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.]