Survey of recent developments

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1 Bulletin of Indonesian Economic Studies ISSN: (Print) (Online) Journal homepage: Survey of recent developments B. Raksaka Mahi & Suahasil Nazara To cite this article: B. Raksaka Mahi & Suahasil Nazara (2012) Survey of recent developments, Bulletin of Indonesian Economic Studies, 48:1, 7-31, DOI: / To link to this article: Published online: 14 Mar Submit your article to this journal Article views: 518 View related articles Citing articles: 6 View citing articles Full Terms & Conditions of access and use can be found at

2 Bulletin of Indonesian Economic Studies, Vol. 48, No. 1, 2012: 7 31 SURVEY OF RECENT DEVELOPMENTS B. Raksaka Mahi and Suahasil Nazara * University of Indonesia, Jakarta SUMMARY Despite a turbulent global economy and expectations that declining exports would cause an economic slowdown, the Indonesian economy grew at 6.5% in The growth rate was supported by high consumer confidence the result of lower inflation of just 3.8% in Nevertheless, there were indications that the global financial crisis had had an impact on Indonesia in the last quarter of 2011, notably on the growth of exports and imports. In October 2011, President Yudhoyono reshuffled his cabinet, citing a need to improve its performance in the administration s remaining three years. The reshuffle showed that the president is still subject to political party pressures. Moreover, the governing coalition of parties remains weak. Agreements made within coalition meetings are often broken in the parliament, and coalition parties are frequently distracted by media polemics. The case of former Democrat Party treasurer Nazaruddin, arrested in Colombia following a two-month manhunt, has revealed the magnitude of the money politics surrounding the Democrat Party, whose ratings are declining rapidly. Indonesia enters 2012 bolstered by the restoration of its investment-grade credit rating. This will expose Indonesia to increased capital flows, since many funds are permitted to invest only in investment-grade countries. The effects on foreign direct investment (FDI) are not automatic, however. These investors evaluate the wider business climate and economic governance in making their investment decisions. The fuel subsidy remains a challenge for Indonesia in 2011/12. Parliament rejected a proposal to limit fuel consumption from April 2012 over doubts about the government s readiness to handle the policy s technical complexity. Now the government is again considering a fuel price increase, and will have to seek parliamentary approval soon. Indonesia faces a long-term problem of regional inequality. After four decades of economic development there is little variation in the shares of GDP across regions, but GDP per capita in some regions is slipping behind that of Java. Regional development policy needs to generate more economic activities in the outer islands, and to learn from the mistakes of past initiatives to promote economic development and growth centres in the regions. It is important to align policies with the current decentralisation arrangements. The government is revising Law 33/2004 on Intergovernmental Finance with the aim of improving some dimensions of decentralisation in Indonesia. Revenue certainty is to be enhanced in part through changes to the general allocation grant (DAU) formula and the disbursement mechanism for intergovernmental transfers. The planned revision has not, however, addressed sufficiently the problem of inefficiency in regional spending. In fact, some of the proposed solutions may well create further spending inefficiency. The main barrier to increased FDI is infrastructure development, whose progress has been slowed by land procurement problems. Unfortunately, Law 2/2012 on Land Procurement for Public Purposes seems unlikely to deliver a clear solution to the key problem of determining fair prices for land compensation. What is needed is the creation of more independent pricesetting committees, with sufficient capacity to disentangle the problems of land acquisition. * The authors thank Witri Indriyani and Astrid Dita for data assistance. Special thanks go to Anton H. Gunawan and Abdurrochman for valuable help and advice. ISSN print/issn online/12/ Indonesia Project ANU

3 8 B. Raksaka Mahi and Suahasil Nazara POLITICAL DEVELOPMENTS In October 2011, President Susilo Bambang Yudhoyono (SBY) reshuffled his cabinet. The announcement of the planned reshuffle about three weeks earlier provoked much media speculation. While officially intended to improve the performance of the cabinet in the three remaining years of the SBY administration, the reshuffle showed that the president is still subject to political party pressures. The number of ministries in the reshuffled cabinet remains at 34. There were changes in two ministerial portfolios: the former Ministry of National Education becomes the Ministry of Education and Culture, while the Ministry of Tourism and Culture has become the Ministry of Tourism and Creative Economy. From an economic policy perspective, a significant feature of the reshuffle was the transfer of Mari Pangestu from the Ministry of Trade to the Ministry of Tourism and Creative Economy. This suggests a change in President SBY s trade policy direction. On many occasions, despite the international focus of his business experience and of his role as chair of the Investment Coordinating Board, the new Minister of Trade, Gita Wirjawan, has stressed the need to improve and strengthen the domestic market. 1 His appointment was seen by some as an indication of weakened commitment to free trade, and thus a source of concern that Indonesia will adopt more protectionist trade policies (Hill and Wihardja 2011). Another notable aspect of the reshuffle was the appointment of several new deputy ministers. According to Presidential Regulation 76/2011 which was enacted specifically for this reshuffle the post of deputy minister, established in 2009 (Patunru and Von Luebke 2010: 13), is a career, first-echelon position, and hence deputy ministers are not members of the cabinet. There are now 19 deputy ministers, up from 10 previously. The appointment of new deputy ministers began with interviews, and upon leaving the interview sessions the prospective appointees were instructed to announce their appointments to the media. It is widely believed that the respective ministers were not consulted about the appointments. This contrasts with the appointment of other first-echelon positions such as those of director general and secretary general, over which the relevant minister has considerable influence. It is not entirely clear how the expansion of deputy-ministerial positions will affect the quality of policy-making processes. The move poses risks for coordination among top management in the ministries, especially in the two that acquired an additional deputy minister the Ministry of Finance and the Ministry of Education and Culture. In these cases, each deputy minister has been tasked with coordinating a group of directorates general within the ministry. The impact of this cabinet reshuffle on the markets was markedly different from that of the reshuffle in 2005, when the current vice president, Boediono, was appointed coordinating minister for economic affairs and Sri Mulyani Indrawati was made finance minister. This time, the rupiah gained only 0.2%, to reach Rp 8,801/$, whereas in 2005, because of high expectations that the two new ministers could implement prudent and coherent economic policies, the rupiah appreciated by 7.5%, from around Rp 10,000/$ on 5 December to Rp 9,245/$ on 21 February (Kuncoro and Resosudarmo 2006: 9). 1 For example, on food production (Jakarta Post, 21/10/2011) and on Indonesian manufacturing being unready for global competition (Jakarta Post, 18/11/2011).

