Office of Chief Economist. Indonesia Update January 2016

Office of Chief Economist Indonesia Update January 2016

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Contents Government Budget Utilization (Challenges and Opportunities) Andry Asmoro and Rully Arya Wisnubroto. 4 Urgent Reform of Indonesia s Exports Nurul Yuniataqwa Karunia Assessing Business Prospects in 2016 Nadia Kusuma Dewi and Mamay Sukaesih 14..20 The Bittersweet Sugar Industry Araminta Setyawati 21 The Historical Persistence of Dutch Education System in Indonesia Romauli Panggabean..31 Mandiri Leading Economic Index Mandiri Banking Pressure Index Indonesia Current Data Table 42 45 48 Office of Chief Economist Page 3

Government Budget Utilization (Challenges and Opportunities) Andry Asmoro and Rully Arya Wisnubroto Through the budgetary policy, Government aims to reallocate resources in accordance with the economic and social priorities of the country Government Budget is a government s forecast of its expenditures revenues for a specific period of time, usually a year, known as a financial or fiscal year. Government prepares the budget for fulfilling certain objectives, which are the direct outcome of government s economic, social and political policies. Government earns money broadly from taxes, fees and fines, interest on loans given to states and dividend by state owned enterprises. At the other hand, Government spends mainly on securing and providing goods and services to citizens, law and order and internal security, defense, staff salaries, etc. Some of the important objectives of government budget are as follows: 1) Reallocation of resources, 2) Reducing inequalities 3) Economic stability 4) Management of public enterprises 5) Reducing regional disparities. Through the budgetary policy, Government aims to reallocate resources in accordance with the economic (profit maximization) and social (public welfare) priorities of the country. Government can influence the allocation of resources through tax and subsidies or directly producing goods and services. If the private sector has less incentives to produce goods, than the Government will undertake the production. The goods and services provided by the Government usually are the public goods, such as roads, bridges, irrigation, etc. In reducing inequalities, government aims to influence distribution of income by imposing higher taxes on the rich and spend more on the welfare for the poor. One of the most important roles of Government budget is to maintain macroeconomic stability. Government aims to control the different pace of fluctuation through its budgetary policy. In the periods of slowing economic growth or recession, Government is supposed to be conducting expansionary fiscal policy, which comes in form of tax cuts, rebates and increased government spending. This is usually called the deficit budget, where the estimated Government expenditure will be higher than the Government receipts. On the contrary, in the periods of high economic growth and inflation, Government will undertake contractionary fiscal policy to prevent an overheating economy. This is usually called the Office of Chief Economist Page 4

surplus budget where the estimated Government receipts are expected to be higher than the estimated Government expenditure. Government uses the budget with the objectives of making various provisions for managing public enterprises and providing financial help. Lastly, Government budget aims to reduce regional disparities through its taxation and expenditure policy for encouraging setting up production units in economically backward regions. Fiscal Decentralization The implementation of fiscal decentralization in Indonesia effectively started in 2001. The main objectives of fiscal decentralization are: 1) Increase national allocation and improve operational efficiency of local governments 2) Fulfill regional aspirations, improving the overall fiscal structures and mobilize regional income. 3) Improving transparency and accountability, and developing regional participation in decision making 4) Reducing regional fiscal discrepancy, ensuring the implementation of basic services for the community 5) Improving social wealth of Indonesian people Figure 1. Composition of Central and Local Government Budget. Central government s expenditure in regional transfer and village funds is source of revenue for Local Government. (Source: Bank Mandiri) Main instruments for the implementation of fiscal decentralization are giving the authority for regional government to impose tax and retribution. Because of regional tax and retribution is very small and Office of Chief Economist Page 5

limited, the Central Government does the transfer to region to support activities that had been handed on to the Regional Government in form of Regional Transfer and Village Fund that consists of Balance Fund (Dana Perimbangan), Local Incentives Fund (Dana Insentif Daerah of DIR). Balanced Fund consists of three sources. The first one is Sharing Funds (Dana Bagi Hasil or DBH) is instruments to reduce the fiscal discrepancies between Government and the region. But because of there are various availability of resources between regions, the DBH creates another discrepancies between Regional Governments. The second one, which is General Allocation Funds (Dana Alokasi Umum or DAU) is aimed to reduce fiscal discrepancies between the region. The amount of DAU is determined according to the number of population and the total area. The third one, Special Allocation Funds (Dana Alokasi Khusus or DAK) is allocated to help local governments that have relatively lower financial capabilities. The allocation of regional transfers had been increasing from time to time since the starting of the regional autonomy and fiscal decentralization policy. Balanced fund had been increasing by nearly seven times from only IDR124.3 trillion in 2005 to IDR516.4 trillion in 2015. Most of the Balance Fund was transferred to provinces in the form of DAU. In 2005, 71% of the Balance Fund was DAU, while 25% was Sharing Funds, and the other small proportion was DAK. The amount of DAU had increased from IDR88.8 trillion in 2005 to IDR353 trillion in 2015 Government Budget. DAK, or special allocation fund increased from IDR4,3 trillion in 2005 to IDR208.9 trillion in 2016. Meanwhile Sharing Funds at the same period increased from IDR59.3 trillion to IDR127.7 trillion. The Sharing Fund is calculated according to certain proportion of the revenue realization, either from tax or natural resources, each region contributed. Figure 2. Overall Balance Fund (2005-2015). Total Balance Fund (Dana Perimbangan) increased from IDR124.3 trillion in 2005 to IDR516.4 trillion in 2015. (Source: CEIC) Office of Chief Economist Page 6

On the expenditure side, the spending of the local government had also increased quite significant, from IDR233.5 trillion in 2006 to IDR606.9 in 2015 (higher than the balanced fund). During the periods, the local government spending was growing with average of 12.9%. Largest proportion of local government expenditure still allocated to personnel, and the proportion was increasing from time to time. In 2006, spending for personnel was IDR79.8 trillion or 34.2% of total local spending. In 2015, the proportion of personnel expenditure to total local government spending increased to 46.8% or IDR283.9 trillion. The next largest proportions of local spending are capital spending and spending on goods and services. Realization of Capital expenditure increased from IDR60.5 trillion in 2005 to IDR153.1 trillion in 2014, but at the same time, its proportion to total expenditure had decreased from 25.9% to 25.2%. Local Government spending on goods and services increased from IDR31.3 trillion in 2005 to IDR124 trillion in 2014. The proportion of spending on goods and services to total spending increased from 13.4% to 20.4%. Figure 3. Local Government Expenditure (2006-2014). Local government expenditure increased from IDR124.3 trillion in 2005 to IDR516.4 trillion in 2015. (Source: CEIC) The fiscal decentralization now is directed by Government to support the implementation of National Middle Term Development Plan (Rencana Pembangunan Jangka Menengah Nasional or RPJMN) 2015 2019 in accordance with the vision and mission of new elected President that of Nawa Cita. New Government is Office of Chief Economist Page 7

undertaking a change in the structure and the scope of Regional Transfer and the Village Fund (Dana Desa). There are some basic changes related to Regional Transfer: 1) Regional transfer is grouped in to three big classifications, which are: (i) Balance Fund, (ii) Regional Incentives Fund, (iii) Special Autonomy Fund and Jogjakarta Specialty Fund. 2) Balanced Fund is transformed to two main components which are General Purpose Grant (DAU) and Specific Purpose Grant (DAK). General Purpose Grant consists of Sharing Funds and General Allocation Fund. Specific Purpose Grants consists of Physical Special Allocation Fund (Physical DAK) and Non Physical Special Allocation Fund (Non physical DAK). Physical DAK includes: (i) regular DAK that focus on fields that are national priorities set by the Government Working Plan (Rencana Kerja Pemerintah or RKP) 2016 and RPJMN 2015 2019, (ii) Public Infrastructure DAK that is directed to support the acceleration of infrastructure development, and (iii) Affirmation DAK that is directed to support the acceleration of infrastructure development in backward regions, borders and islands. 3) Regional Incentives Fund (Dana Insentif Daerah or DID), that previously was part of other regional transfer, now stands apart as new classification in regional transfer. The goal is giving reward for regions that have good performances in fiscal and regional financial management, basic public services, and management of economy and quality of community welfare. 2016 will be the second year the Government allocates village fund in Government budget as an implementation of UU No.6 2014 about village funds. This fund acts as a source of income that is sufficient to fund the authority given to the Head of the Village (Kepala Desa). Village fund can be used to finance the operation of the regency, development, social coaching and community empowerment. The allocation of village fund is calculated using the formula of 90% based on equalization (basic allocation) and 10% based of number of population, poverty level, total area and geographical difficulties. The Government is committed to increase the amount of Regional Transfers and Village fund in the future to support the regional development, and increase the regional contribution to national economic growth. Office of Chief Economist Page 8

