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Sluggish growth raises questions about Widodo strategy

JAKARTA -- Indonesian President Joko Widodo told a group of prominent economists Monday he was prepared to change his cabinet team to rebuild confidence in the country's stuttering economy and meet growing pressure for change.

     The World Bank and International Monetary Fund lowered their Indonesia growth forecasts for 2015 to 4.7% in June, following similar downward revisions from investment banks, including Goldman Sachs and JPMorgan Chase.

     Rumors of a cabinet reshuffle have been circulating in Jakarta for several months, with State Enterprises Minister Rini Soemarno and other members of the economic team topping the list of likely casualties. Polls indicate the public wants to see more results-oriented technocrats and fewer politicians in economic posts.

     A key plank in the government's economic strategy when it came to power in October 2014 was a sharp reduction in fuel subsidies and the redeployment of funds to build roads, ports, power stations and irrigation systems. The new administration cut fuel subsidies in December, freeing up about $15 billion for public investment, even after taking into account a decline in tax revenues stemming from lower prices for the country's oil exports.

     But Finance Minister Bambang Brodjonegoro said in late June the government spent only 8% of its 290.3 trillion rupiah ($21.8 billion) infrastructure budget in the first half of the year. Indonesia's cumbersome bureaucracy typically underspends in the first half of the year because budgeting, tendering and procurement procedures take months to complete. A recent IMF report said in most years 60% of government spending takes place in the final quarter of the fiscal year.

     A reshuffle of government departments, including the merger of several ministries, has added to the confusion.

     Investment in infrastructure is sorely needed after years of delays and underfunding. According to the World Bank, Indonesia's infrastructure is now among the poorest in the region, imposing heavy costs on business. Irrigation systems have fallen into disrepair; power outages are routine in some regions; and most city dwellers do not have access to clean water and sanitation.

     The planning ministry has identified projects valued at 4,780 trillion rupiah to be completed during the 2015-2019 period, most of which require the participation of private investors. However, attracting private financing has proven difficult because of problems with pricing and risk-sharing, and implementation snags, including delays in land clearance.

     The government has turned to protectionist measures in hopes of stimulating domestic manufacturing, continuing a trend that began under former President Susilo Bambang Yudhoyono. The 2009 mining law, which came into effect in 2014, bans exports of unprocessed minerals, forcing mining companies to process output domestically. A bill now in parliament would require companies to build processing facilities near mines to boost regional development.

Local difficulty

This year, importers of mobile phones were required to set up manufacturing facilities in Indonesia or lose their import licenses. New local content requirements for all smartphones sold in the country are expected to be announced this month.

     Import duties on steel of between 15% and 40% were announced in May, a policy that will raise costs for exporters of car parts, kitchenware and other products.

     Last week Bank Indonesia, the central bank, relaxed loan requirements for the purchase of property, cars and motorcycles in an effort to boost domestic spending. At the same time, the bank said that it will enforce a ban on the use of foreign currency for domestic transactions that came into force Wednesday. International transactions are exempt, as are those for the oil and gas sector and the government.

     Restricting the use of dollars, the bank hopes, will prompt companies to favor rupiah deposits and loans, which would help stabilize demand for foreign exchange. But the ban runs counter to a separate rule requiring businesses to hedge short-term foreign loans not offset by foreign exchange balances. The moves have raised concerns the government will attempt to shore up the rupiah by imposing tighter restrictions on foreign exchange transactions.

     Slower growth in China and a weaker-than-expected recovery in the U.S. and Japan have added to gloom among policymakers about the outlook for Indonesia's exports, reinforcing the view that the country should rely on measures to stimulate domestic consumption and investment.

     Yet if past experience is any guide, Indonesia's growth prospects are closely tied to export earnings. In Indonesia, as in most countries, the contribution of domestic private consumption to growth is relatively stable. Spending on necessities and services is routine, following patterns that change only under exceptional circumstances, such as sharply rising prices.

     Since 2011, consumption has consistently added between 3 and 4 percentage points to economic growth every year.