4 Survey of recent developments 9 The reshuffle did not result in a significant overhaul of the balance of political parties in the cabinet but, rather, served the coalition parties political interests and missed an opportunity to establish a structure of power based on Indonesia s reform priorities (Wihardja and Kristiadi 2011). Some in the inner circles of the Justice and Prosperity Party (PKS) and the president s Democrat Party (Partai Demokrat, PD), including their parliamentary members, had been bickering in public for months before the reshuffle about issues that were supposedly already settled in coalition meetings. 2 PD members accused PKS of disloyalty to the coalition because its members continued to criticise the president and the Democrat Party. Yet despite these disagreements, PKS members had been convinced that the president would keep the same number of PKS ministers in the cabinet because the party was part of the coalition. When the president announced the new ministerial positions, there was one less minister from PKS, but this could have been seen as being balanced by a reduction of one in PD s ministerial positions. PKS did consider pulling out of the coalition, but evidently pragmatism prevailed. Nevertheless, the president s broad-based coalition remains weak. Agreements made within Setgab meetings are not necessarily followed during policy-making processes in the parliament, and coalition parties often disagree publicly in the media. An example of the coalition s ineffectiveness in meeting PD s goals was evident during the selection of the leadership of the Corruption Eradication Commission (KPK). PD s candidate was neither elected as a KPK leader nor even appointed as a commissioner. Another test for Setgab is the preparation of a revised election law, likely to be considered by parliament in March. A contentious issue within the coalition is the parliamentary threshold the minimum percentage of votes that a party needs to be represented in the parliament. The smaller parties are fighting for a 3% threshold, while the larger parties, such as Golkar and the Indonesian Democratic Party of Struggle (Partai Demokrasi Indonesia Perjuangan, PDI P), want the threshold to be set at 5%. PD supports the government s proposed 4% threshold (Jakarta Post, 22/12/2011). PD does face serious reputational challenges. In addition to the challenges at Setgab, it now faces a potentially damaging corruption scandal. Its former treasurer, Nazaruddin, is on trial after a two-month manhunt by the KPK, leading to his arrest last August in Colombia. During the investigation and the trial, Nazaruddin has accused several members of parliament, notably the PD chair, Anas Urbaningrum, of being part of a high-level web of corruption, involving the parliament and political parties in rent-seeking business activities. Nazaruddin has also alleged that Anas s appointment as party chair involved vote buying. Discussion about replacing the party chair has mushroomed just at a time when the party is beginning to prepare for the 2014 elections. 2 The coalition meets in the Joint Secretariat or Sekretariat Gabungan (abbreviated as Setgab ). The parties in the coalition, apart from PD and PKS, are the Golkar Party (one of the major post New Order parties) and three smaller parties, the National Mandate Party (PAN), the United Development Party (PPP) and the National Awakening Party (PKB).