APBNP 2015 (IDR tn) APBN 2016 (IDR tn) A. Regional Transfer 643.8 723.2 1. Balance Fund 521.8 700.4 a. General Transfer of Fund: 495.5 491.5 1) Sharing fund 110.1 106.1 2) General Allocation Fund 352.9 385.4 b. Special Transfer Fund 163.2 208.9 1) Physical Special Allocation Fund 58.8 85.5 2) Non Physical Special Allocation Fund 104.4 123.5 2 Regional Incentive Fund - 5.0 3 Special Autonomy Fund and Prefential Fund 17.6 17.8 B. Village Fund 20.8 47.0 Total 665 770 Figure 4. Regional Transfer and Village Fund. Government set the regional transfer and village funds of IDR770 trillion in 2016 (Source: APBN 2016) Government is targeting to increase the Regional Transfer and Village Fund from 6.4% of GDP in 2017 to 6.5% of GDP in 2019 Government is targeting to increase the Regional Transfer and Village Fund from 6.4% of GDP in 2017 to 6.5% of GDP in 2019. Government set the Regional Transfer and Village Fund of IDR770.2 trillion in 2016 s budget (IDR723.2 trillion of Regional Transfer and IDR47 trillion of Village Fund). The amount is higher compared to IDR664.4 trillion (IDR643.8 trillion of Regional Transfer and IDR20.8 trillion of Village Fund) in 2015 s Revised Budget (APBN-P 2015). The realization of the Regional Transfer and Village Fund had not been optimized yet in 2015, which it was only realized by 78.5% (IDR521.4 trillion) of the total APBN-P 2015 as of October. General Purpose Grant allocations set at IDR491.5 trillion, consists of IDR106.1 trillion of Sharing Fund and IDR385.4 of General Allocation Funds (DAU). Specific Purpose Grant set at IDR208.9 trillion, consists of IDR85.5 trillion of physical DAK and IDR123.5 trillion of non physical DAK. In regular DAK, Government is focusing on 10 fields, which are : education, health and family planning, housing infrastructure, sanitation and drinking water, food security, small scale energy, maritime and fisheries, environmental and forestry, transportation, trade facility, small scale industry and tourism and Regional Government and Infrastructure. Meanwhile public infrastructure DAK is allocated to regencies/cities to help accelerate the public infrastructure development and support the connectivity transportation, houses repairmen, increase agriculture production and development of maritime and fisheries. In the middle term, Transfer to Regions and Village Funds is directed to accelerate the regional developments, improving the quality of public services, and reduce the discrepancy of public services Office of Chief Economist Page 9

Local governments needs to spend more in capital and goods and services spending rather than personnel spending to increase the contribution to national economy and improve the public services. between the regions. Besides that, the improvements of the transparency and the accountability of Regional Transfer and The Village Funds will needs to be undertaken by the Central and Local Governments. At the other hand, the authorization given to the local governments has to be followed by the ability of the local governments to fulfill the increasing demand of better public services. The success of a region in increasing the prosperity of the people largely depends on the policies that undertaken by every local government. The policies can be done by allocating the sources of financing into the programs and activities that are oriented to the people s needs (public needs) so that it creates employments and reducing a level of poverties. As mentioned earlier that local governments until now still allocate higher proportion of expenditure in personnel s spending rather than in goods and services and capital spending. The proportion of personnel expenditure to total spending is increasing, to nearly 50% of total spending in 2015. It is not a quite encouraging indicator, because to increase higher contribution of local spending to national economic growth, the local governments have to spend more on goods and services and capital so that it will create multiplier effect on economic activities. The Main Direction of 2016 Central Government budget The Central Government budget in 2016 reached Rp1,325.6 trillion with main focuses of: 1. Maintaining government officers income to boost their productivity and improve their public services through Holy Day incentive (THR) disbursement as much as 1 month of salary for active employees and 50% of the salary for the retirees (outside of the baseline policy: the 13 th salary and pension); 2. Continuing efficiency policies in operational spending and focusing on non-operational spending (including government s building moratorium and leasing policies on the government s operational vehicles); 3. Directing to a more targeted subsidy; 4. Continuing development priority program (connectivity infrastructures, education, health, food and energy security, maritime, tourism, inequality reduction) to improve the development quality; Office of Chief Economist Page 10

5. Fulfilling the education development 20% of the APBN to increase the education access and quality, through: 12 years compulsory education via Smart Indonesia Card (KIP) Improving education quality Improving access to education services and skill training 6. Fulfilling the health budget as much as 5% of the total APBN, through: Improvement of health status and mother and children nutrition Improvement of disease control Improvement of access and basic health service quality 7. Harmonizing fiscal decentralization policies by shifting the Deconcentration fund allocation from Ministries and Institution to the Special allocation Fund at regional level; 8. Improvement of poor people s wealth through a more sustainable social aid program (KIP (Smart Indonesia Card) and (Health Indonesia Card) KIS); 9. Housing needs sufficiency through million houses program for low income people; 10. Enlargement and sharpening of KUR (micro credit guarantee program) in coverage and interest subsidy starting 2015. Main focus or Ministries or Institutions (K/L) spending I. K/L spending in APBN 2016 amounted at IDR784.1 trillion. The amount grew by IDR3.7 trillion from the proposed APBN 2016 of IDR780.4 trillion. II. Factors affecting changes in K/L spending include: a. Budget adjustment due to exchange rates volatility amounted to IDR0.5 trillion in Foreign Ministry and Ministry of Defense b. Change in limit use of non-tax revenues as a result of changes in non-tax revenues targets around negative IDR2.1 trillion in The Ministry Of Laws And Human Rights and POLRI c. Delays K/L spending at IDR21.3 trillion, which is done selectively on the K/L with pure rupiah ceiling above IDR1.0 trillion will be proposed by the outside education and health activities will be proposed again by Government in RAPBNP 2016 Office of Chief Economist Page 11

d. The education budget adjustment amounted to IDR2.5 trillion (the ministry of research and technology) Operational costs State, as well as additional scholarships and SNMPTN or SBMPTN e. Adjustment health budget around IDR0.6 trillion Ministry of Health f. Supplementary budget to meet spending needs urgent IDR5.5 triliun The Ministry of Defense IDR3 trillion, POLRI Rp2 trillion and IDR0.5 trillion The Ministry of Youth And Sports g. Additional priority spending amounted to IDR18.1 trillion at 21 K / Ls No. Ministry/Agency 2015 2016 APBNP APBN Gap 1 The Ministry of Public Works 118.5 104.1 (14.5) 2 The Ministry Of Defence 102.3 99.5 (2.8) 3 National Police (POLRI) 57.1 73.0 15.9 4 The Ministry Of Health 51.3 63.5 12.2 5 The Ministry Of Religions 60.3 57.1 (3.2) 6 The Ministry Of Education And Culture 53.3 49.2 (4.0) 7 The Ministry Of Transportation 65.0 48.5 (16.5) 8 The Ministry Of Research And Technology 43.6 40.6 (2.9) 9 The Ministry Of Finance 25.7 39.3 13.6 10 The Ministry Of Agriculture 32.8 31.5 (1.3) Others 185.7 177.9 (7.8) Total 795.5 784.1 (11.4) Figure 5. 10 Ministry/ Agency with the largest budget allocation. (Source: APBN 2016) Main focus or Ministries or Institutions (K/L) spending Non K/L spending 2016 is targeted at IDR541,4 T or lower than the proposed APBN 2016 of IDR558,7 T. Lower in Non K/L spending is primarily due to lower energy subsidy to IDR102,1 T from IDR121,0 T. On the other hand, there is an increase allocation for reserves on social protection, reserve on education budget and fiscal risk. Transfers to Regions and Village Fund in 2016 1. Transfer budget to Regions dropped by IDR12.0 T from RAPBN 2016, thus becoming IDR770.2 T. Office of Chief Economist Page 12

2. Budget reductions are included on sharing funds (DBH or Dana Bagi Hasil that is cut by IDR1.1 T) largely due to lower revenue from natural resources and tax that are being shared. Meanwhile, physical specific allocation funds (DAK) is being cut IDR6.3 T due to education budget adjustments. 3. General Allocation Fund (DAU) fell to IDR385.4 T (being cut by IDR2.9 T from the proposed APBN 2016) due to lower net National Domestic Revenue (PDN). 4. There are some important policies related to Transfer to Regions and the Village Fund, such as: the sharpening areas of DAK, the provision of greater incentives to regions that have performed well, supporting the implementation of the Special Autonomy for Papua, West Papua and Aceh, as well as implement village fund gradually in accordance with Law No. 6 of 2014 on village. Office of Chief Economist Page 13

