Chapter 7

Balance of Payments

100

Chapter 7: Balance of Payments

Indonesia’s Balance of Payments continued to show positive performance. At the end of 2007, the Balance of Payments recorded a surplus that mainly came from current account amounting to 2.5% of GDP. The increase in the current account surplus was driven by higher commodity prices in international markets and fairly strong global demand. Meanwhile, the surplus in the capital and financial accounts was supported by the attractive return on rupiah in the domestic financial market and the continued domestic macroeconomic stability. With these developments, foreign exchange reserves continued to accumulate, thereby having a positive impact on the confidence of players in the economy whilst also subduing the impact of the shocks from global financial markets. In general, the Balance of Payments performance and external vulnerability indicators continued to improve, such that rupiah stability was achieved.

The Balance of Payments in 2007 shows continuing

strong developments. The condition of global economy

and the domestic economy were still conducive

for improvements in the performance of Balance of

Payments. From the international side, despite slower

than 2006, the global economy in 2007 still expanded

fairly rapidly. The impact of slowing US economy on

global economy was offset by strong growth in the

developing countries like China and India. Nonetheless,

the fairly rapid global economic expansion which

continued in the first semester of 2007 was hampered

due to shocks in the global financial markets as a result

of the US sub-prime mortgage crisis. The main impact

of this crisis was the reversal of private capital flow

from developing countries, starting at the beginning

of the second semester of 2007. The strength of the

economies of emerging market countries increased

foreign investors’ interest, and hence supported the

positive developments of Indonesia’s financial markets.

From the domestic side, various improvements in

the macroeconomic field already provided a strong

foundation, such that Indonesia’s financial markets

stood up well when facing external shocks. The inflow

of foreign capital, either in the form of direct investment

(FDI) or portfolio investment, have continued and

increased compared to their levels in 2006. The return

on the rupiah was still attractive compared to the returns

offered in neighboring countries, and was in line with the

lower risk factor, as shown by the rating upgrades from

various ratings agencies, thus bringing in more foreign

investment to Indonesia.

The increase in domestic economic activities as reflected

in higher investment and consumption, helped boost

imports. Nonetheless, the increase in the value of

exports, which is greater than the increase in the value of

imports, resulted in a higher trade surplus. Given these

developments, the Balance of Payments recorded a fairly

high surplus of $12.5 billion such that the nation’s foreign

exchange reserves rose to $56.9 billion equivalent to

5.7 months of imports and repayments of government

foreign debt (Table 7.1). In line with these developments,

the external vulnerability indicators showed an

improvement compared to 2006 (Table 7.2).

To improve the performance of the external sector, the

government has coordinated with the relevant parties

in making various efforts. From the side of regulations,

the government has already issued a number of

policies involved with regulating Foreign Investment,

the development and empowerment of Micro, Small

and Medium size businesses, and policies which are

related to the implementation and monitoring of policies/

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regulations1. Besides that, the government also issued a

policy to boost exports, especially of textile commodities

and textile products, by giving aid for machinery

purchases as well as providing low cost financing. Other

policies in managing the government’s foreign debts in a

more independent way were marked with the scrapping

of the CGI forum which had for some time been a forum

for Indonesia’s creditors. The scrapping of the CGI was

also in line with the government’s policy to lessen the

country’s dependency on foreign financing and efforts

to lower Indonesia’s debt ratio such that resistance to

external shocks has improved.

1 Among others are the Law No. 25/2007 concerning Foreign Investment and Presidential Instruction No. 6/2007 concerning policies to accelerate the development of the real sector and the empowerment of micro, small and medium size businesses.

Current Account

The current account recorded a higher surplus of $11.0

billion or 2.5% of GDP (Table 7.3). In line with rising

prices of commodities in the international markets and

the fairly strong external demand, the value of Indonesia’s

exports recorded a fairly large increase. In the non oil and

gas mining sector, the increase in export volume was

also supported by greater production capacity. In the

oil and gas mining sector, especially oil, although there

has been a natural decline in production each year, the

volume of crude oil exports still experienced an increase.

From the side of imports, increasing domestic economic

activities and the relatively stable rupiah exchange rate

helped propel imports growth higher. Imports of crude oil

also experienced an increase to help fulfill the domestic

refinery needs.

Table 7.1

Indonesia’s Balance of Paymentsmillions of $

Descriptions 2005 2006 2007

I. Current Account 278 10,836 11,009

A. Goods, net (Balance of Trade) 17,534 29,660 33,083

– Exports, fob. 86,995 103,528 118,014

– Imports, fob. -69,462 -73,868 -84,930

1. Non-Oil & Gas 13,321 22,875 27,048

– Exports 66,753 80,578 93,142

– Imports -53,431 -57,703 -66,094

2. Oil & Gas 4,212 6,785 6,036

– Exports 20,243 22,950 24,872

– Imports -16,030 -16,165 -18,836

B. Services, net -9,122 -9,888 -11,103

C. Income, net -12,927 -13,800 -15,875

D. Current Transfer, net 4,793 4,863 4,903

II. Capital & Financial Account 345 2,944 2,753

A. Capital Account 333 350 530

B. Financial Account 12 2,594 2,223

1. Direct Investment 5,271 2,211 1,164

2. Portfolio Investment 4,190 4,174 6,981

3. Other Investment -9,449 -3,792 -5,922

III. Total (I+II) 623 13,780 13,726

IV. Net Errors and Omissions -179 729 -1,220

V. Overall Balance (III+IV) 444 14,510 12,543

VI. Reserve and Related Items) -444 -14,510 -12,543

A. Reserve Assets Changes 663 -6,902 -12,543

B. IMF Purchases -1,107 -7,608 0

1. Withdrawal 0 0 0

2. Payment -1,107 -7,608 0

Memorandum:

Reserve Asset Changes 34,724 42,586 56,920

(in months of imports and official foreign debt repayment)

4.0 4.5 5.7

1) (-) surplus; (+) deficit.

Table 7.2

Indicators of External Vulnerability percent

Descriptions 1996 1997 2005 2006 2007

Current Account/GDP -3.4 -2.3 0.1 2.9 2.5

Exports of Goods and Services/GDP

25.7 29.1 37.5 33.5 32.0

Non-Oil & Gas Exports/GDP

16.7 19.7 23.1 21.8 21.2

Foreign Debt Interest/GDP

2.7 3.0 1.0 1.3 1.2

Foreign Debt Payments/Exports of Goods and Services1)

35.9 44.5 17.3 24.8 19.2

Capital Flows/GDP 4.8 1.1 0.1 0.7 1.3

Foreign Debt/Exports of Goods and Services

188.7 207.3 120.7 104.1 97.3

Foreign Debt/GDP 48.5 60.3 45.3 34.9 31.2

International Reserves/ Debt Services2)

91.2 73.4 185.6 138.8 210.8

International Reserves/Foreign Debt

17.4 15.7 26.6 33.1 41.7

International Reserves/Imports and Government Foreign Debt Payments (months)3)

5 5.5 4.3 4.5 5.7

Foreign Debt (billions $) 110,171 136,088 130,652 128,736 136,640

International Reserves (billions $)4)

19,215 21,418 34,724 42,586 56,920

Source: Bank Indonesia and BPS-Statistics Indonesia.1) Debt Service Ratio (DSR) increase in 2006 due to IMF debt repayment.2) Foreign debt repayments including principal and interest.3) In 1996 and 1997, the international reserves divisor did not include payments on government

foreign debt.4) In 1996, the concept of official reserves was used. In 1997-1999 based on Gross Foreign Assets,

and beginning of 2000, the International Reserve and Foreign Currency Liquidity (IRFCL) concept was used.

102

The services account and the net income account

recorded a higher deficit compared to 2006. The

increase in the services account deficit is related to the

increase in the number of foreign tourist visits, while

for the income account the increase was related to an

increase in profit transfers to company head offices

overseas as business activities in Indonesia improved

further.

For the current account, the surplus was relatively

the same as in the previous year, among other things

supported by hikes in the wages of Indonesian overseas

workers in 2007, especially in a number of countries in

the Middle East.

Export Developments

Exports grew fairly strongly, driven mainly by non oil

and gas exports. The total value of exports in 2007

rose 14.0% to $118.0 billion (Table 7.4). The increase

in the value of exports was mainly attributable to higher

commodity prices, although the increase in export

volume was also seen among several commodities.

Nonetheless, the increased volumes were not uniform

and were still concentrated in natural resource

commodities, especially mining commodities. This

was in line with the tendency of price increases among

mining commodities which has been evident since

2004. Meanwhile, increases in industry volume exports

had not been uniform, and there was even a decline in

exports of main commodities such as CPO derivatives

Table 7.3

Current Account

millions of $

Descriptions 2005 2006 2007

Current Account 278 10,836 11,009

– Non-Oil & Gas -2,548 5,424 6,225

– Oil & Gas 2,826 5,412 4,784

Goods, net (Balance of Trade) 17,534 29,660 33,083

– Non-Oil & Gas 13,321 22,875 27,048

– Oil & Gas 4,212 6,785 6,036

Exports, fob 86,995 103,528 118,014

– Non-Oil & Gas 66,753 80,578 93,142

– Oil & Gas 20,243 22,950 24,872

Imports, fob -69,462 -73,868 -84,930

– Non-Oil & Gas -53,431 -57,703 -66,094

– Oil & Gas -16,030 -16,165 -18,836

Services, net -9,122 -9,888 -11,103

Income, net -12,927 -13,800 -15,875

Current Transfer, net 4,793 4,863 4,903

Table 7.4

Exports

Descriptions

2006 2007 2007

Changes (%)fob Value

(millions of $)Share(%)

Non-Oil & Gas Exports 20.7 15.6 93.142 78.9

Agriculture 255.4 14.7 11.704 9.9

Mining 130.1 17.2 21.609 18.3

Industry -7.0 15.2 59.829 50.7

Oil & Gas Exports 13.4 8.4 24.872 21.1

Total 19.0 14.0 118.014 100.0Source: BI and BPS-Statistics Indonesia.

IHKEI Growth (yoy)

2005 2006 2007

Non Oil and Gas 12.6 33.8 14.9 Agriculture 13.4 35.7 9.5 Mining 26.6 50.3 10.5 Manufacturing -2.8 9.9 26.1Oil and Gas 29.6 19.0 6.6Total 17.0 29.5 12.7

103

and electrical equipment. This was also the case for

the performance of the oil and gas sector, which has

not shown a significant improvement and still shows

a decline in natural production due to the rather slow

response of investors in regard to the exploration of new

oil fields.

The increase in commodity prices on international

markets is still the main factor behind the increase

in the value of non oil and gas exports. The price of

Indonesia’s non oil and gas export commodities rose by

14.9% overall compared to 2006 (Chart 7.1). In more

detail, the increases in prices in the agriculture group,

the mining group, and the manufacturing group reached

9.5%, 10.5%, and 26.1%, respectively. A number of

commodities that experienced fairly large price increases

include CPO (74.1%), nickel (55.6%), tin (65.5%),

and coffee (25.7%). In line with price increases which

have gone on for some time now, a number of export

commodities showed increased volumes, among others

nickel, aluminum, machinery and mechanical equipment,

along with chemical products. Nonetheless, a number

of commodities experienced lower volume, among

them some main commodities such as CPO derivatives,

shrimps, copper, textile and product textiles, as well as

electrical equipment.

Amidst the rising prices of commodity globally, the

opportunity to raise export volume of a number of

commodities could not be realized due to a number

of problems. One commodity which experienced a

fairly significant drop in export volume is CPO and its

derivatives. The drop in CPO export volumes which

occurred at the beginning of the year was related to

the peak in the harvesting of fresh palm fruits which

shifted forward to the end of 2006 from the beginning

of 2007. Meanwhile, the reason for the drop in exports

of CPO derivatives was related to the increase in CPO

export taxes in the middle of the year following scarcity

of cooking oil in the domestic market2. The government

increased export taxes to safeguard the stability of the

prices of basic needs – especially cooking oil - in the

domestic market. However, in terms of potential, the

opportunity to increase CPO exports is still open given

the wide area of CPO plantations in Indonesia, which

have continued to increase and become the largest in

the world. Currently, the total area in use is around 5.5

million hectares with around another 3.7 million hectares

that can be developed.

The problems of increasing export volumes were also

seen in copper commodities. The drop in copper

export volume was related to labor force problems.

Meanwhile, the drop in shrimp exports was related to

the continuation of mudflows in Sidoarjo which had an

impact on the centralized shrimp ponds in the province

of East Java, which is one of the centers of shrimp

production. Problems regarding textile and textile-related

products, in relation to the relatively low productivity

of the machinery used, have been evident for some

time now. The low productivity levels reduced output

and had an impact on the variation and quality of the

products. With regard to this matter, the government

issued a policy on the development of exports of textile

and textile-related products by providing help for the

purchase of machinery in addition to low interest rate

loans. This policy is expected to help in the restoration of

2 Minister of Finance Regulation No. 61/PMK,011/2007 dated15 June 2007 concerning the fifth change of Minister of Finance Regulation No. 92/PMK,02/2005 concerning the determination of types of export goods and rates of export tariff.

Table 7.5

Major Non-Oil and Gas Export Commodities Share by Country of Destination in Year 2007

Japan United States Singapore China India

Commodities Share Commodities Share Commodities Share Commodities Share Commodities Share

Metal Ores & Metal Residual

4.22 Garments 3.84Electrical Machines. Tools & Fittings

1.35Fixed Vegetable Oil & Fats

1.33Fixed Vegetable Oil & Fats

2.36

Coal, Coke & Briquettes

1.4 Crude Rubber 1.29Office Machinery & Automatic Data Processing

1.05Metal Ores & Metal Residual

0.82Coal, Coke & Briquettes

0.93

Nonferrous Metal 1.23 Fish & Crust 0.81 Nonferrous Metal 0.98 Crude Rubber 0.78Metal Ores & Metal Residual

0.57

Electrical Machines, Tools & Fittings

0.93Manufacturing Goods

0.62Telecommunication & Rep App

0.64Organic Chemicals

0.59Fixed Animal Oils. Vegetable & Fats

0.12

104

machinery in the textile and textile-related sector, such

that more competitive products can be produced for sale

in the international market.

The good performance of exports at a time of slowing

global growth was also driven by efforts to diversify the

countries to which Indonesia’s products are exported.

Although exports are still focused to a number of main

destination countries, intraregional trade (i.e. in Asia)

increased. The five main destination countries for

Indonesia’s non oil and gas exports are Japan (14.3%),

the US (12.0%), Singapore (9.6%), China (7.3%), and

India (5.3%) (Chart 7.2). The total share of exports to

these five countries reached around 48.5% of Indonesia’s

total non oil and gas exports, slightly down compared

to 2006. Scrutinized more closely, it can be seen that

there are positive developments such that Indonesia

has become less dependent on developed nations as

main trading partners. The share of non oil and gas

exports to the US, Japan and the European region are

currently around 40% of the total, or down from 50% in

2000. By spreading out the share of exports to different

destination countries, it is hoped that Indonesia’s exports

performance will become more flexible in anticipating

the changes in the economic cycle in a number of the

county’s trading partners, especially any slowdown in

the economies of developed nations (Box: Intraregional

Trade in Asia).

The types of commodities exported to Indonesia’s

main trading partners were quite mixed (Table 7.5). The

main non oil and gas commodities exported to the US

and Japan were clothing and metal ore, respectively.

Meanwhile, exports to China and India, were dominated

by exports of vegetable oils and fats. The other

commodity exports were relatively well distributed –

a positive development. Such a condition can lessen

Table 7.6

Revealed Comparative Advantage (RCA)

Description SITCRCA World Rank1)

2004 2005 2006 2004 2005 2006

Agriculture

– Shrimps, Crust, etc, fresh/frozen 036 9.4 6.2 7.1 3 6 4

– Coffee 071 3.9 4.0 4.1 9 6 5

– Cocoa 072 12.1 9.4 10.8 3 4 4

– Natural Rubber Latex & Other Natural Rubber 231 66.0 14.5 35.6 1 2 2

Mining

– Copper Ores 283 20.6 12.8 16.9 2 2 2

– Coal 321 11.6 9.5 14.0 4 3 2

– Tin Products 687 29.1 34.3 31.5 1 1 1

Industry

– Textile Products

– Textile Yarn 651 8.1 4.9 4.9 7 7 7

– Men/Boy Apparels Knitted 843 2.8 2.3 3.2 12 12 6

– Wood & Wood’s Products

– Charcoal 245 7.2 5.6 6.0 5 2 3

– Plywood, etc 634 8.4 8.8 6.8 4 3 5

– Wood Goods 635 5.2 4.4 4.2 6 7 6

Other Fixed Vegetable Oil, liquid or thick (CPO) 422 46.6 39.5 42.2 2 1 1Source: UNCOMTRADE.1) Ranking based on export value in world market as SITC Code.

105

the dependency on certain products as well as certain

export destinations.

In general, Indonesia’s export products are still

concentrated on natural resource based commodities.

Based on the competitiveness indicator which is

measured from the Revealed Comparative Advantage

(RCA), Indonesia’s prime commodities exports are still

competitive. Agricultural commodities (such as natural

rubber) have a high RCA and are ranked second in terms

of value of Indonesia’s exports. Mining commodities,

such as tin, copper and coal, also have a fairly high

competitiveness and are ranked first in world trade.

Meanwhile, in the industrial goods group, CPO had the

highest RCA (Table 7.6).

During 2007, the rupiah remained stable, thereby

supporting Indonesia’s competitiveness. On average,

the rupiah tended to strengthen in 2007. Nonetheless,

compared with other countries in the region, the

strengthening of the rupiah was still relatively low such

that it supported Indonesia’s exports competitiveness

from the side of prices.

The value of Indonesia’s oil and gas exports rose in line

with the rising price of crude oil in international markets.

The value of oil and gas exports rose by 8.4% to $24.9

billion. This growth was driven more by soaring prices of

crude oil. On average, the price of various types of crude

oil in international markets experienced increases, and

for the WTI type the price even approached the $100 per

barrel in November 2007 (Chart 7.3).