5 10 B. Raksaka Mahi and Suahasil Nazara MACROECONOMIC DEVELOPMENTS Growth Despite turbulence in the global economy, and contrary to expectations of an economic slowdown driven by declining export receipts, growth in the fourth quarter (Q4) of 2011 remained constant at 6.5% (table 1). In the same quarter, export growth fell to 7.9% from the rate of 17.8% recorded in Q3 2011, while import growth slowed to 10.1% from the Q3 figure of 14.0%. Private consumption picked up slightly in Q (4.9% compared with 4.8% in Q3), in response to lower inflation and rising consumer confidence. 3 Growth of investment soared from 7.1% in Q3 to 11.5% in Q4, with strong contributions from the machinery and equipment and transport sub-sectors. Machinery and equipment growth was, however, still lower than a year earlier because of its relatively slow growth in Q The high growth in transport was spurred by significant growth in foreign transport (49.8%); domestic transport actually contracted by 9.1% (CEIC Asia Database). The significantly lower growth of exports in Q was due to a decline in global commodity prices in response to weakening global demand. The fall in commodity prices, together with slower economic growth in Indonesia s trading partners, resulted in a slowdown in non-oil and gas exports (Danamon 2012: 2). There were, however, signs of rising global commodity prices in January 2012, 4 and therefore one can expect Indonesian export growth to recover in the near future. Although the growth of total imports slowed in Q4 2011, over the whole of 2011 merchandise imports increased faster (30.7%) than merchandise exports (29.1%) (Danamon 2012: 2). The increase in imports was led by capital goods and consumption goods, driven by vibrant growth in domestic investment and consumption. The growth of government consumption spending in Q remained constant at 2.8%. The budget deficit for 2011 was 1.3% of GDP, lower than the planned 2.1% (Bisnis Indonesia, 3/1/2012). Low disbursement of budgeted funds continued to cause concern. The Coordinating Minister for Economic Affairs, Hatta Rajasa, himself admitted that government was not yet playing an optimal role in boosting economic growth (Kompas, 19/12/2011). On the production side, the growth of non-tradables continued to outstrip that of tradables, at almost twice their rate. Over the whole of 2011, all non-tradables sectors except the small utilities (electricity, gas and water supply) sector grew more rapidly than total GDP. The primary sector (agriculture and mining and quarrying) is holding back economic growth, with mining and quarrying recording a contraction of 0.3% in Q The growth of this sector has been declining 3 Bank Indonesia s December consumer survey (BI 2012) showed an increase in the consumer confidence index in relation to current economic conditions, and also for the six months ahead, despite an expectation of inflationary pressures over the next two quarters (to March and June 2012, respectively). The consumer confidence index in December 2011 reached its highest level for three years. Bank Indonesia s November 2011 retail sales survey (BI 2011) predicted a rise in retail sales in the following three months and six months (to February and May 2012, respectively). 4 After an overall decline in December 2011, the World Bank s Commodity Markets website at < reports: [i]n January 2012 most commodity price indices posted modest gains. Energy prices rose by 2.6%, non-energy prices... by 2.9%, and food... by 2.2%; beverages edged up by 1.3%, raw materials rose by 2.5% and metals strengthened by 5.6%, but [fertiliser] fell by 2.7%.

6 Survey of recent developments 11 TABLE 1 Components of GDP Growth (2000 prices; % year on year) Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Gross domestic product GDP excluding oil & gas By expenditure Private consumption Government consumption Investment Construction Machinery & equipment Transport Exports Imports By sector Tradables Agriculture, livestock, forestry & fisheries Mining & quarrying Manufacturing Non-tradables Electricity, gas & water supply Construction Trade, hotels & restaurants Transport Communication Financial, rental & business services Services Source: CEIC Asia Database. since Q This may be a reflection of the fall in international commodity prices. However, it may also reflect problems with the implementation of the 2009 Mining Law, which still causes some uncertainty for investors in relation to benchmark pricing and asset divestment. Thus far Indonesia is weathering the global uncertainty fairly well. The global crisis has had an impact on emerging markets primarily through trade and financial flows. However, Indonesia s main trading partners, notably China, have not experienced a sharp decline in imports, although China s year-on-year GDP growth slowed to 8.9% in Q from 9.1% in the previous quarter. Most of Indonesia s exports to China are primary commodities, mainly for domestic consumption and investment. China s exports to the European Union, on the other hand, are primarily manufacturing products with minimal inputs from Indonesia. The indirect trade impact on Indonesia of the EU slowdown via China is therefore likely to be minimal.

7 12 B. Raksaka Mahi and Suahasil Nazara Inflation, monetary and exchange rate policy Inflationary pressure continued to decrease in the second half of The year-onyear (December 2010 December 2011) inflation rate was 3.8%, a marked decline from 7.0% a year earlier, and below the 5±1% inflation target of the central bank and the government. 5 Core inflation 6 for the whole year was 4.3%, close to that recorded in There was, however, a notable decline in administered price inflation, 7 from 5.4% in 2010 to 2.8% in Even more significant was the decline in volatile goods inflation, 8 from 17.7% in 2010 to 3.4% in Rice is still the highest contributor to annual inflation. In 2011, the rice price contributed 0.5% to total inflation, a marked difference from the contribution of 1.3% in In 2011 the Central Statistics Agency (BPS) recorded a rice price increase of 11.2%, just over one-third of the increase in 2010 (30.9%). Since rice is an important commodity affecting poverty, there may be a significant decline in the poverty rate in the results of the upcoming 2012 National Socio-Economic Survey (Susenas). In light of these lower inflationary pressures, Bank Indonesia (BI) cut its policy rate in October and November 2011 (by 25 and 50 basis points, respectively) and again in February 2012 (by 25 basis points) to the current level of 5.75% (figure 1). BI used the momentum of declining inflation throughout 2011, and especially the October deflation, for its aggressive November policy rate cut, with an expectation that this would further lower bank lending rates. Such an outcome is by no means certain, however. Commentators have pointed out that other factors such as the cost of funds and minimum reserve requirements have a greater impact than the policy rate on lending rates (Jakarta Post, 17/10/2011). Despite the declining policy rate, the nominal (6-month) Bank Indonesia Certificate (SBI) rate remains constant at slightly below 6.1% (figure 1). With declining inflation, the SBI rate continued to increase in real terms through to January This lowered money growth rates after the monetary easing in August September Entering 2012, there is room to lower the SBI rate. This should serve as a disincentive for banks to place their excess liquidity with the central bank, and also allow BI to reduce the cost of monetary operations. It is important to watch for potential inflationary pressures in 2012, as the government pursues its plan to cut energy subsidies. In the month of January 2012 alone inflation was 0.8% (Danamon 2012: 1), and the rice price increased by 3.4% over its December 2011 level. The American and European debt crises contributed to high capital inflow to Indonesia. Many funds that had invested in the US or Europe transferred to Indonesia, and foreign exchange reserves continued to grow until September High economic growth, increasing real SBI rates and a stable exchange rate made Indonesia an attractive investment destination. Foreign reserves showed a fairly consistent upward trend to August 2011 (figure 2). Pressures due to the 5 This paragraph draws extensively on BPS (2012). 6 Core inflation reflects price changes caused by fundamental factors such as demand supply interaction, expectations, the exchange rate, international commodity prices, and inflation in trading partner countries. 7 Administered price inflation reflects changes in government-regulated prices of goods and services such as fuel, electricity and transport. 8 Volatile goods inflation (sometimes called volatile foods inflation) represents the food price changes that are related to harvests, disruptions caused by natural events, or movements in domestic and international food commodity prices.