Urgent Reform of Indonesia s Exports Nurul Yuniataqwa Karunia Intracen data indicates that 79.6% of Indonesian exports are still made up of commodities Indonesia s export characteristics need to be improved. Intracen data indicates that 79.6% of Indonesian exports are still made up of commodities. This share of export commodities ranks second among the ASEAN countries, after Brunei Darussalam (91.4%). This shows that Indonesian exports have a sizeable dependency on raw commodities and are thus severely affected by fluctuations in world commodity prices. When commodity prices start to decline significantly, as is presently the case, then Indonesia's export growth will slow down, eventually adversely impacting the country's overall rate of economic growth. Myanmar Commodities: 29.1% Manufactured Products: 62.3% Services: 8.7% Thailand Commodities: 18.5% Manufactured Products: 62% Services: 19.5% Malaysia Commodities: 30.2% Manufactured Products: 55.4% Services: 14.4% Brunei Darussalam Commodities: 91.4% Manufactured Products: 3.5% Services: 5% Singapore Commodities: 17.9% Manufactured Products: 56.6% Services: 25.5% Vietnam Commodities: 16.7% Manufactured Products: 76.9% Services: 6.4% Philippines Commodities: 14.5% Manufactured Products: 56.8% Services: 28.7% Indonesia Commodities: 79.6% Manufactured Products: 8.6% Services: 11.8% Figure 6. ASEAN s exports characteristics (% of total exports). Exports from Brunei Darussalam and Indonesia are still dominated by commodities. In contrast, Indonesian exports of manufactured products are still very small compared to those of most other ASEAN countries. Going ahead, the government should pay greater attention to this situation. (Source: Intracen) Indonesia's ratio of exports to GDP in 2014, which remained relatively small at 23.7%. This ratio has continually decreased since 2006 when it stood at 33.5% Exports from Brunei Darussalam and Indonesia are still dominated by natural resource-based commodities. In contrast, Indonesian exports of manufactured products are still very small compared to those of most other ASEAN countries. Going ahead, the government needs to pay greater attention to this situation as it is one of the factors why Indonesian exports do not contribute to the national economy as much as they could. This can be seen from Indonesia's ratio of exports to GDP in 2014, which remained relatively small at 23.7%. This ratio has continually decreased since 2006 when it Office of Chief Economist Page 14

stood at 33.5%. In fact, Indonesia's ratio of exports to GDP is far lower than that of many other ASEAN countries including Singapore (187.6%), Vietnam (86.4%), Malaysia (79.7%), and Thailand (75.1%). Some of these countries can also boast that more than 50% of their total exports are comprised of manufactured products. Brent Crude Oil USD 44.8/bbl WTI Crude Oil USD 40.1/bbl CPO USD 483/MT Coal USD 52.8/MT Rubber USD 1.16/Kg 2014: -35% 2015: -17% 2014: -32% 2015: -21% 2014: -20% 2015: -25% 2014: -18% 2015: -11% 2014: -38% 2015: -23% Figure 7. Global commodity prices slumped. The prices of Indonesia's main export commodities declined sharply in 2014. This has happened again in 2015 and is expected to continue. Indonesia's main commodities, such as palm oil and rubber, have weakened in price terms by even more than 20% in 2015. (Source: Bloomberg, as of 1 December 2015) As of November 2015, the value of Indonesia's exports had contracted by 14.3% (YoY), the deepest contraction since 2009 The pressure on the rupiah against USD increased in 2015, triggered by uncertainties surrounding a possible rise in the Federal Funds Rate as well as the depreciation of the Yuan. Throughout 2015, the rupiah exchange rate continued its declining trend that started in the middle of 2013. The rupiah reached its lowest position of IDR 14.698 per USD in September, a fall of 18.7% compared to its value at the close of 2014. With the weakening of the rupiah against the USD which began some time ago, the value of Indonesia's exports should have been pushed higher. However, because of the significant fall in prices of certain commodities - such as palm oil, coal and rubber - over recent years, the value of Indonesia's exports has instead declined. As of November 2015, the value of Indonesia's exports had contracted by 14.3% (YoY). This figure represents the deepest contraction since 2009 when Indonesia's exports shrank by 15% in value (YoY). Office of Chief Economist Page 15

Period Exports (USD mn) % YoY Imports (USD mn) % YoY Trade Balance (USD mn) 2008 136,870 20 129,197 74 7,673 2009 116,510-15 96,829-25 19,681 2010 157,779 35 135,663 40 22,116 2011 203,497 29 177,436 31 26,061 2012 190,032-7 191,691 8-1,626 2013 182,567-4 186,630-3 -4,064 2014 176,293-3 78,179-5 -1,886 Jan - Nov 2015 138,529-14 130,608-20 7,921 Figure 8. Indonesia's exports and imports in 2008 to 2015. As of November 2015, Indonesia's accumulated exports had weakened by 14% compared to the same period in 2014. This situation was strongly influenced by falling global commodity prices. Prior to this, in contrast, Indonesia's exports recorded significant growth in 2010 when world commodity prices were on the rise. (Source: BPS) Reforming Indonesia s exports In order for Indonesia's exports to be fixed, simultaneous support is required on both the macro and micro side. Investment is needed from the government as well as the business sector in a number of highly exportoriented industries Firstly, on the macro side, investment is needed from the government as well as the business sector in a number of highly export-oriented industries, such as palm oil manufacturing, electronics, pulp and paper, wood processing and automotives. Exports from this group of industries constitute more than 40% of the total exports of industrial products. As the amount of natural resources utilized by these industries is very high, the full support of the government is needed to enhance their added value through down-streaming. Investment should be sought and channeled to industries that perform down-streaming. In addition, various facilities, such as tax holidays and tax allowances, will have a positive effect if given to these types of industries. Office of Chief Economist Page 16

Country Overall LPI rank Infrastructure 2014 2010 2014 2010 Singapore 5 2 2 4 Malaysia 25 29 26 28 Thailand 35 35 30 36 Vietnam 48 53 44 66 Indonesia 53 75 56 69 Philippines 57 44 75 44 Cambodia 83 129 79 114 Lao PDR 131 118 128 132 Myanmar 145 133 137 134 Figure 9. Logistics Performance Index (LPI) of ASEAN countries. Indonesia's LPI ranking for 2014 was 53rd, up significantly from its previous position of 75th in 2010. This improved ranking saw Indonesia overtake the Philippines which had previously been ranked above Indonesia. However, in order to push up export performance in the future, infrastructure improvements are necessary to support entrepreneurs and facilitate the country's export processes. (Source: World Bank) Indonesia's LPI ranking lagging behind Malaysia and Thailand in the index, in 25th and 35th position respectively Secondly, it is hoped that the government will be able to improve Indonesia's ranking in the Logistics Performance Index, which will precipitate a rise in the value of exports. Indonesia's LPI ranking for 2014 was 53rd, far better than its previous position of 75th in 2010. However, this improved ranking still saw Indonesia lagging behind Malaysia and Thailand in the index, in 25th and 35th position respectively. Reducing the cost of logistics is one way of increasing the value of exports. More specifically, this could be done by shortening dwelling times and providing more efficient transport systems. With the government undertaking to carry out vast infrastructure improvements, it is essential that improvements to logistics are also made so as to improve Indonesia's competitiveness and bring it to the top of the pile among its ASEAN peers. This will ultimately serve to expand its export volumes and attract both domestic and foreign investors into investing and opening businesses in Indonesia. Thirdly, Indonesia needs to diversify its markets to a number of potential countries. Whenever Indonesia's main export destinations, such as the US, Japan and China, endure economic weakness, the value of Indonesian exports declines. As such, these exports should at least in part be shifted to other countries with a positive outlook for the future. These include African countries whose value of exports has increased over the last five years. This Office of Chief Economist Page 17

has occurred in Egypt, South Africa and Nigeria. In addition to African countries, in terms of exports Indonesia still needs to take into account the market share of its neighboring countries, the ASEAN countries. This very large and geographically accessible market represents a non-oil & gas export market for Indonesia that tends to be stable. Countries 2005 2008 2011 2014 Share (%) CAGR Growth (2005-2014) World 85.66 137.02 203.50 176.04 100.0 8.33 Japan 18.05 27.74 33.71 23.13 13.14 2.79 China 6.66 11.64 22.94 17.61 10.00 11.40 Singapore 7.84 12.86 18.44 16.75 9.52 8.81 US 9.89 13.08 16.50 16.56 9.41 5.90 India 2.88 7.16 13.34 12.25 6.96 17.46 South Africa 0.31 0.62 1.44 1.38 0.78 17.87 Egypt 0.29 0.79 1.40 1.34 0.76 18.53 Nigeria 0.17 0.29 0.47 0.65 0.37 16.14 Figure 10. Indonesia s export based on destination. Indonesia needs to diversify its markets to a number of potential countries, as its main export destinations, such as the US, Japan and China, are enduring economic weakness. As such, exports should be shifted to various African countries which have enjoyed fairly high growth in export value over the last several years, such as Egypt, South Africa and Nigeria. (Source: Intracen) Indonesia should take advantage of the market opportunities offered by ASEAN, given the relatively high growth of its middle-class population In the period from January to November 2015, the share of Indonesia's exports to ASEAN countries stood at 21% of its total non-oil and gas exports. The thing to note here is that demand in the ASEAN market has begun to diversify towards value-added products such as electronics, machinery, and locomotives. In light of this, Indonesia should take advantage of the market opportunities offered by ASEAN, given the relatively high growth of its middleclass population. In addition to the macro side, improvements are also needed on the micro level. At the same time as the macroeconomic environment is conditioned to support exports, direct support is also needed for exporters. On the micro level, the government needs to support domestic re-industrialization as one way of addressing the problem of cash flow from export-oriented industries with a high dependence on imported raw materials such as footwear, electronics and machinery. In this way, it is expected that economic Office of Chief Economist Page 18

growth can be boosted by promoting the marketing of products of export quality with high local content. Conclusions The government should give full support to natural resource-based industries to produce valueadded products by providing incentives to the companies concerned When looking at the development of Indonesia's exports, it seems that the government should give full support to natural resourcebased industries to produce value-added products by providing incentives to the companies concerned. Along with this, full support should also be sought for direct investment that leads to enhanced capabilities and technology, as a way of improving the competitiveness of domestic products. Furthermore, the financial support of the banking industry also needs to be directed to assist exporters in carrying out their business activities. With respect to exports, the government is expected to continue supporting and promoting the export of domestic products. As such, it needs to seek alternative export markets over and above the countries that currently make up its traditional markets. Moreover, it is equally important to solve the off-putting problem of too much bureaucracy so as not to dampen investor interest or confidence. The bureaucratic reforms in question are related to the improvement of investment regulations and the availability of a one-stop service for investment and export licenses. It is expected that such reforms along with the policy packages issued by the government will have a positive impact on Indonesia's exports. One thing is certain, although the proportion of exports in Indonesia's GDP is still far below public consumption, an increase in the value of exports will always enhance public purchasing power. Office of Chief Economist Page 19

