Slower-than-Expected Growth in 2007?

28 03 2007

Recent statements made by high-ranking Indonesian officials suggest that the Indonesian economy may not grow as briskly as earlier expected. A deeper analysis, however, suggests that the country’s growth momentum remains intact.

In its assessment of Indonesian economic conditions in 2006, the central bank has stated that the quality of the economic growth is deteriorating. This, according to Burhanudin Abdullah the governor of the central bank, can be seen in lower-than-expected economic growth, a rising unemployment rate, and an increase in the number of people who are classified as being “poor”. In 2006, the Indonesian economy grew by 5.5 percent, or lower than the government’s growth target, and even lower than the growth rate of 5.7 percent in 2005. Furthermore, the central bank has implied that economic conditions were not likely to improve in the near term.

Meanwhile, Sri Mulyani the finance minister has also expressed her doubts in regard to the nation’s economic growth prospects for 2007. The minister has even suggested that the Indonesian economy is likely to grow by only around 5.6 to 6.0 percent, or significantly lower than the government’s target of 6.3 percent growth for 2007. According to the minister, slow investment activities may limit the potential growth in 2007. The minister contended that it would not be easy for investment activities to see double digits growth in 2007. Indeed, investment has struggled in recent years. Despite growing by 14.2 percent in 2004, investment only grew by 10.8 percent in 2005 and by a paltry 2.9 percent in 2006.

However, such concerns are overdone. And, in fact, there are several factors that point to faster economic growth going forward.

First of all, a turnaround in the economic growth trend has already occurred. Although the Indonesian economy grew at a slower rate in 2006 than in 2005, it should nonetheless be noted that the growth trend is actually on the up. But looking at the data in finer detail, brisker economic growth is clearly apparent. In the first half of 2006, the Indonesian economy grew by only 5.0 percent. But in the third and fourth quarters of the year, however, the economy grew at much faster rates of 5.9 percent and 6.1 percent respectively. This strongly suggests that the Indonesian economy is no longer in a slowing down phase, and that it is actually in the accelerating phase – i.e. the economy should see brisker growth going forward.

Note that the slow economic growth in the first half of 2006 was largely attributable to the sharp hikes in fuel prices that took place in October 2005. These fuel price hikes had a significant adverse impact on consumer purchasing power. In addition, in a bid to contain inflation, the central bank hiked interest rates aggressively to 12.75 percent by the end of 2005. Against this backdrop, economic activities slowed sharply in the first half of 2006.

However, the brisker economic growth in the second half of 2006 provides a strong indication that Indonesian consumers – and the economy overall – had started to recover from the big blow of October 2005’s fuel price hikes. And going forward, it is very likely that household financial conditions – and indeed overall economic conditions – shall improve further – provided of course that there will not be any significant shocks for the rest of the year.

Lower interest rates were crucial in stimulating economic activity in the second half of 2006. On the back of relatively benign inflation, BI started to cut its benchmark rate in May 2006. And since August 2006, BI has been cutting interest rates aggressively. Indeed, the central bank cut its benchmark rate by 50 basis points each month from August to December 2006. By the end of 2006, the BI rate had fallen to 9.75 percent. This year the central bank has continued to cut interest rates, and by March 2007 the BI rate had been lowered to 9.0 percent.

Going forward, interest rates are likely to fall further, underpinning the ongoing economic recovery. Note that lower interest rates mean a lower opportunity cost of money, meaning borrowing money is cheaper (for those who do not have cash) while, at the same time, for those who have money, they will be encouraged to spend it given that their interest income is not as high as before.

Yet despite the falling interest rates, higher than expected inflation in the first two months of 2007 has prompted some concerns. This is because the higher inflation has eroded consumer purchasing power rather significantly, hitting household consumption in the first quarter of the year. Nevertheless, the outlook for inflation for the full year of 2007 has not changed significantly. The higher-than-expected inflation figures at the beginning of the year were mainly attributable to seasonal factors. And the seasonal effects on inflation are likely to disappear completely from the inflation figures once the harvesting season arrives at the end of March/in April. As such, inflation for the full year of 2007 is expected to only reach as high as 5.8 percent. Against this backdrop, consumer purchasing power should recover significantly after March.

Such benign inflationary pressures will allow BI to cut its benchmark rate further. Indeed, by the end of the year, the BI rate is expected to have fallen to around 7.5 percent. Interest rates at this level should be enough to help propel Indonesian economic growth to above 6 percent in 2007.

At the same time, low interest rates should support increasing investment activities. Past experience suggests this is the case. In 2003, when interest rates were still relatively high, investment grew below 5 percent. However, in the period Q3 2004 to Q2 2005, investment rose sharply as the central bank cut its benchmark rate to around 7.4 percent. In each quarter of that period, investment grew by above 15 percent.

And although investment grew by only a paltry 2.9 percent for the full year of 2006, there was an improvement on a quarterly basis. Indeed, on the back of falling interest rates, investment grew by 8.2 percent in the fourth quarter of 2006. And given that interest rates are likely to fall further going forward, investment growth is likely to increase further. If interest rates do indeed fall below 8 percent in 2007, then investment growth of around 14 percent may be achieved.

In conclusion then, the concerns on possible sluggish economic growth are unwarranted. As such, the economy should remain on course to record growth of 6.2 percent in 2007.


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