Developments in fundamental factors, which were

reflected in a limited increase in supply and low remaining

oil production capacity, meant the price of oil was

vulnerable to non-fundamental factors such as sentiment

and geopolitical factors. Besides that, the weakening

trend in the value of the US dollar triggered an increase

in speculation by increasing noncommercial transactions

in the oil market. As a result of these developments,

the average price of Indonesia’s crude oil exports rose

12.2% to $70.1 per barrel in 2007.

Based on contribution, the value of gas exports were

slightly lower than the value of oil exports. In 2007, gas

exports reached $12.4 billion, while oil exports reached

$12.5 billion. From the volume side, although there was

a tendency for oil production to decline, crude oil exports

still showed an increase. This stemmed from the fact

that the use of domestic oil for processing in domestic

refineries is still not optimal. From another aspect, oil

imports, either crude or derived products, also continued

to show an increase for fulfilling refinery requirements

and domestic fuel consumption. Meanwhile, for gas, the

increase in the value of exports was not accompanied

by an increase in volume. This condition was related to

government policies that prioritized the use of natural

gas for domestic use, among others to support the

government’s program to persuade the public to switch

from using kerosene to LPG.

Import Developments

Imports growth was quite high and in line with the more

rapid pace of economic growth. Overall, total imports

(C&F) grew by 15.0% to $92.4 billion (Table 7.7). The

Table 7.7

Imports

Description

2006 2007* 2007

Changes (%)C & F Value (millions $)

Share (%)

Non-Oil & Gas Imports

8.0 14.6 71.907 78.2

Consumer Goods 18.4 46.8 7.241 6.1

Raw Materials 7.8 12.0 50.502 56.1

Capital Goods 5.4 11.0 14.164 15.9Oil & Gas Imports 3.0 16.7 20.474 21.8Total 6.9 15.0 92.381 100.0

106

quite significant increase in imports was experienced

by oil due to higher oil prices, the decline in domestic

production and the increase in domestic fuel

consumption. The stability of rupiah helped push imports

of non oil and gas products higher, especially imports

of consumption goods which rose 46.8%. Nonetheless,

the increase in imports needs to be looked at in closer

detail, since it might indicate that the competitiveness

of domestically made products has declined further.

Meanwhile, imports of capital goods and raw materials

also showed an increase in line with the domestic

economic expansion.

Based on the country of origin, the proportion of imports

from the five main countries was relatively unchanged.

Overall, the proportion of non oil and gas imports (C&F)

from the top five countries reached 54.5% or $39.2

billion, or relatively unchanged from the proportion in

2006 of 56.5% (Chart 7.4). The higher penetration of

goods imported from China means that the proportion

of goods imported from China is already as large as the

proportion of goods imported from Japan. The imports

of cheap products from China are a substitute for

imports of goods from other countries, such that imports

from Japan and the US tended to show a decline. The

type of imported products from Indonesia’s main trading

partners was fairly mixed. Imports of vehicles were

mainly from Japan and Thailand. Meanwhile, imports of

machinery generally originated from Indonesia’s top five

trading partners, with Singapore providing the largest

proportion (Table 7.8).

Developments in the Services Account, the Net

Income Account, and the Current Account

The deficit in the services account and the net income

account experienced an increase, while the surplus in the

current account was relatively unchanged. The increase

in the deficit for the services account mainly originated

from an increase in transportation costs for imports

and the flow of Indonesian tourists to other countries,

including overseas travel for Hajj and Umroh. From the

side of receipts, the flow of incoming foreign exchange

was mainly contributed by foreign tourists whose number

increased to 5.5 million or reaching a new high. The

increase in foreign tourist visits reflects the improved

security conditions, along with an increase in MICE

(meetings, incentives, conferences and exhibitions) on

an international scale. Various efforts have already been

made by a number of parties including the government

to attract foreign tourists including promotions in a

number of tourism exhibitions, developments in main

tourism regions, in addition to the increase in the number

of countries which received the visa on arrival (VOA)

facility from 52 in 2006 to 63 at the end of 2007.

The deficit in the net income account rose 15.0%

to $15.9 billion. The increase in the deficit mainly

stemmed from an increase in the profits transferred

and the reinvested earnings of multinational companies

in Indonesia. This reflects the better profitability of

multinational companies resulted from Indonesia’s

improving business prospects. Meanwhile, the

current account recorded a surplus mainly due to the

contribution from money transfers made by Indonesian

overseas workers. In 2007, the incoming funds

transferred by Indonesian overseas workers recorded

Table 7.8

Major Non-Oil and Gas Import Commodities Share by Country of Origin

Singapore Japan China United States Thailand

Commodities Share Commodities Share Commodities Share Commodities Share Commodities Share

Electrical Machines, Tools & Fittings

2.24 Motor Vehicles 1.92 Iron & Steel 1.65Other Transportation Equipment

0.89 Motor Vehicles 1.53

Telecommunications & Rep. App

1.44 Iron & Steel 1.56Telecommunications & Rep. App

1.23Industrial Machinery & Fittings

0.54 Sugar & Honey 0.49

Organic Chemicals 1.43Specialized Industrial Machinery

1.25Electrical Machines, Tools & Fittings

0.96Textile Fiber & their waste

0.53Industrial Machinery & Fittings

0.43

Office Machines & Automatic Data Processor

1.10Industrial Machinery & Fittings

1.23Textile, Textile Yarn & Textile Products

0.93Oil Ores, Nuts & Seeds Oil

0.52Electrical Machines, Tools & Fittings

0.38

107

a surplus of $4.9 billion or up 7%. One effort related to

the development of Indonesian overseas workers was

the wage increases for Indonesian overseas workers in

a number of countries and especially the Middle East

in 20073. Based on country, Saudi Arabia and Malaysia

remained the largest employers of Indonesian overseas

workers. Overall, positions filled by Indonesian overseas

workers in 2007 reached 4.3 million, or lower than the

4.6 million in 2006.

Capital and Financial Transactions

Compared to the previous year, the capital account

and the financial account recorded a lower surplus

of $2.8 billion. Based on its composition, the net

inflow of portfolio investment was still quite dominant,

while foreign direct investment (FDI) showed positive

developments. The continued high return on the rupiah

and the macroeconomic stability encouraged inflows of

portfolio investments. Meanwhile, some progress on the

infrastructure front has helped create a more conducive

investment climate, thus giving a boost to FDI.

Direct Investment Transactions

In 2007, FDI recorded a surplus that was lower than in

the previous year, yet with a more balanced composition

than in 2006. The increase in net incoming FDI was

offset by an increase in net FDI outflows (Table 7.9).

From the liabilities side, FDI recorded a bigger surplus

in line with the improving investment climate and more

rapid economic activities. FDI investment in the oil and

gas sector has continued to increase as crude oil prices

have soared. This increase also reflects government

efforts to raise oil production through direct bidding of a

number of oil and gas blocks since 2006. In 2007, new

contracts were obtained for 35 upstream projects and 26

oil and gas blocks with total commitment reaching $13.0

billion. It was a similar story for FDI in the non oil and

3 Regulated through Circulation Letters No. 01/BNP2TKI/V/2007 dated May 16, 2007 dan No. 02/BNP2TKI/VI/ 2007 dated June 14, 2007 concerning the increase of minimum wages of Indonesian overseas workers in Singapore and Saudi Arabia, respectively.

gas sector which recorded an increase in 2007. The FDI

inflow, either from loan withdrawals from parent company

head offices overseas or from increasing capital (equity)

rose quite significantly. One source for quite significant

increase in FDI was in the form of reinvested earnings.

The increase from this source reflects the greater

certainty in Indonesia’s business climate as investors

continued to expand their businesses. In 2007, the

inflow of net FDI in the oil and gas sector recorded

increases of 18.3% and 12.4% to $0.9 billion and $4.6

billion respectively. From the asset side, there was an

increase in capital outflows by 63.0% to $4.4 billion.

This can be viewed as a positive development since

Indonesian companies were better able to compete

overseas. As such, although overall the net FDI recorded

a surplus which was relatively unchanged, based on its

composition it showed a positive development.

Various efforts have been made to attract foreign

investors to Indonesia. One of them, which is to improve

business certainty, has already been carried out through

Law No 25 / 2007 concerning foreign investment and

Presidential Instruction No. 6/2007 concerning policies

to accelerate the development of the real sector and

the empowerment of micro, small and medium size

businesses. Through adoption of this regulation, the

certainty of foreign business in Indonesia is expected

to be better guaranteed, for example from the risk of

nationalization, the determination of business sectors

which are open and closed, along with integrated

services from a better structured bureaucracy. Through

this presidential instruction all action plans can be

implemented, by monitoring implementation of each

action plan which had already been proposed in 2006

and 2007. In 2007, foreign investor confidence in

Indonesia’s investment climate tended to improve.

Various rating agencies raised their sovereign ratings for

Table 7.9

Foreign Direct Investment (FDI)millions of $

Description 2005 2006 2007

FDI (net) 5,271 2,211 1,164

Abroad (net) -3,065 -2,703 -4,407

In Indonesia (net) 8,336 4,914 5,571

Non-Oil and Gas 7,282 4,122 4,633

Oil and Gas 1,054 793 938

Table 7.10

Portfolio Investment (Liabilities Side)millions of $

Description 2005 2006 2007

Public Sector, net 4,826 4,514 5,270

Foreign Exchange Bond 2,095 1,930 1,425

Government Securities 2,054 2,209 2,612

SBIs 677 375 1,233

Private Sector, net 444 1,593 4,711

Stocks -165 1,898 3,559

Corporation Securities 609 -305 1,152

Total 5,270 6,107 9,981

108

Indonesia. In turn, Moody’s, Rating and Investment, and

Japan Credit Rating Agency raised their ratings to Ba3,

BB+, and BB, respectively.

Portfolio Investment Transactions

The portfolio investment transactions recorded a bigger

surplus and showed greater resilience toward the effect

of global financial shocks. During 2007, the total surplus

of the portfolio investment transactions reached $7.0

billion or higher than in the previous year. From the

external side, the increases in portfolio capital inflows

were still supported by significant liquidity in the global

financial markets. From the domestic side, the increased

surplus mainly stemmed from improved confidence in

macroeconomic condition and economic prospect. The

investment return in rupiah terms was also relatively still

more attractive compared to the returns available in other

emerging markets. Indonesia’s capital markets showed

greater resilience to the impact of global market shocks.

Capital outflows, as a result of shocks in global financial

markets that were triggered by the sub-prime mortgage

crisis in the US, were not too large.

Based on each component, portfolio investment inflows

on liabilities side increased compared to the previous

year, while on the asset side there was relatively little

change. Overall, portfolio investment on the liabilities side

recorded a higher surplus of $10.0 billion (Table 7.10). In

the public sector, the increased surplus was contributed

by rupiah denominated SUN and SBI, while the

contribution from foreign currency denominated SUN

declined. In the private sector, the increased surplus was

contributed by foreign purchases of stocks and bonds

issued by domestic companies.

Table 7.11

Other Investment Transactionmillions of $

Description 2005 2006 2007

Other Investment, net (Public Sector) -848 -2,497 -2,363

Assets 0 0 0

Liabilities -848 -2,497 -2,363

Other Investment, net (Private Sector) -8,601 -1,296 -3,559

Assets -8,646 -1,588 -5,633

Liabilities 45 292 2,075

Total -9,449 -3,793 -5,922

Table 7.12

Indonesia’s Foreign Debt Position

millions of $

Notes 2005 20062007

March June September December*

Government 75,406 67,722 69,085 66,155 68,088 69,340Private 48,601 50,983 51,127 52,073 53,641 53,909

a. Financial Institutions 6,371 6,560 6,992 6,900 6,948 7,465 – Bank 4,042 4,544 4,963 4,935 4,837 5,351 – Non-Bank 2,329 2,017 2,029 1,965 2,111 2,114b. Non-Financial Institutions 42,229 44,423 44,135 45,173 46,693 46,444

Securities 6,646 10,031 11,071 15,253 15,218 13,391– Government 4,666 8,087 9,105 13,233 13,147 11,269– Bank 15 30 47 75 52 50– Non-Financial Institutions 1,965 1,914 1,919 1,944 2,019 2,073

Total 130,652 128,736 131,283 133,482 136,947 136,640* Provisional figures

109

Other Investment Account

Other investment transactions recorded a higher deficit

than in the previous year, which is of $5.9 billion, in

line with the government’s more independent debt

management strategy. In the public sector, other

investment transactions recorded a higher deficit of $2.4

billion (Table 7.11). This is a reflection of government

policy which tried to reduce the burden of foreign debts

by adopting a strategy that withdrawals should be lower

than than debt repayments. An interesting development

in the management of government debts in 2007

was the scrapping of the CGI forum at the beginning

of 2007. As a result, flexibility in the management of

government foreign debts could be better conducted on

a bilateral basis. These efforts were also accompanied

by the effectiveness of disbursement of remaining loan

commitments which had not been withdrawn.

The scrapping of the CGI did not immediately bring

about a drastic decline in drawdowns of government

debts. Although the drawdown of project loans

declined, drawdown of program loans increased.

Drawdown of government loans in the form of program

loans which were obtained in 2007 even rose to $1.9

billion from $1.5 billion in 2006. The same was also

the case with the drawdown of project loans which

were mostly CGI commitments from the previous year.

Although the drawdown of government loans did not

in general experience any obstacles, the size of the

loans was adjusted in accordance with fiscal repayment

requirements and was maintained at a lower level than

the payments. The government’s independent debt

management strategy was also reflected in the priority of

domestic financing.

In the private sector, the other investment transaction

recorded a higher deficit to $3.6 billion. One factor

causing the increase in the deficit was capital outflows

recorded on the asset side in the form of savings owned

by residents living overseas. Based on experience,

these capital outflows can become a source of supply

of foreign currencies if there is a shock which results in

increased demand for foreign currencies in the domestic

market. This phenomenon is also one factor which can

explain the relative stability in the movement of the rupiah

exchange rate amidst uncertainty in global financial

markets.

External Vulnerability Indicator

By attaining a surplus in the current account, the capital

account, and the financial account as stated above, the

total Balance of Payments in 2007 recorded a surplus

of $12.5 billion. The improvement in the performance

of the Balance of Payments was also accompanied

by a better Balance of Payments structure, thereby

helping to support rupiah stability in 2007. Although the

role of short-term capital inflows was still quite large,

the long-term capital flows continued to show positive

developments. The external vulnerability indicators

tended to improve. Even though the position of foreign

debts rose to $136.6 billion (Table 7.12), the ratio of

foreign debts toward GDP and exports continued to

decline to 31.2% and 97.3%, respectively (Chart 7.5).

These two indicators show a continued improvement

from the critical level as defined by the World Bank. The

same is also true for the ratio of debt repayments to

exports of goods and services to 19.2%, or below the

critical level of 20%.

110

Asia intraregional trade has tended to increase in the last

few years. The increase in intraregional trade has thus

reduced Asia’s share of trade with developed countries.

The share of intraregional trade in ASEAN, ASEAN+4,

and developing countries in Asia has continued to

increase relative to the total world trade (Chart 1)1.

Intraregional trade growth in developing countries in

Asia reached 44% in 2006, or increased sharply from

33% in 1990 (Chart 2). As such, the share of trade from

developing countries in Asia to the main developed

nations or the G3 (the US, the European region, and

Japan) declined from 53% in 1990 to around 42% in

2006. Although the role of trade to the G3 developed

nations is still quite large, the decline in the trade

share to developed nations is a positive development

amidst the current economic slowdown taking place in

developed countries. This shows greater independence

in the trade of developing countries in Asian region.

Asia intraregional trade to the US, European region and

Japan has continued to decline, while trade with China

has increased rapidly (Table 1). With the economies of

developed nations slowing, the impact of the slowdown

can be partly compensated by increased trade with

China and other countries in Asian region.

The increase in intraregional trade has been supported

by rapid economic growth in Asian region, especially in

China and India. Strong GDP growth and the very large

size of the population underpinned the external demand

in Asian region. In 2007, the share of Chinese and Indian

GDP toward GDP of developing countries in Asia was

already more than 50% combined, or amounting to

47.6% and 16.0%, respectively2. Other developments

which supported increased intraregional trade were

industry relocation policy by developed nations,

especially from Japan, to various countries in Asia. This

1 (Asia Developing Nations = Asia-Japan-Middle East countries). (ASEAN = Indonesia, Malaysia, Singapore, Thailand, Vietnam, Philippines, Brunei Darussalam, Cambodia, Myanmar, dan Laos). (ASEAN+4 = ASEAN + Japan+ China + India + South Korea).

2 Using nominal GDP from WEO-IMF Oktober 2007 database.

development was also supported by large foreign direct

investment flows to Asia along with various bilateral and

multilateral trade cooperation policies in the Asia region

which have been quite intensive since the 1990s.

Asia Intraregional Trade

111

Lower intraregional dependency on the G3 was

supported by an intraregional trade structure,

which was intra-industry in nature, while trade with

developed nations was more inter-industry in nature3.

Intra-industry trade in the trade with Asia countries

indicates specialization in line with the comparative

competitiveness of each country for export purposes.

This is in line with the increased business cycle

correlation to the countries in Asia, while the business

cycle correlation of developing countries in Asia with

developed nations tended to decline (Table 2)4. The

decline in the dependency of trade with developed

nations was also reflected in the decline in the business

cycle correlation between Indonesia with those three

developed regions. The correlation was even negative (in

the period 2003-2007), as Indonesia’s economic growth

tended to accelerate amidst the economic slowdown

taking place in developed nations.

From the aspect of traded commodities, intraregional

trade in Asia is dominated by raw materials or

intermediate goods. In general, the export share from

developing countries in Asia, including Indonesia,

is mainly in the form of raw materials (Table 3)5. The

tendency of raw materials to dominate the share of

3 Intra industry trades tend to increase business cycle correlations among countries, while inter industry trades tend to decrease business cycle fluctuation. See Harm Zebregs, Intraregional Trade in Emerging Asia, IMF Policy Discussion Paper, PDP/04/1, April 2004.