Assessing Business Prospects in 2016 Nadia Kusuma Dewi and Mamay Sukaesih Global economic slowdown, low realization of government spending, continuing slow investment growth and weak public purchasing power have an impact on Indonesia economy Economic growth in the third quarter of 2015 stood at 4.73% YoY, slightly better than that in the second quarter of the year of 4.67% YoY. Nevertheless, in cumulative terms economic growth up until the third quarter of 2015 was lower than that over the same period in 2014 (4.71% YoY vs 5.03% YoY). Several factors led to this slowdown in economic growth in Indonesia. On the external overview, the reasons behind the slowdown were related to uncertainties in the global economy, China's slowing economic growth, increasing US interest rates (the Fed Funds Rate) and the slow recovery of the European economy, in particular the handling of the Greek crisis. On the domestic front, the slowdown was caused by a low realization of government spending, continuing slow investment growth and weak public purchasing power. Bank Mandiri's economic team predicts that economic growth in 2015 will stand at just 4.7%. Indonesia Quarterly GDP Growth (%, YoY) 6.48 6.27 6.01 5.94 6.11 6.21 5.94 5.87 5.61 5.59 5.5 5.61 5.14 5.03 4.92 5.01 4.71 4.67 4.73 1Q11 3Q11 1Q12 3Q12 1Q13 3Q13 1Q14 3Q14 1Q15 3Q15 Figure 11. Indonesia GDP Growth. Indonesia's current economic slowdown is of our concern. Economic growth in the third quarter of 2015 stood at 4.73% YoY, slightly better than that in the second quarter of the year of 4.67% YoY. Nevertheless, in cumulative terms economic growth up until the third quarter of 2015 was lower than that over the same period in 2014 (4.71% YoY vs 5.03% YoY). (Source: BPS) Office of Chief Economist Page 20

Decline in commodity prices weaken Indonesia GDP growth as Indonesia is a commodity sector export based country The global economic slowdown has been followed by a decline in commodity prices in the international market. As Indonesia is a country whose economy is sustained by the commodity sector, these price falls have resulted in a subsequent decline in the performance of sectors related to the commodity sector. For example, the mining and quarrying sector suffered a contraction of 4.48% yoy from the first to the third quarter of 2015. In addition, exports have been hit because Indonesian exports are dominated by the commodity sector. From the first to the third quarter of the year, exports contracted by 13.29%. In contrast, sectors that are not related to the commodity sector experienced the highest growth. For example, the information and communications sector enjoyed growth of 10.23% YoY. This sector has indeed shown great growth over the last 5 years, averaging more than 10%. Commodity Price Index (1Q00=100) 1.000 900 Global Financial Crisis European Debt Crisis 800 700 600 500 400 300 200 100 Coal Price Index Oil Price Index CPO Price Index Rubber Price Index 0 3Q15 2Q15 1Q15 4Q14 3Q14 2Q14 1Q14 4Q13 3Q13 2Q13 1Q13 4Q12 3Q12 2Q12 1Q12 4Q11 3Q11 2Q11 1Q11 4Q10 3Q10 2Q10 1Q10 4Q09 3Q09 2Q09 1Q09 4Q08 3Q08 2Q08 1Q08 4Q07 3Q07 2Q07 1Q07 4Q06 3Q06 2Q06 1Q06 4Q05 3Q05 2Q05 1Q05 4Q04 3Q04 2Q04 1Q04 4Q03 3Q03 2Q03 1Q03 4Q02 3Q02 2Q02 1Q02 4Q01 3Q01 2Q01 1Q01 4Q00 3Q00 2Q00 1Q00 Figure 12. Commodity Price Index. The global economic slowdown has been followed by a decline in commodity prices in the international market. As Indonesia is a country whose economy is sustained by the commodity sector, these price falls have resulted in a subsequent decline in the performance of sectors related to the commodity sector. (Sources: Bloomberg) Office of Chief Economist Page 21

Growth & Amount of GDP by Sector from the First to Third Quarters of 2015 Figure 13. Growth & Amount of GDP by Sector from the First to Third Quarters of 2015. Mining and quarrying GDP sector suffered a contraction of 4.48% YoY from the first to the third quarter of 2015 as a decline in commodity prices in the international market. In contrast, sectors that are not related to the commodity sector experienced the highest growth. For example, the information and communications sector enjoyed growth of 10.23% YoY. (Sources: BPS) For the period ahead, provinces whose economies are based on the commodity sector should look for new sources of economic growth, in the face of the fact that the commodity sector boom has ended Moreover, Indonesia s weakening economic growth has varied from region to region in the country, depending on the extent to which the economy of the province in question is sustained by the commodity sector. Provinces whose economies are highly dependent on the commodity sector are naturally badly hurt by falling commodity prices. From the first to the third quarter of 2015, these provinces endured a contraction in economic growth. The provinces in question are Aceh (-1.53% YoY), Riau (-1.5% YoY) and East Kalimantan (-1.65% YoY), all of whose economies rely on mining, especially coal and oil & gas. For the period ahead, provinces whose economies are based on the commodity sector should look for new sources of economic growth, in the face of the fact that the commodity sector boom has ended. One way of promoting economic growth in these areas is to develop industries that produce goods and provide added value to manufactured goods, Also, the acceleration of infrastructure development in these areas should be encouraged. Office of Chief Economist Page 22

Growth of GDRP by Province from the First to Third Quarters of 2015 (%) Figure 14. Growth of GDRP by Province from the First to Third Quarters of 2015 (%). Indonesia s weakening economic growth has varied from region to region in the country, depending on the extent to which the economy of the province in question is sustained by the commodity sector. Provinces whose economies are highly dependent on the commodity sector are naturally badly hurt by falling commodity prices. (Sources: BPS) Business Prospects in 2016 Bank Mandiri's economic research team estimates that the Indonesian economy in 2016 will grow by 5.0%, slightly better than the growth posted in 2015 Bank Mandiri's economic research team estimates that the Indonesian economy in 2016 will grow by 5.0%, slightly better than the growth posted in 2015. This is based on the assumption that the turmoil in financial markets will begin to subside after there is certainty as to the direction of the Fed's monetary policy. On top of that, domestically the positive effects of the government stimulus package will begin to take effect next year if the policy is carried out in a consistent manner. Nonetheless, this projection of Indonesia's economic growth is lower than that assumed in the 2016 state budget of 5.3%. This is because we still see a number of risks, both of an external and internal nature, that could restrict economic growth from achieving the significant improvement targeted. In general, the sectors oriented towards the domestic market still have great potential for strong growth in 2016. For example, the consumer goods and infrastructure sectors are likely to enjoy relatively robust growth in 2016, in comparison to many other sectors. Other sectors with the potential for strong growth in 2016 Office of Chief Economist Page 23

In general, the sectors oriented towards the domestic market still have great potential for strong growth in 2016, such as consumer goods and infrastructure sectors include the information and communications sector, the transportation and warehousing sector and the services sector, in particular educational services, health services and social activities. There are several reasons as to why the consumer goods sector has fairly good prospects, especially in urban areas, and even more specifically in the provinces in Java. Firstly, the demographic structure of Indonesia, which is dominated by young people, has led to an increase in the number of productive workers with disposable income and the ability to spend quite highly. Secondly, changes in lifestyle and consumption patterns along with an increasing trend of urbanization are serving to boost this sector. Thirdly, the number of middle income earners continues to grow, also driving demand for consumer goods. Indonesian Population Projection and Middle Income Class Proportion 300 250 200 150 100 50 0 284.8 271.1 255.5 238.5 82.0% 68.4% 76.1% 56.5% 2010 2015 2020 2025 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Population (million people) Middle income class (% of population) Figure 15. Indonesian Population Projection and Middle Income Class Proportion. The huge population of Indonesia and growing middle income class will spur on the development of the consumer goods sector market. The proportion of the population in the middle income class in itself is estimated this year at 68.4% of the total population of Indonesia, with this figure likely to rise to 76.1% in 2020 (Sources: BPS, ADB) In the midst of global economic uncertainties, the role of state expenditure is set to be key in providing a stimulus to encourage economic growth In the midst of global economic conditions still replete with uncertainties in 2016, the role of state expenditure is set to be key in providing a stimulus to encourage growth in various sectors of the national economy. This is especially true for the infrastructure sector, particularly as it relates to government priority projects, which can boast good prospects in the coming year. This sector is sure to benefit from some of the government's flagship projects primarily aimed at establishing interregional connectivity, such as the construction of ports, airports, highways and other public transport facilities. Office of Chief Economist Page 24