8 Survey of recent developments FIGURE 1 Monetary Policy and Inflation a (% p.a.) SBI rate 6 months CPI inflation Currency in circulation (rhs) BI policy rate Real SBI rate Jan-2011 Mar-2011 May-2011 Jul-2011 Sep-2011 Nov-2011 Jan a Currency in circulation is used as the indicator of money supply in preference to base money because of the distorting impact of occasional changes in banks minimum reserve requirements on the effective supply of base money; currency is the major component (about 75%) of base money. The growth rate shown has been smoothed based on the 2-month moving average values to clarify the underlying trend. The real SBI (Bank Indonesia Certificate) rate is approximated by the nominal rate less the contemporaneous CPI (consumer price index) inflation rate. Source: CEIC Asia Database. 150 FIGURE 2 Foreign Exchange Reserves Level of reserves ($ billion) Growth in reserves (% year on year) 0 Jun-2010 Sep-2010 Dec-2010 Mar-2011 Jun-2011 Sep-2011 Dec-2011 Source: CEIC Asia Database.

9 14 B. Raksaka Mahi and Suahasil Nazara CSPI 5,000 FIGURE 3 Composite Stock Price Index (CSPI) and Exchange Rate Exchange rate Rp/$ 10,000 4,000 8,000 3,000 CSPI 6,000 2,000 4,000 1,000 2, Jan Mar May Jul Sep Nov Feb-2012 Source: Indonesia Stock Exchange; Pacific Exchange Rate Service. global crisis can be seen from the decline in the stock market index in the third quarter (figure 3). In September 2011 foreign investors reduced their holdings of Indonesian stocks in response to emerging market risk sentiment. The composite index bottomed at 3,316 on 26 September, a 21% dip from the record high on 1 August. It recovered as Indonesia fared reasonably well through Q By 2 February 2012, the composite index had increased 4.1% from its opening level on 3 January. The rupiah came under pressure in Q3 2011, especially in September, driven primarily by global risk. It depreciated by 2.3% to Rp 8,804/$ in Q3 2011, with high volatility, and by 3.1% to Rp 9,080/$ in Q (figure 3). BI conducted aggressive foreign exchange market intervention, especially in August and September, and foreign reserves fell by $10 billion. The depreciation in the second half of 2011 was still in line with movements in other countries exchange rates in the region. In early 2012 the rupiah began appreciating again, in January alone by 1.2%. Anticipating the need for better foreign exchange monitoring, BI has modified its exchange rate policy. In September 2011, BI issued Bank Indonesia Regulation (Peraturan Bank Indonesia, PBI) 13/20/PBI/2011 on Foreign Exchange Export Proceeds and Foreign Exchange Debt Drawdown. The PBI stipulates that, effective 2 January 2012, all foreign exchange export proceeds should go into foreign exchange banks in Indonesia. Exporters must report their export activities to the banks, which in turn are required to report foreign exchange disbursements to BI. There is neither a minimum length of time to keep the proceeds in Indonesia nor an obligation to convert them into rupiah. This regulation would allow BI to have better records of export-related foreign exchange transactions. One should therefore expect quality improvement in statistics on exports, imports, foreign debt and the balance of payments. Indonesia s overall balance of payment flows reversed sharply in Q3 2011, moving from record inflows to outflows. Portfolio capital outflows over August and