4 The computation of business cycle correlations is based on Phase Average Trend model developed by OECD.

5 The commodity classification is based on Broad Economic Indicators (BEC), United Nations Statistic Division, April 9, 2007.

exports occurred in both intraregional trade and trade

with the G3 developed regions. These exports of raw

materials are mainly primary products which have to be

processed further. This exports structure, unfortunately,

has a relatively low added-value in real sector activities,

for example, in the absorption of workers. For

Indonesia, the structure of exports to the US is already

relatively good, dominated by consumption goods

(55%), especially textile and textile-related products.

Nonetheless, Indonesian exports to other countries are

still dominated by raw material commodities (primary

products). Exports dominated by primary commodity

also took place to main export destination countries such

as Japan (mining goods, unprocessed rubber), China

(CPO and unprocessed rubber), and India (CPO and

mining goods).

For the domestic economy, the not so well-balanced

structure of exports implies the need to make

improvements on the supply side and to enhance the

competitiveness of exports to benefit from the high

growth momentum in developing countries and the

need for an industrial strategy directed toward exports of

finished goods such that the added-value is greater.

Table 1

Intraregional Export Destination to Several Countriespercent

Origin Countries

Export’s Destination*

USA Euro Zone Japan China India

1990 1999 2006 1990 1999 2006 1990 1999 2006 1990 1999 2006 1990 1999 2006

Asia’s Developing Countries 21.9 21.9 16.9 16.9 17.0 16.2 14.3 11.1 8.5 15.7 17.4 22.2 0.7 1.0 1.6

ASEAN 19.4 20.1 14.1 16.0 16.5 13.0 18.9 12.4 10.6 6.4 8.6 14.8 1.2 1.7 2.4

ASEAN+4 25.1 24.4 18.2 18.2 17.2 16.0 8.4 7.8 6.9 5.0 7.7 10.8 0.7 0.9 1.5

Indonesia 13.1 14.2 11.5 12.3 15.1 12.2 42.5 21.4 19.4 5.7 6.9 9.3 0.2 1.9 3.2* Share to origin country ‘s total export,Source: IMF Trade Directions Statistics

Table 2

Business Cycle Correlations to Developed Countries

USA Euro Zone Japan

1995-98 1999-02 2003-07 1995-98 1999-02 2003-07 1995-98 1999-02 2003-07

EM Asia -0.64 0.71 0.56 0.16 0.28 0.17 0.66 0.36 0.04

Indonesia -0.50 0.10 -0.53 0.14 0.27 -0.50 0.64 0.55 -0.58

112

Table 3

Intraregional’s & Indonesia’s Exports Commodities to Several Zonespercent

Origin Countries

Country of Export’s Destination*

USA Euro Zone Japan China India

1995 1999 2006 1995 1999 2006 1995 1999 2006 1995 1999 2006 1995 1999 2006

Asia’s Developing Countries

Capital Goods 20.1 20.0 26.0 17.5 20.6 27.0 10.2 12.5 16.6 12.5 11.8 19.0 14.9 11.1 22.0

Raw Materials 34.8 35.3 34.0 39.4 39.9 39.3 49.3 46.5 53.2 66.5 66.1 67.4 75.8 73.7 68.4

Consumer Goods 43.6 42.0 36.6 40.2 36.3 29.6 39.9 37.5 25.6 20.2 18.4 9.6 6.3 8.2 5.1

Indonesia

Capital Goods 12.1 6.0 4.9 3.8 4.4 7.8 1.0 1.6 2.5 2.4 1.6 4.9 1.1 0.8 2.8

Raw Materials 42.5 39.5 39.4 55.9 50.2 59.1 81.3 81.7 84.7 84.6 83.2 87.8 89.7 81.4 91.8

Consumer Goods 45.3 51.3 55.4 40.3 40.6 33.1 17.0 13.2 6.8 12.5 13.1 5.0 5.7 6.3 3.9* share to origin country’s total exports. Source: UNCOMTRADE

Chapter 8

Government Finances

114

Chapter 8: Government Finances

Implementation of fiscal policies in 2007 faced some fairly serious challenges. The high price of crude oil on international markets, which was accompanied by a decline in domestic oil lifting put fairly significant pressures on efforts to keep the fiscal deficit within a safe level. Nonetheless, various government policy measures which included the extensification and intensification of government revenues, the policy to cut down and increase efficiency of Ministry/Institutional spending were able to safeguard fiscal sustainability. This was reflected in the decline of government debts to GDP ratio and the preservation of the primary balance surplus.

Fiscal policy in 2007 was, in general, aimed at increasing the fiscal stimulus by continuing to ensure fiscal sustainability. With this expansionary direction, the APBN-P 2007 deficit was fixed at 1.5% of GDP, or higher than the 2006 realized deficit of 0.9% of GDP. Fiscal expansion was expected to increase the fiscal contribution to the real sector, either through government consumption or investment. Besides the direct contribution, the government also gave a number of tax incentives to increase activity in the real sector without sidelining efforts to increase government revenues. Meanwhile, to reduce the level of poverty the government still carried out various programs to help the people. The increase in the deficit has not harmed the prospects for fiscal sustainability, as reflected in estimates of a fall in the outstanding Government debt ratio and the continuing primary balance surplus.

Implementation of the 2007 APBN faced a number of challenges which originated from both external environment and internal problems. On the external side, the budget was implemented at a time of continued increases in the price of crude oil since the second quarter of 2007. Overall, the yearly price of crude oil reached around $72.3/barrel1 on average, or above the assumption in the 2007 APBN-P of $60/barrel. Accompanied by various parameters in the calculation of energy subsidies, which exceeded the initial estimates at the beginning of the year, the increases in the price of crude oil significantly pushed up the amount of subsidies, thereby potentially increasing the budget deficit toward

1 Average ICP January-December 2007 used to calculate fuel and electricity subsidies.

2% of GDP. Entering the third quarter of 2007, the subprime mortgage crisis in the United States triggered a decline in the price of Government debts which could affect the financing of the budget deficit. From the domestic side, national finances were impacted by the domestic oil lifting which continued to decline. Overall, yearly oil lifting reached on average 899,000 barrels per day, or below the 2007 APBN-P assumption of 950,000 barrels per day. This condition led to lower revenues from the oil and gas sector. Other internal challenges concerned the absorption of Government Expenditure which lagged behind in the first half of 2007 although efforts have already been made in regard to regulations connected to the procurement of government goods and services. This lag in the absorption of Government Expenditure was caused by increased caution and efficiency in the carrying out of procurement auctions for government goods and services.

Facing various challenges, the government was still consistent in undertaking fiscal consolidation such that it was able to control the budget deficit which, in turn, had a positive impact on macro economic stability. From the aspect of tax revenues, various government policies have helped the 2007 APBN-P tax revenues target be realized. This is an improvement from the situation last year. From the aspect of non tax revenues, the higher price of crude oil and the greater rupiah depreciation than assumed in the 2007 APBN-P meant that there was additional revenues from CPO export taxes and dividend payments by state owned companies. The realization of these tax and non tax revenues meant that the target of Government Revenue and Grants was

115

surpassed. From the aspect of expenditures, increased efficiency in Ministry/Institutional spending allowed the government to pay energy subsidies in the framework of safeguarding price stability. With these steps, the deficit is still expected to remain in line with the target set in the 2007 APBN-P, that is 1.5% of GDP. From the aspect of financing, the front loading strategy in issuing Government Debts (SBN) meant that the financing target deficit could be met before financial sector conditions experienced volatility due to the sub-prime mortgage crisis in the United States.

The realization of a lower-than-targeted budget deficit was mainly attributable to the absorption of Ministry/Institutional spending (K/L spending) which was below the target set in the 2007 APBN-P. Steps taken to improve efficiency, which were accompanied by greater caution in the procurement of government goods and services, meant that the government was still able to provide fuel subsidies despite large increases in the price of crude oil. Nonetheless, as a consequence, the realization of the Government Spending was lower than the realization of the State Income such that realization of the deficit lagged behind. From March until November 2007, government financial operations continued to accumulate a budget surplus. At the end of the year, the deficit only reached 1.3% of GDP2, or below the 2007 APBN-P target of 1.5% of GDP. This deficit was supported by the prospect of fiscal sustainability. The ratio of government debt declined from 39% of GDP in 2006 to 35% of GDP in 2007. Meanwhile, the

2 Or 1.2% of GDP by using realized 2007 GDP of Rp3.957 trillion.

primary balance still recorded a surplus of 0.8% of GDP (Chart 8.1 and Chart 8.2).

Government Revenues and GrantsThe performance of Government Revenues and Grants in 2007 was marked by good performance in tax collection, but was overshadowed by weak performance in the oil and gas sector due to further declines in oil lifting. As estimated in the 2007 APBN-P, the performance of Government Revenues and Grants in 2007 recorded lower growth than in 2006 when the growth reached 29%. This slowdown in growth was mainly due to the decline in revenues from the oil and gas sector. Meanwhile, the performance of the tax sector was quite reasonable. The tax revenue increased by 20% in line with the 2007 APBN-P. This figure is higher than the growth in 2006 of 18%. With this development, Government Revenues and Grants reached around 19% of GDP, relatively unchanged from the level in 2006 (Chart 8.3). Around 69% of Government Revenues and Grants stemmed from tax revenues with a tax ratio of 13% of GDP, while the rest stemmed from non tax revenues (PNBP) amounting to 6% of GDP (Chart 8.4).

The less than optimal performance of the oil and gas sector is reflected in lower oil and gas revenues at a time when crude oil price continued to increase and reached a level of $69.7/barrel3. This condition can be partly explained by the lower domestic oil lifting which has continued to decline to 899,000 barrels/day. From

3 Average ICP December 2006-November 2007 to calculate oil and gas revenues.

116

Table 8.1

Summary of Government Finance Operation

Description

Realization in 2006 Budget of 2007Revised Budget

of 2007Realization in 20071

Trillions Rp

% GDP % yoy% of

Revised Budget

Trillions Rp

% GDPTrillions

Rp% GDP

Trillions Rp

% GDP % yoy% of

Revised Budget

A. Total Revenues and Grants 638.0 19.1 28.8 96.8 723.1 20.5 694.1 18.5 708.5 18.7 11.0 102.1I. Domestic Revenues 636.2 19.1 28.8 97.1 720.4 20.4 690.3 18.4 706.8 18.7 11.1 102.4

1. Tax Revenues 409.2 12.3 17.9 96.3 509.5 14.4 492.0 13.1 491.8 13.0 20.2 100.02. Non-Tax Revenues 227.0 6.8 54.5 98.7 210.9 6.0 198.3 5.3 215.0 5.7 (5.3) 108.4 – Oil and Gas 158.1 4.7 52.4 98.9 139.9 4.0 107.7 2.9 124.8 3.3 (21.1) 115.9

II. Grants 1.8 0.1 40.6 43.3 2.7 0.1 3.8 0.1 1.7 0.0 (7.6) 44.3B. Total Expenditures 667.1 20.0 30.9 95.4 763.6 21.6 752.4 20.0 757.2 20.0 13.5 100.6

I. Central Government

Expenditures

440.9 13.2 22.8 92.2 504.8 14.3 498.2 13.2 504.0 13.3 14.3 101.2

a. Personnel Expenditures 73.3 2.2 35.0 92.6 98.5 2.8 98.0 2.6 90.4 2.4 23.4 92.3b. Goods Expenditures 47.2 1.4 61.7 84.3 71.9 2.0 61.8 1.6 54.2 1.4 14.9 87.7c. Debt Interest Payment 79.1 2.4 21.3 95.9 85.1 2.4 83.6 2.2 79.6 2.1 0.6 95.2d. Subsidies 107.4 3.2 (11.0) 99.8 103.0 2.9 105.1 2.8 150.2 4.0 39.8 142.9e. Capital Expenditures 55.0 1.6 67.1 78.8 76.9 2.2 71.7 1.9 64.4 1.7 17.1 89.8f. Grants Expenditures 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0g. Social Assistance 40.7 1.2 63.5 99.2 50.7 1.4 52.3 1.4 50.7 1.3 24.6 97.1h. Other Expenditures 38.3 1.1 19.9 90.7 18.8 0.5 25.8 0.7 14.6 0.4 (62.0) 56.4

II. Regional Budget

Expenditures

226.2 6.8 50.3 102.4 258.8 7.3 254.2 6.8 253.3 6.7 12.0 99.6

C. Primary Balance 49.9 1.5 117.5 44.6 1.3 25.3 0.7 30.8 0.8 121.9D. Budget Surplus/(Deficit) (29.1) (0.9) 72.9 (40.5) (1.1) (58.3) (1.5) (48.8) (1.3) 83.7

E. Financing 29.1 0.9 40.5 1.1 58.3 1.5 48.8 1.3

I. Domestic Financing 55.7 1.7 55.1 1.6 70.8 1.9 72.7 1.91. Domestic Bank 18.6 0.6 103.9 13.0 0.4 10.6 0.3 14.9 0.4 140.32. Domestic Non-Bank 37.1 1.1 54.9 99.3 42.1 1.2 60.2 1.6 57.8 1.5 56.0 96.1

a. Privatization (net) 0.4 0.0 40.0 2.0 0.1 2.0 0.1 0.3 0.0 (25.0) 15.0b. Sales of Banking

Restructuring

Program Asset

2.7 0.1 (58.9) 104.7 1.5 0.0 1.7 0.0 2.4 0.1 144.8

c. Government Bond

Sales, net

36.0 1.1 59.4 100.6 40.6 1.1 58.5 1.6 57.1 1.5 58.8 97.6

d. Government

Investment Funds

(2.0) (0.1) (61.5) 100.0 (2.0) (0.1) (2.0) (0.1) (2.0) (0.1) 100.0

II. Foreign Financing (net) (26.6) (0.8) 158.6 173.9 (14.6) (0.4) (12.5) (0.3) (23.9) (0.6) (10.0) 190.61. Foreign Withdrawal

(gross)

26.1 0.8 (2.7) 69.5 40.3 1.1 42.2 1.1 34.0 0.9 30.2 80.5

2. Amortization (52.7) (1.6) 42.0 99.7 (54.8) (1.6) (54.8) (1.5) (57.9) (1.5) 9.9 105.8

Assumptions:Economic Growth (%) 5.5 6.3 6.3 6.3Inflation (%) 6.6 6.5 6.0 6.59Average Exchange Rate (Rp/$) 9.063 9.300 9.050 9.140Average 3-months SBI Rate (%) 11.7 8.5 8 8International Oil Prices ($/

barrel)

63.8 63 60 69.7

Indonesian Oil Lifting

(million barrel/day)

0.959 1.000 0.959 0.899

Source: Ministry of Finance1 Provisional Figures, January 2008

the point of view of the 2007 APBN-P target, the tax income target was able to be achieved due to the fact that all components of tax revenue exceeded its target. Meanwhile, realization of non tax revenue (PNBP) also surpassed its target. This is still mostly contributed by oil and gas income, albeit lower than last year’s, due to the fact that higher increase of oil prices outweighed the decline in oil lifting. With this development, the realization

of Government Revenues and Grants exceeded the target in the 2007 APBN-P (Table 8.1).

The better performance in the tax sector was partly due to the impact of more conducive macro economic conditions. Continuation of tax policies from previous years, such as extensification through widening the type of businesses which have to pay tax, intensification

117

toward tax subjects and objects, improvement of the tax system and administration, increased monitoring efforts and increased excise tax tariffs, combined with the better macro economic conditions, resulted in better performance in tax collection. This better performance was reflected in both the increase of the tax ratio which reached 13% of GDP, up from 12.3% of GDP in 2006 as well as the increase in the number of tax objects from around 20.8 million in 2006 to around 23.1 million in 20074. The increase in tax revenues occurred in all components of tax revenues with the largest increase stemming from Export Tax revenues. The increase in Export Tax revenues was mainly due to higher exports of CPO, mineral fuels and mining products along with rubber and rubber made goods, which were driven by higher oil prices. In terms of Domestic Taxes, the main increase occurred in Value Added Taxes (VAT), and other taxes and excise taxes in line with private consumption growth which has continued to rise since the first quarter of 2007.

The increase in tax revenues was also influenced by policy factors. Especially concerning excise taxes, the increase in excise tax revenues was supported by both higher production volumes of products such as cigarettes and alcoholic drinks and the impact of increases in the retail selling prices (HJE) for all types of cigarette by 7% per stick/gram effective March 1, 2007 and the imposition of specific taxes of Rp3-7/stick according to the industry group effective as of July 1,

4 Including tax payer (WP) who doesn’t have a NPWP.

20075. Efforts to prevent the sale of cigarettes without banderole or with fake banderole also helped to boost excise tax revenues. From all components of income tax revenues, only the realization of non oil and gas income tax (PPh) failed to reach its target. This was due, among other things, to a decline in the amount of PPh Section 25 (PPh for firms) year 2007 due to the low realization of profits in a number of large companies and a number of potential tax payers in 2006, as well as because of natural disasters in 2006-2007 which affected activities in the real sector for a time.

Implementation of tax polices also included providing a limited fiscal stimulus and continuing a program to harmonize tariffs. Various tax facilities were given in 2007 which were aimed at raising production activities and investment. In the field of income tax, facilities given include a reduction in net income by 30% from the specified amount of investment, speeding up depreciation and amortization, lowering the Income Tax rate on dividends which are paid to Overseas Tax Subjects, lengthening of the period for loss compensation6; the granting of exception facilities for agriculture goods7; along with the granting of PPN facilities on contributions and donations in the

5 Finance Minister regulation No. 118/PMK.04/2006 concerning the two changes above PMK No. 43/PMK.04/2005 on Setting the Base Price and Excise Tax Tariffs for Cigarette Products.

6 Government Regulation No. 1 Year 2007 Concerning Income Tax Facilities for Investment in Certain Areas and/ or Certain Regions.

