MONETARY POLICY REPORT

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2 MONETARY POLICY REPORT Quarter IV 2014 EXECUTIVE SUMMARY Indonesia s economy maintained macroeconomic and financial system stability during the third quarter of 2014 and January Such conditions were reflected in the declining current account deficit together with controlled inflation. Meanwhile, stronger economic growth was achieved in comparison to the previous month despite moderating slightly in general for The economic gains accomplished were closely tied to consistent and measured economic stabilisation policy instituted by Bank Indonesia in conjunction with the Government. The policies are further supported by stronger coordination with the Government in terms of inflation control and reducing the current account deficit as well as structural policy to bolster economic fundamentals in the medium-long term. The global economic recovery persisted, albeit at an uneven pace. The US economy is forecasted to grow beyond previous projections. Conversely, the economies of Japan and China are expected to expand more slowly than previously thought. The protracted recovery in Europe is predicted to persist, overshadowed by diminishing consumer confidence and the threat of deflation. Such conditions prompted the European Central Bank (ECB) to stimulate the economy through implementation of its Expanded Asset Purchase Program (EAPP). The planned monetary stimulus package is expected to spur an influx of foreign portfolio capital to emerging market countries, including Indonesia, despite potential global financial market uncertainty and volatility. Indonesia s economic growth accelerated during the fourth quarter of 2014 in comparison to the preceding quarter, despite annual growth for 2014 slowing down. The Indonesian economy achieved 5.01% (yoy) growth in the fourth quarter, up from 4.92% (yoy) in the previous period, indicating that the current contractionary phase of the economic cycle, which has persisted for several years, passed its nadir in the third quarter of National economic gains are primarily associated with stronger domestic demand in the form of construction investment and government consumption. Meanwhile, household consumption remained robust but moderated slightly in line with economic stabilisation policy. From an external standpoint, exports contracted relatively deeply as demand from emerging market countries ebbed and commodity prices dropped. Despite early signs of improvement during the fourth quarter of 2014, annual growth slowed in 2014 to 5.02%, which is lower than that posted in the preceding year but consistent with weaker global economic growth and macroeconomic stabilisation policy. By region, economic downswings affected several mining-based provinces, including Aceh, East Kalimantan, Riau and Papua. In contrast, regions that rely on manufacturing, such as Java and Jakarta, continued to enjoy relatively robust growth. The Indonesia balance of payments (BoP) improved in the fourth quarter of 2014, primarily due a smaller current account deficit. The current account deficit totalled US$6.2 billion (2.81% of GDP) in the fourth quarter, down from US$7 billion (2.99% of GDP) in the third. A growing non-oil/gas trade surplus, together with a decreasing oil and gas deficit, helped boost current account performance. The increasing non-oil/gas surplus was attributed to stronger export growth of manufactured products. Meanwhile, the capital and financial account recorded a large surplus, backed predominantly by foreign Laporan Kebijakan Moneter 1

3 direct investment (FDI) congruent with the positive perception investors hold concerning the domestic economic outlook. In January 2015, the trade surplus totalled US$0.7 billion, exceeding that posted in the preceding quarter, bolstered by a smaller oil and gas deficit. Consequently, foreign exchange reserves swelled in January 2015 to US$114.2 billion, equivalent to 6.8 months of imports or 6.6 months of imports and servicing external debt, which is well above international adequacy standards of around three months. The rupiah depreciated in line with broad-based US dollar appreciation. During the fourth quarter of 2014, the rupiah depreciated on average by 3.9% (qtq) to a level of Rp12,244 per US dollar. An increasingly solid US economy precipitated US dollar appreciation against all global currencies. Pressures on the rupiah persisted into January 2015 as the US dollar continued to appreciate in light of the ECB s plan to loosen its monetary policy stance, which was repeated in a number of other countries. On average, the rupiah depreciated 1.21% (mtm) to a level of Rp12,581 per US dollar. Bank Indonesia considers the recent rupiah fluctuations beneficial in terms of the current account deficit through lower imports, in particular of consumer goods, as well as greater export competitiveness, especially of manufacturing exports. Inflation remained under control, thus supporting the prospect of achieving the 2015 inflation target, namely 4±1%. The Consumer Price Index (CPI) experienced deflation of 0.24% (mtm) in January 2015 as a tangible outcome of lower fuel prices and less intense inflationary pressures on volatile foods. In addition, core inflation was controlled at a level of 0.61% (mtm) or 4.99% (yoy). Bank Indonesia will continue to strengthen coordination with the central and local government in terms of managing inflation of volatile foods and administered prices in order to ensure attainment of the inflation target. Financial system stability was maintained with the support of steadfast banking system resilience and relatively sound financial market performance. Banking industry resilience remained solid with credit risk, liquidity risk and market risk well mitigated and the support of a healthy capital base. At the end of the reporting quarter, the Capital Adequacy Ratio soared to 19.40%, well above the statutory minimum of 8%, while non-performing loans (NPL) were low and stable at around 2.0%. Liquidity position improved primarily due to the expansion of government accounts, with the gains expected to persist into January 2015 as currency flows back into the banking system after the recent end-of-year celebrations. In terms of the intermediation function, credit growth decelerated to 11.6% (yoy) from 13.2% (yoy) at the end of the third quarter in line with ongoing economic moderation. Meanwhile, deposit growth in December 2014 was 12.3%, down from 13.3% in the preceding quarter. On the other hand, capital market performance improved as the IDX Composite continued to rally. Moving forward, Bank Indonesia projects the national economy to continue improving, underpinned by stronger economic growth and maintained macroeconomic stability. A more robust economy is predicted in 2015 with growth forecasted in the range of %. Stronger economic growth will primarily stem from expansive government investments as fiscal capacity expands to catalyse productive economic activity, including infrastructure development as approved by the People s Representative Council in the 2015 budget. In addition, government-led measures to enhance the investment climate, including integrated licensing services (PTSP), are also expected to further boost investment activity. Meanwhile, inflation will continue to improve and is projected at the lower end of the 4±1% range in 2015, supported by controlled core inflation, a lower international oil price and increased food security. In terms of the external Monetary Policy Report 2

4 balance, the current account deficit will remain under control with a better structure in line with the monetary and macroprudential policy mix implemented by Bank Indonesia coupled with the Government s fiscal reforms. Concerning the financial sector, in accord with lower interest rates, adequate liquidity and stronger economic growth, deposit and credit growth are projected to accelerate respectively to 14-16% and 15-17%. Bank Indonesia will continue to monitor a variety of risks prevalent in the domestic economy, although some of the risks are minimised through the array of structural reforms implemented by Bank Indonesia in conjunction with the Government. From a global perspective, the risks associated with the proposed normalisation of the Federal Reserve s monetary policy stance will be partially offset by the planned monetary stimulus policy response in Europe, which is expected to spur capital flows into Indonesia. Additionally, a higher quality fiscal structure in 2015 will also attract foreign capital inflows. Regarding the risk of an economic downswing in China, structural reforms specifically targeted at expediting infrastructure projects and enhancing the investment climate along with exchange rate policy based on the rupiah s fundamental value are expected to boost export competitiveness in Indonesia. Consequently, pressures on the external balance will relatively ease. From an internal standpoint, inflation risks are minimal due to lower commodity and oil prices amidst minimal demand-side inflationary pressures coupled with the government s food security policy. Concerning growth, the government s avowed commitment to implement infrastructure projects will alleviate the risk of realised government investment falling short of the planned total. Taking into consideration the latest conditions as well as future economic risks and the outlook, the BI Board of Governors, convening on 17 th February 2015, decided to lower the BI Rate 25 bps to 7.50%, with the Deposit Facility rate also reduced 25 bps to 5.50% and the Lending Facility rate maintained at 8.00%, effective 18 th February Such policy measures were instituted based on Bank Indonesia s conviction that inflation will remain under control at the lower end of the 4±1% range in 2015 and Furthermore, the current policy direction is consistent with Bank Indonesia s efforts to reduce the current account deficit to a more sustainable level. Moving ahead, Bank Indonesia will continue to strengthen its monetary and macroprudential policy mix, as well as tighten coordination with the Government to ensure inflation remains low and the current account deficit is managed at a sounder level. Monetary Policy Report 3

