RISKY
BUSINESS Indonesia's sinking
economy By Jephraim P Gundzik
Indonesian government officials and
foreign analysts are excessively optimistic about
the country's medium-term economic outlook.
Economic growth in 2005 was much weaker than
indicated by Indonesia's questionable
national-accounts statistics. In 2006, economic
growth will struggle to reach 3%, while an
economic recession appears likely in 2007. Much
weaker-than-expected economic growth could
accelerate capital flight and trigger the
devaluation of the rupiah in the next 12 months.
Despite devastation and dislocation caused
by the December 2004 tsunami, political and social
instability caused by the removal of fuel-price
subsidies, surging inflation, and interest rates
and capital flight, real GDP (gross domestic
product) growth surged ahead in 2005, reaching a
nine-year high of 5.6%. Rather
than
an indication of profound underlying economic
strength, Indonesia's very surprising economic
performance in 2005 was the result of shortcomings
in the country's national-accounts statistics
produced by Badan Pusat Statistik (BPS, or
Statistics Indonesia).
These shortcomings
were apparent in the 275% real growth of
statistical discrepancies used to balance
expenditure-based GDP with production-based GDP by
BPS in 2005. The meteoric growth of statistical
discrepancies accounted for more than one-half of
the real growth of expenditure-based GDP last
year. In other words, without the growth of
statistical discrepancies, real GDP growth would
have been below 3% in 2005.
The large
statistical discrepancies in 2005 balanced lower
expenditure-based GDP against higher
production-based GDP. Examining production-based
GDP, the only sector that experienced unusually
strong growth was wholesale and retail trade.
Agriculture and manufacturing output, which
combined account for 42% of total production-based
GDP, weakened in 2005. Construction and services
output, which account for another 15% of
production-based GDP, were flat. Mining output,
which accounts for 10% of production-based GDP,
registered a very weak recovery.
Meanwhile, real growth of wholesale and
retail trade, which accounts for 17% of
production-based GDP, nearly doubled in 2005 to
9%. The strong growth of trade stands in contrast
to slowing domestic demand indicated by weaker
manufacturing output and import growth.
Manufacturing growth slowed to a real rate of 4.5%
in 2005 from 6.4% in 2004. Import growth slowed to
26% in 2005 from 43% in 2004.
Slowing
manufacturing and import growth imply that fewer
goods circulated in the economy in 2005. As a
result, the surge in wholesale and retail trade
was entirely accounted for by higher prices or
inflation. The GDP deflator should offset
inflation in calculating real GDP. It appears that
Indonesia's GDP deflator greatly understated
inflation in 2005, prompting the large addition to
expenditure-based GDP from statistical
discrepancies.
Unless data are being
purposefully manipulated by authorities, the large
statistical discrepancies and the understated GDP
deflator of 2005 should be washed out in 2006,
leaving economic growth much lower. Economic
growth will also be pushed lower in 2006 by
further deceleration of private consumption and
investment growth as well as weakening government
expenditure - a product of decentralization and
deteriorating governance.
Economic
reality check Collapsing real wages, high
inflation, rising unemployment and contracting
consumer credit are likely to push real growth in
private consumption expenditure to about 2% in
2006 from 4% in 2005. Last year, consumer price
inflation hit 17% as a result of fuel-price hikes
administered by President Susilo Bambang
Yudhoyono's government in March and October. The
surge of inflation is estimated to have pushed
real wages lower by 12% in 2005. Though inflation
will decline in the final quarter of 2006 as last
October's fuel-price hike falls out of inflation
calculations, inflation will remain quite high.
Consumer price inflation has proved quite
sticky in the first seven months of 2006,
remaining above 15%. Last year's fuel price hikes
are still feeding through the economy. Rising
international oil prices, driven higher by
instability in the Middle East and the onslaught
of hurricane season in the United States, could
force the Yudhoyono government to raise domestic
fuel prices again, or lose its hard-earned fiscal
credibility. Consumer price inflation will
probably be close to 11% in 2006, pushing real
wages down a further 8%.
In 2005,
unemployment breached 10%, marking Indonesia's
highest unemployment rate in modern times. The
unemployment rate will climb higher in 2006 as
manufacturing output slows further. According to
the Industry Ministry, growth in industrial
production was a paltry 2.4% in the first half of
2006 against the government's target of 7%.
Falling real wages and rising unemployment have
brought very rapid real consumer credit growth,
which was about 20% in 2005, to a screeching halt
in the first half of 2006.