7 Government Regulation No. 7 Year 2007 Concerning the Third Amendment to Government Regulation No. 12 Year 2001 concerning Imports and/ or the surrender of certain taxable goods that are Strategic in Nature which were Exempted from the Imposition of Value Added Tax.

118

framework of the rehabilitation and reconstruction of Nanggroe Aceh Darussalam (NAD) and Nias8. In the field of international tax, the Program to Harmonize Import Duties is still carried out. This program was aimed at raising the efficiency and competitiveness of domestic industry, providing business certainty to investors, anticipating economic globalization, increasing customs administration efficiency and preventing smuggling.

In terms of non-tax revenues, the continued decline in domestic oil lifting was the main factor in the decline of the non tax revenue realization (PNBP). As assumed in the 2007 APBN-P, the performance of PNBP experienced a decline compared to 2006, mainly due to the fall in receipts from oil and gas. The decline in oil and gas PNBP was due to domestic oil lifting which only reached 899,000 barrels/day, or lower than the assumption of 950,000 barrels/day, while the price of crude oil actually rose to $69.7/barrel, or above the assumption of $60/barrel. This decline in domestic oil lifting was related to high natural declining rate of oil wells in Indonesia now reaching around 5%-11% per year due to its mature age, while new wells like Cepu and Lapangan Jeruk are not yet producing.

The decline in the realization of PNBP was also caused by lower profits contributed by SOE and other PNBP. This was because the carried over SOE dividends and the excess Surplus of Bank Indonesia were not included in the calculation of SOE 2007 profit as was the case in 2006. Receipts from excess surplus of Bank Indonesia were put in a separate component in the 2007 APBN-P and were realized in line with the target, that is around Rp13 trillion. Nonetheless, SOE contributed profits exceeded the target in the 2007 APBN-P because of an increase in the dividends contribution in relation to higher crude oil prices. Meanwhile, the lower increase in other PNBP, among other things, was because receipts from the auction for rights to use certain radio frequencies to support third generation based cellular telecommunication services were not included in the calculation as they were in 2006.

Government ExpenditureThe implementation of Government Expenditure in 2007 was marked by price stabilization policy, greater fiscal stimulus and continuation of poverty alleviation programs.

8 Finance Minister Regulation No. 43/PMK.03/2007 concerning the imposition of PPN and PPnBM on the Carrying out of Government Projects for the Rehabilitation and Reconstruction of Districts and the People’s Lives in the Province of Nanggroe Aceh Darussalam and the Nias Province of North Sumatra Post the earthquake and Tsunami Natural Disasters which were Funded by Overseas Grants.

Policy to safeguard price stability was carried out through the commitment to providing various types of subsidy. The policy to increase the stimulus was carried out through raising State Apparatus Income; improving the quality, efficiency and effectiveness of services and governance through raising the budget for Expenditure on Goods; increasing the budget for infrastructure in Capital Expenditure; along with increasing the education budget. To reduce the level of poverty, programs in the fields of education and health - especially for poor people - were maintained. With this policy direction, Government Expenditure in 2007 reached around 20% of GDP, or the same as in 2006, with the bulk (33%) used for Regional Spending which was followed by expenditures for Subsidies and Debt Interest (31%), around 27% for fiscal stimulus from the Central Government (Spending on Salaries, Spending on Goods and Capital Spending) and the remainder (9%), among other things, for poverty alleviation programs through the Social Aid budget. From all these components of Government Expenditure, only the components on Spending on Employees, Subsidies and Regional Spending experienced an increased share of GDP compared to 2006 (Chart 8.5). Meanwhile, the share of Capital Expenditure and Expenditure on Goods was still minimal and stable as it was in 2006, that is only around 1%-2% of GDP.

Efforts to increase the fiscal stimulus were still hampered. As targeted in the 2007 APBN-P, the achievement of Government Expenditure of 20% of GDP was attributable to slower growth in Government Expenditure than that in 2006, either from Central Government Expenditure or Regional Spending. At the central level, unlike in the 2007 APBN-P, which expected that the slowdown in Central Government Expenditure in 2007 would stem from lower subsidies, the slowdown in Central Government Expenditure was, in fact, due to the slowdown in nearly all components of Central Government Expenditure which were larger than the 2007 APBN-P target along with declines in Other Expenditures, while the Subsidies actually experienced an increase due to developments in the price of crude oil (Chart 8.6). This condition was due to the absorption of Central Government Expenditure, especially for Expenditure on Salaries, Spending on Goods, Capital Expenditure and Other Expenditures which were below the 2007 APBN-P. In the last two years following the reformation of government finances in 2005, absorption of a number of components in Central Government Expenditure were always below target, although various efforts to improve regulations concerning the procurement of government goods/services had already

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been carried out9. This condition was related to the increased caution in carrying out Government auctions for the procurement of goods and services as well as steps to economize Ministry/Institutional spending (K/L) in anticipation of increased needs for payments of energy subsidies. At the regional level, the realization of Expenditures for the Regions was relatively in line with the target although overshadowed by payments for Special Allocation Funds (DAK) and Special Autonomy Funds and Adjustments (DOKP) that were below target.

In general, the increases in Central Government Expenditures were influenced by policy factors. Central Government Expenditures rose around 14% with the increase occurring in all expenditure components, except Other Expenditures. With regard to the civil service, the main policies included adjustments to the basic salary of state workers by around 15%, payment of the thirteen-month salary10 and adjustment of structural allowance along with functional allowance. In the area of education, the education budget rose from the realized Rp29.3

9 A number of important points in Presidential Decree No. 8 Year 2006 and Presidential Decree No. 79 Year 2006 stated ministries and state institutions along with Regional Governments and leaders of SOE and BUMD can conduct the procurement process of goods/services before the budget document is approved for related activities which have already been allocated, with the stipulation they issue an appointment letter to supply goods/services (SPPBJ) and a signed contract for the goods/services is done after the budget document for activities/projects is approved. Beside that, the PP also regulates when certification is not required for officials making a commitment as well as allowing for direct appointment for auctions of projects up to Rp50 million.

10 Regulation of the Director General of the Treasury No.33/PB/2007 dated 13 June 2007 concerning 13 month Salaries/pensions/allowances in the 2007 budget to Civil Servants, State Officials and Receivers of Pensions/Allowances.

trillion in 2005 to Rp45.3 trillion in 2006, and is expected to increase to Rp51.3 trillion in the 2007 APBN-P. This increase was related to Government efforts to fulfill the constitutional mandate to allocate at least 20% of the APBN for the education budget11. The increase in Expenditure on Goods was used to assist developments in activities requiring support for operational cost and maintenance (around half of the Expenditure on Goods budget), to handle post-flooding expenditures, and to procure the bird flu vaccine. In the area of investment, the infrastructure budget rose from around Rp32.2 trillion in 2006 to around Rp43.8 trillion in 200712 which, among other things, was used to speed up development of east flood canal and west flood canal to tackle floods in the Jabodetabek area, to construct Kuala Namu Airport in Medan, and Hasanudin Airport in Makassar.

In regard to subsidies, both energy subsidies and various other subsidies experienced an increase. Food subsidies rose from Rp10.8 million in 2006 to Rp15.8 million in 2007 due to an increase in the number of targeted poor households (RTM) receiving subsidies. Fertilizer subsidies rose in connection to increases in the maximum retail price (HET) of fertilizer as of January 2007. This increase was due to the national program to boost rice production by two million tons which needs an additional 800 thousand tons of subsidized fertilizer. Meanwhile, subsidies on interest for program loans rose in order to support the increase of the volume of subsidized house construction, a program to subsidize bio-fuels energy

11 Source: Financial Notes for the 2008 APBN.12 Source: Office for the Coordinating Minister of the Economy,

December 2007.

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and a program to revitalize plantations. To guarantee the continuation of the aid program to the people which has been in effect for a few years, the Government increased the Social Aid budget. This budget increase was used for a program to support school operations (BOS), scholarships for gifted pupils (BKM) in the field of education, free health services in Puskesmas and government hospitals and appointed third-class private hospitals, and on direct aid projects in the field of health and education. Meanwhile, the realization of Other Expenditure was lower than in 2006, mainly because of the discontinuation of Direct Cash Aid program. Other Expenditure budget included funds for policy measures, national movement to rehabilitate the forests, activities which had not yet been budgeted, and also rehabilitation and reconstruction of Yogyakarta and Central Java.

Policies to maintain subsidies amidst external shocks meant that the realization of Central Government Expenditures exceeded the target. Absorption and increases in Central Government Expenditures – which were above the target – were mainly because of Subsidy payments, especially fuel (BBM) Subsidies and Electricity Subsidies. This increase in fuel subsidies was driven by greater disparities between the price of fuel fixed by the Government with its economic price along with the realization of subsidized fuel consumption which exceeded the quota, that is from 36 million kilo liters to around 38 million kilo liters (Chart 8.7). The increase in subsidized fuel consumption was also related to the slow progress made in the program to get people to switch from kerosene to LPG (realization was only around 20,638 kilo liters or 6% of the target.

Meanwhile, the increase in electricity subsidies was also influenced by the increasing disparity between Basic Electricity Tariffs as set by the Government and production costs which have continued to increase. This increase in electricity production costs was caused by rising fuel prices, the increase in the portion of fuel used in producing electricity and the increase in the price of fuel set by Pertamina (as a result of an increase in profit margin from 6.5% to 9.5%), along with an increase in electricity sales to the public compared to what was originally planned. The commitment to maintain subsidies demonstrates the role of the Government in safeguarding economic stability13.

At the regional level, transfers of Expenditure for the Regions increased in line with increased Government revenue and infrastructure needs. In general, the expenditure policy for the regions was directed to lessen the fiscal inequities between the central government and regional governments and between the regions, to lessen the inequities in public services between regions, to support fiscal sustainability in macro economic policy, to increase regional capacity in harnessing the potential of regional income, to increase efficiency in national resources, and to increase the transparency and accountability of the allocation of Expenditure for the Regions. Realization of regional Expenditure in 2007 was relatively stable compared to 2006, that is around 6.7%-6.8% of GDP. All components of the Regional Spending Budget rose except for Profit Sharing Funds (DBH). This reflects the decline in oil and gas

13 In line with the results of the study “Fiscal and Monetary Interaction in Indonesia” (Hermawan, Munro, 2007).

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receipts which was due to lower domestic oil lifting. The increase in the General Allocation Fund (DAU) reflects the increase in net government revenue. The increase in Special Allocation Fund (DAK) reflects the increasing transfers of deconcentration funds, aids and the policy to place shortage of DAK payment in 2005 to this years’ DAK. Furthermore, the increase in Autonomous Fund and Adjustment (DOKP) was due to the allocation of adjustment funds for infrastructure. 30% of the DAK allocation was used in the fields of education, while another 30% was used in infrastructure; around 20% was used for health and the remainder was used for government infrastructure, maritime and fisheries, agriculture and environment. The realization of DAK and DOKP that were below target was due to, among other things, the delay in setting the APBD. This, in turn, resulted in delays in undertaking activities and absorbing funds.

Deficit FinancingFinancing of the 2007 APBN deficit was relatively in accordance with the target, especially the financing sourced domestically. Three strategic steps for the financing included increasing the use of domestic source of financing, reducing outstanding debts and reducing ratio of debts toward GDP in a progressive manner, also fulfilling debt repayment obligations on time. Implementation of these three strategies were carried out smoothly such that the target for deficit financing sources originated domestically could be attained and that debt repayment was done on time. Up to the end of December 2007, the amount of rupiah and foreign currency SBN already issued had reached Rp99.8 trillion14. After taking into account the government bond (SUN) maturity, the SUN buyback and the repayment of a portion of Government debts owed to Bank Indonesia (SRBI-01) (around Rp13.7 trillion), the net issuance of SBN reached Rp57.1 trillion, which was slightly below the 2007 APBN-P target of Rp58.5 trillion. From the point of view of assets sales, realization of the privatization program up to December was below target, whereas the banking asset sales from PT Perusahaan Pengelola Aset (PT PPA) was in line with the target. In 2007, the Government obtained funds from the SOE privatization program of around Rp3 trillion, slightly below the 2007 APBN-P target of Rp3.3 trillion. In December there were also payments for a number of SOE through PMN program of around Rp2.7 trillion, which exceeded the target of Rp1.3 trillion. As such, the net privatization proceeds obtained were around Rp0.3 trillion, or below the target of Rp2 trillion. Meanwhile, from the bank

14 Source: Bank Indonesia.

restructuring program, the State Asset Management Company (PPA) contributed around Rp2.4 trillion, exceeding the 2007 APBN-P target of Rp1.7 trillion. In regard to external sources, the withdrawals of foreign loans only reached around 81% of the APBN-P target because the policy matrix was not met.

The main source of foreign loans still originated from the World Bank and ADB. These loans were used to fund various development programs in nearly all economic sectors. Meanwhile, repayments on principal were carried out on time which actually resulted in net withdrawals of foreign loans that were below target. With net issuances of SBN exceeding the target, and the deficit being lower than the target, the position of the government account in Bank Indonesia experienced a slight increase. This was contrary to what was expected in the 2007 APBN-P where the Government account in Bank Indonesia had been initially expected to show a decline since it was used to repay the deficit. Similar to the two previous years, financing policy was marked by government expenditures to fund infrastructure through Public Private Partnerships (PPP) that amounts to around Rp2 trillion.

The financing strategy enables the continuing down trend of outstanding Government debts to GDP ratio. The actual net issuance of SBN and net repayment of foreign loans caused outstanding Government debts ratio to decline to around 35% of GDP, from 39% of GDP in 2006. This decline stemmed from the drop in the amount of foreign debts outstanding from around 18% of GDP in 2006 to around 16% of GDP in 2007 and the decline in domestic debts from 21% of GDP in 2006 to 19% of GDP in 2007. From the perspective of its share, domestic and foreign loans share were stable, each at 53% and 47% of total Government debts. This condition was in line with the Government’s long-term debt strategy which is directed more toward domestic debts, mainly as part of efforts to minimize exchange rate risk. The year 2007 was marked by the termination of CGI in January 2007, this was done in order to improve Indonesia’s autonomy in bilateral debt negotiations such that loan conditions more advantageous. Furthermore, in accordance with the budget refinancing strategy which was aimed at reducing refinancing risks, the Government continued its SUN buyback program in 2007, as well as switching short-term SUN with long-term SUN through an auction mechanism. The SUN buyback program was carried out for Rp2.9 trillion of SUN which will mature in the period 2008-2012, while the debt switching program was carried out by reorganizing the maturity profile of

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ORI SPNForeign

Exchange Bond

Issuing Date 28-Mar 12-Sep 30-May 27-Jun 25-Jul 7-FebSeries ORI 002 ORI 003 SPN2008052801 SPN2008052801 SPN2008052801 INDO 37Indicative Target (trillion Rp/billion $) n.a. n.a. n.a. n.a. n.a. n.a.Bidding Amount (trillion Rp/billion $) 6.3 9.5 12.9 3.9 2.7 5.0Issuing Amount (trillion Rp/billion $) 6.2 9.4 2.0 1.9 0.3 1.5Coupon (%) 9.28 9.40 – – – 6.63Weighted Average Yield (%) – – 8.5 8.45 8.46 6.75Maturity 3/28/10 9/12/11 5/28/08 5/28/08 5/28/08 2/7/37

around Rp16 trillion of SUN which will mature in 2007-2012 to 2018-2025. This program gives room for the government to issue government securities (SBN) in shorter tenors in order to develop the SBN market and increase the confidence of investors and other market players toward the Government’s ability in managing its debt portfolio.

The success in meeting the financing target through issuance of SBN was supported by conducive macro economic conditions. As in 2006, the Government again faced a condition of oversubscription in nearly all of the SBN auctions in 2007. This condition reflects the confidence of market players in government macroeconomic policies and the prospects for fiscal

Table 8.2

Summary of Government Bonds Issued in Year 2007

Government Securities (SUN)

Issuing Date 23-Jan 22-Feb 20-Mar 17-Apr 24-May 19-Jun 17-Jul 21-Aug 28-Aug 20-Sep 25-Sep 30-Oct 20-Nov 4-Dec

Series FR042 FR043 FR028,

FR043

FR028,

FR044

FR042,

FR045

FR043,

FR045

FR045,

FR046

FR046,

FR047

FR047,

ZC001

ZC002 FR047,

FR048

FR047,

FR048

ZC003 FR027;

ZC004

Indicative Target (trillion

Rp)

3 4 3 3; 3 3 2 3 3 3 3 3 3 2 2

Bidding Amount (trillion

Rp)

20.0 7.6 7.0; 8.6 11.1;

8.9

10.4;

10.8

9.9; 6.5 3.2; 4.3 2.1; 2.3 4.5; 9.1 6.5 6.3;

11.1

3.1; 4.0 2.2 6.2; 4.5

Issuing Amount (trillion

Rp)

4.8 4.0 4.1; 5.1 3.0; 4.0 2.6; 1.7 2; 2.5 2.2; 3.6 1; - 3.5; 6.0 3.0 3.5; 3.5 0.9; 0.1 1.5 4.1; -

Coupon (%) 10.25 10.25 10;

10.25

10;

10.25

10.25;

9.75

10.25;

10.56

9.75;

9.5

9.5; - 9.5; - - 10; 9 10; 9 - 9.5; -

Weighted Average

Yield (%)

10.48 10.68 9.93;

10.48

9.82;

10.38

9.76;

10.07

9.35;

9.53

9.81;

9.71

10.61; - 10.34;

8.41

8.74 9.89;

9.39

10.15;

9.45

9.87 9.62; -

Maturity 15/7/27 15/7/22 15/7/17;

15/7/22

15/7/17;

15/9/24

15/7/27;

15/5/37

15/7/22;

15/5/37

15/5/37;

15/7/23

15/7/23;

15/2/28

15/2/28;

20/11/08

20/9/09 15/2/28;

15/9/18

15/2/28;

15/9/18

20/11/12 15/6/15;

20/3/09

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sustainability which was further supported by an attractive return (Table 8.2). From the international perspective, strong foreign investor interest was supported by the continued global excess liquidity in line with the high price of crude oil and the high expectations of the yield spread on SBN returns. In 2007, the Government carried out as many as 20 auctions for various types of SBN – both domestically and overseas – which had been carried out since January (frontloading). SBN which were issued were more varied than in previous years to accommodate various types of investor. In 2007, the Zero Coupon SBN series and the Treasury Bills (SPN) were first issued to complement the SUN, Government Retail Bond (ORI) and foreign currency debts auction. With these developments, the position of SBN at the end of 2007 reached Rp477.7 trillion with a composition of 57.7% in Fixed Rate series, 35.3% in Variable Rate series, 4.0% in ORI, 2.2% in Zero Coupon series and 0.9% in SPN series. The frontloading strategy meant that net issuances of SBN up to the third quarter of 2007 already reached around 90% of the target such that the target was relatively unaffected by the conditions of the financial market, which in the third quarter of 2007, were affected by the impact of the US sub-prime mortgage crisis. The belief of market players in sustainable fiscal conditions also increased as reflected in SUN yield developments and foreign currency obligations which were relatively stable although the price of crude oil continued to rise from the first quarter of 2007 onward. Meanwhile, increasing yield during the third quarter of 2007 was due to the impact of

the sub-prime mortgage crisis, but this impact began to ameliorate soon after (Chart 8.8 and Chart 8.9).