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6 1 THE ECONOMY AND MONETARY POLICY Indonesia s economy maintained macroeconomic and financial system stability during the third quarter of 2014 and January Such conditions were reflected in the declining current account deficit along with controlled inflation. Meanwhile, stronger economic growth was achieved in comparison to the previous month despite moderating slightly in general for Current account performance improved during the fourth quarter of 2014, primarily supported by a non-oil/gas trade surplus and a declining oil and gas trade deficit. Recent economic accomplishments are closely linked to consistent and measured economic stabilisation policy instituted by Bank Indonesia and the Government. Such policy is further bolstered by stronger coordination with the Government in terms of inflation control and managing the current account deficit as well as to promote structural policy in order to reinforce economic fundamentals in the medium-long term. The Global Economy The global economic recovery persisted, albeit at an uneven pace. The US economy is forecasted to grow beyond previous projections. Conversely, the economies of Japan and China are expected to expand more slowly than previously thought. The protracted recovery in Europe is predicted to persist, overshadowed by diminishing consumer confidence and the threat of deflation. Such conditions prompted the European Central Bank (ECB) to stimulate the economy through implementation of its Expanded Asset Purchase Program (EAPP). The planned monetary stimulus package is expected to spur an influx of foreign portfolio capital to emerging market countries, including Indonesia, despite potential global financial market uncertainty and volatility. US economic growth surpassed previous projections, primarily supported by stronger domestic demand. Strong domestic demand, reflected by a higher Consumer Confidence Index (CCI) (Graph 1.1), was driven by an increase in terms of real income as the price of oil dropped and conditions on the labour market improved. A lower oil price, amidst strong US consumption, will continue to catalyse the US economy. On the other hand, improvements in the labour sector were reflected by a lower level of unemployment (5.6%), as job openings continued to increase (Graph 1.2). Monetary Policy Report 5

7 Graph 1.1. US Consumer Confidence Index Graph 1.2. US Unemployment Rate and Job Opening The economic recovery in Europe continued at a moderate pace, indicated by a decline in the Purchasing Managers Index (PMI) index. The PMI of Italy and France continued to contract, while that of Germany and Spain actually expanded (Graph 1.3). Congruously, the euro zone entered into a period of deflation during December 2014 (Graph 1.4). Consequently, the European Central Bank (ECB) will commence a program of quantitative easing in the form of an Expanded Asset Purchase Program (EAPP) worth EUR 60 billion each month from March 2015 until September The monetary stimulus is predicted to augment global liquidity, however the additional inflow of portfolio capital to emerging market countries, including Indonesia, will not be as large as that precipitated by the quantitative easing program of the Federal Reserve initiated in 2008 (Graph 1.5). Graph 1.3. European PMI Graph 1.4. Eropean Inflation Graph 1.5. Capital Inflow The economy of Japan grew slower than previously projected. Such conditions were evidenced by persistently weak consumption growth. Additionally, retail sales remained weak and consumer confidence is slipping (Graph 1.6). Meanwhile, the labour sector is yet Monetary Policy Report 6

8 to support stronger demand, with job hires declining and salary growth remains weak (Graph 1.7). On the other hand, the quantitative easing policy of the Bank of Japan successfully stemmed further yen depreciation, which boosted exports from Japan. Looking ahead, various government policies will help turn Japan s economy around, such as the 3.5 trillion stimulus package, tax breaks for companies that raise employee salaries, and structural reforms (known as Abe s Third Arrow). Graph 1.6. Japan Retail Sales Graph 1.7. Japan Salary and Job Hires The Chinese economy decelerated to a level lower than previously projected. Weaker growth in China was the result of slower investment growth as indicators of fixed asset investment worsened (Graph 1.8). In addition to investment, consumption indicators, such as retail sales, continued an ongoing downward trend. On the production side, the production index decreased along with manufacturing PMI, which entered a contractionary phase (Graph 1.9). The potential for persistent economic decline in China remains, indicated by large downside risks in the housing sector (property/housing prices remain weak) together with escalating deleveraging risk. Graph 1.8. China Investment and Consumption Growth Graph 1.9. China PMI Economic performance in India continued to improve but was lower than previously forecasted. Such conditions are congruent with weaker external demand, especially from China. Nevertheless, the adverse impact of weaker external demand was offset by an improvement in the Terms of Trade due to the lower oil price. On the other hand, industrial and investment activities increased after the application of reform policies, as confirmed by higher production and manufacturing indices (Graph 1.10). Furthermore, such circumstances ultimately boosted the level of business confidence (Graph 1.11). Monetary Policy Report 7

9 Graph India PMI Graph India Business Confidence Index In terms of global financial markets, potential uncertainty and volatility appeared on global financial markets as the European Central Bank (ECB) announced its planned monetary stimulus policy. Uncertainty surrounding implementation of the ECB s Expanded Asset Purchase Program (EAPP) stems from its somewhat complex execution, involving numerous central banks in the euro zone along with political risk factors in Europe, such as the ongoing developments in Greece. Such conditions are in line with sluggish economic growth in emerging market countries, which triggered additional liquidity from Europe to enter US investments that have a more attractive yield. Consequently, the US dollar will appreciate with greater potential volatility on global financial markets. Economic Growth Indonesia s economic growth accelerated during the fourth quarter of 2014 in comparison to the preceding quarter, despite annual growth for 2014 slowing down. The Indonesian economy achieved 5.01% (yoy) growth in the fourth quarter, up from 4.92% (yoy) in the previous period (Table 1.1), indicating that the current contractionary phase of the economic cycle, which has persisted for several years, passed its nadir in the third quarter of National economic gains are primarily associated with stronger domestic demand in the form of construction investment and government consumption. Meanwhile, household consumption remained robust but moderated slightly in line with economic stabilisation policy. From an external standpoint, exports contracted relatively deeply as demand from emerging market countries ebbed and commodity prices dropped. Despite early signs of improvement during the fourth quarter of 2014, annual growth slowed in 2014 to 5.02%, which is lower than that posted in the preceding year, consistent with weaker global economic growth and macroeconomic stabilisation policy. By region, economic downswings affected several mining-based provinces, including Aceh, East Kalimantan, Riau and Papua. In contrast, regions that rely on manufacturing, such as Java and Jakarta, continued to achieve relatively robust growth. Monetary Policy Report 8

10 %Y-o-Y, 2010 Price Table 1.1 Economic Growth - Demand Side Component I II III IV I II III IV 2014 Private Consumption Non Profit Private Consumption (-0.23) Government Consumption (-1.50) Investment Export (-4.53) 1.02 Import (-0.85) GDP Source : BPS - Statistics Indonesia Despite remaining strong, household consumption continued a slowing trend during the fourth quarter of 2014 in accordance with macroeconomic stabilisation policy. Household consumption growth decelerated from 5.08% (yoy) in the third quarter of 2014 to 5.01% (yoy) during the reporting period, attributable to weaker purchasing power as a result of higher inflation stemming from the fuel price hike as well as a drop in export earnings. Furthermore, consumption was also curtailed by macroeconomic stabilisation policy. Declining purchasing power was evidenced by sliding consumer confidence in economic conditions along with lower income expectations amongst the public (Graph 1.12). Meanwhile, decelerating household consumption growth was observable through weaker retail sales together with a contraction in automobile and motorcycle sales data during the fourth quarter (Graph 1.13). Graph Consumer Confidence Index Graph Retail and Motor Vehicle Sales In contrast to household consumption, government consumption accelerated during the fourth quarter of Government consumption recorded growth of 2.83% (yoy), up from 1.33% (yoy) in the preceding quarter. An increase in procurement contributed to the boost in government consumption. Investment performance improved on the back of robust construction investment growth. Investment growth gained momentum from 3.86% (yoy) in the third quarter of 2014 to 4.27% (yoy) in the subsequent period. Investment growth was supported primarily by construction investment, which posted 7.06% (yoy), in line with the recommencement of investment activity in the wake of the general election. Such conditions are demonstrable by the increase in imports of construction materials coupled with stable Monetary Policy Report 9

11 growth in terms of cement sales data (Graph 1.14). Nonetheless, stronger investment growth was stifled by a contraction of non-construction investment as household consumption slowed and exports also contracted. The contraction of non-construction investment manifested in declining imports of capital goods and sales of domestic heavy equipment during the fourth quarter of 2014 (Graph 1.15). Graph Building Investment Indicators Graph Nonbuilding Investment Indicators Externally, export performance contracted relatively deeply, predominately due to waning demand from emerging market countries together with lower commodity prices. Exports contracted 4.53% (yoy) during the fourth quarter of 2014, significantly lower than the positive 4.86% (yoy) achieved in the preceding quarter. Such conditions were attributed to sluggish demand from emerging market countries (Graph 1.16) and lower commodity prices. In addition, the export contraction was also blamed on the base effect of expansive mining export growth during the third quarter of 2013 as enforcement of the Mineral and Coal Mining (Minerba) Act approached at the beginning of 2014 (Graph 1.17). Despite the general decline in exports, manufacturing exports still performed positively as the US recovery persisted and the rupiah fluctuated in accordance with its fundamental value. Graph World Trade Volume (Import) Graph Non-oil Export (Real Value) Import performance improved during the fourth quarter of 2014 in response to stronger domestic demand (Graph 1.18). Imports recorded 3.22% (yoy) growth during the reporting period, up from 0.28% (yoy) in the previous quarter. Concerning non-oil/gas, raw material imports surged as the manufacturing requirement increased to meet domestic demand (Graph 1.19). Additionally, import growth was also driven by oil and gas imports as an anticipatory measure implemented by Pertamina to mitigate increased consumption prior to the proposed subsidised fuel price hike in the middle of November Monetary Policy Report 10