In addition, government infrastructure development will prioritize areas outside of Java, especially in eastern Indonesia. Connectivity infrastructure projects to be prioritized in 2016 in eastern Indonesia include the construction of the Sorong-Manokwari railway line, the development of Domine Eduard Osok airport in West Papua, the construction of the Manado-Bitung highway, as well as the construction and development of the port of Bitung in North Sulawesi as an international hub. Meanwhile, connectivity infrastructure projects in the western and central regions of Indonesia include the construction of the Samarinda-Balikpapan highway, the construction and development of the port of Kuala Tanjung in North Sumatra and the construction of the Soekarno Hatta-Halim airports railway line. Connectivity, energy and electricity infrastructure are to be prioritized in 2016 Manufacturin g industries which utilize local natural resources also have quite a promising outlook for 2016 This connectivity infrastructure is predicted to become a motor of growth for local economies and will serve to facilitate the flow and distribution of goods between regions. In addition to connectivity infrastructure, energy and electricity infrastructure are also to be prioritized in 2016. Energy infrastructure development will encompass a 250 MW MG-Barge Mounted gas power plant in North Sumatra, a 100 MW MG-Truck Mounted gas power plant in Jambi, the 350 MW Tanjung Awar-Awar steam power plant in East Java east and a 200 MW MG - Mobile PP gas power plant in South and Central Kalimantan. Manufacturing industries which utilize local natural resources also have quite a promising outlook for 2016. This pertains especially to those industries whose production processes create added value for natural resource-based products derived from the agricultural, fisheries and plantations sectors. Manufacturing industries which use natural resources have particular potential in the provinces of eastern Indonesia. For example, the province of West Sulawesi has the potential to further develop a manufacturing industry based on cocoa. The province of Central Sulawesi, meanwhile, has the potential to further develop maritime resource-based industries such as seaweed and fish meal. The development of the commodities sector, including palm oil, rubber and petroleum, is very dependent on price developments. We expect commodity prices to begin rebounding slowly in 2016, depending on the extent to which demand increases in the wake of possible improvements in global economic growth. However, these commodity prices are not going to return to the levels reached during the commodities boom, as they have been subject to corrections on the supply side in terms of greater supply. They have also been subject to corrections in terms of speculative effects, in that speculative motives have been dampened due to the tightening of liquidity in the US. Office of Chief Economist Page 25

Conclusion Bank Mandiri's economic research team estimates that the Indonesian economy in 2016 will grow by 5.0%, slightly better than the growth posted in 2015. This projection of Indonesia's economic growth is lower than that assumed in the 2016 state budget of 5.3%. This is because we still see a number of risks, both of an external and internal nature that could restrict economic growth from achieving the significant improvement targeted. In general, the sectors oriented towards the domestic market still have great potential for strong growth in 2016. For example, the consumer goods and infrastructure sectors are likely to enjoy relatively robust growth in 2016, in comparison to many other sectors. In the midst of global economic uncertainties, the role of state expenditure is set to be key in providing a stimulus to encourage economic growth. Office of Chief Economist Page 26

The Bittersweet Sugar Industry Araminta Setyawati The government set a target of white crystal sugar production in 2015 of 2.7 million tons. However, achieving this target has not proved easy due to a number of issues The government set a target of white crystal sugar production in 2015 of 2.7 million tons. However, achieving this target has not proved easy due to a number of issues. These include the occurrence of El Nino and a decrease in planting area, both of which have made the business players in this sector pessimistic about being able to achieve the intended target. Based on data from the Directorate General of Plantations of the Ministry of Agriculture, total sugar production as of August 2015 had only reached 1.24 million tons from 16.3 million tons of milled sugarcane. This means that sugarcane production stood at just 47.8% of this year's target of 34.15 million tons. Sugar production in 2015 is only expected to reach a maximum of 2.5 million tons, down from last year's production level of 2.54 tons. The production of the aforementioned 1.24 million tons derived from an area of 225,000 hectares with productivity of 5.51 tons of sugarcane per hectare. In 2014, the land area of sugarcane harvested stood at 473,000 hectares, while this year the area harvested for milling as of October stood at about 462,000 hectares. A senior advisor to the Indonesian Sugar Association (AGI) said that this year's drought has disrupted the growth and development of the milled sugarcane crop. As such, the land area of sugarcane harvested in 2015 is slightly lower than that of last year. However, despite the decreasing land area harvested this year, sugar production is still expected to be sufficient to meet the demand for sugar until April 2016. Land Area of Sugarcane Harvested (ha) 477,881 454,111 451,788 451,184 469,227 462,000 2010 2011 2012 2013 2014 2015 as Okt Figure 16. Land Area of Sugarcane. According to the figure, the land area of sugarcane that harvested in Indonesia has been declining in 2015. It caused by El Nino and a decrease in planting area. (Source: BPS) Office of Chief Economist Page 27

Based on data from the United States Department of Agriculture (USDA), as of May 2015 the world's largest producer of sugar was Brazil with total production of 36 million tons per year Based on data from the United States Department of Agriculture (USDA), as of May 2015 the world's largest producer of sugar was Brazil with total production of 36 million tons per year. In contrast, Indonesian production only amounts to around 2.25 million tons per year. The world's second largest producer is Thailand with total production of 10.6 million tons per year from its 50 sugar mills. However, Thailand's domestic needs only amount to around 2 million tons per year. Thus, its surplus production of 8.6 million tons is thrown into the export market, making Thailand one of the world's largest sugar exporters after Brazil. Currently, approximately 30% of exported Thai sugar is sent to Indonesia. Furthermore, the total milling capacity of sugar mills in Thailand stands at 940,000 tons of sugarcane per year, just enough to meet the country's household needs. The 2.25 million tons produced by Indonesia make up about 1.3% of the world's total sugar production and are also just enough to meet the country's household needs. However, sugar for industrial needs still has to be imported. Moreover, Indonesia's overall sugar milling capacity remains smaller than its needs, and well below that of Thailand, at only 205,000 tons of sugarcane per year. In addition, rendement (the amount of sugar recovered per ton of beets processed) hovers at around just 7-8%. Sugar consumption in Indonesia stands at 5.3 million tons per year. This consumption consists of household consumption of 2.8 million tons along with 2.5 million tons used as a raw ingredient in the food and beverage industry. With average annual growth of the food and beverage industry recorded at more than 8% from 2011 to 2014, the demand for sugar from industries in Indonesia is sure to keep rising. If domestic sugar production is unable to meet the demand for sugar, then imports will automatically increase. In light of this, in 2016 imports of raw sugar look set to rise to 3.22 million tons. This represents a 5% increase from the 2015 figure of 2.89 million tons. Meanwhile, the demand for refined sugar is predicted to reach 3.03 million tons in 2016. As raw sugar is an essential material for the food and beverage industry, certainty as to the rules on its importation is required. The Chairman of the Indonesian Refined Sugar Association (AGRI) has said that national refined sugar production is completely sufficient for the purposes of the food and beverage industry. Based on data from the Ministry of Trade, in 2014 permission was granted for the importation of 2.8 million tons of raw sugar destined for the refinery industry, of which 2.67 million tons was realized. Meanwhile, in 2015, permission was granted for the importation of 3.10 million tons of raw sugar, of which just 2.64 million tons has been realized. Office of Chief Economist Page 28

Total Import of Sugar Indonesia, 2014 Figure 17. Sugar Import of Indonesia. According to the figure. currently, approximately 30% of exported Thai sugar is sent to Indonesia. Thailand one of the world's largest sugar exporters after Brazil. (Source: USDA and Trademap) The Ministry of Industry considers sugar production at this time, both by private and state-owned companies, not to have reached its maximum level. As such, the development of additional sugar mills and new sugarcane planting land is required in various regions. However, the construction of new sugar mills and the expansion of land face at least five problems. Firstly, there is a difficulty in finding suitable land with a sugarcane agro-climate. More specifically, what is required is a flat topography with a climate of six wet months for growing the sugarcane and six dry months for processing the sugar. Secondly, a single sugar mill with a capacity of 10 thousand TCD (tons of cane per day) requires a fairly large sugarcane plantation area of about 20 thousand hectares. Thirdly, in accordance with Presidential Decree No. 36 of 2010, the establishment of a new sugar mill should be integrated with a sugarcane plantation. This creates a time mismatch in that a sugarcane plantation takes fairly long to be established - about 4 to 5 years - while the construction of a mill takes 2 years. Fourthly, it takes a considerable investment for a mill with a milling capacity of 10 thousand TCD - around IDR 1.5 trillion to IDR 2 trillion - while the period for a return on the investment is about 8 to 10 years. Lastly, there exist quite high risks in the industry including sugarcane crop diseases, climate anomalies and the absence of any price guarantees. Office of Chief Economist Page 29

Nevertheless, the Minister of Industry has said that there are various ways of solving these problems. These include the following; firstly, the provision of clear and clean land; secondly, refined sugar mill owners should be given preference when it comes to inviting potential investors to establish new sugarcane plantations and build new sugar mills; thirdly, the government must provide the necessary infrastructure in new areas where the sugar industry is to be developed, such as on the islands of Aru and Seram; and finally, incentives in the form of tax allowances or tax holidays should be given. Indonesia s Sugar Production Area (2014) Figure 18. Indonesia s Sugar Production Area. According to the figure, the area that produce sugar above 150.000 ha is only in Java. Even the area in between 50.000 and 100.000 is in Java too. The Ministry said that the sugar production area must be clean and clear and be provided the infrastructure. (Source: BPS) Office of Chief Economist Page 30