10 Survey of recent developments 15 September contributed to an overall balance of payments deficit of $4.0 billion in Q (World Bank 2011). This was the first quarterly deficit since the height of the financial crisis that followed the collapse of Lehman Brothers in Q The deficit was driven by a sharp reversal in portfolio flows, as foreign investors sold down their shares and government bonds in the wake of heightened uncertainty surrounding the euro zone debt crisis (World Bank 2011). Nevertheless, a major positive factor has been the achievement of investmentgrade status, with the announcement by Fitch Ratings on 15 December 2011 of a change in Indonesia s long-term foreign and regional currency rating to BBB. On 17 January 2012, Moody s Investors Service also upgraded Indonesia s foreign and regional currency rating, to Ba1. Indonesia is now back at investment grade after losing this status in December 1997 during the Asian financial crisis. It is expected that Standard & Poor s will eventually follow suit with a status upgrade. Such ratings upgrades should expose Indonesia to many funds that are restricted to investing in investment-grade countries. Portfolio investors and pension funds are likely to be among the first to respond, but in the medium term the positive effect of the investment-grade status may be outweighed by the impact of the European economic crisis. By contrast, foreign direct investors are likely to attach less weight to the investment grade. Direct investors evaluate a wider range of factors, including the business climate and economic governance, and make their investment decisions accordingly. Corruption problems and weak infrastructure in particular will need serious attention if Indonesia is to benefit from its investment-grade status. The fuel subsidy The fuel subsidy is once again a problematic element of the budget. In 2011, actual fuel subsidy expenditure reached Rp trillion, or 127.4% of the revised budget target of Rp trillion (Manning and Purnagunawan 2011: 317; Antara News, 5/1/2012). The 2011 quota of 40.5 million kilolitres was exceeded by 1.4 million kilolitres, and the $111.55/barrel ICP (Indonesian crude price) average for January December 2011 (figure 4) was well above the revised 2011 budget assumption of $95/barrel. There was an internal government discussion about whether to increase the subsidised fuel price in December, but this was not done on the grounds that the budget could sustain the extra subsidy. However, the result is a continuing misallocation of budget funds that would be better used for activities such as building infrastructure and improving social protection programs and their coverage. In the 2012 budget, the government set the subsidy at Rp trillion and the quota at 40 million kilolitres. These targets do not seem feasible if the government wishes to keep the price of Premium fuel at the current level. The budget assumes an oil price of $90/barrel (Manning and Purnagunawan 2011: 317), which is well below the January 2012 ICP of $ Instead of increasing the subsidised price, the government has revived an initiative to end the sale of subsidised fuel to private cars in Greater Jakarta from April Subsidised fuel would be available only to public transport vehicles, motorcycles and fishing vessels (Jakarta Post, 3/1/2012). The limitation for private cars would in due course be expanded 9 Suryadarma and Sumarto (2011) analyse a similar initiative in 2010.

11 16 B. Raksaka Mahi and Suahasil Nazara FIGURE 4 Premium and Pertamax Prices and Indonesian Crude Price (ICP) a (Rp/litre; $/barrel) Rp/litre 16,000 $/barrel ,000 ICP (rhs) 120 8,000 4,000 Premium Pertamax Feb-2011 Apr-2011 Jun-2011 Aug-2011 Oct-2011 Dec-2011 Feb-2012 a Pertamax prices are those on the first day of each month for the Jakarta area. Source: Premium and Pertamax: Pertamina; ICP: Ministry of Energy and Mineral Resources. further to cover all of Java, and later the regions outside Java. This initiative failed to gain parliamentary approval in January, because of doubts about the government s readiness to handle the policy s technical complexity (Jakarta Post, 31/1/2012). This judgment relates in part to the lack of infrastructure to produce and distribute the non-subsidised Pertamax fuel. There may not be a problem for Jakarta, but there would be for the rest of Java and much more so for the outer islands. Another option, namely fuel-to-gas conversion for vehicles, also suffers from a lack of infrastructure, or even of a plan. Despite these problems, the parliament s rejection of the government proposal was a disappointing outcome, especially given that it was based on technical issues. The parliament requested the government to conduct a comprehensive study of the impact of restrictions on the use of Premium fuel, and to produce a complete roadmap for the conversion from oil to gas fuels. In reality, this is merely another way for the parliament to avoid taking a much-needed yet unpopular decision. There is an urgent need to curb consumption of the highly subsidised Premium fuel, and end the serious misallocation of budgetary resources that the subsidy represents. Given the high dependency that Indonesians have on this subsidy, not to mention its intricate link with the electricity subsidy, 10 no comprehensive plan could address all the potential negative effects of a reduction in the subsidy. Limits on consumption, price increases, oil-to-gas conversion and other measures need to be taken gradually. The potential impact on the poor needs serious consideration. However, past experience with compensation measures, existing 10 Some electricity generators are fuel-based. Higher fuel prices would therefore imply a higher electricity subsidy.