12 Graph Domestic Demand and Import Graph Non-oil Import (Real Value) During the fourth quarter of 2014, improvements in a number of economic sectors 1, especially non-tradeable sectors (Table 1.2), helped boost the national economy. In terms of non-tradeable sectors, gains affected the construction sector as optimism abounded regarding new demand. Conversely, tradeable sector performance moderated in comparison to the preceding quarter. The agricultural sector decelerated as some of the area allocated to rice production was converted to maize and soybean. Meanwhile, the manufacturing sector also grew slower due to a prevailing trend of weaker private consumption and declining exports towards yearend Table 1.2 Economic Growth - Supply Side %Y-o-Y, 2010 Price Sector I II III IV I II III IV 2014 Agriculture Mining and Quarrying Manufacturing Industries Electricity and Gas Supply Water Supply Construction Trade and Car Repair Transportation and Warehousing Accommodation, Food and Water Supply Information and Communication Finance Real Estate Business Services Government Administration Education Services Health Services Other Services GDP GDP data published by BPS-Statistics Indonesia on 5 th February 2015, using 2010 as the base year and applying the 2008 System of National Accounts (SNA2008). Based on the SNA concept, the classification of GDP was improved from nine economic sectors previously to 17 fields of business currently. Monetary Policy Report 11

13 Geographically by region, the national economic recovery was bolstered in the fourth quarter of 2014 by sounder economic performance on the island of Java (Figure 1.1). Economic gains in various regions of Java were precipitated by persistently solid industrial performance. Kalimantan also performed well as mining activities were ramped up, although performance was limited by low prices. Meanwhile, economic performance on the island of Sumatra began to stabilise as the plantation sector improved. In contrast, economic growth in Eastern Indonesia was restrained by a mining sector contraction in a number of provinces, such as Papua, West Papua, Southeast Sulawesi and Central Sulawesi. Figure 1.1. Economic Growth by Region Quarter IV 2014 Despite promising signs of recovery during the fourth quarter of 2014, in general growth in 2014 slowed to 5.02% (yoy), below that posted in the preceding year. Recent developments are in line with listless global economic growth and macroeconomic stabilisation policy. Economic expansion decelerated in 2014 primarily due to declines in exports and domestic demand. Exports decreased as world trade volume declined, principally in emerging market countries, and restrictions on unrefined mining exports were introduced. Meanwhile, weaker domestic demand affected government consumption and investment. Slower government consumption growth was attributed to a program of budget cuts implemented to maintain the fiscal balance. On the other hand, weaker investment growth was a response to persistently sluggish exports and stabilisation policy. Indonesia Balance of Payments The Indonesia balance of payments (BoP) continued to improve during the fourth quarter of 2014, primarily supported by reductions in current account deficit. In general, the balance of payments recorded a surplus of US$2.4 billion in the fourth quarter (Graph 1.20). The surplus was propped up by current account deficit reductions and a sufficiently large capital and financial account surplus. The fourth quarter BoP surplus in turn augmented the position of foreign exchange reserves in the country from US$111.2 billion at the end of the third quarter to US$111.9 billion (Graph 1.21), equivalent to 6.4 months of imports and servicing external debt, which is well above international adequacy Monetary Policy Report 12

14 standards of around three months. Furthermore, the forex position increased again in January 2015 to US$114.2 billion. Graph Indonesia s Balance of Payment Graph Indonesia s International Reserves Against the backdrop of a slower-than-expected global economic recovery, current account performance improved. The current account deficit was reduced in the fourth quarter of 2014 to US$6.2 billion (2.81% of GDP) from US$7.0 billion (2.99% of GDP) in the third quarter (Graph 1.22). A growing trade surplus for goods in line with a larger nonoil/gas trade surplus and smaller oil and gas trade deficit supported reductions in the current account deficit (Graph 1.23). The non-oil/gas surplus expanded due to greater exports, particularly of vegetable oil and manufactured products. In terms of the oil and gas account, despite an increase in the volume of oil imported, the oil and gas trade deficit narrowed as the global price of crude oil dropped continuously. In January 2015, the trade balance registered a US$0.7 billion surplus, exceeding that of the previous month, boosted by a smaller oil and gas deficit. Graph Current Account Graph Trade Balance The approving perception investors hold concerning the domestic economic outlook maintained the influx of foreign capital and offset the current account deficit. During the fourth quarter of 2014, the capital and financial account surplus was bolstered by inflows of foreign direct investment (FDI) along with surplus of other investments stemming from withdrawn savings of citizens abroad and withdrawn corporate external debt (Graph 1.24). Nevertheless, the capital and financial account surplus was smaller than that reported in the third quarter due to foreign funds flowing out of rupiah portfolio instruments in December 2014, triggered by growing investor concerns regarding the planned hike in the Fed Funds Rate after improved US economic data was released. Monetary Policy Report 13

15 Graph Capital and Financial Account In general, the Indonesia balance of payments improved significantly during 2014 due to successful stabilisation policy persued by Bank Indonesia and the Government. The 2014 BoP recorded a US$15.2 billion surplus after previously experiencing a US$7.3 billion deficit in The improvement was due to current account deficit reductions and a flourishing capital and financial account surplus. The current account deficit narrowed to US$26.2 billion (2.95% of GDP) from US$29.1 billion (3.18% of GDP) in 2013 as a result of declining imports in line with sluggish domestic demand stemming from economic moderation. On the export side, despite a general decline, manufacturing exports prospered as the US recovery persisted, which ultimately bolstered overall performance. In addition, a shrinking services deficit and wider secondary income account surplus contributed to sounder current account performance. On the other hand, the capital and financial account surplus in 2014 totalled US$43.6 billion, up from US$22.0 billion in The burgeoning capital and financial account surplus was fueled by investor confidence in the economic outlook of Indonesia. Rupiah Exchange Rate The rupiah depreciated in line with broad-based US dollar appreciation. During the fourth quarter of 2014, the rupiah depreciated on average by 3.9% (qtq) to a level of Rp12,244 per US dollar. An increasingly solid US economy precipitated US dollar appreciation against all global currencies (Graph 1.26). Graph Exchange Rate Graph Apr./Depr. Regional Currencies Monetary Policy Report 14

16 Pressures on the rupiah persisted into January On average, the rupiah depreciated 1.21% (mtm) to a level of Rp12,581 per US dollar as the US dollar continued to appreciate in light of the ECB s plan to loosen its monetary policy stance, which was repeated in a number of other countries. The euro depreciated in line with expectations of quantitative easing implemented by the European Central Bank (ECB), prompted by increasing US dollar appreciation. Furthermore, rupiah depreciation also stemmed externally from growing concerns over the potential exit of Greece from the European Union, otherwise known as the Grexit. Escalating risk factors associated with rupiah depreciation were also reflected in a higher VIX Index and CDS (Graph 1.27). During the month of January 2015, rupiah volatility eased and was relatively well mitigated in comparison to other peer countries (Graph 1.28). Graph 1.27 VIX and CDS Graph 1.28 Exchange Rate Volatility (Peer Group) Bank Indonesia considers recent rupiah fluctuations beneficial in terms of the current account deficit through lower imports, in particular of consumer goods, as well as greater export competitiveness, especially of manufacturing exports. Moving forward, Bank Indonesia will strive to tirelessly maintain rupiah stability in accordance with its fundamental value, thereby underpinning macroeconomic stability and economic rebalancing in a sounder and more sustainable direction. Inflation Inflation remained under control, thus supporting the prospect of achieving the 2015 inflation target, namely 4±1%. Fourth quarter inflation was 4.49% (qtq) or 8.36% (yoy), up from 1.68% (qtq) or 4.53% (yoy) in the third quarter, driven by subsidised fuel price hike and undulating domestic food prices at yearend Notwithstanding, core inflation remained under control during the reporting quarter at 4.93% (yoy) due to coordinated inflation control between Bank Indonesia and the Government. Recent developments indicate that the Consumer Price Index (CPI) experienced deflation of 0.24% (mtm) in January 2015 as a tangible outcome of lower fuel prices and less intense inflationary pressures on volatile foods. In addition, core inflation was controlled at a level of 0.61% (mtm) or 4.99% (yoy). Inflationary pressures on volatile foods intensified during the fourth quarter of 2014 due to limited supply of several varieties of chilli and rice. Inflation of volatile foods was 6.23% (qtq) or 10.88% (yoy), which is up from 2.11% (qtq) or 4.21% (yoy) in the preceding quarter. Limited supply, especially of various chillies and rice due to drought Monetary Policy Report 15