1 I nt r oduct ion Indonesia Update January 2016 Indonesia The Historical regained independence Persistence of fromdutch the Netherlands Education in System 1945 and in has Indonesia been an independent Romauli Panggabean country for the past 70 years. However, unequal performance of the education sector across Indonesia regained independence from the Netherlands in 1945 and has been an independent country for the past 70 years. However, unequal performance of the education sector across regions is still apparent to date I. Introduction Indonesia regained independence from the Netherlands in 1945 and has been an independent country for the past 70 years. However, unequal performance of the education sector across regions is still apparent to date. Figure 19 presents a comparison of education attainment, especially between primary and tertiary education, by provinces in Indonesia. As for the primary education, most provinces, except Papua, have 90 per cent education attainment in elementary school. However, the numbers for higher education differ dramatically. Average education attainment for age 7-12 years old (elementary school) is approximately 98.42 per cent, whereas for age 16-18 years old (senior high school) the average is only 63.84 per cent. For Papua, the far eastern part of Indonesia, the number of higher education attainment even less than the national average of 60 percent. regions is still apparent to date. Figure 1 presents a comparison of education attainment, especially between primary and tertiary education, by provinces in Indonesia. As for the primary education, most provinces, except Papua, have 90 per cent education attainment in elementary school. However, the numbers for higher education di er dramatically. Average education attainment for age 7-12 years old (elementary school) is approximately 98.42 per cent, whereas for age 16-18 years old (senior high school) the average is only 63.84 per cent. For Papua, the far eastern part of Indonesia, the number of higher education attainment even less than the nat ional average of 60 per cent. School Participation by Province in Indonesia, 2013 (%) Figure 1: School Participation by Province in Indonesia, 2013 (Per cent) Age$7&12$(Elementary$School)$ Age$16'18$(Senior$High$School)$ Papua#Barat# Papua# Maluku#Utara# Maluku# Sulawesi#Tenggara# Sulawesi#Barat# Sulawesi#Selatan# Sulawesi#Tengah# Gorontalo# Sulawesi#Utara# Kalimantan#Timur# Kalimantan#Selatan# Kalimantan#Tengah# Kalimantan#Barat# Nusa#Tenggara#Timur# Nusa#Tenggara#Barat# B#a#l#i# Jawa#Timur# DI#Yogyakarta# Jawa#Tengah# Banten# Jawa#Barat# DKI#Jakarta# Lampung# Bengkulu# Kep#Bangka#Belitung# Sumatera#Selatan# Jambi# Kepulauan#Riau# R#i#a#u# Sumatera#Barat# Sumatera#Utara# Aceh# 50# 60# 70# 80# 90# 100# Papua#Barat# Papua# Maluku#Utara# Maluku# Sulawesi#Tenggara# Sulawesi#Barat# Sulawesi#Selatan# Sulawesi#Tengah# Gorontalo# Sulawesi#Utara# Kalimantan#Timur# Kalimantan#Selatan# Kalimantan#Tengah# Kalimantan#Barat# Nusa#Tenggara#Timur# Nusa#Tenggara#Barat# B#a#l#i# Jawa#Timur# DI#Yogyakarta# Jawa#Tengah# Banten# Jawa#Barat# DKI#Jakarta# Lampung# Bengkulu# Kep#Bangka#Belitung# Sumatera#Selatan# Jambi# Kepulauan#Riau# R#i#a#u# Sumatera#Barat# Sumatera#Utara# Aceh# 50# 60# 70# 80# 90# 100# Source: Indonesian Central Statistic Agency (Badan Pusat Statistik), 2015 Figure 19. School Participation by Province in Indonesia. Elementary school participation in almost all of Indonesia s provinces is relatively high, except for Papua. However, move to higher education participation, or senior high school participation, inequalities between provinces is quite high. (Source: BPS) Moreover, that condition may lead to an unequal economic development level across regions faced by Indonesia presently. The education attainment Office of Chief iseconomist a fundamental Page 31 aspect on its relation to economic development. Higher education attainment will provide higher quality of human capital, and hence, ceteris paribus, labour productivity is high as well

The unequal education performanceis a prime suspect thatcouldlead to theeconomic development disparitiesacross regions in Indonesia. One of the indicators for education performance is education attainment. It is a fundamental aspect on its relation to economic development. Higher education attainment provides higher quality of human capital, which, ceteris paribus, will potentially advance higher labour productivity (Mankiw et al., 1992). Therefore, the link between education attainment and productivity level can be seen from population education completion. Knowing how important the education is to boost the human capital quality, the Indonesian government had initiated several programs to boost regional education attainment Knowing how important the education is to boost the human capital quality, the Indonesian government had initiated several programs to improve regional education attainment. One major program is the 20 per cent allocation of regional budget which is specifically dedicated for education. It is a major breakthrough for the economic development in Indonesian because physical infrastructures, such as road, bridge, or port, that are often receiving the lion's share of the budget allocation. The wider budget space empowers education agencies in all regions to formulate various policies, especially to make education to be more accessible to the whole society. Another popular policy is the regulation amendment to oblige a minimum of 9 years education completion. This program ensures the minimum education attainment for all Indonesian citizens. Another important program is an education package dedicated for dropout students. The initiative enables all citizens who could not finish their study in the past to take an accelerated education package, include its exams, so they have an opportunity to receive their diploma certificate. These two programs are only few examples of many policies taken by the government. We suspect the beginning of that different path of education outcome might be associated with the Dutch colonial expansion, which introduced mass education in Indonesia Although the government has implemented various programs as elaborated above, practically the economic development gap between regions is still apparent. As briefly explained earlier, the quality of human capital, which can be seen from the education completion level of a region, influence the extent to which of the economic development. Figure 20 shows a positive correlation between the regional performances of education completion, both in primary and tertiary education, and the gross domestic product (GDP) contribution of that region to the national economy. The figure indicates that the relationship seems stronger for tertiary education completion to increase regional contribution. Could the key reason is that larger proportion of the population with tertiary education will improve Office of Chief Economist Page 32

quality of human resources and promote higher productivity. This relation indicates the importance of education provision from economic point of view (Nomura, 2007). Different education completions across regions in Indonesia are an interesting phenomenon that needs to be examined further, which is the starting point of this study. Our study investigates what the main reason behind it. We argue that the educational disparity across regions in Indonesia can be associated with the Dutch colonial expansion, which introduced mass education in Indonesia. Various studies discover that the education quality in the past persistently determines current education outcome Various studies discover that the education quality in the past persistently determines current education outcome. Wietzke (2014) provides a summary of those studies analyzing the variation of education outcome in former British and French colonies. He argues that the variation is mainly due to the different education services provided by the missionaries. For example, the presence of Protestant missionaries in the non-settler colonial in India gives benefit to natives since missionaries was the one who established school to educate the people (Gallego and Woodberry, 2008). Other studies also find the same conclusion in African countries concerning the historical persistence of colonial to present education outcome (Huillery, 2009). Hence, we can conclude that education quality in the colonial era can be the reason of persistence effect of current education outcomes inequality in Indonesia. Relationship between Population Education Completion and GDP Contribution by Province Figure 20. Education Completion and GDP Contribution. The relationship between GDP contribution by province and school completion is positive. However, higher school completion give stronger relationship, represent by steeper correlation line in the second graph. (Source: BPS) Office of Chief Economist Page 33

The history of Dutch Education provision in Indonesia can be traced to the Dutch expansion in Indonesia. Since 18 th century Dutch settlement in Java lead to an extremely poor and degenerated life quality of native people, especially during the cultuurstelsel policy implementation. The condition of Javanese people, which was portrayed in a satirical novel book entitled Max Havelaar, brought a global-wide attention and urged the Dutch to implement ethical policy in the early 1900s. One follow-up policy to improve the natives quality of life was education provision. Since then, schools were not exclusively for students from the Dutch and Europeans only, but also for natives. The result was strikingly significant, native students surged tenfold to 1.5 million pupils in 1930, from approximately 150,000 pupils in 1900. Furthermore, active movements from Indonesian nationalists, such as Kartini and Dr. Soedira Oesada, helped to promote education awareness among natives in Java. One nationalist, R.M.S Soeryaningrat, even took further action by providing education through his private school called Taman Siswa that was based in Java as well (Furnivall, 1939). The above ethical policy can be associated to the beginning of a literate and informed society in Indonesia. A number of young scholars, who received the Dutch education, became prominent nationalist figures on this era. The above ethical policy can be associated to the beginning of a literate and informed society in Indonesia. A number of young scholars, who received the Dutch education, became prominent nationalist figures on this era. Later they initiated the fight for Indonesia to gain its independence. Most of those scholars had been sent by the Dutch colonial government to study in the Netherlands in pursuing higher education. This is due to the fact that over the period, higher education provision was still in the early stage of development. Furthermore, through education, many Indonesian pupils learned Dutch language, especially those who studied in the first class or the high-quality school that was important to improve the communication with the colonial government. The direct benefit of a reduced language barrier was better knowledge transfer from the Dutch to Indonesian. The knowledge transfer was, for instance, in the area of trade administration, business management, or agricultural techniques. In summary, in the region where the Dutch had settled, mass education was introduced and benefited Indonesian. Against this backdrop, education performances across region, which are depicted in Figure 19, are presumably related to the historical persistence of Dutch education establishment. As Nunn (2009) has pointed out, historical event and colonial rule are able to explain the heterogeneity of economic development in the world. It also means that historical events of the Dutch colonial period might explain the different education outcomes in Indonesia. Therefore, our main question of this study is: does the Dutch education establishment in Office of Chief Economist Page 34