12 Survey of recent developments 17 TABLE 2 Distribution of Regional GDP, and Regional GDP per Capita Relative to Indonesia, by Major Island Group a (%) Regional GDP Distribution Regional GDP per Capita Relative to Indonesia Sumatra Jakarta Java (excluding Jakarta) & Bali Nusa Tenggara Kalimantan Sulawesi Maluku and Papua a Proportions are calculated based on current price regional GDP. Source: BPS, Statistik Indonesia, various years. policies and programs on social protection, and the availability of the latest data on potential social protection beneficiaries 11 should all give the government and the parliament sufficient confidence to allow them to adopt this much-needed policy. The government plans to submit an early budget revision, anticipating the need to increase fuel prices before too long (Jakarta Post, 4/2/2012). REGIONAL INEQUALITY Deep-seated regional inequality may cause social problems, especially if the imbalances are associated with regional differences in natural resource endowments. It is important for the government to protect marginalised groups in society, including especially backward areas that face specific economic challenges. Indonesia has witnessed the use of sentiments about regional inequality as a basis for separatist claims or requests for special regional autonomy status. Regional inequality is a long-term phenomenon in Indonesia. 12 Table 2 shows that there has been no significant redistribution of regional GDP in Indonesia for four decades. In 2010, Java (including Jakarta), Bali and Sumatra generated about 11 The government has established a single registry system for its social protection programs. The registry is now administered by the Secretariat of the National Team for the Acceleration of Poverty Reduction in the Office of the Vice President. (For a discussion of this National Team, see Suryadarma and Sumarto 2011.) The registry is based on the Social Protection Registration (PPLS) conducted by BPS in 2011, and covers approximately 25 million households in the lowest socio-economic status groups. 12 Regional inequality within a country is an international phenomenon. In many countries, the majority of economic activities are centred on certain regions. In China, eight coastal provinces accounted for more than 40% of total GDP in In Thailand, approximately 44% of 2005 GDP was produced in greater Bangkok.

13 18 B. Raksaka Mahi and Suahasil Nazara 82.4% of Indonesia s total GDP. Jakarta s share alone in 2010 was 16.3% of the total, almost twice that of four decades earlier. An interesting phenomenon is apparent in the trends in regional GDP per capita between 1971 and As a share of the country s per capita income, Jakarta s GDP per capita grew very rapidly (table 2), leaving all the other regions behind. Sumatra s GDP per capita is on a marked declining trend, while the rest of Indonesia shows a virtually unchanging share of GDP per capita over four decades. Java has a high concentration of economic activity and population, and this places intense pressure on the environment. The conversion of Java s fertile land to non-agricultural uses threatens food production capacity, primarily in respect of rice. Although such conversion is essential to support population growth and economic activity, it may also limit the island s ability to support the economy in the future. There is evidence of regional catch-up, but at a slower rate in the last decade. For the period prior to the Asian financial crisis, García and Soelistianingsih (1998) and Nazara (1999) confirmed the presence of income convergence, on a per capita basis, across provinces. Recently, Resosudarmo and Vidyattama (2006), Hill, Resosudarmo and Vidyattama (2008) and Sufii (2008), while further confirming the existence of convergence, also noted that the speed of convergence is declining. Income is not the only dimension of inter-regional inequality. Inequality is also apparent in the provincial Human Development Index (HDI), which reflects achievements on three dimensions: income, education and health. Figure 5 shows the increase in HDI values between 1996 and Higher values were apparent for West Papua and West and East Nusa Tenggara, and also for some provinces in Java and Sumatra. Twelve provinces improved at a faster rate than the nationwide figure, five of them in Java and Sumatra. Gorontalo was the only province to record a decline. 13 Overall, these figures support the hypothesis that inter-provincial convergence is occurring. The economic dominance of Java involves more than just total income and population. Java s economy benefits significantly from investments in other parts of Indonesia. Studies conducted by Hulu and Hewings (1993) and Nazara (2006) show that a positive shock such as investment outlays in off-java regions will in turn increase Java s output. Java is a major source of raw materials and other production inputs, and at the same time it is the main market for selling products. Policy options It is therefore important to assess the government s strategic policy options for addressing inter-regional inequality. The major policy response to date has of course been regional autonomy and decentralisation. Yet even though horizontal equity was one of decentralisation s main objectives, a decade after its effective implementation in 2001, decentralisation has not significantly changed the provincial shares of regional GDP. There have been numerous government initiatives to foster regional economic development by establishing new growth centres in the outer islands, and lessons can be learned from these initiatives. They have included the Batam Authority and the concept of integrated economic development zones (kawasan pengembangan ekonomi terpadu, or Kapet). Currently in Batam there is the free trade 13 Gorontalo province, established in 2001, was previously part of North Sulawesi.

14 Survey of recent developments 19 FIGURE 5 Improvement in Provincial Human Development Indicators (HDI) between 1996 and 2010 a West Papua West Nusa Tenggara East Nusa Tenggara East Java South Sulawesi West Kalimantan Central Java Riau South Sumatra Bangka Belitung Archipelago Papua Central Sulawesi Indonesia Bengkulu Riau Islands North Sulawesi East Kalimantan West Java DI Yogyakarta Lampung Southeast Sulawesi West Sulawesi South Kalimantan Jambi Central Kalimantan Maluku Banten Bali West Sumatra DKI Jakarta North Sumatra Nanggroe Aceh Darussalam North Maluku Gorontalo a The darker shaded area of each bar denotes the 1996 HDI. The lighter shaded area denotes the change in HDI values between 1996 and The provinces are sorted in descending order of the values in the latter series. New provinces established after 1996 (Riau Islands, Bangka Belitung Archipelago, Banten, Gorontalo, West Sulawesi, North Maluku and West Papua) show the 1996 HDI values of their respective provinces of origin. Source: Central Statistics Agency (BPS). zone and the Free Port Area (Kawasan Perdagangan Bebas dan Pelabuhan Bebas, or KPBPB), the successor to the Batam Authority. Another initiative to promote regional development is the Rehabilitation and Reconstruction Agency (Badan Rehabilitasi dan Rekonstruksi, or BRR) in Aceh Nias. The success of these experiments depends on two factors. First, the institutional setup must identify clearly the respective roles of the institutions and the regional autonomous government. Contradictory or overlapping roles will only result in disputes among the parties. On the other hand, full acquisition of one of these institutions by the regional government potentially diminishes the effectiveness of the initiative, because of the bureaucratic nature of government.