17 from the end of September to the beginning of November, coupled with heavy rainfall from the end of November into December, exacerbated price pressures on volatile foods. Besides, more expensive distribution costs due to the cost-push inflation of the subsidised fuel price hike in the middle of November 2014 also placed additional pressures on volatile foods. Finally, the suspension of the Raskin (rice subsidies for the Poor) program in November and December also amplified price pressures on volatile foods during the fourth quarter. In January 2015, inflationary pressures on volatile foods eased due to a price correction affecting various chilli varieties. Volatile food inflation was relatively low at 0.55% (mtm), down from 3.53% (mtm) in the preceding month (Graph 1.30). Price corrections of various chillies, as a consequence of entering the main harvest season at several production hubs including Tasikmalaya, Sukabumi, Magelang, Rembang, Kediri, Blitar, Banyuwangi and Gorontalo, helped alleviate inflation of volatile foods. Although volatile food inflation was relatively low in general, price pressures influenced chicken meat, fresh fish and rice. Higher chicken meat prices were the result of less production at large poultry farms due to sluggish demand in the preceding period, while fresh fish prices were affected by inclement weather that has befallen Indonesia since the beginning of January Meanwhile, higher rice prices were predominantly due to limited supply as the planting season was delayed, coupled with a higher Government Purchase Price as of 14 th January Graph Diaggregation of Inflation Graph Volatile Food Inflation/Deflation Administered price inflation intensified during the fourth quarter of 2014 as a result of the subsidised fuel price hike. In the reporting quarter, administered price inflation increased from 2.51% (qtq) or 6.53% (yoy) to 12.03% (qtq) or 17.57% (yoy). Government policy to hike subsidised fuel prices on 18 th November 2014 drove up prices directly and indirectly through the second-round effect on transportation fares. In addition, sources of inflationary pressures on administered prices throughout the fourth quarter also emanated from higher electricity rates as well as more costly household fuels and airfreight tariffs. Notwithstanding trends in the fourth quarter, administered prices experienced deflation in January 2015 after the Government readjusted fuel prices. Administered price deflation was -3.51% (mtm), down from 6.10% (mtm) posted in the preceding month (Graph 1.31). Government policy to lower the prices of petrol and diesel on 1 st January and 14 th January 2015 contributed to the deflation, namely of -0.71% (mtm) for petrol and -0.02% (mtm) for diesel (Table 1.3). Such policy was followed by reductions in urban transportation fares, which contributed a further 0.07% (mtm) to deflation. Monetary Policy Report 16

18 Meanwhile, administered price inflation primarily affected household fuels as well as commercial and residential electricity rates with a capacity exceeding 2200 VA, which came into effect on 1 st January Table 1.3. Administered Prices Inflation Contributor-January 2015 Graph Administered Prices Inflation Core inflation was controlled during the fourth quarter of 2014, despite encountering external and domestic pressures. Core inflation was recorded at 1.70% (qtq) or 4.93% (yoy), up slightly on the 1.28% (qtq) or 4.04% (yoy) of the previous quarter. External pressures predominantly stemmed from rupiah depreciation but were offset by lower international prices, as indicated by a lower Imported Inflation Price Index (IIPI). On the other hand, domestic pressures were more attributable to the cost-push inflation of the subsidised fuel price hike, while demand-side pressures were managed in line with moderating economic growth. Controlled core inflation persisted into January 2015 as external and domestic pressures eased. Core inflation was 0.61% (mtm) or 4.99% (yoy) in January 2015, down from 1.03% (mtm) or 4.93% (yoy) in the previous month. External pressures abated as rupiah depreciation eased. Furthermore, less intense external pressures in January 2015 were also reflected by a decline in traded core inflation. Higher inflation was minimised on the external side by persistently low international prices, as demonstrated by negative growth of the Imported Inflation Price Index (IIPI), excluding gold and crude palm oil (CPO) (Graph 1.32). On the domestic front, both retail sales and consumer credit data experienced slower growth. Moreover, the supply side successfully responded to domestic demand pressures, thereby avoiding further pressures on prices. Lower non-traded core inflation was indicative of easing domestic inflationary pressures. Graph Core Traded Inflation and External Factor Graph Core Nontraded Inflation Monetary Policy Report 17

19 Controlled core inflation was bolstered in the fourth quarter of 2014 by wellanchored inflation expectations at the retailer and consumer levels. In terms of retailers, an increase in inflation expectations after the fuel price hike in November 2014 indicated less intense price pressures for the upcoming three and six months in comparison to the fuel price hike implemented in 2013 (Graph 1.34). In addition, inflation expectations at the consumer level for the next three and six months declined in line with confidence that the impact of the fuel price hike is merely temporary (three months from November) and optimism concerning greater availability of goods during the upcoming year. Graph Retailer s Inflation Expectation Graph Consumer s Inflation Expectation Geographically, inflationary pressures escalated in various regions during the fourth quarter of Inflationary pressures were intense but evenly dispersed throughout nearly all provinces in the reporting quarter. The most intense inflationary pressures were found in Sulawesi-Maluku-Papua, Bali-Nusa Tenggara and Jakarta. Nevertheless, the majority of provinces on the islands of Sumatra and Java experienced deflation in January 2015 despite a number of other regions continuing to contend with inflation. The deepest deflation was felt in West Sumatra, triggered by a significant price correction for red chilli as well as the commencement of price corrections for rice upon entering the harvesting season. On the island of Java, however, deflation affected Jakarta as fuel prices declined and the supply of chilli surged. Nonetheless, several regions noted an increase in inflation, including Maluku, East Nusa Tenggara and the majority of Kalimantan due to rising fresh fish prices, as well as more expensive household fuels and other produce such as chicken meat and vegetables (Figure 1.2). Figure 1.2. Map of Inflation by Region (%, mtm) Monetary Policy Report 18

20 Monetary Developments Interest rates and money supply remained in alignment with the monetary policy direction adopted by Bank Indonesia. The interbank rate was relatively stable during the fourth quarter of 2014, while bank interest rates continued to climb. Upward interest rates amidst economic moderation in the fourth quarter subsequently influenced liquidity dynamics in the economy. Such conditions were demonstrable through relatively stable liquidity on the interbank money market and in the banking industry. The interbank money market experienced a relatively stable overnight (O/N) rate, accompanied by growing average volume. The weighted average overnight interbank rate was relatively stable at 5.81% in the fourth quarter of 2014 compared to 5.86% in the preceding quarter (Graph 1.36). Tight liquidity on the money market eased as the interbank rate declined for tenors exceeding overnight, which narrowed the spread between various tenors against the overnight. As tight liquidity eased, average interbank money market volume increased to Rp12.9 trillion from Rp10.8 trillion in the previous quarter (Graph 1.37). Graph Overnight Interbank Market Rates Graph Overnight Interbank Volume Bank rates continued to follow a rising trend during the fourth quarter of The weighted average deposit rate, which actually decreased during the first two months of the fourth quarter due to improved liquidity conditions and the application of the OJK cap, increased again during December in response to a higher BI Rate. Consistent with rising deposit rates, lending rates also increased but at a lesser magnitude and with a lag. By quarter, the weighted average lending rate climbed 8 bps to 12.95% from 12.87% (Graph 1.38). The higher weighted average lending rate stemmed from a 20-bps increase in the consumer credit rate to 13.58%. Meanwhile, the rates on working capital credit and investment credit increased 1 bps to 12.79% and 2 bps to 12.36% respectively. Consequently, the spread between the lending rate and 1-month deposit rate narrowed to 437 bps in the fourth quarter from 439 bps (Graph 1.39) in line with a greater magnitude increase in the 1-month deposit rate compared to the lending rate. Liquidity in the economy (M2) swelled during the fourth quarter of 2014, primarily due to an increase in quasi-money. M2 growth increased to 11.8% (yoy) in the fourth quarter from 11.7% (yoy). By component, an increase in quasi-money contributed most to M2 growth. Higher deposit rates and less economic activity encouraged the public to increase their savings held at banks. In contrast, another component of M2, namely M1, decelerated to 6.2% (yoy) from 9.4% (yoy) as a result of weaker currency and rupiah Monetary Policy Report 19

21 demand deposit growth, declining from 9.8% (yoy) and 9.1% (yoy) to 4.9% (yoy) and 7.3% (yoy) respectively (Graph 1.40 and Graph 1.41). Graph Loan Rates Graph Bank Interset Rates Graph Growth of M2 and Its Components Graph Growth of M1 and Its Components Based on its determinants, the increase in M2 primarily stemmed from greater net claims on the central government (NCG). In the fourth quarter of 2014, NCG accelerated from 1.0% (yoy) to 2.5% (yoy) in line with the prevailing trend of government spending at yearend. Meanwhile, Net Foreign Assets (NFA) tended to decline (Graph 1.42). Graph Growth of M2 and Its Contributing Factors Monetary Policy Report 20