The credit
crunch that has ensnared consumers in 2006 was
already problematic for corporate borrowers last
year. In 2005, real corporate credit for
investment began contracting while the real growth
of corporate credit for working capital slowed to
single digits. In the first five months of 2006,
real total corporate credit contracted by 14%. In
addition to falling incomes and earnings, the very
sharp contraction of consumer and corporate credit
thus far in 2006 has been driven by soaring
non-performing loans in the banking sector,
especially among Indonesia's largest banks, which
are state-owned.
In the midst of a credit
crunch and slowing manufacturing output growth,
private-sector investment growth can not be
expected to accelerate in 2006. Slowing export
growth will also undermine investment. In 2005,
export growth of 20% was fueled mainly by rising
prices for Indonesia's commodity exports. In the
first five months of 2006, export growth slowed to
about 12%. Slowing external demand will push
export growth down further in the second half of
2006.
In 2005, strong growth of government
consumption and investment expenditure offset
weakening private consumption and investment
growth. This is not likely to be repeated in 2006.
In the first six months of this year, total
government expenditure was only 30% of the amount
budgeted for the entire year. Weak and
deteriorating governance arising from fiscal
decentralization will make it very difficult for
the government's expenditure targets to met.
Indonesia's regional governments, which
are responsible for planning and executing about
one-half of total government expenditures, are
ill-prepared for such a task. As a result, a large
proportion of central government funds allocated
to regional governments have simply been shunted
into the banking system, inflating deposit growth
and opening the door to greater corruption. Though
indications of broad-based economic weakness are
manifold, Indonesian government officials,
multilateral lenders and most analysts continue to
believe economic growth will remain above 5% in
2006 and will accelerate in 2007. A rude awakening
may be close at hand.
Expectations meet
reality While Indonesia's second-quarter
GDP growth statistics won't be released by BPS
until mid-August, recently released second-quarter
GDP growth statistics in the United States offer a
preview of what's to come. Real economic growth in
the US slowed to 2.5%, much weaker than the 3.5%
consensus forecast. Worse, inflation has moved
sharply higher. Consumer and producer price
inflation in the US reached an annualized rate of
4.5% and 5%, respectively in the first half of
2006. Core inflation has also increased sharply,
reaching an 11-year high in June of 2.4%.
Higher energy prices, inflation and
interest rates have already begun to slow the
world's largest economy. This slowdown may
accelerate in the second half of 2006, pitching
the US economy into recession in 2007. Increasing
instability in the Middle East and waning global
oil supply carries enormous potential to push
international oil prices toward US$125 per barrel
over the next several months. Higher energy prices
will push US inflation and interest rates up,
leaving economic growth much weaker. A US economic
recession in 2007, or even a slowdown in real GDP
growth below 2%, will have strong negative
implications for many countries especially those
that are dependent on commodity exports such as
Indonesia.
Misleading national-accounts
statistics in 2005 and misplaced expectations for
economic growth in 2006 have attracted a
substantial amount of foreign portfolio investment
to Indonesia over the past 18 months. The lion's
share of this investment is parked in domestic
government debt securities. This investment is
very sensitive to exchange-rate depreciation.
Weaker-than-expected economic growth in Indonesia,
especially weaker export growth, could begin to
undermine the rupiah, triggering foreign-capital
flight.
In addition to foreign-capital
flight, domestic-capital flight could accelerate
sharply if wildly optimistic economic expectations
are not met. Domestic-capital flight, which can be
discerned in the "errors and omissions" component
of Indonesia's balance of payments, has increased
steadily over the past several years. Last year,
domestic-capital flight amounted to nearly $10
billion.
Slowing economic growth and an
accompanying increase in political and social
instability could encourage accelerated
domestic-capital flight in 2006 and 2007. The
combination of foreign and domestic capital flight
could easily swamp Indonesia's foreign-exchange
reserves of $34 billion, prompting the devaluation
of the rupiah.
Sound dire? Very few
anticipated the capital flight that triggered
balance-of-payments crises and exchange-rate
devaluations in several emerging markets over the
past 10 years. These crises and devaluations
occurred when misplaced expectations suddenly met
economic reality. Expectations are very high in
Indonesia. Reality may be hard pressed to meet
these expectations.
Jephraim P
Gundzik is president of Condor Advisers, which
provides investment risk analysis to individuals
and institutions worldwide.
(Copyright
2006 Asia Times Online Ltd. All rights reserved.
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