15 20 B. Raksaka Mahi and Suahasil Nazara Secondly, any form of regional economic growth centre must be part of a business solution. Indonesia should learn from the Kapet initiative. Established by Presidential Decree 89/1996 later amended by Presidential Decree 150/2000 the Kapet zones were intended to redistribute economic activities to less developed regions. However, they proved to have weak links with local economic activities and hence were never a successful model for new economic growth centres. The recently enacted Law 39/2009 on Special Economic Zones (Kawasan Ekonomi Khusus, or KEK) faces similar challenges. KEK proposals submitted by many provinces are still very much bureaucracy-driven rather than businessdriven. Moreover, various agencies within the central government are still reluctant to provide strong incentives such as tax reductions, fearing an erosion of their tax base. This fear is groundless: tax reductions should be granted only within the zone, which in turn should promote linkages with other taxable economic activities outside the zone. On the other hand, the identification of primary products for processing in these zones is based more on potential than on established results. It is important that KEK status, along with its regulatory and fiscal privileges, should be granted only to a well-established processing zone that has previously been supported by the local government. Another means of promoting more balanced regional economic development is through the provision of infrastructure in less developed areas, to improve the investment climate and boost growth. Two types of infrastructure need to be given priority in the outer islands (Nazara 2010). The first is energy, particularly electricity, since its availability is the key to many new economic activities. The second is transport infrastructure, as a means of improving inter-regional connectivity (Baird and Wihardja 2010: ), and hence regional equality. REVISIONS TO THE INTERGOVERNMENTAL FINANCE LAW It is now more than 11 years since Indonesia embarked on its major decentralisation program. Since 2000 the government has consistently increased fiscal transfers to the regions (table 3). In 2006, intergovernmental transfers rose sharply as a result of the oil price windfall in The oil price hike boosted central government revenues from non-tax income as well as from income tax, further increasing the level of general-purpose grants and shared revenues going to the regions. 14 Under the SBY administration, fiscal transfers per capita grew at around 6% annually in real terms for the period Intergovernmental transfers in the 2012 budget are projected to be 32.8% of total expenditure (MOF 2012: 2), or approximately 6% of GDP. For the last seven years, the implementation of decentralisation in Indonesia has been guided by Law 32/2004 on Regional Government and Law 33/2004 on Central Regional Government Fiscal Balance. There is a need to revise the laws because of difficulties with implementation. Despite the rise in transfers from the central government, regional governments often demand additional 14 Shared revenues are taxes and natural resource revenues shared between the centre and the regions. 15 This rate is calculated from data provided by the Directorate General of Central Regional Financial Balance, Ministry of Finance.

16 Survey of recent developments 21 TABLE 3 Intergovernmental Transfers (Rp trillion, 2005 prices) a 2012 b Intergovernmental grants Shared Revenue Funds (DBH) Taxes Natural resources General Allocation Funds (DAU) Specific Allocation Funds (DAK) Special Autonomy and Adjustment Funds Special Autonomy Funds Adjustment Funds Total a Revised budget. b Planned budget. Source: Adapted from data provided by the Directorate General of Central Regional Financial Balance, Ministry of Finance. increases. They also express concern about the uncertainty and unpredictability of intergovernmental transfers from the central government. Regional welfare has improved little over this period, because there has been both allocative and productive inefficiency in regional spending (Mahi 2010). Allocative inefficiency results from mismatches between what is needed and what the budget expenditure provides; productive inefficiency refers to low quality in the outcomes of the spending, resulting, for example, from corruption. Surveys and studies of basic health indicators and access to public health services in the regions show that conditions are deteriorating (Jakarta Post, 11/2/2012). Weaknesses in regional finance management constitute a serious problem in the implementation of decentralisation (Antara News, 6/7/2011). In addition to implementation issues, there is also a need to accommodate changes in laws and regulations pertaining to regional government that affect the central local relationship. 16 These factors have motivated the government to revise the two decentralisation laws. The Ministry of Home Affairs is in charge of drafting the revisions to Law 32/2004, while the Ministry of Finance is responsible for the revision of Law 33/2004. We now discuss several important elements of the revisions pertaining to Law 33/ Examples include Law 39/2007 on Excise Tax, which regulates revenue sharing for the tobacco excise tax, and Law 28/2009, which changed the property tax from a central government tax shared with local governments to a local tax. 17 The latest draft of the revision is available at <