colonial era produce different population education completions across regions in Indonesia?. II. The Historical Persistence: Why is it important? For more than a decade, studies in the realm of historical persistence have helped to explain the different nature of economic development across countries (Nunn, 2009). Among the first generation of those studies, the main objective was to examine the long-term impact of early institution on current economic development. The early establishment of institutions in the world links to the various European settlements during colonial era. Along with their expansion, the Europeans might bring their institutions from back home to the colonies. The hypothesis is that in an area where the Europeans could settle, they established the Europeanstyle institutions, whereas in a place where they could not settle, they implemented the extractive institution (Acemoglu et al., 2001). Institution surely has an important role because institution influences each country s productivity and widens the economic gap among them Institutions surely has an important role because institutions influences each country s productivity and widens the economic gap among them. They discover that in countries where European colonial established good institutions, they have the favourable social infrastructures for workers to pursue more output or higher productivity. This has something to do with the fact that the good institutions will ensure the return to human capital will be around its dispersion line, and thus increase productivity and economic performances. The effect is persistently affecting current economic performances because the early institutions is rigid, which is very difficult and expensive to change it. The relation to the current condition of Indonesia is straightforward. The theory of colonial settlement and institutions cannot be applied to the Indonesian case because neither native nor foreign institutions from the Dutch colonial government were better (Day, 1966). The colonial era might determine the current development level across regions as a result of different education provision in each area and not due to the institutions that the Dutch had brought. As the Dutch settled in some parts of Indonesia, in 1900s they introduced education to the natives to follow up the ethical policy. The colonial government formulated this policy after receiving pressures from the global community, not long after Multatuli (the alias of Douwes Dekker) published a satirical novel book about the long-suffering of Javanese people under the Dutch agriculture policy in 1800s. Therefore, we can conclude that Dutch was the one who introduced mass education system to Indonesia. They brought mass education to Indonesia along with their settlement. In regions where the Office of Chief Economist Page 35

Dutch did not settle, the Dutch missionary was solely the education provider, which obviously did not have sufficient funds to organize mass education as compared to the colonial government (Furnivall, 1939). Hence, in the region where the Dutch had settled, education outreached the larger part of the society than the region where there was only missionary in place. Since the ethical policy was implemented in 1900s, the Dutch intended to increase the natives welfare through education. Consequently, following the success story of Volksschool, the Dutch introduced second generation of school type Hollandsch-Inlandsche School (HIS), which used the Dutch language in the higher-grade classes (Fahmi, 2007). This kind of school was more advanced and facilitated the natives to receive better education and hence found a better job as compared to Volksschool. During the colonial period, mastering Dutch language would help to accelerate the transfer of knowledge and to accommodate the demand for skilled labor that could speak Dutch. This fact is important for this study, because we will use the Dutch literacy rate in each region. We would like to know whether the establishment of modern and good quality education would have persistent effects on the different educational outcomes currently. For this reason, the Dutch literacy would be useful as an indicator to measure the quality of education in an area as a result of Dutch ethical policy. The discussion of the role of education is crucial, because education essentially affects human capital quality (Mankiw et al., 1992). The discussion of the role of education is crucial, because education essentially affects human capital quality (Mankiw et al., 1992). If we compare developing and developed countries, the main difference between the two can be explained with the variation of school attainments (Barro and Lee, 2010). The average schooling attainment for high-income countries is approximately 11 years, while in developing countries is around 7 years. The fact that that gap narrowed only by 1 year over the past 40 years indicates the difficulty to alleviate the inequality in education provisions. Thus, it is not surprising that the income level between developing and developed countries differs sustainably. Based on the above elaboration, our study analyses the relationship between settlements and education persistence, which will in turn determine labour productivity in Indonesia and eventually differentiate regional development. In the region where the Dutch did not settle, we suspect that there was backwardness in education as compared to the other part of island. One parameter that can be used to measure education backwardness is the literacy rate, since literacy rate provides information concerning the condition of the societies primary education (Hanson, 1989). Hanson study reveals that the colonies with high literacy rate during imperialism will have a positive impact on the current number of industrial labour force. Office of Chief Economist Page 36

Following the result, he also finds that historical literacy rate will support countries to have higher income per capita through the export of mineral, fuels, and oils, as well as mining. Up to this point, we predict that education (measured by literacy rate) during colonial era has persistent effects to influence the current economic condition. III. Empirical Estimation One of many facts that we can rely on is that the Dutch was the one who introduced education in Indonesia. Since the implementation of ethical policy, they had started to build schools for natives, as well as for their descendants who lived in Indonesia. Thus, education performance was not a major reason why the Dutch settle in one area. Their settlement in Indonesia was mainly to exploit the natural resources and to maximize their revenues, especially in Java. In the other part of Indonesia, their settlement was only to enlarge their colonial territorial base. Therefore, the Dutch settlement in Indonesia will only affect the current education performance through Dutch education outcome in the past. In addition, to solve endogeneity problem in our empirical estimation, we instrumented the education performance in the Dutch colonial era (i.e., literacy rate) with the Dutch settlement (Gujarati and Porter, 2009). By using this method, we can isolate the historical persistence of education performance. Secondary Education Inequalities in Indonesia (%) Figure 21. Secondary Education Inequalities in Indonesia. Secondary education (junior high school) in Papua is the worst performer among other islands in Indonesia. The red colour represents the lowest education attainment in that area or below 50 per cent. (Source: Case Study Report ODI 2014) Office of Chief Economist Page 37

In the first stage of our empirical estimation, we use the Dutch settlement as the instrument of the Dutch literacy rate. We expect positive and significant sign for this regression. It means in the place where the Dutch had settled, we expect higher Dutch literacy rate compared to non-settled area because in the place where the Dutch had settled, they built good quality school with Dutch as their language. The result is confirming our prediction that education in colonial era persistently determine current education outcome IV. Empirical Findings The result is confirming our prediction that education in colonial era persistently determines current education outcomes. In the first stage, all variables of Dutch literacy rate, i.e. young and adult age, are used as the instrument variables that can explain the Dutch literacy rate. Dutch settlement in a region would support higher rates of Dutch literacy because in the place where the Dutch decided to settle, they would also introduce education, specially the high quality one. High quality education was then reflected in the higher Dutch literacy rate. The second stage regression deals with the regression of literacy rate during colonial era to variables of education completion. The result is quite straight forward; higher literacy rate in the past would improve current education completion in the region. An important message from the regression using the literacy rate is the fact that the Dutch literacy rate has higher and more significant Office of Chief Economist Page 38

effect than the total literacy rate to determine current education completion. The logical explanation is as follow. The Dutch literacy rate reflects a good quality of education provision due to the fact that the Dutch colonial government had better resources than the local providers. Thus, higher Dutch literacy rate will also mean that most population received a high education standard. This condition persistently influences current economic performance, because higher Dutch literacy rate means higher tertiary education completion in a region. Further, we argue that the persistence effects of Dutch education to current economic performance can possibly occur through three channels. First, the Dutch education system enables natives to experience good quality mass education. This means higher possibility to receive good job position and increase the possibility of their descendants to receive proper education as well. Second, Dutch schools trigger private education provision in Indonesia. Nationalists, such as Ki Hajar Dewantara and Raden Ajeng Kartini, were among the pioneer of independent school providers reaching all society in Indonesia that persistently influence current education completion. Last but not least, education in the ethical policy era produced Indonesian nationalist leaders which helped the country to develop in post-colonial era. As a result, in the area that has good quality education, it will persistently have higher education completion. Hence, to increase regional competencies and to improve regional economic growth it is better to boost education performance in the area where Dutch never settled there Although the persistence effect of colonialism is important to determine the current education performance, but we also find other variables that contribute to education completion, that is GDP per capita. GDP per capita gives a positive impact to the current education completion. This means that economic condition of a general society determines the opportunity to complete their education. In contrast, the variable that represents government policy in education, which is regional government budget of education, fails to explain the current education completion variation. One possibility might be because the high rate of corruption in the budget disbursement management. IV. Policy Recommendation In conclusion, our study finds the correlation between the historical persistence of the Dutch education system to the current education completion. The main reason of this relationship is the Dutch ethical policy that introduced mass education system to the Indonesian society. Those regions with high number of Dutch literacy rates would have higher current education completion, especially tertiary education completion. Office of Chief Economist Page 39

Consequently, to increase regional competencies and to improve regional economic growth,the government should promote education performance in the area where Dutch never settled there. The reason is that those area have education backwardness persistencies since the colonial era. Moreover, although there will be a mass students concentration in some cities in Indonesia, the government should allocate more fundsto the villages where good school never exist. This sound cliché and many research findings had shared this similar result. However, the urgencies is real given the persistencies in education performance that never change since the 18 th centuries. Office of Chief Economist Page 40