Implications on the Real Sector and the Monetary SectorThe policy of safeguarding fiscal sustainability while continuing to give a fiscal stimulus was still able to be done in 2007 although at a slower pace. The lag in Government consumption and investment was due to slower growth in Personnel Expenditures, Good Expenditures, Capital Expenditures and DAU in addition to the decline in Other Expenditures and DBH (Chart 8.10 and Chart 8.11). This lag was larger than that targeted in the APBN-P because the absorption of a number of expenditures were below the 2007 APBN-P target. Meanwhile, transfers to the real sector, such as Subsidies, Social Aid and Domestic Debt Interest, experienced an increase, especially due to an increase in Subsidy payments (Chart 8.12). These Subsidy payments also caused transfer payments to exceed the target in 2007. With this development, the fiscal impulse indicator15 (Chart 8.13) indicated that the Government’s

15 The Fiscal Impulse Indicator (FI) is calculated by comparing the actual value of the deficit with the potential deficit (structural balance) which in conceptual terms should occur. The calculation of the FI indicator follows the Chand Model (1992) which incorporates a number of macro economic indicators in the calculation of the FI, such as MPC, sensitivity of tax toward economic growth and the multiplier from Government expenditures. If the value of the actual deficit exceeds the potential deficit then it can be said that fiscal impulse is expansive toward economic growth. The threshold from the FI value is contractive toward economic growth if FI < 2% GDP, expansive if FI > 2% GDP and neutral if -2% GDP < FI < 2% GDP. The fiscal deficit only calculates domestic components of the APBN and excludes foreign components such as oil and gas income and interest payments on foreign debts.

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financial operations were still expansionary toward economic growth.

From monetary point of view, in line with the budget deficit, the Government’s financial operations recorded a rupiah expansion in 2007. In accordance with the budget surplus in January-November 2007 and the frontloading of SBN issuance, the Government’s financial operations continued to have a contractive impact on base money. Yet in December 2007, there was significant rupiah

expansion especially to pay for projects, DBH and various subsidies such that the Government’s finances were expansive in nature over the year. With the expansion in December, the Government’s finances had an expansionary impact of Rp66.9 trillion over the year (Chart 8.14). The size of the expansion was less than the rupiah expansion in 2006 when it reached around Rp100 trillion with a lower deficit. The lower rupiah expansion was possible because of the greater use of domestic debt and the smaller use of Government accounts in Bank Indonesia compared to the previous year.

Chapter 9

Banks and Other Financial Institutions

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One noteworthy aspect from Indonesian banking performance in 2007 is the vastly improved banking system stability in post-crisis. This is evident from banking performance and conditions in 2007, reflected both in the intermediary function and the resilience of the system itself. This achievement is hand in hand with the stable condition of the economy and also owes much to policies designed to promote the intermediary function and strengthen banking resilience. Regarding intermediation, progress was reflected in credit expansion well ahead of the target set at the beginning of 2007. Also attesting to the improved resilience is the continued stability of the banking system reflected in high levels of capital and declining non-performing loans (NPLs). The subprime mortgage crisis that has struck the banking system in various countries has so far had minimal impact in Indonesia. Sharia banking also made heartening progress, reflected in expansion of service coverage, funding growth and higher levels of financing compared to past years. In other financial institution sector, the capital market charted significant performance gains as indicated by the soaring Indonesian Composite Index (IDX Index). The bond market, mutual funds, multifinance companies, insurance companies and pension funds also demonstrated improving trends.

Chapter 9: Banks and Other Financial Institutions

Bank performance recorded significant gains in 2007,

buoyed by more conducive economic conditions.

This improvement was reflected in above-target

credit expansion, improved credit quality and capital

adequacy ratios far above the regulatory minimum.

Bank lending to micro, small and medium enterprises

(MSMEs) remained strong, as demonstrated by the

expansion in MSME credit during the year under review.

Concerning capital, the banking system achieved

compliance with the Rp80 billion minimum capital

requirement established by Bank Indonesia. Consistent

with the positive trends for commercial banks,

sharia banks and rural banks also reported steady

improvement in performance.

Performance of the capital market and other financial

institutions also showed buoyant trends. Surging

performance on the capital market was reflected in

the Composite Index, which reached an all-time high

in Indonesia’s stock market history. The upbeat trend

on the bond market was reflected in both government

and corporate bond trading. Companies tapped the

opportunity presented by soaring activity on the capital

market to raise investment funds, as demonstrated

by the escalating number of share and bond issues.

On the mutual funds market, net asset value climbed

significantly, tracking upward movement on the

stock and bond markets. Performance gains were

also recorded by multifinance companies, insurance

companies and pension funds, with increases in total

assets, extended financing and managed investment

funds.

The improved performance of banks, the capital market

and other financial institutions is closely correlated

to the policy packages released by Bank Indonesia

and the Government. In the banking sector, credit

expansion received a boost from the policy decisions

to lower the BI Rate and amendments in various

regulations, most importantly the changes in quality

rating of earning assets announced in March 2007. On

the capital market, policy focused on improvements in

infrastructure, efficiency, competitiveness and quality

of supervision. One landmark action was the merger of

the Jakarta Stock Exchange (JSX) with the Surabaya

Stock Exchange (SSX) to form the Indonesian Stock

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Exchange (IDX). In further action to support financial

market deepening, the Government issued a policy to

promote the development of sharia financial products,

municipal bonds and other products.

Commercial Banks

Growth in number of bank offices has brought

banking services even closer to the public. Economic

advancement in some regions and keen competition for

customers has prompted banks to do more to improve

and expand their service offering to the public. As part

of this, banks have increased the number of outlets in

their office networks to make services accessible to all

levels of society. During the year under review, banks

added 570 offices to their networks, bringing the total

number of bank offices to 9,680 (Table 9.1).

This improvement in banking services led to gains in

bank performance (Table 9.2). One indicator of stronger

bank performance was credit expansion that reached

25.5%, ahead of the targeted 22%. Accompanying

this was improvement in bank credit quality reflected

in lower NPLs ratios, both gross and net. Increased

lending alongside lower deposit rates helped to boost

bank profitability, as indicated by rising net interest

income (NII). Banks also successfully kept their capital

adequacy ratios (CAR) at a high level well above the

Bank Indonesia-prescribed minimum. These positive

developments also point to improved resilience in

the banking system in 2007 compared to past years,

which places banks on a strong footing for confronting

challenges and strengthening bank intermediation in

2008.

Credit expanded at a faster rate than bank funds

mobilisation. Total bank lending at end-2007 stood at

Rp1,045.7 trillion, with credit expansion at 25.5%. At

the same time, bank depositor funds were up 17.4% at

Rp1,510.7 trillion. The significant growth in bank lending

also widened the share of credit in bank earning assets

from 53.6% to 57.3% (Chart 9.1) and boosted the

loan to deposit ratio (LDR) to 69.2%, the highest level

since the crisis (Chart 9.2). As a result of this lending

performance, banks expanded their role in financing

economic activity.

Banking credit, like before, was dominated by working

capital and consumption credit of short term nature.

During the year, the share commanded by working

capital credit widened to 53.2% while consumption

credit and investment credit narrowed to 28.2% and

18.6% of the total (Table 9.3). Analysed by growth,

investment credit recorded 23.2% expansion, behind

28.6% and 24.9% for working capital credit and

consumption credit. Nevertheless, the expansion

in investment credit was well ahead of that of the

Table 9.1

Number of Banks and Bank Offices1

Category of Bank 2000 2001 2002 2003 2004 2005 2006 2007

Commercial Banks

Number of Banks 151 145 141 138 133 131 130 130

Number of Offices 6,510 6,765 7,001 7,730 7,939 8,236 9,110 9,680

State Owned Banks

Number of Banks 5 5 5 5 5 5 5 5

Number of Offices 1,736 1,807 1,885 2,072 2,112 2,171 2,548 2,765

Regional Development Banks

Number of Banks 26 26 26 26 26 26 26 26

Number of Offices 826 857 909 1,003 1,064 1,107 1,217 1,205

Private Foreign Exchange Banks

Number of Banks 38 38 36 36 34 34 35 35

Number of Offices 3,302 3,432 3,565 3,829 3,947 4,113 4,395 4,694

Private Non-Foreign Exchange Banks

Number of Banks 43 42 40 40 38 37 36 36

Number of Offices 535 556 528 700 688 709 759 778

Joint Venture Banks

Number of Banks 29 24 24 20 19 18 17 17

Number of Offices 58 53 53 57 59 64 77 96

Foreign Banks

Number of Banks 10 10 10 11 11 11 11 11

Number of Offices 53 60 61 69 69 72 114 142

1 Excluding village units operated by BRI

128

preceding year. One key factor preventing accelerated

investment credit growth was slow disbursements

of infrastructure loans, reflected in the 26.7%

disbursement ratio on approved infrastructure

lines of credit. This low portion of investment credit

demonstrates that banks have not achieved an

optimum level of credit expansion in support of long-

term financing.

Consumption credit1 was the product of choice for

banks, offering greater diversification and ability to

measure risk with loans spread out among many

debtors with low individual ceilings. At 20 banks,

consumption credit accounted for more than 75%

of the lending portfolio and the share at a further 13

banks ranged from 50%-75%. Consumption credit

was dominated by home mortgages at 33.4%, or 9.0%

of total bank lending. Home mortgages were also the

fastest growing segment of the credit market at 29.6%,

followed by credit cards at 19.7% (Chart 9.3). Private

foreign exchange banks and state-owned banks held

sway on the mortgage market with 45.8% and 40.8% of

these loans. On the other hand, credit cards operations

were dominated by foreign banks at 49.7%, followed by

private foreign exchange banks at 26.5% and state-

owned banks at 15.9%. Leading in other forms of

consumption credit were the state-owned banks with

31.8%, followed by private foreign exchange banks and

regional development banks at 29.5% and 25.4%.

Overall quality of consumption credit was fair except

for credit cards. Nominal NPLs from credit cards

mounted significantly (65.0%) over the previous year,

with gross NPLs in this segment up from 9.1% to

1 Consumption credit offered by banks include home mortgages, credit cards, car loans, credit for household or electronic purchases, home renovation loans, educational loans, holiday loans, unsecured loans and multipurpose loans.

12.2%. In contrast, gross NPLs for home mortgages

and other consumption credit was quite low at 3.0%

and 1.9%. Despite the slight increase in gross NPLs for

home mortgages and other consumption credit from

the previous year, the trend is low and stable. However,

the gross NPLs trend for credit cards mounted sharply

in 2006 (Chart 9.4). The credit card marketing strategy,

which offers many conveniences, encourages the

public to indulge in more consumptive spending,

resulting in increased card use. On the other hand,

economic conditions and public purchasing power

have not fully recovered from the previous fuel price

hike. For this reason, banks must be more selective in

issuing credit cards to avoid further build-up of NPLs.

The largest share of credit expansion during the

year under review was channelled into the trade and

business services sectors, which are regarded as

Table 9.2

Commercial Bank Performance Indicators

Key Indicators 1999 2000 2001 2002 2003 2004 2005 2006 2007

Total Assets (Trillions Rp) 1,006.7 1,030.5 1,099.7 1,112.2 1,196.2 1,272.3 1,469.8 1,693.5 1,986.5

Depositor Funds (Trillions Rp) 617.6 699.1 797.4 835.8 888.6 963.1 1.127.9 1.287.0 1,510.7

Credit (Trillions Rp)1 277.3 320.5 358.6 410.3 477.2 595.1 730.2 832.9 1,045.7

LDR (Credit/Deposits, %) 44.9 45.8 45.0 49.1 53.7 61.8 64.7 64.7 69.2

NII (Trillions Rp) 1.1 2.9 3.1 4.0 3.2 6.3 6.2 7.7 8.9

ROA (%) (6.1) 0.9 1.4 1.9 2.5 3.5 2.6 2.6 2.8

Gross NPLs (%) 32.8 18.8 12.1 8.1 8.2 5.8 8.3 7.0 4.6

Net NPLs (%) 7.3 5.8 3.6 2.1 3.0 1.7 4.8 3.6 1.9

CAR (%) (8.1) 12.7 20.5 22.5 19.4 19.4 19.5 20.5 19.21 including channeling loan.

129

having manageable risks. The two sectors received

Rp53.5 trillion and Rp31.3 trillion in additional lending,

representing a contribution of 25.5% and 14.3% to

overall bank credit expansion in 2007. Trailing was the

manufacturing sector with a contribution of 10.3%.

However, measured by growth, the most robust credit

expansion took place in the mining sector at 85.9%.

This surge was prompted by soaring prices for mining

commodities, including oil, gas, coal and nickel, which

encouraged business to forge ahead with expansion in

order to profit from the price momentum.

Foreign currency lending climbed significantly, buoyed

by growth in international trade. Expansion in foreign

currency-denominated loans reached 36.8% in 2007,

up considerably from only 18.5% in the previous year,

while rupiah credit expansion during the year under

review reached 24.0%. These developments indicate

that the external shocks that reared their head midway

through the year have not impacted business demand

for credit.

Credit quality underwent significant improvement.

Gross NPLs fell from 7.0% to 4.6%, the first drop below

the indicative 5% limit since the financial crisis, while net

NPLs eased from 3.6% to 2.3%. The improvement in

credit quality came mainly in response to the corporate

debt restructuring programme at state owned banks.

Most of the restructured corporate debt was in the

manufacturing sector, a traditional customer for working

capital credit, investment credit and foreign currency

credit facilities. As a result of the debt restructuring,

gross NPLs for the manufacturing sector fell from

10.5% to 7.1%, with similar decline in gross NPLs for

working capital credit from 6.3% to 3.7%, gross NPLs

for investment credit from 10.3% to 6.6% and gross

NPLs for foreign currency credit from 9.9% to 5.1%.

Table 9.3

Bank Credits

NotesPosition (Trillions Rp) Growth (%) Share (%)

2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007

Economic Sector

– Agriculture 24.4 33.1 37.2 45.2 56.9 7.7 35.6 12.2 21.6 25.9 5.6 5.9 5.3 5.7 5.7

– Mining 5.1 7.8 8.1 14.1 26.2 31.1 52.7 4.0 73.6 85.9 1.2 1.4 1.2 1.8 2.6

– Industry 122.4 144.9 171.3 184.0 205.6 (0.2) 18.3 18.2 7.4 11.7 28.1 25.9 24.6 23.2 20.5

– Electricity, Gas and Water 4.5 6.0 5.4 7.2 7.9 2.9 33.7 (10.2) 34.1 10.0 1.0 1.1 0.8 0.9 0.8

– Construction 12.5 20.0 27.0 33.1 44.1 32.8 60.2 35.2 22.6 33.2 2.9 3.6 3.9 4.2 4.4

– Trade 84.0 113.1 135.8 163.4 216.9 26.8 34.6 20.1 20.3 32.7 19.3 20.2 19.5 20.6 21.6

– Transportation 16.3 17.7 19.8 27.1 36.8 29.7 8.2 12.3 36.6 35.8 3.8 3.2 2.9 3.4 3.7

– Business Services 44.3 56.4 72.6 78.4 109.7 39.3 27.2 28.9 8.0 40.0 10.2 10.1 10.4 9.9 11.0

– Social Services 10.8 8.1 10.0 12.0 13.9 135.7 (25.3) 24.5 19.8 15.7 2.5 1.4 1.4 1.5 1.4

– Others 110.8 152.5 208.4 227.7 284.0 19.3 37.6 36.7 9.3 24.7 25.5 27.3 30.0 28.7 28.3

Category of Use

– Working Capital 231.2 289.6 354.5 414.7 533.2 11.9 25.3 22.4 17.0 28.6 53.1 51.8 51.0 52.3 53.2

– Investment 94.5 118.7 134.4 151.2 186.2 12.0 25.6 13.2 12.5 23.2 21.7 21.2 19.3 19.1 18.6

– Consumption 109.4 151.1 206.7 226.3 282.6 36.8 38.1 36.8 9.5 24.9 25.1 27.0 29.7 28.6 28.2

Currency

– Rupiah 330.6 431.6 565.8 638.4 791.6 23.1 30.6 31.1 12.8 24.0 76.0 77.2 81.3 80.6 79.0

– Foreign Currency 104.5 127.8 129.8 153.8 210.4 1.9 22.3 1.6 18.5 36.8 24.0 22.8 18.7 19.4 21.0

TOTAL 435.1 559.4 695.6 792.2 1.002.0 17.2 28.6 24.4 13.9 26.5 100.0 100.0 100.0 100.0 100.0

Channeling 42.1 35.7 34.5 40.7 43.7 7.4 (15.3) (3.2) 18.0 7.2

130

On the funding side, downward movement in deposit

rates did not diminish public interest in holding funds in

the banking system. Bank funds mobilisation mounted

again in 2007 by Rp223.8 trillion to Rp1,510.7 trillion.

