Sanjeev Sanyal, Singapore
Indonesia's economy is gathering momentum. The gross domestic product (GDP) growth accelerated to 5.5 percent yoy in the third quarter from 5.3 percent in the previous quarter. Manufacturing grew by 5.3 percent while construction grew 8.4 percent during the quarter. The transport and communications sector was especially strong at 13.5 percent.
Interestingly, the economy gathered pace despite a slowdown in domestic consumption to 2.8 percent from 5.6 percent in the previous quarter. Gross fixed capital formation also slowed to -0.3 percent from 1.2 percent in the second quarter. However, growth was helped by an acceleration in net exports as well as some accumulation of inventories. Despite these demand-side indicators, we feel that domestic demand conditions will be strong enough into 2007 to support an acceleration in growth.
There are a number of reasons why we feel that growth will accelerate next year. The most important factor is that interest has declined very sharply over the year, reversing the equally sharp monetary squeeze seen in the latter half of 2006.
As monetary conditions ease, we expect the private sector to feel far more confident about borrowing to consume or invest. As shown in the chart below, the absolute level of bank credit to the private sector has been growing strongly for several months now (even if the year-on-year growth rate has not yet recovered).
The second reason for expecting growth to pick up is that the Government's finances are now looking very strong. The public debt-to-GDP ratio will fall below 40percent in 2007 and the government can take advantage of low interest rates to borrow and invest in infrastructure.
The country's infrastructure is now creaking from the lack of spending since the Crisis and there has been a lot of talk about pushing investment into the sector. Unfortunately, actual spending has lagged due to procedural delays. However, we now hear that the experience of rebuilding Aceh and other disaster affected areas is smoothening the procedures so that we can expect a more generalized spending program in the next two years.
As had been widely expected, the inflation rate declined sharply in October as the statistical base effect of last year's fuel price hike was absorbed. However, trend in prices has proven to be even weaker than what had been anticipated in subsequent months with consumer price index rising barely 5.2 percent yoy in November (core at 5.9 percent).
One important factor is that food prices have been especially well behaved this year but almost all other categories (expect clothing) saw at least some declines in yoy inflation. The acceleration in the economy will probably improve pricing power in some categories next year but overall, inflation should remain subdued at 5.4 percent (unless oil price flares up again).
This is a very reasonable level by Indonesia standards and should allow the central bank to keep reducing rates into early 2007. We expect the benchmark rate to be reduced from 9.75 to 8.5 percent in a series of 25 basis point cuts.
Non-oil exports have been reasonably strong going into 2006, while non-oil imports have been weak and volatile. This has allowed Indonesia to run a sizeable merchandise trade surplus this year's resulting in a current account surplus despite growing services imports.
Although we do expect non-oil imports to pick-up next year as the economy accelerates, we feel that the trade balance will rise moderately next year's good enough to keep the current account surplus over US$7 billion. We feel that a current account surplus of this level (i.e. 2percent of GDP), rising foreign exchange reserves and an external debt-to-GDP ratio of 35 percent suggests an economy that is now robust enough to survive fairly significant external shocks. In other words, there is scope for another sovereign upgrade by rating agencies in 2007.
With external accounts in surplus and the US dollar weakening, Rupiah will probably be under some pressure to appreciate. However, Bank Indonesia's behavior in 2006 suggests that it will have a preference towards accumulating foreign exchange reserves. We expect foreign exchange reserves will stand at $43.3 billion at the end of this year, compared to $34.6 billion at the end of 2005 (despite accelerated repayment of debts to the International Monetary Fund).
It is likely that the central bank will continue to prefer further accumulation of reserves in 2007 and this will hold back the rupiah. In our view, this is a prudent approach given the history of this currency (especially with simultaneous reductions in interest rates and the risk that portfolio inflows could reverse in the second half if bond investors decide to take-profit).
From a macroeconomic stability perspective, Indonesia has finally recovered from the Asian Crisis: public finances look healthy again, external debt is manageable, the exchange rate appears stable and even inflation appears tamed.
However, it does not yet seem to have regained the economic dynamism that characterized many South-East Asian countries before the Crisis. Over the last decade, investor attention has drifted away to China, India and even Vietnam. Nonetheless, Indonesia's industrial sector is at last showing some signs of competitiveness.
Manufactured goods exports rose 18 percent yoy in the first eight months of the year and, if sustained, they will probably bring back much needed fresh investment. A Special Economic Zone in the Riau islands is under implementation and this may trigger a revival. This could be an important step towards bringing back dynamism to the Indonesian economy.
The writer is senior economist of Global Markets Research, Deutsche Bank. This is a personal view
