Demystifying the Macro-Real Sector Missing Link

5 06 2007

The Indonesian macroeconomic condition has been improving. Some economists, however, have claimed that the Indonesian real sector has not improved. Is there any missing link between the macroeconomic condition and the real sector?

Latest GDP data show that the Indonesian economy is still expanding. The Indonesian economy grew by 6.0 percent year on year in the first quarter of 2007, slightly slower than 6.1 percent year on year in the fourth quarter of 2006. In the first quarter of 2007, household consumption posted strong growth of 4.5% year-on-year (YoY). Exports grew by 8.9% YoY, and investments grew by 7.5% YoY. Meanwhile, government spending grew by 4.3% YoY.

The main driver of the relatively firm economic growth is lower interest rates. Lower interest rates mean a lower opportunity cost of money. In this regard, consumers and firms are more willing to borrow from banks since the cost of borrowing is not as high as before. At the same time, those who have excess savings (both households and consumers) have more incentive to spend their money (on consumption goods or by making investments) since the interest earned from putting their money in the bank would not be as much as before.

That is, lower interest rate is likely to push investment activities up. And with the prospects of benign inflation (Danareksa Research Institute expects around 5.8 percent by the end of the year) and lower interest rate (Danareksa Research Institute expects around 7.5 percent by year end), investments are expected to increase further in the near future. This will make the engines of economic growth for 2007 more balanced, thus meaning the current economic expansion is more sustainable.

Nevertheless, some economists and analysts are still skeptical about the recent (macro economic) development. They have claimed that the Indonesian real sector is still on the doldrums. Some have even suggested that the real sector has not grown at all. These, according to them, have resulted in increasing unemployment and poverty rates. The improvements, they further have pointed out, have only occurred at the macro level in the form of booming stock market, strengthening rupiah, low inflation rate, and improving GDP growth number. In short, there is a missing link between macro economic condition and the real sector condition.

The statement that Indonesian real sector has not moved despite the improving macro economic condition, however, is rather misleading. First of all, the macro economic condition is the aggregation of the micro economic condition (including the condition in the real sector). As such, it is very unlikely that there exists a situation where the macro economic condition is good, but at the same time the general condition at the micro level is bad.

Furthermore, the statement that real sector has not grown is not entirely true. On the contrary, almost all sectors in the economy grew significantly since the third quarter of 2006. The manufacturing sector, for example, grew by 5.9 percent YoY in the fourth quarter of 2006 and by 5.4 percent YoY in the first quarter of 2007. The construction sector grew by 10.4 percent YoY in the fourth quarter 2006 and by 9.3 percent YoY in the first quarter 2007. Meanwhile, the Trade Hotel & Restaurant sector grew by 7.0 percent YoY in the fourth quarter of 2006 and by 8.5 percent YoY in the first quarter of 2007.

If we assume that the definition of the real sector is all sectors excluding financial (grew by 7.1 percent YoY in the first quarter of 2007) and services (grew by 7.0 percent in the first quarter of 2007), then the aforementioned paragraph clearly provides compelling evidence that activities in the real sector have picked up.

If the Indonesian economy is expanding, why then the unemployment rate has not fallen significantly and why some economic pundits still believe that the real sector has not moved?

The main reason is that because the economy has not grown fast enough. According to our calculation, the Indonesian economy needs to grow by at least 6.7 percent just to absorb new workers that enter the labor force. As such, as long as the economic growth rate is below that level, it is very likely that unemployment rate to stay at its currently high level. The unemployment rate even tends to increase. And under this condition, it is difficult to see a significant reduction in poverty rate.

Meanwhile, there are some weaknesses in the economy that has started to occur since the last quarter of 2006 on the back of long dry season. The extended dry season has led to the delay in the rice (and other food crops) planting season, which to some extent explains the year-on-year contraction in the Agriculture sector by 0.5 percent in the first quarter of 2007. This has eroded income and purchasing power of farmers.

In addition, the delay in rice planting season has resulted in increases in rice prices starting in December, which apparently have a negative impact on overall consumer purchasing power. Under normal conditions, the impacts of rice price increases on purchasing power are not usually significant and only last for a month or two. This time around, however, the impact has been more severe than usual (the negative impact has lasted for at least five months).

The negative impact of the high rice prices on consumer purchasing power is clearly evident in Danareksa Consumer Confidence survey. Our survey shows that the Consumer Confidence Index (CCI) started to fall in December, and that it continued to decline in the following months. By April 2007, the CCI had fallen to 80.7 from 91.6 in November 2006 (down by 11.9%).

Against this backdrop, the economic activities in the first quarter of 2007 did not grow as fast as it should. And, accordingly, the number of new job creation was not as high as expected. These have led to the inaccurate impression of sluggish condition in the real sector.

In summary, there is no missing link between the macro economic condition and the real sector. In line with the positive development in macro condition, the real sector has also grown. However, the growth rate has not been fast enough to significantly reduce unemployment rate or poverty rate.