     Changes in the rate of investment have a more pronounced impact on growth, ranging between 1 and 3 percentage points on an annual basis. An extra $15 billion in infrastructure spending would raise domestic investment by around 7%, which would give growth a lift, but probably not by much. The main benefits of investment in infrastructure are indirect: lower transport costs, faster turnaround times at ports and higher agricultural productivity in well-irrigated areas.

     That leaves net exports -- exports minus imports -- as the biggest contributor to growth. During the commodity boom of 2004 to 2011, net exports added as much as five percentage points to growth. A sharp drop in such exports cut growth by one percentage point in the last quarter of 2014.

     During the commodity boom, Indonesia enjoyed high prices for its mineral, energy and agricultural exports. Large trade surpluses boosted growth and tax revenues, which the government spent on fuel and other consumer subsidies. The downside of the boom was the steady appreciation of the real exchange rate, which made Indonesian exports more expensive and imports cheaper.

     The real exchange rate -- the buying power of the rupiah after accounting for the difference between foreign and domestic inflation -- reached its post-crisis peak in mid-2010. It is still above pre-boom levels despite the recent fall in the nominal exchange rate. A higher real exchange rate makes Indonesian exports more expensive and imported goods cheaper.

Go global

The idea that trade is central to Indonesia's growth is disputed by most Indonesian economists, who tend to believe a country of 250 million people should be able to rely mostly on domestic consumption to drive economic growth.

     But although it is true that domestic consumption has been the main component of growth in recent years, there is limited scope for increasing domestic demand in the absence of a strong push from trade. Growth in domestic consumption depends greatly on higher national income in the home market, whereas exports tap into far larger larger global markets.

     Lower transport costs, modular manufacturing and trade liberalization have helped shift manufacturing from North America, Europe and Japan to Asia and Latin America. The share of manufactured goods produced in low- and middle-income countries has risen from 10% in 1990 to about 33% today.

     Gustav Papanek, a professor at Boston University and a longtime observer of the Indonesian economy, argues the country is well placed to penetrate export markets for labor-intensive manufacturing because approximately 25 million workers in the agriculture and informal sectors are underemployed and need steady jobs. As wages rise in China, makers of garments, shoes, electronics, furniture and other goods will look to relocate to countries such Indonesia, Vietnam and Bangladesh where labor costs are lower.

     To attract these manufacturers, Indonesia needs to upgrade its infrastructure, cut the red tape that hampers inward investment and tackle corruption.

     Another benefit of increased exports is that it helps countries avoid leaning too heavily on short-term capital flows like bonds and bank loans. As the balance of trade has turned negative in Indonesia, the government and private sector have come to rely more on foreign borrowing to prop up demand.

     The resulting buildup in foreign liabilities poses risks to the economy, particularly at a time when the rupiah is already under pressure. Foreign borrowing has more than doubled since 2008 and now stands at nearly $300 billion, with private borrowing up more than 150% over the same period. Private foreign borrowing is concentrated in the property sector and some developers could come under financial pressure if demand for housing and office space weakens.

     If Indonesia sticks with its inward-looking strategy, the likely result will be slower growth and greater risk of financial turbulence.

     Meanwhile, regional competitors are moving to capture export markets that Indonesia is leaving uncontested. Vietnam and Malaysia are negotiating to join the Trans-Pacific Partnership, a 12-country trade deal that would ease access to the U.S. and Japanese markets. Vietnam has emerged as a major destination for electronics assembly, with industry leaders like Samsung of South Korea and Intel of the U.S. making major investments this year.

     There are signs that Indonesia's sluggish economic performance is prompting business leaders to question the current strategy. Rizal Ramli, president of state-owned Bank Negara Indonesia and a former economics minister, argues that if India and the Philippines can post growth rates of more than 7%, Indonesia should not be content with 4.7%.

     "In the last decade, Indonesia went into accelerated de-industrialization," he said. "Now is the time to turn this around, mobilizing our excess capacity as a platform for export growth."

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