The highest growth was recorded in savings deposits

(31.4%), which accounted for 46.8% of expansion in

depositor funds. Next were demand deposits with

20.0% growth, contributing 30.1% of additional funding.

The steep rise in savings deposits came in response

to a range of marketing campaigns offering prizes to

depositors. On the other hand, time deposits narrowed

slightly as a share of total depositor funds due to the

effect of falling interest rates (Table 9.4). The shift in the

deposit structure lowered the cost of funds, enabling

banks to cut lending rates despite also constraining

flexibility for extending long-term credit.

Foreign currency deposits gained wider popularity

following the revocation of the Bank Indonesia ruling

prohibiting banks from accepting savings deposits in

foreign currencies, a move that led to increased volume

of foreign currency savings at banks. Total foreign

currency deposits mounted Rp32.4 trillion, representing

growth of 16.7% over the previous year’s position. In

addition, some customers took pre-emptive action with

the weakening trend in the rupiah, particularly in the

second half of 2007, by transferring funds placements

from rupiahs to foreign currency.

The more modest downward trend in lending rates

compared to deposit rates has strengthened bank

revenues. Also contributing to accelerated revenue

growth was credit expansion and reduction in NPLs

reflected in the rise in bank net interest income (NII)

from Rp7.7 trillion to Rp8.9 trillion. With the improved

profitability, return on assets (ROA) similarly climbed

from 2.6% to 2.8%, the highest ROA reported in Asia.

Bank capital remained stable even with the credit

expansion. Higher lending brought with it the

consequence of increases in risk-weighted assets that

would have to be backed by bank capital. Even so,

the credit expansion produced only a slight reduction

in the bank capital ratio from 20.6% to 19.2%, which

remained the highest in Asia. At this level, capital

provides a robust buffer for even greater credit

expansion and in anticipation of future risks.

MSME Credit

During 2007, bank lending to micro, small and medium

enterprises (MSMEs) exceeded target. MSME lending

growth reached 22.5%, up considerably from the

15.7% recorded in the previous year. This growth was

Table 9.4

Bank Deposits

NotesPosition (Trillions Rp) Growth (%) Share (%)

2003 2004 2005 2006 2007 2003 2004 2005 2006 2007 2003 2004 2005 2006 2007

Demand Deposits 219.1 245.9 281.3 338.0 405.5 11.2 12.2 14.4 20.2 20.0 24.7 25.5 24.9 26.3 26.8

– Rupiah 150.1 171.0 193.8 249.5 309.3 15.3 13.9 13.3 28.8 23.9 68.5 69.5 68.9 73.8 76.3

– Foreign Currency 69.0 74.9 87.5 88.4 96.2 3.3 8.6 16.8 1.1 8.8 31.5 30.5 31.1 26.2 23.7

Savings Deposits 240.7 296.8 281.5 333.9 438.5 25.0 23.3 (5.2) 18.6 31.4 27.1 30.8 25.0 25.9 29.0

– Rupiah 240.7 296.8 281.5 333.9 434.5 25.0 23.3 (5.2) 18.6 30.1 100.0 100.0 100.0 100.0 99.1

– Foreign Currency – – – – 4.1 – – – – – – – – – 0.9

Time Deposits 428.8 421.5 565.0 615.1 666.7 (3.9) (1.7) 34.0 8.9 8.4 48.3 43.7 50.1 47.8 44.1

– Rupiah 351.8 351.9 455.0 509.9 541.0 (3.5) 0.0 29.3 12.1 6.1 82.0 83.5 80.5 82.9 81.1

– Foreign Currency 77.0 69.6 110.0 105.2 125.7 (5.6) (9.6) 58.0 (4.4) 19.5 18.0 16.5 19.5 17.1 18.9

Total 888.6 964.2 1.127.8 1.286.9 1.510.7 6.3 8.5 17.0 14.1 17.4 100.0 100.0 100.0 100.0 100.0

– Rupiah 742.6 819.7 930.3 1.093.3 1.284.7 8.1 10.4 13.5 17.5 17.5 83.6 85.0 82.5 85.0 85.0

– Foreign Currency 146.0 144.5 197.5 193.6 226.0 (1.6) (1.0) 36.7 (2.0) 16.7 16.4 15.0 17.5 15.0 15.0

131

ahead of the 20% target, but still below non-MSME

credit expansion, causing the share of MSME lending

to narrow to 50.2% (Table 9.5). Accompanying this was

improved quality in MSME loans, with the NPLs ratio

down from 4.2% in 2006 to 3.5%. This was attributable,

among others, to a series of policies launched in 2007

including amended rules for micro, small and medium

enterprises (MSMEs) in Bank Indonesia Regulation

No. 9/6/PBI/2007 concerning the Second Amendment

to Bank Indonesia Regulation No. 7/2/PBI/2005

concerning Asset Quality Rating for Commercial Banks,

the loan guarantee scheme, the linkage program for

commercial bank and rural bank cooperation in MSME

financing and the provision of technical assistance to

banks and Business Development Services Providers

(BDSPs) for improved MSME access to financing.

MSME credit growth was dominated by consumption

credit. During 2007, consumption credit mounted by

Rp51.3 trillion (25.4%), ahead of expansion in working

capital credit and investment credit at only Rp33.6

trillion (19.7%) and Rp7.4 trillion (20.0%). The expansion

in consumption credit accounted for 55.5% of total

MSME credit increase during 2007, consistent with the

rise in domestic demand and especially in household

consumption. Analysed by sector, additional lending to

MSMEs during 2007 was dominated by trade, followed

by business services and construction (Table 9.5).

Analysed by category of bank, private domestic banks

again led the way in lending to MSMEs at Rp217.6

trillion, with state owned banks next at Rp176.7 trillion

and regional development banks trailing with Rp67.8

trillion.

Rural Banks

The downward trend in numbers of rural banks

continued with further progress in mergers. During

2007, Bank Indonesia issued approvals in principle

for 27 rural banks and operating licences for 25 rural

banks, while 105 rural banks were approved for

merger/consolidation into 19 entities. In addition, Bank

Indonesia revoked the operating licences for 5 rural

banks beyond rescue due to structural problems.

Through these actions, the total number of rural banks

eased to 1,817 at end-2007, down 63 from the end of

the preceding year (Table 9.6).

Rural banks, like before, are concentrated in Java and

found mainly in regencies. Java accounted for 75.6% of

Indonesia’s rural banks, with the remainder dispersed

among other regions. In addition, 79.3% of rural banks

were operating in regencies or rural areas. Under the

master plan for rural banks, Bank Indonesia is pursuing

actions to reduce this disparity and encourage the

Table 9.5

MSMEs Credits1

NotesPosition (Trillions Rp) Growth (%) Share (%)

2005 2006 2007 2006 2007 2006 2007

Category of Use

Working Capital 142.6 171.1 204.8 20.0 19.7 41.7 40.7

Investment 33.0 37.1 44.6 12.5 20.0 9.0 8.9

Consumption 179.2 202.2 253.5 12.8 25.4 49.3 50.4

Total 354.8 410.4 502.8 15.7 22.5 100.0 100.0

Economic Sector

Agriculture 12.6 13.9 16.1 10.5 15.7 3.4 3.2

Mining 1.0 1.3 1.5 31.0 14.5 0.3 0.3

Industry 32.5 36.7 37.8 12.8 3.1 8.9 7.5

Electricity, Gas and Water 0.2 1.5 0.3 640.0 (79.7) 0.4 0.1

Construction 7.7 10.1 13.2 31.4 30.4 2.5 2.6

Trade 87.5 107.3 134.6 22.6 25.5 26.1 26.8

Transportation 6.5 6.6 7.2 1.5 9.1 1.6 1.4

Business Services 20.6 23.5 30.5 14.1 29.7 5.7 6.1

Social Services 5.3 6.0 6.7 13.6 11.3 1.5 1.3

Others 180.9 203.5 254.9 12.5 25.2 49.6 50.7

Total 354.8 410.4 502.8 15.7 22.5 100.0 100.0

MSMEs Loan Ratio/Total Bank Loan 51.0 51.8 50.2 –1 excluding loan of Rural Banks

132

spread of these institutions throughout Indonesia. The

objective of this policy is to ensure that all members

of society and especially MSMEs have access to and

benefit from the presence of rural banks.

The rural bank industry reported positive performance

gains (Table 9.6). Total rural bank assets in 2007

were up Rp4.7 trillion (20.4%) over the previous year’s

position to Rp27.7 trillion. This asset growth resulted

mainly from Rp3.6 trillion in credit expansion (21.2%)

to Rp20.5 trillion, in line with the Rp2.9 trillion (18.7%)

growth in depositor funds. In response, the LDR for

rural banks widened from 107.5% to 109.7%, well

ahead of the LDR for commercial banks.

Demand for credit continued to rise, despite relatively

high rates on offer. At the end of the year under review,

rates for savings deposits at rural banks were 7.6%

and for time deposits 11.6%. Although down from

the previous year, these rates remained well above

the levels offered by commercial banks. The relatively

high cost of funds borne by rural banks was also

passed on to their customers in high loan interest rates

at 22.7% per annum. However, the most important

considerations for rural banks customers when

applying for loans were speed and service, and these

customers were therefore not deterred by the relatively

high loan rates.

Rural bank lending again focused on consumption

credit. Although the majority of rural banks are located

right within rural communities, funds channelling

was still dominated by the trade sector (37.6%) and

the miscellaneous sector (44.1%). In contrast, the

agricultural sector, the primary source of livelihood for

the rural population, received only 6.5% of financing.

Lending for industry was even smaller at just 1.6%.

Credit quality at rural banks has improved. The

gross NPLs ratio at rural banks fell from 9.7% to

8.0%, although at this level, NPLs were above those

of commercial banks. The main contributor to high

NPLs was micro enterprises (78.0%), which also

accounted for the largest share of rural bank lending.

Micro enterprises are simply another expression for

the informal sector, which is highly susceptible to

business failure because of the nature of business not

supported by technology or qualified human resources.

In addition, the majority of micro enterprises operate

without formal business licences, and it is therefore

difficult to monitor business survival. Analysed by

category of use and economic sector, the most

important contribution to rural bank NPLs came from

working capital credit and credit to the trade sector.

The high capital levels at rural banks function as a

buffer to risk while also supporting more vigorous credit

expansion. Reflecting this was the rural bank CAR at

22.3%. The majority of rural banks (52.5%) operate

with Tier 1 capital in the Rp1-10 billion range, while only

16.4% have Tier 1 capital below Rp500 million. On an

individual level, 66 rural banks were unable to meet the

minimum 40% minimum paid up capital requirement

within the December 2006 deadline.

Policy for Conventional Banking

Banking policy in the year under review focused

again on promotion of the intermediary function

and strengthening of the condition or resilience of

the banking system. These policy objectives were

interrelated, given the essential importance of a

structurally robust banking system to maximizing the

banking role of lending in support of economic activity.

To achieve these objectives, policy implementation

in 2007 gave emphasis to short to medium-term and

long-term programmes.

Short to Medium Term Programme

Implementation

The following are some short to medium term policies

pursued by Bank Indonesia during 2007:

a. Provision of business data and information to

facilitate the bank intermediary function for the real

sector. To this end, Bank Indonesia launched the

National Economic Database and the Economic

Research Information Centre in July 2007.

Table 9.6

Rural Bank Performance Indicators

Indicators 2003 2004 2005 2006 2007

Number of Rural Banks 2,141 2,158 2,009 1,880 1,817

Total Asset (Billions Rp) 12,635 16,707 20,393 23,045 27,741

Depositor Funds (Billions Rp)

8,868 11,161 13,178 15,771 18,719

Credit (Billions Rp) 8,985 12,149 14,654 16,948 20,540

LDR (Loan/Deposits, %) 101.32 108.85 111.20 107.46 109.73

Gross NPL (%) 7,96 7,59 7,97 9,73 7,98

CAR (%) - - 19,34 19,50 23,38

133

technical assistance for rural bank managerial level

staff to build technical competence and hosting of

workshops for rural bank financing for productive

sectors; (v) continuation of the Apex programme2

with monitoring of Apex institutions already in

operation at the regional level and preparations

for establishment of national-level Apex institution;

(vi) research on the causes of NPLs at rural banks;

(vii) study of rural bank efficiency levels to identify

ways of building rural bank efficiency to enable

reductions in loan interest rates; and (viii) research

on unsecured rural bank loans for productive

businesses.

Long-Term Programme Implementation

The long-term programme for the banking sector is set

out in the Indonesian Banking Architecture (API). During

the year under review, implementation of API Pillar 1

reached the final preparation stage. The following is the

progress achieved on Pillar 1 during 2007: (i) successful

compliance with the Rp80 billion minimum Tier 1

capital requirement; (ii) upscaling of the linkage

program between commercial banks and rural banks

to more than 1,000 rural banks with total credit lines

of Rp3.3 trillion and piloting of cooperation between

commercial banks and cooperatives with credit lines

totalling Rp576 billion; and (iii) improvements to the loan

guarantee scheme aimed at improving access to credit

for MSMEs unable to provide loan collateral, i.e. feasible

but not bankable.

To improve the quality of banking regulation (Pillar

2), banking research institutions were established at

the regional level. During 2007, four regional banking

research institutions were set up in collaboration

with four higher educational institutions: Brawijaya

University, North Sumatera University, Hasanudin

University and Andalas University. Research findings

from the individual institutions will be incorporated into

the policy making for strengthened intermediation at the

regional level.

Improvement in the oversight function (Pillar 3) was

achieved through reorganisation of the banking sector

at Bank Indonesia and improvements to the system

for risk-based supervision. Internal consolidation

in the bank supervision units included the setting

up of specialist supervisor groups, liaison officers

2 Umbrella institutions for providing bridging funds for rural banks experiencing liquidity difficulties due to mismatch.

b. Facilitation of mergers in support of the bank

consolidation programme, focusing on compliance

with the minimum capital requirement.

c. Amendment to regulatory content and clarified

interpretation of some previously issued regulations.

This policy emphasizes the risk management

capability in the banking system in extending

and evaluating credit rather than fulfilment of

requirements. It is now possible for various

requirements for assessment of loan collectibility,

now regarded as burdensome, to be waived insofar

as banks have a proper understanding of their

risk exposures and are ready with the necessary

mitigation measures.

d. Regulation of bank employment of expatriates in

order to build competence and ensure greater

opportunity for Indonesian employees. Employment

of expatriates in middle management positions is

restricted to two levels below the board of directors,

unless it can be proved that a position cannot

be filled by local staff. In such a case, expatriate

contracts are restricted to a maximum of 3 years.

e. Active development of the domestic financial market

and expansion of available instruments, such as:

(i) new regulations released to support Treasury

Note issues; (ii) creation of larger market for longer-

term SBIs; (iii) provision of effective regulatory

environment for development of broader range of

products and markets encompassing medium term

notes, corporate bonds and commercial papers;

and (iv) greater opportunity for activities related

to asset securitization, universal banking and

development of sharia-compliant instruments.

f. Rural bank industry development targeting

improved competitiveness, expanded service

coverage and increased rural bank financing for

the MSME sector. Specific actions in support of

this policy include: (i) improvements to rural bank

regulatory framework; (ii) more effective supervision

with launching of the Rural Bank Supervision

Information System and online reporting by rural

banks; (iii) institution building for rural banks through

continuation of the rural bank industry restructuring

policy; (iv) capacity building for rural banks through

promotion of the Professional Certification (CERTIF)

Programme for rural bank directors, provision of

134

and transfer of licensing for bank office networks.

To support the risk-based supervision system, draft

guidelines were prepared for loan sampling and

improvements were made to the judgement mechanism

in the Supervision System (SIMWAS) application. In

addition, work was completed on the study for the

Bank Supervision System Blue Print, which identifies

issues in the bank supervision system and contains

recommendations for improvements to the regulatory

framework, supervision framework and management of

supervision resources.

Further progress took place in risk management

certification and good corporate governance (GCG)

to strengthen the quality of bank management and

operations (Pillar 4). During 2007, risk management

certification examinations were held for 12,865 level 1,

4,267 level 2 and 829 level 3 participants, with 9,024,

1,874 and 416 participants awarded passing grades. To

pave the way for GCG, discussions were held on how

best to implement GCG in the banking system with

participation from banks, associations, institutions and

non-government organizations involved in GCG.

Development of banking infrastructure (Pillar 5)

focused on development of the Credit Bureau. In

2007, discussions were held on the final draft road

map for the development of Credit Bureau. In addition,

Bapepam-LK, the capital market and financial

institutions supervisor, and Bank Indonesia signed a

memorandum of understanding on collaboration in the

operation of the Debtor Information System (SID) for

financing institutions.

The programme for enhanced consumer protection

(Pillar 6) focused on improvements in the complaints

mechanism, mediation and public education. During

the year under review, Bank Indonesia developed a

program for automated online reporting of customer

complaints to Bank Indonesia, slated for use in early

2008. In addition, the banking mediation function

performed by Bank Indonesia will end on 31 December

2007 and will be taken forward by a banking mediation

agency established by banking associations. However,

because banking associations are not currently in

a position to take over the mediation tasks, Bank

Indonesia will retain this function until the banking

associations have achieved the required readiness.

In the area of public education, Bank Indonesia

cooperated with the Banking Education Working

Group in the launching of the national public education

campaign on banking in November 2007.

MSME Credit Policy

Bank Indonesia has worked consistently to support the

development of micro, small and medium enterprises

(MSMEs). MSME development activities during the year

under review include technical assistance, provision

of information and research. Technical assistance was

provided in the form of training sessions for bankers

and Business Development Service Provider (BDSP)

and the MSME Development Pilot Project programme.

