia 53 59 - - -IndonesiaIndonesiaIndonesiaIndonesiaIndonesia 5454545454 5252525252 5959595959 5858585858 5757575757Venezuela 55 53 60 60 59

TotalTotalTotalTotalTotal 5555555555 5555555555 6060606060 6060606060 5959595959

Table 2.5 Table 2.5 Table 2.5 Table 2.5 Table 2.5 Competitiveness Ratings by IMDCompetitiveness Ratings by IMDCompetitiveness Ratings by IMDCompetitiveness Ratings by IMDCompetitiveness Ratings by IMD

Source: International Institute for Management Development (IMD)

Indonesia 2006 2007

Indonesia 69 54Overall indexOverall indexOverall indexOverall indexOverall index 5454545454 5454545454Basic requirementsBasic requirementsBasic requirementsBasic requirementsBasic requirements 7575757575 8282828282Institutions 60 63Infrastructures 78 91Macroeconomic stability 73 89Health & primary education 93 78Efficiency enhancersEfficiency enhancersEfficiency enhancersEfficiency enhancersEfficiency enhancers 4444444444 3737373737Higher education and training 70 65Goods market & efficiency 33 23Labor market efficiency 51 31Financial market sophistication 58 50Technological readiness 75 75Market size 15 15Innovation & sophistication factorsInnovation & sophistication factorsInnovation & sophistication factorsInnovation & sophistication factorsInnovation & sophistication factors 4141414141 3434343434Business sophistication 41 33Innovation 39 41

Table 2.6 Ranking of CompetitivenessTable 2.6 Ranking of CompetitivenessTable 2.6 Ranking of CompetitivenessTable 2.6 Ranking of CompetitivenessTable 2.6 Ranking of CompetitivenessComponentsComponentsComponentsComponentsComponents

Source: World Economic Forum, Global Competitiveness Report 2006 & 2007

required in neighbouring countries in ASEAN, such

as Singapore (5 days), Malaysia (24 days), Thailand

(33 days), Vietnam (50 days) and even the Philippines

(58 days) (see Graph 2.10). In this category, Indonesia

holds 168th position out of 178 countries.

Even so, Indonesia is still regarded as anIndonesia is still regarded as anIndonesia is still regarded as anIndonesia is still regarded as anIndonesia is still regarded as an

attractive location for FDI. attractive location for FDI. attractive location for FDI. attractive location for FDI. attractive location for FDI. In a 2007 survey by

UNCTAD, Indonesia ranked among the 15 most

attractive countries for FDI (see Graph 2.11).8

Graph 2.9 The Most Problematic Factors forGraph 2.9 The Most Problematic Factors forGraph 2.9 The Most Problematic Factors forGraph 2.9 The Most Problematic Factors forGraph 2.9 The Most Problematic Factors forDoing BusinessDoing BusinessDoing BusinessDoing BusinessDoing Business

Inadequate supply of infrastructure 20.50Inefficient government bureaucracy 16.10

Access to financing 10.80Policy instability 10.70

Restrictive labour regulations 8. 50Tax regulations 8.00

Inadequately educated workforce 5.60Inflation 5.50

Corruption 4.20Foreign currency regulations 3.70

Government instability/coups 2.20Tax rates 2.00

poor work ethic in national labour force 1.80Crime and theft 0.50

5 10 15 20 250Source: World Economic Forum. Global Competitiveness Report 2007

8 UNCTAD, World Investment Prospects Survey 2007-2009.



Another UNCTAD publication states that Indonesia

has achieved steady improvement in rating for FDI

performance and potential.9 This demonstrates

that while Indonesia is still beset with structural

Rank Time Rank Time Rank Time Rank Rank Time Cost(days) (days) (days) (days) (% debt)

IndonesiaIndonesiaIndonesiaIndonesiaIndonesia 2006 133 163 97 117 224 123 42 49 142 570 122,7IndonesiaIndonesiaIndonesiaIndonesiaIndonesia 2007 123 168 105 99 196 121 42 51 141 570 122,7Malaysia 2006 21 74 30 102 285 65 144 4 62 600 27,5Malaysia 2007 24 74 24 105 285 67 144 4 63 600 27,5Thailand 2006 17 27 33 11 156 19 2 32 26 479 14,3Thailand 2007 15 36 33 12 156 20 2 33 26 479 14,3Philippines 2006 130 135 58 75 177 81 33 141 113 842 26Philippines 2007 133 144 58 77 177 86 33 141 113 842 26Singapore 2006 1 11 6 5 102 13 9 2 5 120 17,8Singapore 2007 1 9 5 5 102 13 9 2 4 120 17,8India 2006 132 93 35 133 224 108 62 32 177 1,420 39,6India 2007 120 111 33 134 224 112 62 33 177 1,420 39,6Honduras 2006 126 143 44 98 184 89 36 147 126 480 30,4Honduras 2007 121 135 21 72 125 78 24 147 124 480 30,4Brazil 2006 113 120 152 95 316 109 47 62 112 616 16,5Brazil 2007 122 122 152 107 411 110 45 64 106 616 16,5Lesotho 2006 119 120 73 146 601 129 101 141 99 695 16,6Lesotho 2007 124 126 73 146 601 132 101 141 99 695 16,6Algeria 2006 125 119 24 104 240 153 51 62 120 630 17,4Algeria 2007 125 131 24 108 240 156 51 64 117 630 17,4Egypt 2006 152 126 19 165 249 147 193 105 146 1,010 25,3Egypt 2007 126 55 9 163 249 101 193 83 145 1,010 25,3China 2006 92 128 35 175 349 28 29 81 20 406 8,

indonesian economic outlook

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