22 The Banking Industry Financial system stability remained solid, underpinned by banking system resilience and relatively well-maintained financial market performance. Banking system resilience remained robust, with credit risk, liquidity risk and market risk well mitigated. Furthermore, banking industry resilience was also preserved with the support of a sound capital base. Credit growth slowed mainly due to working capital credit. Credit growth in the fourth quarter of 2014 decelerated once again to 11.6% (yoy) from 13.2% (yoy) in the preceding quarter (Table 1.4). The decline in credit growth was predominantly attributed to working capital credit, which slowed from 13.3% (yoy) in the third quarter to 10.8% (yoy) in the reporting period. Meanwhile, investment credit growth also followed a declining trend, from 16.4% (yoy) in the third quarter to 13.2% (yoy). Conversely, growth of consumer loans accelerated from 10.1% (yoy) to 11.5% (yoy). By sector, weaker credit growth stemmed from the trade sector and manufacturing sector, slowing from 13.9% (yoy) and 16.1% (yoy) to 12.4% (yoy) and 14.3% (yoy) respectively. Deposit growth also decelerated during the reporting quarter. Deposits recorded growth of 12.3% (yoy) in the fourth quarter, down from 13.3% (yoy) in the previous period, affecting all components (Graph 1.43). Table 1.4. Credit Growth Monetary Policy Report 21

23 Graph Deposit s Growth Banking sector conditions were maintained amidst moderating credit growth. Capital remained sufficient during the fourth quarter of 2014, with a capital adequacy ratio of 19.36%. In terms of profitability, banking industry ROA was sound at 2.85% (Table 1.5). Table 1.5 Banking Indicators Main Indicators 2014 Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Des Total Asset (T Rp) 4, , , , , , , , , , , ,615.1 Deposits (T Rp) 3, , , , , , , , , , , ,114.4 Credit * (T Rp) 3, , , , , , , , , , , ,674.3 LDR* (%) NPLs Gross* (%) CAR (%) NIM (%) ROA (%) * without channeling ** with channeling The Stock Market and Government Securities Market Bullish sentiment helped drive positive domestic stock market performance during the fourth quarter of The IDX Composite peaked at a level of 5, on 31 st December 2014, increasing 1.7% (qtq) (Graph 1.44) on that achieved in the third quarter (5,137.60). The rally was triggered by positive investor sentiment surrounding the smooth government post-election transition process. Furthermore, government policy to raise subsidised fuel prices on 17 th November 2014, followed by Bank Indonesia raising its benchmark BI Rate 25 bps, elicited a favourable response on the stock exchange. Nevertheless, global investor anticipation of the FOMC meeting in the middle of August, which erred on the side of hawkish, placed additional pressures on the stock market. Pressures on the stock market eased and then intensified again after the FOMC announced the Federal Reserve would delay raising its reference Fed Funds Rate. In comparison to other stock exchanges in the region (Vietnam, the Philippines, Thailand and Malaysia), the Indonesia Stock Exchange performed soundly during the reporting quarter, achieving positive growth while other bourses in the region tended to contract. Monetary Policy Report 22

24 The domestic stock market performed positively again in January The IDX Composite closed at a level of 5, on 30 th January 2015, rallying 2.71% (mtm) (Graph 1.45) on the position recorded in December 2014 at 5, The index hit an all time high on 23 rd January 2015 at a level of 5, On the domestic front, fuel subsidy reforms helped push up the IDX Composite. Externally, however, stock market gains were influenced by market sentiment stemming from the Fed s decision to postpone raising its benchmark rate in the near future. Additionally, sentiment linked to the ECB s stimulus policy also garnered investor optimism to enter the domestic stock market. Graph JCI and Global Stock Index Quarter IV-2014 (qtq) Graph JCI and Global Stock Index January 2015 (mtm) Positive domestic sentiment spurred stronger performance on the tradeable government securities (SBN) market. Positive domestic sentiment concerning the smooth and opportune post-election government transition, together with Bank Indonesia policy to raise its BI Rate in anticipation of higher inflation stemming from the recent fuel price hike, prompted sound SBN market performance. Nonetheless, external negative sentiment originating from economic downswings in China and Japan, a lower international oil price towards yearend 2014 and global investor anticipation of a hawkish FOMC announcement in the middle of August 2014 stifled further rally of IDX Composite. Furthermore, the FOMC s announcement that the Federal Reserve would delay raising its benchmark Federal Funds Rate precipitated positive sentiment on the domestic tradeable government securities market. Global investors re-entered the domestic bond market, thereby pushing down SBN yield towards the end of In general, SBN yield declined 57 bps in the fourth quarter of 2014 to 7.80% compared to 8.37% in the previous period (Graph 1.46). Accordingly, short, medium and long-term yields dropped 35 bps, 65 bps and 70 bps respectively to 7.41%, 7.78% and 8.36%. SBN market performance rebounded in January SBN yield declined 74 bps for all tenors to 7.06% compared to 7.80% in December Short, medium and long-term SBN yield decreased by 68 bps, 73 bps and 82 bps respectively to 6.73%, 7.04% and 7.54%. Meanwhile, the benchmark yield declined 63 bps to a level of 7.17% from 7.80% in December International positive sentiment as investor concerns eased due to the Fed s postponement of raising its reference rate triggered stronger SBN market performance. In addition, sentiment regarding the ECB stimulus package and the release of better-than-expected Chinese GDP data spurred optimism concerning the tradeable government securities market. From a domestic perspective, persistently oversubscribed government auctions helped lower yields on the SBN market. Solid SBN market performance was in line with prevailing foreign investor behaviour, namely net purchases. During the fourth quarter of 2014, non-residents Monetary Policy Report 23

25 continued to purchase on the tradeable government securities market, albeit at a lower level of net purchases than that recorded in the third quarter. Non-resident net purchases totalled Rp13.99 trillion in the reporting quarter, down considerably from Rp43.79 trillion in the third quarter. The decline was triggered by non-resident redemptions as a result of external negative sentiment, predominantly during the month of December, with net redemptions amounting to Rp19.84 trillion. In comparison to a number of other countries in the region, yield in Indonesia was higher due to pressures in the middle of December coupled with soaring inflation. Foreign SBN holdings increased during the fourth quarter of Foreign SBN holdings accounted for 37.04% in the fourth quarter, exceeding the share reported in the third quarter. Foreign SBN purchases affected all tenors, with the majority of purchases focussed on long-term tenors (Graph 1.47). The SBN holdings of banks and insurers tended to decline during the reporting period to 29.45% and 12.09% respectively, while holdings of pension funds remained relatively stable and those of Bank Indonesia increased. Graph Changes of Government Bonds Yield Quarter IV-2014 Graph Government Bonds Yield and Net Foreign Buy/Sell (Quarterly) Nonbank Financing Nonbank economic financing increased. Total financing during the fourth quarter of 2014 through initial public offerings (IPO), rights issues, corporate bonds, medium-term notes, promissory notes and other financial instruments amounted to Rp37.1 trillion, far surpassing the Rp9 trillion documented in the third quarter (Table 1.6). During the reporting quarter, six companies initiated an IPO, namely Bluebird, Soechi Lines, Impack Pratama Industri, Intan Baruprana Finance, Golden Plantation and Bank Agris. Monetary Policy Report 24

26 Table 1.6 Non-Bank Financing Rp Trillion Q1 Q2 Q3 Q4 Total Q1 Q2 Q3 Q4 Total Nonbank Stocks w/o Financial sector issuers Bonds w/o Financial sector issuers MTN and Promissory Notes + NCD w/o Financial sector issuers Source: OJK and BEI (processed) The Payment System The cash payment system generally performed in line with the national economy, specifically household consumption. Average daily currency in circulation totalled Rp478.6 trillion in the fourth quarter of 2014, growing 6.8% (yoy) in comparison to 12.6% (yoy) in the third quarter (Graph 1.48). Such performance is in line with slower household consumption growth. Graph Currency in Circulation (yoy) Amidst slower currency in circulation growth, Bank Indonesia continued to enhance the quality of currency fit for circulation. During the fourth quarter of 2014, as many as 1.5 billion banknotes and coins unfit for circulation, to the tune of Rp30.7 trillion, were destroyed and replaced with rupiah fit for circulation. Total currency destroyed in the reporting quarter exceeded that of the previous period, amounting to 1.4 billion banknotes and coins with a value of Rp29.7 trillion. The increase in the amount of currency destroyed was due to a corresponding increase in the amount of currency unfit for circulation, despite a smaller quantity of currency deposited by banks at Bank Indonesia. Payment system transactions were settled securely and without interruption throughout the fourth quarter of Compared to conditions in the third quarter, noncash payment system transactions increased in the fourth quarter in terms of both value and volume. The increase in transaction value amounted to Rp4,526.9 trillion, equivalent to Monetary Policy Report 25