The pilot project involves a cluster approach as a

key strategy in upstream-downstream linkages in

commodity-based industries, with this approach

applied to leading products in 6 regions3. At the

same time, provision of information involves mainly

the organisation of intermediation bazaars, seminars,

talk shows and public awareness campaigns and

uploading of the Small-Scale Business Information

System (SIPUK) in the Indonesian Business Information

Database (DIBI). Research activities in support of

MSME development to date includes: (i) identification

of regional and central government regulations

related to MSME development; (ii) identification and

development of mainstay products in the MSME

sector; (iii) identification of lending models with potential

for development; and (iv) database on MSMEs with

potential for bank financing, disseminated on a website.

The results of this research can be used as a baseline

for MSME development policy and strategy and

provision of recommendations to the government and

particularly regional governments.

Sharia Banking

Sharia banking has taken on an expanding role within

the national economy. Despite a second quarter

downturn in the growth of sharia banking from the

knock-on effects of higher fuel prices among some

sections of society, the sharia banking industry

reported improved growth for the year overall. The

sharia banking industry reported stronger performance

in both funds mobilisation and financing, in so doing

widening its share of national economic activity.

3 Serdang Badagai Regency (cassava), Pandeglang Regency (melinjo crackers), Bandung Regency (paprika), Sukoharjo Regency (rattan furniture), Mojokerto Regency (footwear) and Central Lombok Regency (seaweed).

135

the preceding year to Rp36.5 trillion. The increased

business volume saw the share of sharia banking

assets to total banking assets in Indonesia improve

from 1.6% at end-2006 to 1.8% at end-2007.

Growth in depositor funds held at sharia banks in 2007

was driven by rising numbers of customers. Office

network expansion proved successful in attracting

significant numbers of new customers. During 2007,

customer accounts increased by 853,777, of which

97.7% were held by individuals and 2.3% by corporate

customers. Funding growth was also bolstered by

competitive profit sharing returns, which stimulated

public interest in placing funds in sharia banks.

Depositor funds held at sharia banks increased by

Rp7.3 trillion (35.3%) over the preceding year to Rp28.0

trillion. As a result, the share of sharia bank depositor

funds in the national banking system improved from

1.6% at end-2006 to 1.9% at end-2007.

Performance of Sharia Banks

During 2007, sharia banking office networks underwent

significant expansion. Key milestones were the

establishment of 9 sharia rural banks, opening of 6

sharia Divisions at conventional banks and network

expansion totalling 66 offices (including cash offices,

sub-branch offices and sharia service units) (Table 9.7).

In addition, the decision to allow office channelling

provided a significant boost to business volume in the

sharia banking industry. This is indicated by the almost

tripling of sharia service outlets from 456 offices to

1,195 offices at end-2007. Sharia bank office networks

also expanded their outreach to over 70 regencies

and municipalities in 31 provinces. The office network

expansion is an indication of the strong need or

demand in society for sharia financial services.

Sharia banks made considerable strides in 2007, as

indicated by key performance indicators. The improved

performance was closely related to network expansion

by sharia banks during the year under review that

paved the way for funds mobilisation and financing.

Growth in depositor funds reached 35.5%, while

disbursed financing mounted by 36.7% (Chart 9.5).

With disbursed financing expanding more rapidly than

depositor funds, the sharia bank financing to deposit

ratio (FDR) widened from 98.9% to 99.8%. With

these achievements, business volume in the sharia

banking industry climbed Rp9.8 trillion or 36.7% over

Table 9.7

Sharia Banking Offices

2003 2004 2005 2006 2007

Sharia Commercial Bank (SCB)

2 3 3 3 3

Sharia Business Unit (SBU) 8 15 19 20 26

Sharia Rural Bank 84 88 92 105 114

Number of SCB & SBU 253 355 458 531 597

Number of Sharia Service Unit

– – – 456 1,195

Table 9.8

Composition of Sharia Banking Depositor Funds

DescriptionsTotal (Billions Rp) Growth (%) Share (%)

2005 2006 2007 2006 2007 2006 2007

Wadiah Deposits 2,045 3,416 3,750 67.00 9.80 16.52 13.39

Mudharabah Savings 4,371 6,430 9,454 47.13 47.02 31.11 33.75

Mudharabah Deposits 9,166 10,826 14,807 18.11 36.77 52.37 52.86

Total 15,582 20,672 28,012 32.66 35.50 100.00 100.00

136

The funding structure in sharia banks was again

dominated by mudharabah (investment) deposits.

Unlike in past years, funding growth saw a shift

towards mudharabah-based deposits. Growth in

wadiah demand deposits plunged from 67% in 2006

to 9.7% in 2007 while expansion in mudharabah

deposits mounted dramatically from 18.1% to 36.4%.

The sharply reduced wadiah growth narrowed the

share of these deposits from 16.5% of total funds

to 13.4%, in contrast to the expanding share of

mudharabah deposits (Table 9.8). Analysed by tenor,

the mudharabah deposit structure also shifted in favour

of longer-term funds.

The predominant share of investment funds in the

funding composition may mitigate liquidity risks in

sharia-compliant banking. Potential for liquidity risks

is related primarily to fluctuation in funds held by

corporate depositors, most of which are sensitive

to the competitiveness of offered profit sharing.

Corporate depositors account for a very large share

of deposits (44.4% of total depositor funds) even

though representing a very small number of customer

accounts (2.3%).

Healthy progress was achieved in the financing

channelled by sharia banks. In 2007, sharia bank

disbursed financing grew by Rp7.5 trillion or 36.7%

to Rp27.9 trillion, bringing the share of sharia bank

financing within overall national bank lending to 2.7%.

This rate of disbursed financing growth was well ahead

of credit expansion in the conventional banking system,

underscoring the growing sharia banking contribution

to financing in the real sector. This positive contribution

Table 9.9

Sharia Financing

DescriptionsTotal (Billions Rp) Growth (%) Share (%)

2005 2006 2007 2006 2007 2006 2007

Musyarakah 1,898 2,335 4,406 23.0 88.7 11.4 15.8

Mudharabah 3,124 4,062 5,578 30.0 37.3 19.9 20.0

Murabahah Receivable 9,487 12,624 16,553 33.1 31.1 61.7 59.2

Istishna Receivable 282 337 351 19.6 4.2 1.6 1.3

Qardh Receivable 125 250 540 100.6 115.6 1.2 1.9

Ijarah 316 836 516 164.7 (38.3) 4.1 1.8

Total 15,232 20,445 27,944 34.2 36.7 100.0 100.0

137

Despite some levelling in earnings growth, return on

assets (ROA) remained strong at 1.78%, above the

1.55% recorded in the preceding year. The reduced

earnings growth is explained by the expanded

proportion of operating revenues allocated to

depositors to improve profit sharing and sustain

competitiveness. Added to this, sharia banks increased

their loss provisioning in anticipation of financing risk

in order to maintain capital levels above the minimum

capital adequacy requirement.

Sharia Rural Banks

Sharia rural banks, which as financial institutions

offer services to low-income groups, have also seen

rapid growth. The network coverage of these banks

expanded further with the addition of 9 new sharia

rural banks, bringing the total to 114. Strengthened

by this network expansion, business volume mounted

Rp300.9 billion (33.2%) to Rp1,207.2 billion, with sharia

rural banks widening their share within the national rural

is also supported by the considerable portion of MSME

financing at Rp19.6 trillion or 70.0% of total financing

extended by sharia banks. Analysed by sector,

financing growth is dominated by business services,

trade and construction.

The murabahah contractual arrangement retains

its lead in sharia-compliant financing, despite

some decline in overall share. Murabahah financing

underwent 31.1% expansion in 2007, slightly less than

the 33.1% recorded in the previous year, with the

share in overall financing narrowing to 59.2%. On the

other hand, musyarakah and mudharabah financing

expanded by a robust 88.7% and 37.3% (Table 9.9),

bringing the share of musyarakah and mudharabah

to 15.8% and 20.0% respectively. Key to growth in

the musyarakah profit-share financing was the sharia

bank financing operated in cooperation with micro and

small-scale financial institutions such as sharia rural

banks, cooperatives and sharia financial cooperative

trusts (baitul maal wa tamwil or BMT). This growth is

indicative of the preference in sharia banking for profit-

sharing based financing, which carries higher risk than

other forms.

Non performing financing at sharia banks eased

mainly as a result of restructuring. From early 2006,

the non-performing financing (NPF) ratio mounted to

a high of 6.3% in Q3/2007 (Chart 9.6) due to sluggish

economic conditions. This downturn in financing

quality took place in the manufacturing, transportation

and construction sectors (Chart 9.7). Despite this, the

various actions pursued by sharia banks to reduce non-

performing financing through restructuring succeeded

in lowering the ratio to 4.1% in 2007, down from 4.8%

one year earlier.

Increased risks in funds mobilisation and channelling

were adequately offset by anticipatory measures.

Table 9.10

Sharia Rural Bank Performance Indicators

Key Indicators 2005 2006 2007 ∆ 2007

Total Asset (Billions Rp) 605.0 906.3 1.207.2 33.2%

Depositor Funds (Billions Rp) 353.6 530.2 711.3 34.2%

PYD (Billions Rp) 435.9 636.3 879.7 38.3%

Ratio:

FDR (%) 123.3 120.0 123.7 3.67

NPF Gross (%) 10.6 8.3 8.0 -0.31

NPF Net (%) 9.5 7.1 6.6 -0.47

Tabel 9.11

Sharia Rural Bank Financing

Category 2005 2006 2007 ∆ 2007

Category of Financing (Billions Rp)

a. Murabahah Receivable 355.9 524.0 717.30 36.9%

b. Mudharabah Financing 24.5 26.8 42.17 57.1%

c. Musyarakah Financing 40.1 65.3 96.48 47.8%

d. Others 15.4 19.6 38.49 96.8%

Financing Classifications (Billions Rp)

a. Micro (Rp0-Rp50 million) 297.6 418.0 583.80 39.7%

b. Small (Rp50 million- Rp500 million)

121.7 178.8 263.10 47.1%

c. Others 16.4 39.5 47.53 20.4%

Category of Use (Billions Rp)

a. Working Capital 252.6 378.8 506.49 33.7%

b. Investment 50.2 78.6 126.80 61.4%

c. Consumption 132.9 178.8 261.14 46.1%

Economic Sector (Billions Rp)

a. Agriculture 12.1 41.0 26.45 -35.5%

b. Mining 0.1 0.5 1.18 142.7%

c. Manufacturing 9.4 12.5 13.61 9.2%

d. Electricity, Gas and Water 0.1 0.7 0.56 -25.5%

e. Construction 3.5 6.6 18.59 182.9%

f. Trade, Restaurants and Hotels

195.8 254.2 322.63 26.9%

g. Transportation and Communication

3.6 8.7 8.71 0.0%

h. Business Services 49.5 72.2 114.14 58.2%

i. Social Services/Public 5.2 5.6 10.81 91.9%

j. Others 156.2 233.7 377.77 61.6%

138

bank industry to 4.2%. Funds mobilisation was also

up at Rp711.3 trillion, while financing disbursements

increased to Rp879.7 billion (Table 9.10), bringing

the Financing to Deposit Ratio (FDR) to 123.7%.

Financing quality also improved, as indicated by the

drop in the NPFs ratio, gross and net, to 8.0% and

6.6%, respectively.

The preferred financing arrangements for these banks

are sale and purchase under the murabahah agreement

and musyarakah profit-sharing. Both types of financing

are used primarily to meet the customer needs for

working capital. Murabahah was again the dominant

financing arrangement with an 80.2% share, followed

by musyarakah and mudharabah-based financing at

10.8% and 4.7%, respectively (Table 9.11). Murabahah

financing generally involves amounts smaller than Rp50

million used for purchases of consumer goods, such as

motor vehicles and homes, by micro and small-scale

entrepreneurs.

Sharia Banking Development Policy

Bank Indonesia has formulated a plan for building

capacity in the sharia banking industry through

accelerated development of sharia-compliant banking

under the guidelines of the Blue Print for Development

of Indonesian Sharia Banking (Box: Grand Strategy for

Sharia Banking Development under the Accelerated

Sharia Bank Development Programme). The objectives

of building service capacity are aligned to the target for

accelerated growth in sharia banking to achieve a 5%

share of total national banking volume at end-2008. In

essence, the accelerated sharia banking development

programme simultaneously targets both supply side

and demand side.

Supply Side Reinforcement Programme

To build expertise in sharia compliance and other

technical areas, technical assistance is provided in

the form of a certification programme for sharia rural

bank directors, upgrading of sharia bank management

and preparation of a textbook on Sharia Economics.

During 2007, the certification programme was held for

2 intakes of a total of 53 sharia rural bank directors,

in addition to the sharia bank management upgrading

programme to meet the personnel needs for office

channelling. In a further effort to improve the quality

of university-level graduates joining sharia banks, a

textbook on Sharia Economics was developed to

support teaching processes for sharia-compliant

economics, finance and banking.

Bank Indonesia has encouraged the opening of office

channelling as a means of expanding network coverage

for sharia-compliant banking services. In 2007, office

channelling services were expanded beyond deposit

taking for customers to include financing.

Part of the effort to broaden the range of financial

services offered by sharia banks involves the

compilation of a book codifying sharia-compliant

banking products. In 2007, a codified book was

prepared with information on various sharia banking

products available on the domestic market as reference

material for sharia banks in expanding their range of

financial products.

Demand Side Reinforcement Programme

This programme involves the following actions.

a. Public awareness of sharia banking. The public

awareness programme takes place in various

forums with involvement of many different

stakeholders, including bankers, academics and

the general public. In 2007, a public awareness

campaign was launched for the sharia banking

industry, using information media such as television,

radio, newspapers and other promotional media.

b. Operation of the linkage program as part of the

development of the sharia banking industry. The

objective of the linkage program is to strengthen the

interaction between sharia banks and the business

sector. In 2007, the linkage program was replicated

in the form of training for trainers of MSME for sharia

bank managers, local government officials and

relevant NGOs in Cilegon and Yogyakarta.

c. Appeal to Government for active involvement in the

development of the national sharia banking industry.

One message conveyed to the Government calls for

greater engagement with sharia banks in financing

Government projects and managing Government

sources of funds in the sharia banking system.

d. Improvements to laws and regulations to promote

the development of sharia banking. During the

year under review, consultations were held on

amendments to taxation regulations, including the

139

(Chart 9.8). This achievement placed the Indonesian

Stock Exchange (IDX)4 as the third best performing

stockmarket in Asia Pacific, after Shenzhen (164%)

and Shanghai (98.4%). In fact, the IDX Composite

Index touched a level of 2,811 points in the second

week of December 2007, representing an all-time high

in the history of the Indonesian capital market, before

sustaining correction. Analysed by sector, the most

important contribution to IDX index gains came from

the mining, agriculture and property sectors. Total value

of share transactions also climbed significantly from

Rp445.7 trillion to Rp1,050.1 trillion (135.6%). The index

gains and vibrant trade resulted in a 59.2% increase in

market capitalization to Rp1,988.3 trillion, with the share

of the capital market to GDP rising from 37.4% to 57.0%

at end-2007.

The buoyant performance of the capital market was

supported by improvement in domestic and external

factors. Domestic factors behind the steep index

growth include the cumulative 175 bps cut in the BI

Rate during 2007 and progressive improvement in

macroeconomic indicators. Inflation was subdued

and in decline, international reserves were strong

and economic growth on the rise. At the micro level,

stock exchange-listed companies reported stronger

performance with substantially improved earnings,

especially in Q3/2007. Expectations of earnings growth

4 Formed from the merger of the Jakarta Stock Exchange (JSX) and Surabaya Stock Exchange (SSX), officially commencing operation on 1 November 2007.

imposition of value added tax on products based

on the sale-and-purchase principle. Work also

progressed on the draft Sharia Banking Law and

draft Sharia Treasury Note Law, both of which are

strategic to the future development of the national

sharia banking industry.

e. Promotion of the voluntary sector programme.

This programme has been launched to boost the

potential role of the sharia banking industry in

the social sector, with the Sharia Banking Social

Care programme (Perbankan Syariah Peduli Umat

or PSPU) working in cooperation with existing

charitable institutions managing ZISWaf (Zakat,

Infaq, Sadaqah and Waqaf) funds. This programme

is envisaged as a means of building public

recognition of the benefits of the sharia banking

industry for the public and lower income groups in

particular. In 2007, management of social aid funds

widened by Rp12.6 billion to Rp40.1 billion, with ZIS-

based social assistance at Rp33.3 billion and qardh

(loan) based social aid funds at Rp6.8 billion.

Capital Market and Other Financial

Institutions

The Capital Market

The capital market recorded significant gains in 2007,

building on the achievements of the preceding year. At

end-2007, the IDX Composite Index stood at 2,745.8

points, up 940.3 points (52.1%) from the preceding year

140

for mining and agricultural companies in particular

soared due to escalating commodity prices on the

international market. The improvement in macro and

micro factors boosted market optimism, with capital

market liquidity climbing from Rp1.8 trillion to Rp4.3

trillion per day.

Analyzed by external factors, gains on Indonesia’s

capital market were driven by renewed positive

sentiment on international and regional stock

exchanges. Although global markets in 2007 were

rocked by the US subprime mortgage crisis, the

bursting of the asset bubble in China and soaring

international oil prices, response by global authorities

to the crisis restored market optimism, paving the way

for renewed stock index growth. The Indonesian Stock

Exchange bounced back on index gains in the United

States and China, which bolstered the Hangseng,

Straits Times and other regional indices, with the IDX

index mounting to an all-time high (Chart 9.9). Also

fuelling index performance were the attractive levels of

the price earnings ratio (PER) in Indonesia compared to

other emerging markets in Asia.

During 2007, the capital market recorded fresh rounds

of heavy buying by foreign investors. The net foreign

purchase on the stock market reached Rp32.6 trillion,

a rise of 88.8% over Rp17.3 trillion in the previous year.