17 22 B. Raksaka Mahi and Suahasil Nazara TABLE 4 Central and Regional Government Civil Servants ( 000) a Central government Regional government 3,217 3,247 3,618 3,682 3,699 Total 4,067 4,083 4,525 4,598 4,638 Rate of change (%) Teachers 1,469 1,601 1,724 1,689 1,695 Share of total (%) Central government Regional government Teachers a For 2011, data are available to June. Source: National Civil Service Agency. Eliminating the salary component of the DAU formula The formula for calculating the general allocation fund (Dana Alokasi Umum, DAU) consists of two main parts. The first part is the basic allocation, which is determined by the salary expenditure of the regional government, and the second part is the fiscal gap, which is calculated as the difference between the fiscal needs and the fiscal capacity of the regional government. The calculation of fiscal needs is based on several indicators, such as the region s population, area, HDI and gross regional domestic product. Fiscal capacity is the sum of the regional government s own revenues and shared revenue. Since the formula for calculating the DAU includes the basic allocation, which is for civil service salaries, this implies that civil service salaries are guaranteed by the DAU transfers, sending a signal to regional governments that increases in the number of civil servants will always be met by additional DAU transfers from the central government. Currently the basic allocation is about half of the total DAU. The revisions to Law 33/2004 eliminate salaries from the basic allocation. This change is designed to encourage regional governments to save on personnel spending, partly by reducing new recruitment. With salaries eliminated, the formula for calculating the DAU will be determined solely by the fiscal gap. The revised DAU plan looks promising, but it would be more effective if it were accompanied by civil service reform. According to the National Civil Service Agency, there are about 4.6 million civil servants in Indonesia, representing approximately 4.2% of the country s employed workers. About 80% of these are regional government civil servants. Teachers, whose salaries are paid by regional governments, represent the largest portion of the government s payroll, accounting for 36.5% of total civil servants. Table 4 indicates that the number of civil servants is increasing, especially at the regional level. The increasing number of regional government officials results in rising annual personnel spending, the largest category of regional government expenditure (figure 6). This has prompted the National Bureaucracy Reform Team to urge

18 Survey of recent developments FIGURE 6 Composition of Regional Government Expenditure a (%) Salaries Capital expenditure Goods & services a The 2011 figure is from the revised budget. Other expenditure Source: As for table 3. a moratorium on civil servant recruitment (Jakarta Globe, 27/6/2011), aimed at improving the system and avoid[ing] unqualified workers holding positions in state institutions. The team also suggested that the government thoroughly evaluate the organisational structures of central and regional government institutions. McLeod (2005: 155 6) proposes a number of reforms to improve the performance of the bureaucracy. They include allowing recruitment from outside the civil service at all levels; reforms to pay structures to make them more transparent; the use of fair and transparent performance evaluation procedures in promotion decisions; and returning to a system in which all civil service positions are professionally classified allowing recruitment to be matched to the skill requirements of each part of the bureaucracy. In response, the government has issued an agreement letter signed by the Ministers of Finance, State Administrative and Bureaucracy Reforms, and Home Affairs, declaring a moratorium on civil service recruitment, effective from September 2011 to 31 December Exceptions will be possible in selected categories such as teachers and lecturers, because of high numbers of impending retirements (Antara News, 24/8/2011). Promoting capital expenditure In order to promote infrastructure development, the government plans to encourage larger capital expenditures by regional governments. For this purpose, the revisions to Law 33/2004 propose that a minimum of 20% of regional budgets be dedicated to capital expenditure (including goods and services expenditure for maintenance). Given the diverse needs of regional governments across the country, setting a

19 24 B. Raksaka Mahi and Suahasil Nazara FIGURE 7 Regional Government Budget Realisation Surpluses as a Share of Regional Government Total Budgeted Spending for 2009 a (%) North Maluku Bengkulu Central Kalimantan Nanggroe Aceh Darussalam Southeast Sulawesi Riau West Sulawesi West Papua Lampung West Nusa Tenggara Maluku North Sulawesi North Sumatra Banten South Sulawesi Papua West Kalimantan South Sumatra Gorontalo Jambi East Kalimantan Riau Islands Central Java Central Sulawesi DI Yogyakarta DKI Jakarta East Nusa Tenggara West Java Bangka Belitung Archipelago South Kalimantan East Java Bali West Sumatra a Spending data: 2009 regional budgets. The surplus is calculated using 2009 budget realisation data. Source: As for table 3 fixed minimum expenditure for capital will reduce fiscal discretion at the regional level, potentially creating another type of allocative inefficiency. Instead of setting a minimum percentage of capital expenditure, the government could use the special purpose grants (Dana Alokasi Khusus, DAK) to encourage regions to allocate more funds to capital expenditure. The DAK is a regional transfer whose objectives include encouraging regional governments to fulfil national priorities such as the development of infrastructure. Since the DAK requires matching regional budget shares, regional governments receiving DAK funds for infrastructure purposes would need to allocate part of their capital expenditure budgets to DAK projects. Improving budget disbursement A large proportion of government expenditures occur in the fourth quarter (Baird and Wihardja 2010: 156). In the case of infrastructure projects, this often impairs