27 11.0% (qtq), while the growth in volume totalled 63.1 million transactions or 5.3% (qtq) (Tables 1.7 and 1.8). In general, the increase in transaction value affected all types of transaction, particularly monetary operations that shot up Rp2,483.0 trillion or 15% on the previous quarter. On the other hand, the increase in volume was attributed more to public transactions using noncash instruments, especially those offered by the industry. The most notable increase in transaction volume affected card-based payment instruments, growing 3.9% (qtq) or 43.6 million transactions. Table 1.7 Value of Non-Cash Payment System Non Cash Payment System Value (Rp Trillion) %increase/decrease Transaction Q III Q IV Q I Q II Q III Q IV QtQ (III to IV) BI RTGS 26, , , , , , % BI SSSS 8, , , , , , % Clearing % Card Payment 1, , , , , , % Credit Card % Debit and ATM/Debit Card , , , , , % Electronic Money % Total 36, , , , , , % Consistent with the increase in noncash payment system transaction value and volume during the fourth quarter of 2014, payments settled through the Bank Indonesia Real Time Gross Settlement (BI-RTGS) system also experienced an increase in terms of both value and volume. The availability of the Bank Indonesia Real Time Gross Settlement (BI-RTGS) system as a means to settle funds, the Bank Indonesia Scripless Securities Settlement System (BI-SSSS) to settle Bank Indonesia and government securities as well as the National Clearing System achieved 100% during the fourth quarter of Payment transaction value settled through the BI-RTGS system increased by Rp3,169.3 trillion (10.6%, qtq) on the preceding quarter, pushing up the total from Rp29,872.4 trillion to Rp33,041.6 trillion. Meanwhile, transaction volume settled through the BI-RTGS system surged by 60 thousand transactions (1.3%, qtq), with the total increasing from 4.52 million to 4.58 million transactions. Table 1.8 Volume of Non-Cash Payment System Monetary Policy Report 26

28 2 ECONOMIC OUTLOOK Bank Indonesia projects domestic economic growth in 2015 to exceed that posted in 2014, namely in the % range. Stronger growth will result from tenacious household consumption and the propitious contribution of greater fiscal capacity to catalyse productive economic activities, including infrastructure development. That prognosis was announced by the government and contained within the national budget of 2015, which has been approved by the People s Representative Council (DPR). In addition, government-led measures to enhance the investment climate, including integrated licensing services (PTSP), are also expected as a further boon to investment activity. The export contribution to growth is also forecasted to increase but not significantly. Inflation in 2015 is projected at a lower rate than in 2014, at the bottom end of the target inflation corridor. Such conditions are supported by controlled core inflation, a lower international oil price and improved food supply. Well-anchored inflation expectations, relatively low international commodity prices and minimal demand-side pressures are expected to help control core inflation. The drop in the global oil price and greater food security are predicted to alleviate inflationary pressures on administered prices and volatile foods. Consequently, inflation at yearend 2015 is projected at the lower end of the 4±1% range. Meanwhile, through measured policy coordination between Bank Indonesia and the Government, inflation at yearend 2016 is also forecasted in the 4±1% range. Bank Indonesia will continue to monitor a variety of risks prevalent in the domestic economy, although some of the risks are minimised through the array of structural reforms implemented by Bank Indonesia in conjunction with the Government. From a global perspective, the risks associated with the proposed normalisation of the Federal Reserve s monetary policy stance will be partially offset by the planned monetary stimulus policy response in Europe. Additionally, a higher quality fiscal structure in 2015 will also attract foreign capital inflows. Meanwhile, structural reforms are expected to enhance export competitiveness, which will reduce the impact of sluggish exports stemming from the downturn in China. From an internal standpoint, inflation risks are minimal due to lower commodity and oil prices amidst minimal demand-side inflationary pressures coupled with the government s food security policy. Global Economic Outlook The global economic recovery is projected to endure in 2015, albeit at an uneven pace. Global economic growth is projected in 2015 at 3.4% (yoy), up slightly on the previous year. The US economy is forecasted to grow beyond previous projections. Conversely, the economies of Japan and China are expected to expand more slowly than previously thought. The protracted recovery in Europe is predicted to persist, overshadowed by diminishing consumer confidence and the threat of deflation. Such conditions prompted the European Central Bank (ECB) to stimulate the economy through implementation of its Expanded Asset Purchase Program (EAPP). Monetary Policy Report 27

29 The US economy is forecasted to grow in 2015 beyond previous projections. Economic growth in Japan is forecasted at 1.0% in 2015, which is lower than the previous projection of 1.2%. Sluggish economic growth in Japan was evidenced by weak consumption growth up to December Retail sales were also down and consumer confidence continues to slide. Meanwhile, the labour force failed to significantly support the economy, with job hires following a downward trend and only Table 2.1 World GDP Projection(%, yoy) 2013 Projection World GDP Advanced economies United States Euro Area Japan Emerging and developing economies China India Other EM moderate growth achieved in terms of salaries. Notwithstanding, Japan s economy is projected to improve in 2015 compared to the previous year, bolstered by various policies instituted by the Government and Bank of Japan. Economic growth in Japan is projected at a lower level than previously assumed. Japan s economy is predicted to grow in 2015 by 1.0%, compared to 1.2% projected previously. Persistently sluggish consumption growth up to December 2014 is indicative of weaker growth in Japan. Furthermore, retail sales data also remains weak, with consumer confidence continuing to slide. Meanwhile, declining job hires mire the labour market and salary growth is slow. Nevertheless, the Japanese economy is expected to rebound in 2015, bolstered by an array of policy measures instituted by the Government and the Bank of Japan. The recovery in Europe is expected to slow further, reflected by a decline in the Purchasing Managers Index (PMI), particularly in three leading European countries, namely Germany, France and Italy. In addition, limited and uneven salary growth in Europe also undermined demand. Moreover, consumer confidence is also following a downward trend. Consequently, Europe has been in a deflation zone since December Nonetheless, the European recovery persists, indicated by a decline in unemployment and positive retail sales data. China s economy continues to decelerate with lower growth projected than previously thought. The Chinese economy is projected to achieve 6.9% growth in 2015, which is less than the 7.0% predicted previously. The revised-down growth figures are partly due to more intense efforts by the relevant authorities to reduce fickle credit and investment growth. In addition, the 7.4% (yoy) level of economic growth recorded in China during 2014 was actually the first time the growth target was not met since In 2015, China targets growth of 7.0% (yoy), which is below the target set in 2014 at 7.5% (yoy). Such conditions are in line with efforts to accomplish more balanced and sustainable economic growth. World trade volume is projected at a lower level but should exceed that reported in the previous year. Based on actual world trade volume (WTV) data up to October 2014, WTV growth is projected in 2014 at 3.16% (yoy). Looking ahead, world trade volume will continue to improve in line with the global economic situation. Monetary Policy Report 28

30 The price of oil is expected to be less expensive in 2015 than previously assumed in line with corrections made by a number of institutions to their forecasts, including the Energy Information Administration (EIA) that revised down its projected price of BRENT 2015 to US$58 per barrel (from US$68 per barrel). Based on the EIA projection, the oil price should rebound in the middle of Meanwhile, greater oil availability in the US during the first semester of 2015 is expected to suppress the oil price. Commodity prices are predicted to decline more dramatically than previously projected. The Indonesia Export Price Index (IHKEI) is forecasted to contract by -5.60%, compared to the previous projection of -3.92%. The drop in the IHKEI is attributed to the ongoing economic downswing in China. Domestic Economic Outlook National economic growth is projected to accelerate to a range of % (yoy) in 2015 (Table 2.2). The increase will stem from resilient household consumption and the positive contribution of infrastructure projects announced by the government. After approval of the 2015 national budget, the fiscal stimulus package and structural policy reforms instituted by the government will catalyse stronger economic growth. Governmentled structural reforms include energy subsidy reforms, a proposed acceleration of infrastructure development and measures to enhance the investment climate, including integrated licensing services (PTSP), which are conducive to future economic strengthening. The export contribution to growth is expected to improve but not significantly. In terms of the labour force, the manufacturing sector as well as the transportation and communications sector are expected to expand to become key economic drivers. Furthermore, the construction sector is also predicted to grow expansively as more government-announced infrastructure projects come online. Table 2.2 Economic Growth - Demand Side %Y-o-Y, 2010 Price Component I II III IV * Private Consumption Government Consumption (-1.5) Investment Export (-4.5) Import GDP Source : BPS *Bank Indonesia's Projection Monetary Policy Report 29

31 In general, household consumption is projected to grow in the % range in Household consumption growth is supported by the demographic advantage enjoyed in Indonesia of a flourishing working age population that boosts the overall size of the labour force. Such conditions are conducive to reduce the level of poverty and swell the ranks of the fledgling middle class (Graph 2.1), which will ultimately raise the level of household consumption. Inflation, which is predicted at the lower end of the 4±1% corridor, will further maintain public purchasing power. The contribution of exports in 2015 is expected to exceed that achieved in the previous year, which will also shore up public purchasing power and contribute to household consumption growth. Expectations of higher consumer income in Indonesia are reflected in the results of a Tower Watson survey (Graph 2.2) that predict an average 8-10% increase in employee wages during 2015, hence exceeding the level of inflation and representing the highest increase in the ASEAN region. Graph 2.1. Middle Class Growth Graph 2.2. Projected Salary Increase in 2015 (Tower Watson Survey) Investment growth will accelerate in 2015 compared to the preceding year in the range of %. Future investment growth will primarily stem from construction investment due to the commencement of several government infrastructure projects implemented to catalyse economic growth. Following the political year of 2014, private investment growth is also assumed to pick up in Potential investment growth remains robust in line with dogged domestic demand and growing external demand for export products from Indonesia. Numerous government infrastructure projects will commence in 2015 as per the National Medium-Term Development Plan (RPJMN) Furthermore, the 2015 Government Work Plan confirms that several infrastructure projects will commence in A number of government ministries and institutions have already begun auctioning infrastructure projects, providing strong indications of government investment. In general for the year, export growth in 2015 will accelerate to the range of %, exceeding that achieved in the previous year. Stronger export growth is congruent with the expected increase in terms of global economic growth. Although a number of leading destinations for Indonesian exports, such as China, are forecasted to experience an economic downturn, such conditions will be offset by other export destinations that are following an upward trend, including India and the United States. Consequently, real exports from Indonesia are projected to grow positively at 1.64% (yoy) in The recommencement of unrefined mineral exports will also benefit export performance in Furthermore, measures to boost export competitiveness, in the form Monetary Policy Report 30