Regression using Dutch Literacy of Young Population and Current Education Completion Regression using Dutch Literacy of Adult Population and Current Education Completion Figure 22. Secondary Education Inequalities in Indonesia. Secondary education (junior high school) in Papua is the worst performer among other islands in Indonesia. The red colour represents the lowest education attainment in that area or below 50 per cent. (Source: Case Study Report ODI 2014) Office of Chief Economist Page 41

Mandiri Leading Economic Index (MLEI) Slightly Stronger Growth in Upcoming Quarters We have just finished a comprehensive revision to our MLEI and MCEI calculation by using 2000-2015 data. The new set of Mandiri Leading Economic Indicators now consists of five indices: (1) Consumer Goods Import, (2) Real US GDP, (3) Import, (4) Export, and (5) 12-Month Time Deposit Rate of State Banks. On the other hand, the new MCEI is formed by another five indices: (1) Import of Raw Materials, (2) 1-Day USD Interbank Call Money Rate, (3) Jakarta Stock Exchange Index, (4) IDR/USD Spot Rate, and (5) Business Activity Expectation. The make up of MLEI in particular is now more dominated by external variables, confirming general understanding that Indonesian economy is getting more integrated with the global economy. More than ever, Indonesian economy is now affected much by international shocks. Indonesia's economy grew by 4.73% (YoY) in the 3Q15, predicted to grow at 4.8% from 2014 to 2015. The Q3 realization meets the prediction if the new MLEI was used in the forecasting. The new MLEI comes with a 1-quarter-ahead prediction power with 73.4% correlation with the GDP cycle; significantly better than the old MLEI. In addition to its visual appeal, the new MLEI can be used to predict the next quarter s GDP growth rate with a higher precision than the old MLEI. Despite the slight drop in MLEI from Q2 to Q3 of 2015, our VAR model is still predicting a 5.09% GDP growth rate in Q4. This means that we are predicting a GDP growth rate from 2014 to 2015 by 4.8%. Office of Chief Economist Page 42

There are some signs of bottoming out for Indonesian GDP growth rate. The slight drop in MLEI was caused by three indices: Real US GDP, Export, and Time Deposit rate. On the other hand, Consumer Goods Import and Total Import Indices gave a little positive push for MLEI not to drop too much. The recent increase of Fed funds rate target is generally viewed as a good signal for a more certain path for the recovery of the US economy. Office of Chief Economist Page 43

note : *) preliminary Index > 100 and increasing indicates expansion Index > 100 but decreasing indicates downturn Index < 100 and decreasing indicates slowdown Index < 100 but increasing indicates recovery Changes in parentheses indicate negative numbers Mandiri Leading Economic Index (MLEI) and Mandiri Coincident Economic Index (MCEI) are composite indices for predicting the movement of GDP (Gross Domestic Product) so they can be useful as an early warning on the movement of Indonesian economy. MLEI is used to predict the movement of GDP in the next 6 months, while MCEI is used to predict the movement of GDP in the same month. MLEI and MCEI composite indices are formed from several indicators deemed important in studying the movement of Indonesian economy Office of Chief Economist Page 44

Mandiri Banking Pressure Index (MBPI) Prospective Outlook in Banking Sector Bank Mandiri considers the importance of being aware of the banking sector development as a whole; both in booming times, recessions and crises through a leading indicator. From the importance of being knowledgeable on the financial (banking) sector development in the country in a clearer and measurable manner, Bank Mandiri established the Mandiri Financial Performance Index (MFPI) which is a reflection of the service sector and financial business performance, both historical and real time. Bank Mandiri also composed an index that can project the direction of MFPI future movement, called Mandiri Banking Pressure Index (MBPI). Looking at the actual condition, MFPI in December 2015 reported at 82.8 levels (-1.2% MoM). This position indicates that the condition of the Indonesian banking sector is still in alert condition. In the mid of global economic uncertainty and currency volatility, deposits grew 8.95% (YoY) in Ocotber 2015, significantly lower than 11.7% (YoY) in September 2015 while credit in October 2015 grew 10.3% (YoY), lower than 11.1% (YoY) in September 2015. Mandiri Banking Pressure Index (MBPI) is a leading indicator of the banking sector in Indonesia. It is an indicator that provides a predicted direction of MFPI s movement in the next 6-9 months. In October 2015, it increased to level 166.4 (-9.0% MoM). Even though it fell, the position of MBPI is still above 103 level, which means we still expect Indonesian banking in prospective condition in the period from March 2016 to June 2016 with better economic prospects. Bank Indonesia had loosened some of its macro prudential policy address the weakening economy. The central bank cut the rupiah primary reserve requirement to 7.5% from 8% starting in December 2015. By lower primary reserves requirement by the central bank, banks will have additional liquidity to lend to the business sector. In our calculation, the banks will have approximately additional IDR18.2 trillion, out of total IDR3,644.4 trillion of rupiah third party fund. The Fed eventually increased fed funds rate by 25 bps to 0.5%. The US Central Bank (The Fed) had eventually raised the benchmark fed funds rate by 25 bps from 0.25% to 0.5% in FOMC meeting this month, calling to an end to near zero cost that have prevailed since US economy struck by financial crash in 2007-2008. The US policymakers expect only gradual future increase in the benchmark rate. Given the current shortfall in inflation compared with its 2%, Fed would carefully monitor actual and expected Office of Chief Economist Page 45

Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec-10 Jul-11 Feb-12 Sep-12 Apr-13 Nov-13 Jun-14 Jan-15 Aug-15 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10 May-11 Oct-11 Mar-12 Aug-12 Jan-13 Jun-13 Nov-13 Apr-14 Sep-14 Feb-15 Jul-15 Dec-15 Indonesia Update January 2016 progress towards their inflation goal. Projections showed that Fed officials median estimate for the federal funds rate next year was 1.375%. 200 Mandiri Financial Performance Index (MFPI) 160 120 80 40 MFPI Prospective Signal Alert Signal Period 2012 2013 2014 2015 MFPI Threshold Dec Dec Nov Dec Nov Dec* Prospective : MFPI > 113 MFPI 95.1 86.2 107.6 117.3 83.8 82.8 Normal : 88 < MFPI < 113 Chg (%MoM) 0.0 (2.3) 8.5 9.0 (1.8) (1.2) Alert : MFPI < 88 250 Mandiri Banking Pressure Index (MBPI) 200 150 100 50 0 MBPI Prospective Signal Alert Signal Period Nov 2013 Dec Nov 2014 Dec 2015 MBPI Threshold Sep Oct* Prospective : MBPI > 103 MBPI 107.0 109.4 131.9 134.5 182.9 166.4 Normal : 61 < MBPI < 103 Chg (%MoM) 9.8 2.2 (1.0) 1.9 16.2 (9.0) Alert : MBPI < 61 Mandiri Banking Pressure Index (MBPI) and Mandiri Coincident Banking Pressure Index (MCBPI) are composite indices for predicting Mandiri Financial Performance Index (MFPI) which is a reflection of the service sector and financial business performance, so they can be useful as an early warning on the movement of Indonesian banking sector. MBPI is used to predict the movement of banking condition in the next 6-9 months, while MCBPI is used to predict the movement of banking condition in the same month. MBPI and MCBPI composite indices are formed from several indicators deemed important in studying the movement of Indonesian financial condition Office of Chief Economist Page 46

MACROECONOMIC INDICATORS AND FORECAST Office of Chief Economist Page 47

Disclaimer: This material is for information only, and we are not soliciting any action based upon it. This report is not to be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. The information herein has been obtained from sources believed to be reliable, but we do not warrant that it is accurate or complete, and it should not be relied upon as such. Opinion expressed is our current opinion as of the date appearing on this material only, and subject to change without notice. It is intended for the use by recipient only and may not be reproduced or copied/photocopied or duplicated or made available in any form, by any means, or redistributed to others without written permission of PT Bank Mandiri Tbk. Additional information is available upon request. For further information please contact: Office of Chief Economist, Ph. (021) 524-5272 or Fax. (021) 521-0430. Office of Chief Economist Page 48

Our Team Chief Economist and Executive Director Mandiri Institute Macroeconomic and Financial Market Research Andry Asmoro Reny Eka Putri Nurul Y. Karunia Rully A. Wisnubroto DH Macroeconomic and Financial Market Research Quantitative Analyst Junior Economist Financial Market Analyst Industry and Regional Research Dendi Ramdani Nadia K. Dewi Sindi Paramita Adjie Harisandi Araminta Setyawati Mamay Sukaesih Romauli Panggabean Willi Hastono Putro DH Industry and Regional Research Industry Analyst Industry Analyst Industry Analyst Industry Analyst Regional Analyst Regional Analyst Regional Analyst Strategic Research (Mandiri Institute) Moekti P. Soejachmoen Bobby Hermanus Andjarsari Paramaditha Andrian B. Santoso Elisabeth Carolina Andhi P. Hadi DH Strategic Research Team Leader Strategic Research Senior Manager Manager Manager Clerk Strategic Research Data and Administration Support Fitri Yunita Adhiguna Wahyu Nugroho Istiqomah Marsella A. Ariwandi Romelan Fikri Zulfikar Section Head Clerk Data Support and Administrative Clerk Data Support and Administrative Secretary Distribution and Logistic Support Distribution and Logistic Support Email Website oce@bankmandiri.co.id www.bankmandiri.co.id www.mandiri-institute.id Office of Chief Economist Page 49

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