32 of a more competitive exchange rate combined with market and product diversification, will also support stronger export growth. As a whole, imports in 2015 are projected to grow in the % range. In line with prosperous investment growth forecasted for the year, imports of capital goods in the form of machinery and equipment are also expected to surge. Production activity is assumed to remain robust, which will drive demand for imported raw materials. Meanwhile, imports of consumer goods will grow in accordance with solid household consumption growth. Table 2.3 Economic Growth - Supply Side Sector I II III IV ^ Agriculture Mining and Quarrying Manufacturing Industries Electricity, Gas and Water Supply* Construction Trade, Accommodation, Food and Water Supply** Transportation, Warehousing, Information, and Communication*** Financial, Real Estate, and Business Services**** Other Services***** GDP Source : BPS ^ Bank Indonesia's Projection * Merging of 2 sectors: (i) Electricity and Gas Supply and (ii) Water Supply ** Merging of 2 sectors: (i) Trade and Car Repair and (ii) Accommodation, Food and Water Supply *** Merging of 2 sectors: (i) Transportation and Warehousing, and (ii) Information and Communication **** Merging of 3 sectors: (i) Financial Services, (ii) Real Estate, and (iii) Business Services ***** Merging of 4 sectors: (i) Government Administration, (ii) Education Services, (iii) Health Services, and (iv) Other Services The pace of manufacturing industry growth is expected to accelerate. The manufacturing sector is projected to grow by % (yoy) in 2015, up from the 4.63% (yoy) achieved in 2014, as the global economy continues to recover. Growth projections for the manufacturing industry are buoyed by the persistent influx of foreign investment to the manufacturing sector (secondary). In terms of the transportation subsector, growth is predicted to increase in line with the trade surplus for complete cars. Such expansion will spillover to the base metals industry to meet demand from the automotive industry. Notwithstanding strong demand from the automotive sector, the prospect of persistently low international commodity prices that stifle external demand for industrial goods will slightly negate improvements in the base metals sector. Furthermore, the proposed application of a letter of credit for exports of several commodities, including CPO, CPKO, minerals (including tin), coal as well as natural oil and gas could also undermine performance in Monetary Policy Report 31

33 The transportation and communications sector is projected to grow by % in Improved trade and import/export activity helped bolster transportation subsector performance. Growth in the sector will also benefit from the realisation of infrastructure projects and the provision of different transportation modes by the government as part of the proposed infrastructure development plan from with a value of Rp5,519.4 trillion. A number of auctions have already been held by the Ministry of Transport at the beginning of 2015, including subsidised bus routes on the Riau Islands, six subsidised air routes to and from Tjilik Riwut Palangkaraya Airport, eight subsidised air routes to and from Djalaludin Gorontalo as well as runway extensions and rehabilitation at several other airports. The total value of the auctions for the aforementioned projects is Rp349.8 billion. Furthermore, the state plans to invest Rp8.25 trillion in five state-owned enterprises in the transportation sector during 2015, which will boost growth in the sector this year. Meanwhile, in line with technological development and the nascent middle class, the requirement for a sound communication network drives the continuous need for faster data and traffic communications. Such circumstances demonstrate the large potential for growth in the communications subsector. Figure 2.1. Indonesia Infrastructure Development Plan The financial, real estate and corporate services sector is projected to expand in the range of %, exceeding that reported in the preceding year. The prospects of the banking sector are more favourable, evidenced by credit growth that is starting to rebound after a year of deceleration due to economic stabilisation policy. Stronger bank credit growth will benefit from a persistently stable economy, anchored inflation expectations and managed domestic demand. Furthermore, solid credit growth will ultimately increase the net interest margin (NIM) of the banking industry. Growth in the range of % is projected for the mining sector. From a domestic perspective, the outlook is in line with the plan to construct 15 smelters that are expected to begin operating in 2015, which will help boost mining sector performance. From an external standpoint, however, low international non-oil/gas commodity prices could potentially curtail further gains in the sector. Meanwhile, the oil and gas subsector is predicted to expand as oil production is ramped up at the Cepe Block, with the potential to lift 165 thousand barrels of oil per day. Additionally, a number of upstream projects in the gas subsector will also enhance performance of the subsector. Monetary Policy Report 32

34 The utilities sector (electricity, gas and potable water) is projected to expand in the % range during The electricity subsector will provide the largest contribution in line with planned capacity expansion in 2015, including the construction of hybrid diesel power stations at 47 remote sites and on outlying islands with a total capacity of MW. In the gas subsector, the government will strive to expand the use of natural gas, primarily to meet the industrial, electrical and fertiliser requirement. More than 59% of gas production is allocated to the domestic requirement. The construction sector is projected to grow stably in the % range during Sector development is supported by government efforts to expand the capacity and enhance the quality of the infrastructure network as part of the initiative to strengthen national connectivity. Based on the 2015 Government Work Program, planned infrastructure projects include the construction of km of new roads, 125 km of motorways, 400 km of railways, strategic ports to service six sea tollways in Eastern Indonesia, 27 reservoirs and eight new airports. On top of infrastructure, a favourable construction sector outlook is bolstered by a large housing backlog. In 2015, the government targets the provision of 205 thousand homes for low-income earners, which should boost construction sector growth. The manufacturing sector will also contribute to construction sector growth through the planned construction of 13 industrial zones outside of Java and two industrial zones on the island of Java as well as the development of smelters. Meanwhile, in line with energy diversification policy, the government has earmarked Rp10.82 trillion up to 2017 to build gas infrastructure, including a trans Java gas pipeline (Semarang-Cirebon-Balongan), a gas pipeline on the island of Kalimantan, a floating storage and regasification unit (FSRU), a household gas network and large LPG tanks in Jayapura, Wayame and Bima. The agricultural, livestock, forestry and fisheries sector is expected to accelerate to the % range in Aligned with the government s strategy to strengthen food security, the agricultural sector is assumed to grow through the increase of several production targets. In 2015, the rice production target is 73.4 million tons, maize is 20.3 tons, soybean is 1.3 million tons and beef is thousand tons. Persistently weak international non-oil/gas commodity prices, however, could undermine gains in the sector. Government efforts to augment production and enhance irrigation facilities are supported by an additional budget allocation of Rp16.9 trillion to the Ministry of Agriculture, thereby expanding the total budget to Rp32.8 trillion for The services sector is expected to grow in the range of %. The personal and household services subsector will be the main driver of growth as government infrastructure projects commence, which entails the involvement of consultation services, experts/specialists, project managers and project supervisors. At the beginning of 2015, the Ministry of Public Works auctioned personal services to the tune of Rp42.19 billion, including planning consultants, institutional advisors, project management consultants, investment advisors, technical consultants in Sumatra, database experts, evaluation experts and monitoring experts. Monetary Policy Report 33

35 Inflation Outlook Inflation in 2015 is expected at a lower rate than in 2014 and at the lower end of the inflation target. The prognosis is supported by well-controlled core inflation, a sliding oil price and better food supply. Controlled core inflation will be possible through anchored inflation expectations, relatively low international commodity prices and minimal demandside pressures. A lower oil price and greater food security will precipitate relatively weak inflationary pressures on administered prices and volatile foods. Consequently, inflation at yearend 2015 is forecasted at the lower end of the 4±1% target. Meanwhile, through measured policy coordination between Bank Indonesia and the Government, inflation at the end of 2016 is predicted within the target range of 4±1%. Core inflationary pressures will be moderate in Externally, core inflationary pressures will remain relatively under control due to limited increases in terms of international commodity prices along with a gradual global economic recovery. The global oil price is assumed to decrease compared to that in 2014, with negative growth of nonoil/gas commodity prices also expected. The contraction, however, will not be as deep as that experienced in the preceding year. Inflationary pressures from the exchange rate are also not expected to be as intense as previously projected considering more limited depreciation in Domestically, the supply side is expected to respond favourably to stronger domestic demand, as evidenced by GDP growth that remains below potential. Therefore, demand-side inflationary pressures will be comparatively minimal. In addition, the prevailing policy mix, coupled with coordination between the Government and Bank Indonesia, will help anchor inflation expectations. Volatile food inflation is projected at a lower rate in 2015 than in The forecast is linked to the assumption that food production and distribution as well as the trade system will improve over the upcoming period. Inflation of administered prices is also projected at a lower rate in 2015 than in Such conditions will be the main contributor to lower inflation in The prediction is based on declining international commodity prices that lead to cheaper energy prices. In 2016, with the panoply of policies instituted to control inflation, the rate is projected within the target range of 4±1%. Sources of inflationary pressures are thought to stem from more expensive commodity prices and stronger domestic demand. Core inflation is expected to remain under control in line with anchored expectations. Volatile food inflation will tend to ease as food production ramps up and the terms of trade improve. Meanwhile, administered price inflation will become more dynamic mirroring international prices. Risk Factors Bank Indonesia will continue to monitor a variety of risks prevalent in the domestic economy, although some of the risks are minimised through the array of structural reforms implemented by Bank Indonesia in conjunction with the Government. From a global perspective, the risks associated with the proposed normalisation of the Federal Reserve s monetary policy stance will be partially offset by the Monetary Policy Report 34

36 planned monetary stimulus policy response in Europe, which is expected to spur capital flows into Indonesia. Additionally, a higher quality fiscal structure in 2015 will also attract foreign capital inflows. Regarding the risk of an economic downswing in China, structural reforms specifically targeted at expediting infrastructure projects and enhancing the investment climate along with exchange rate policy based on the rupiah s fundamental value are expected to boost export competitiveness in Indonesia. Consequently, pressures on the external balance will relatively ease. From an internal standpoint, inflation risks are minimal due to lower commodity and oil prices amidst minimal inflationary pressures on the demand side coupled with the government s food security policy. Concerning growth, the government s avowed commitment to implement infrastructure projects will alleviate the risk of realised government investment falling short of the planned total. Monetary Policy Report 35

37 3 MONETARY POLICY RESPONSE On 17 th February 2015, the Bank Indonesia Board of Governors decided to lower the BI Rate 25 bps to 7.50%, with the Deposit Facility rate also reduced 25 bps to 5.50% and the Lending Facility rate maintained at 8.00%, effective 18 th February Such policy measures were instituted based on Bank Indonesia s conviction that inflation will remain under control at the lower end of the 4±1% range in 2015 and The current policy direction is consistent with Bank Indonesia s efforts to reduce the current account deficit to a more sustainable level. In addition, maintained macroeconomic stability was also inextricably tied to close coordination between Bank Indonesia and the Government at the central and local levels. Furthermore, Bank Indonesia warmly welcomes ongoing energy subsidy reforms, the planned expedition of infrastructure development as well as measures to improve the investment climate, including integrated licensing services (PTSP). Bank Indonesia perceives that with approval of the 2015 budget, government-led fiscal stimuli and structural reform policy will catalyse stronger and higher quality economic growth. Moving forward, Bank Indonesia will continue to strengthen its monetary and macroprudential policy mix, as well as tighten coordination with the Government to ensure inflation remains low and the current account deficit is managed at a sounder level. Monetary Policy Report 36

38 Box: Inflation Dynamics after Energy Subsidy Reforms The issue of energy subsidies has forced a number of countries to implement energy reforms. Subsidy reforms are not a small undertaking, however, with numerous countries failing in its implementation. Brazil, Turkey, the Philippines and South Africa are a few examples of countries where subsidy reforms have successfully been implemented with improving inflation and relatively stable economic growth. The key to success in terms of energy reforms in the aforementioned countries was determined by gradual implementation and supported by clear lines of communication. Experience from those countries should be used as an invaluable source of information for the implementation of energy reforms in Indonesia. The extensive provision of energy subsidies not only burdens the state coffers but also undermines the accuracy of other macroeconomic indicators and harms the environment. Subsidies can exacerbate a budget deficit through the burden of the subsidy itself as well as lost income if fuel taxes are regulated at an inefficient level. Energy subsidies can also stifle economic growth because: (i) subsidies make investment in the energy sector unattractive; (ii) subsidies reduce public spending critical for economic growth; and (iii) subsidies lead to an over-allocation of resources to the energy sector. Furthermore, energy subsidies also increase energy consumption, which ultimately places pressure on the balance of payments of net importers. From a social perspective, inappropriate energy subsidies can widen the gap between rich and poor because the rich, who tend to consume more energy than the poor, enjoy the majority of the subsidy. In addition, growing energy consumption can lead to climate change. The international oil price, which is currently experiencing a sharp decline, provides a rare opportunity for developing countries to reform their energy policy. Rare because experience from several countries shows that energy subsidy reforms are difficult to implement. Of the 38 episodes of energy subsidy reforms in various countries acknowledged by the IMF, only 12 were deemed successful and permanent. Meanwhile, 11 episodes were considered partially successful as the subsidy was put back in place after more than one year and 5 episodes failed as the subsidy was reintroduced the moment the oil price increased. Brazil, Turkey, the Philippines and South Africa have all successfully implemented energy reforms. Brazil has incrementally adjusted energy prices in line with market mechanisms since Inflation climbed in the near term but was lower in the long term. In addition to Brazil, Turkey also sets fuel prices based on market mechanisms, with preparations for implementation gradually implemented from 1989 until At the outset, Turkey s government implemented the Automatic Pricing Mechanism (APM) to determine the base price of oil products based on the international oil price and the exchange rate. Since 2005, however, market forces have set fuel prices in Turkey. After introduction of the policy, inflation in Turkey fell from around 50% to single digits, accompanied by less volatility. The Philippines began energy reforms in 1997 in order to overcome a foreign debt crisis. Reforms were implemented gradually and followed by liberalisation of downstream activities. The re- Monetary Policy Report 37

39 forms were also executed incrementally with the support of clear communication and the depoliticisation of fuel price setting. The impact on inflation was an increase in the short term but then a low rate in the long term with less volatility. South Africa also successfully implemented energy subsidy reforms in the 1950s to attract investment. The success of South Africa introducing energy prices based on market mechanisms was determined by policy credibility and transparency. In general, after fuel price policy reforms, inflation in the four mentioned countries improved, with relatively stable economic growth. The gradual implementation of energy reforms over the long term with clear lines of communication to negate uncertainty was the key to success in the four example countries. Graph 1. Economic Performance in Brazil, Turkey, Phillippines, and South Africa Conversely, energy subsidy reforms undertaken in Nigeria and Peru were considered partially successful. Nigeria has limited the price of fuel since During the second semester of 2011, the government campaigned to raise the price of fuel by 117%. The move, however, triggered social unrest with the government finally bowing to public pressure and hiking fuel prices just 49% without raising the price of kerosene consumed by poor households. Such conditions were the result of, amongst others, a lack of transparency when calculating the maximum price. Furthermore, the reallocation of subsidies to mitigate the fallout of the fuel price hike faced administrative constraints and improper mechanisms. Consequently, the situation undermined the government s credibility in terms of implementing energy reforms. In addition to Nigeria, Peru also commenced energy reforms through price smoothing in Thereafter, Peru finally achieved full pass-through of the global oil price to domestic high-octane and regular fuel prices in Nonetheless, diesel and LPG, which account for 80% of fuel consumption, remain subsidised to this day. Such conditions were attributable to the price smoothing method employed, which was applicable to moderate price volatility but not supplemented with an adjustment mechanism for when the international oil price shot up. Monetary Policy Report 38

40 Graph 2. Economic Performance in Nigeria and Peru The experience of several countries in terms of implementing energy reforms has provided some invaluable lessons. The first is the importance of transparent communication with the public concerning the price structure (assumed international oil price, exchange rates, margin, tax), the frequency of price setting by the government (if required), the benefits of reallocating subsidies to productive activities and the design of a social network to protect the poor. The second is the price setting mechanism, which must minimise hoarding and potential losses, while being implemented incrementally (price smoothing) paying due regard to price spikes. The third involves policy support, for instance a mechanism to set fares in the transportation sector to ensure a clearer transmission to domestic prices. In addition, renewable energy reforms should also be considered as an alternative with the fuel subsidy budget reallocated to more productive sectors. Monetary Policy Report 39

41 The Monetary Policy Report is published quarterly by Bank Indonesia after the Board of Governors Meetings in February, May, August, and November. In addition to fulfilling the mandate of article 58 of Act Number 23 of 1999 concerning Bank Indonesia, amended by Act No. 3 of 2004 and Act. No. 6 of 2009, the report has two main purposes: (i) to function as a tangible product of a forward-looking working framework in which formulation of monetary policy is based on economic and inflation forecasts; and (ii) as a medium for the Board of Governors of Bank Indonesia to present to the public the various policy considerations underlying its monetary policy decisions. For further information: Policy Regulation and Communication Division Monetary Policy Group Monetary and Economic Policy Department Telp: /6836 Fax: gkm_komunikasi@bi.go.id Website: Board of Governors Agus D.W. Martowardojo Governor Mirza Adityaswara Deputy Governor Senior Halim Alamsyah Deputy Governor Ronald Waas Deputy Governor Perry Warjiyo Deputy Governor Hendar Deputy Governor Monetary Policy Report 40