At the same time, share ownership by foreign investors

mounted from Rp522.3 trillion at end-2006 to Rp790.8

trillion at end-2007. Heavy foreigner buying, while

encouraged by improving macroeconomic indicators

and corporate performance, was also fuelled by global

excess liquidity in search of outlets for investments on

emerging markets. On the IDX, foreigner buying spree

was hardly dented by the subprime mortgage crisis.

Foreigner net purchase continued unabated amid

downward pressure on the index from the subprime

mortgage crisis, with activity spurred by relatively

low stock prices (Chart 9.8). Domestic investors also

followed suit, pushing the IDX composite index to even

higher levels.

141

Companies moved quickly to take advantage of the

surging stock market performance and keen demand

to raise funds for investment and business expansion.

During 2007, the number of IPOs mounted 100%

from 12 to 24 companies with the value of IPO shares

soaring from Rp3.0 trillion to Rp17.2 trillion (471%). In

addition to IPOs, 25 companies held right issues with

a total issue value of Rp29.8 trillion. This represents a

significant increase over the preceding year, when 16

companies floated rights for Rp9.8 trillion. Accordingly,

the total value of shares issued during 2007 reached

Rp47 trillion (Chart 9.10).

The Bond Market

Like the capital market, the government bond market

gained in volume and frequency of transactions.

Trading volume in government bond climbed 80.1%

to Rp1,468.4 trillion in 2007 from Rp815.1 trillion in the

preceding year (Chart 9.11), driven in part by additional

issues of government securities. During 2007, the

Government held 24 government bond auctions,

including initial offerings and reopenings, besides 3

auctions of treasury notes, netting a total of Rp70.7

trillion. Added to this, the government held 3 auctions of

Indonesia Retail Bonds (ORI), raising a total of Rp15.6

trillion. One successful innovation by the Government

was the issuance of zero coupon (ZC) bonds in 3

auctions. An added factor in the higher trading volume

was escalating frequency of transactions, reflecting

high demand for government bond. Government bond

transactions mounted in frequency by 84.7% from 35.7

thousand transactions in 2006 to 66 thousand in 2007.

Non-residents were again the largest net buyers of

government bond, followed by mutual funds and

insurance companies (Chart 9.12). The high rate of

capital inflows during 2007 resulted in a net foreign

purchase of Rp23.7 trillion. At the same time, net

purchases by mutual funds and insurance companies

reached Rp7.6 trillion and Rp6.7 trillion. Recovery

of investor confidence in mutual fund products

strengthened demand for government bond, with

mutual funds ranking second as net buyer. Following

from the trend the year before, non-recapitalized banks,

recapitalized banks and securities houses recorded net

sales on the government bond market at Rp30.5 trillion,

Rp10.8 trillion and Rp6.0 trillion.

Despite volume trailing that of government bonds, the

corporate bonds market also recorded significant gains.

Increased trading activity in corporate bonds, as on

the capital market and government bond market, was

fuelled by growing investor confidence on the strength

of improved macroeconomic indicators and keen

demand driven by excess liquidity. Some companies

took good advantage of these conditions to launch

public offerings of corporate bonds. During 2007, 39

companies issued bonds worth a total of Rp31.3 trillion

142

(Chart 9.13), significantly more than in the previous year,

when only 14 companies issued bonds for a total value

of Rp11.5 trillion.

Of the total bond issue, Rp1.03 trillion or 3.3%

consisted of sharia bonds issued by 4 companies. At

this level, sharia bond issues were up 413% over Rp0.2

trillion in 2006, when only one company issued these

bonds. Since coming on the market in 2002, sharia

bonds have been issued 21 times for a total of Rp3.2

trillion, or 2.5% of total bonds issued on the market.

Mutual Funds

The mutual funds market gathered renewed momentum

as the stock and bond markets forged gains. Net Asset

Value (NAV) at the end of 2007 reached Rp92.2 trillion,

a rise of 76.4% over Rp52.3 trillion in 2006 (Chart 9.14).

The rise in NAV was related to the increased prices

of underlying securities, most importantly shares,

and expanded net subscription. The year 2007 saw

the launching of 70 new mutual funds, with the total

climbing from 399 to 469 mutual funds (17.5%). Fixed

income funds again predominated with a market share

of 35.3%, followed by protected funds at 24.1%, mixed

funds at 21.8% and equity funds at 11.6%. Other

factors supporting the rise in NAV included redoubled

efforts to educate potential investors and more

balanced perceptions of risk between mutual funds and

bank deposits, following the scaling back of guarantees

by the Indonesian Deposit Insurance Corporation (LPS).

In 2007, four sharia mutual funds received statements

of effective registration, bringing the overall number of

sharia mutual funds to 25, or 5.7% of the total mutual

funds on the market. NAV held by sharia mutual funds

soared 206.5% to Rp2.1 trillion from the previous Rp0.7

trillion. As a result of this expansion, the share of NAV

held by sharia mutual funds widened from 1.3% to

2.4% at the end of 2007.

Multifinance Companies

Multifinance companies charted renewed gains in

2007 on the strength of private consumption. Despite

some reduction in the overall number of multifinance

companies, total assets and turnover improved

significantly (Table 9.12). Total assets during the year

under review reached Rp127.3 trillion, a rise of 16.9%

over the previous year. At the same time, business

turnover mounted 15.6% to Rp107.7 trillion. Like before,

business conducted by multifinance companies was

dominated by consumer financing at Rp67.6 trillion,

or 62.7% of total turnover, and leasing at Rp36.5

trillion (33.9%).

Table 9.12

Performance of Finance Companies

DescriptionsPosition (Trillions Rp) Growth (%)

2005 2006 2007 2006 2007

Number of Companies1) 236 214 205 (9.32) (4.21)

Total Assets 96.5 108.9 127.3 12.81 16.87

Business Turnover 67.6 93.1 107.7 37.67 15.64

Leasing 19.1 32.6 36.5 71.05 11.76

Factoring 1.4 1.3 2.2 (7.80) 69.10

Credit Cards 1.8 1.5 1.4 (16.22) (2.37)

Consumer Finance 45.4 57.7 67.6 27.14 17.09

Source of Funds:

Bank Loans 49.2 55.0 66.4 11.66 20.73

– Domestic 25.0 29.8 36.7 19.09 23.06

– Foreign 24.2 25.2 29.7 3.96 17.96

Other Loans 11.6 10.2 10.5 (12.01) 3.05

– Domestic 4.5 3.4 3.8 (24.41) 13.86

– Foreign 7.1 6.8 6.7 (4.22) (2.32)

Bonds Issuance 10.2 10.1 12.8 (0.83) 27.33

Capital2) 15.2 19.0 24.5 25.22 28.90

Current Year Profit (Loss) 3.5 3.1 4.4 (10.04) 39.791) Number of companies submitting reports.2) Consists of paid in capital, premium, reserves, holding profit, and current year profit.Source: Ministry of Finance

143

In terms of funding structure, the primary source of

funding for multifinance companies is bank loans. Bank

loans in 2007 totalled Rp66.4 trillion, representing

58.1% of total funding. Of this total, Rp36.7 trillion

(55.3%) consisted of borrowings from domestic

banks and the remainder from overseas banks. At the

same time, the proportion of funding from issuance

of securities, other borrowings and additional capital

reached 41.9%. With domestic and foreign interest

rates in decline, multifinance companies expanded

their bank borrowings by 20.7% from Rp55 trillion to

Rp66.4 trillion.

Insurance Companies

Insurance companies reported significant performance

gains in 2007 alongside a general improvement in

efficiency. The overall number of insurance companies

has steadily declined since 2003 (Chart 9.15). Over

a period of 4 years, the number of companies fell

14.5% from 173 to 148, divided into 46 life insurance,

93 general insurance, 4 reinsurance companies and a

further 5 companies operating in social insurance and

insurance for workers, military personnel and police.

However, the reduction in number of companies did not

adversely impact insurance industry performance. As of

144

September 2007, total insurance industry assets were

up significantly at Rp198 trillion compared to the 2003

position of Rp94.1 trillion, a rise of 110.4%. Similarly,

total assets held by commercial insurance companies

(life insurance, general insurance and reinsurance)

mounted 137.6% from Rp50.1 trillion in 2003 to

Rp119.1 trillion.

As part of the overall growth in sharia financial

institutions, more sharia insurance companies have

come on the market. At the end of 2007, Indonesia

reported 3 sharia insurance companies, 32 sharia

insurance branch offices and 3 sharia reinsurance

branch offices. Total assets managed by sharia-

compliant insurance companies in September 2007

reached Rp1.4 trillion, a 46.5% increase over Rp1.0

trillion in the preceding year. Through this, the share of

sharia-compliant insurance assets in total insurance

industry assets widened to 1.2%.

Insurance company investments were dominated

by government bond portfolios and time deposits.

A noteworthy development in insurance industry

investment behavior is the growing interest in

investment in government securities. During the

past five years, government securities portfolios

expanded by Rp35.5 trillion from Rp6.5 trillion at

end-2002 to Rp42.0 trillion in October 2007, while

time deposits were up only Rp9.5 trillion from Rp31.0

trillion to Rp40.5 trillion. The predominance of time

deposits in investment portfolios has thus given way to

government securities, as reflected in the 103.8% ratio

of government securities to time deposits (Chart 9.16).

This change in the investment behavior of insurance

companies has fuelled growth in the government

securities market and indirectly contributed to reduction

of excess liquidity in the banking system.

Pension Funds

Pension funds have also made impressive strides.

Total net assets in the pension funds industry have

maintained a consistent upward trend, despite the fall

in numbers of pension fund operators since 2002. As

of November 2007, pension fund operators totalled 288

companies, down 16% from 343 companies in 2002. At

the same time, total net assets held by pension funds

grew by an estimated 20% to about Rp93.0 trillion.

At this level, net assets value was up 125.6% over the

Rp41.2 trillion position recorded in 2002 (Chart 9.17).

Pension fund investment portfolios, like before, were

dominated by time deposits and bonds, comprising

both government and corporate bonds. Pension funds

have followed an almost identical pattern of behaviour

as insurance companies, starting out by relying heavily

on time deposits, which accounted for 70% of fund

placements. However, from 2003 the proportion of time

deposits progressively declined to the end-2006 level

of 28.6% (Chart 9.18). During this time, bond portfolios,

consisting mainly of government securities, expanded

significantly bringing government securities portfolios

almost on par with time deposits. This is a heartening

development, given the enormous potential for bond

market investments by pension fund as managers

of long-term funds for the public. As such, pension

funds are expected to become major players on the

government securities market.

Policy for Capital Market and Other Financial

Institutions

Following the guidance in the Indonesian Capital

Market Master Plan, capital market policy will continue

to emphasise improvements in infrastructure, efficiency,

competitiveness and oversight. In 2007, the Jakarta

Stock Exchange (JSX) merged with the Surabaya

Stock Exchange (SSX) to form the Indonesian Stock

Exchange (IDX). The merger has not only strengthened

synergy and efficiency in capital market activities,

but is also expected to boost the capacity and

competitiveness of the Indonesian capital market. In a

parallel move, further revisions were made to the draft

law on Amendment to the Capital Market Law to bring

it into line with the draft law on the Financial Services

Authority. In the area of oversight, further improvements

were made to examination and compliance testing for

securities houses.

To strengthen investor confidence, policy also seeks to

improve transparency and good corporate governance.

During the year under review, a regulation was issued

on deadlines for periodical financial statements issued

by listed companies5 in a move designed to ensure

access to information and disclosure. To strengthen

good governance in the mutual funds industry, changes

were made to regulations related to management of

5 Regulation of the Capital Market and Financial Institutions Supervisory Agency (Bapepam-LK) Number X.K7 concerning Deadlines for Release of Period Financial statements and Annual Reports by Public Companies Listed on Stock Exchanges in Indonesia and on Stock Exchanges in Other Countries, Appendix to Decree of the Chairman of Bapepam-LK Number Kep-40/BL/2007 dated 30 March 2007.

145

mutual funds set up as collective investment contracts.

At the same time, to improve the quality of pension

fund financial statements6, a regulation was issued

on Pension Fund Technical Reports. This regulation

focuses on disclosure of pension fund technical data

and information and strengthening the effectiveness

and efficiency of supervision.

New instruments were developed for the deepening

of the financial market. During 2007, two regulatory

packages were issued as a legal foundation for

issuance of new instruments. The first package was

for issuance of municipal bonds. Besides enriching the

diversity of financial market instruments, the issuance of

municipal bonds will also provide a financing alternative

for regional development. The second regulatory

package deals with the issuance of Real Estate

Investment Funds set up as Collective Investment

Contracts (DIRE KIK).

Further progress took place in the development of

the sharia financial market. Since the year under

review, Bapepam-LK, the capital market and financial

institutions supervisor, began regularly issuing the

Sharia Securities List7 as a guide for fund management

by sharia mutual funds. New policies were also issued

to encourage the establishment of sharia multifinance

companies. Two regulations were issued to set out

the legal basis for sharia multifinance activities and

the standardized sharia contractual arrangements

(akad) to be used in these activities8. At the same

time, to support the issuance of sharia bonds (sukuk),

Bapepam-LK completed a study on accounting

treatment for the sukuk ijarah and sukuk mudharabah

instruments.

6 Minister of Finance Regulation Number 100/PMK.010/2007 dated 5 September 2007 concerning Pension Fund Technical Reports.

7 Bapepam-LK Regulation Number II.K.1 concerning Criteria and Publication of the Sharia-Compliant Securities List, Appendix to Decree of the Chairman of Bapepam-LK Number: Kep-314/BL/2007 dated 31 August 2007.

8 Bapepam-LK Regulation Number II.K.1 concerning Activities of Multifinance Companies Based on Sharia Principles and Regulation Number Per-04/BL/2007 concerning Sharia Contractual Arrangements (Akad) for Use in Activities of Multifinance Companies Based on Sharia Principles.

Insurance industry policy was focused on

improvements in quality of corporate management.

In one action to strengthen the integrity and quality

of board of directors and board of commissioners of

insurance companies, improvements were made to the

regulation on the fit and proper test9. Other activities

aimed at expanding business volume in the insurance

industry include: (i) public education and awareness

raising; (ii) development of insurance products; and (iii)

improvement in marketing strategy for bancassurance.

9 Minister of Finance Regulation Number 78/PMK.05/2007 dated 24 July 2007 concerning the Fit and Proper Test for Directors and Supervisory Directors of Insurance Companies.

146

The sharia banking market has enormous potential

for expansion. Reflecting this are the more than 80

million accounts held by public users of banking

services at conventional banks. In response, Bank

Indonesia launched the initiative of the Sharia Banking

Acceleration Programme, subsequently followed by the

“iB Campaign 2008” programme. In this programme,

Bank Indonesia invites all actors in the sharia banking

industry to synergise their public education and

information campaigns in order to build greater public

awareness of the existence of sharia banks and

stimulate public interest in the use of sharia banking

products and services. Ultimately, a successful public

information programme will contribute enormously to

the achievement of the acceleration targets.

This expansion calls for judicious market positioning of

the sharia banking industry for penetrating a broader

market segment in order to expand the customer base

from the current level of 3 million accounts.

Within the context of competitive strategy, the

entrenched position of the conventional banking

system with its massive economy of scale calls for

more innovative response from the Islamic banking

sector. A market driven strategy imitating conventional

banking products will generate only a similar range of

sharia banking products without clear differentiation,

preventing the public from visualizing their added value.

The consequence of this will be lukewarm appeal to

members of the public to try out the use of sharia

banking products. Faced with two similar products,

public users of banking services, which make up the

target market1, will tend to react indifferently and lean

in favour of well-established products. In the long run,

1 “Nielsen Consumer Insight,” the Nielsen Company and Bank Indonesia. November 2007. Data from The Nielson indicates that the profile of the target market for banking products and services in Indonesia lies in the more optimistic sections of the population with material comforts and modern lifestyles.

market-driven strategy will likewise not yield any lasting

comparative advantage for the sharia banking system2.

Given the specific nature of the system that sets it

apart from conventional banking, sharia banking

is in fact able to position itself as a market driving

industry shaping the market in its own right according

to the unique advantages inherent in the system3.

Development of the market driving strategy involves

two major phases, capacity building for innovation in

the initial strategy development and value proposition

to the target market in the subsequent phase of

strategy implementation. Capacity building for

innovation is closely intertwined with the development

of personnel competencies and an organizational

culture that supports and rewards creative processes

and encourages experimentation and out-of-the-box

thinking in the product innovation process. The ability to

anticipate market needs and capture unspoken needs

in the target market must be given leading priority in

product development4 in order to develop products

that do not merely satisfy needs, but can also guide

target market behaviour and form a market structure

appropriate to the advantages of sharia banking.

2 Johnston, Lean L., Ruby Pui-Wan Lee, Amit Sani and Bianca Grohmann, 2003. “Market-focused Strategic Flexibility: Conceptual Advances and an Integrative Model.” Journal of the Academy of Marketing Science 31 (1): 74-89: “If every actor in the market follows a market-driven strategy and every firm adapts to competitors’ strategic moves and stays aligned with consumers requirements, then no actor will be able to offer a value proposition superior to the competition.”

3 Carrillat, François A., Fernando Jaramillo, William B. Locander, “Market-Driving Organizations: A Framework.” Academy of Marketing Science Review 2004, http://www.amsreview.org/articles/carrillat05- 2004.pdf: “Market-driving organizations may achieve greater performance than market-driven organizations by reshaping the structure of the market according to their own competencies and by exploiting the competitors’ weaknesses.”

4 Focus Group Discussion, “Profile of Islamic Banking Market Penetration Strategy in Indonesia: Obstacles and Challenges, 2008,” Bank Indonesia and Islamic banking industry, Jakarta, 6 November 2007.

Grand Strategy for Islamic Banking Development under the Accelerated Islamic Banking Development Programme

147

The increased value proposition stage can be

interpreted as the way in which Islamic banks offer a

higher level of values to target markets compared to

that offered by others. The offered values may lie in

the products, services, business processes, human

resources, communications or physical facilities.

Within this framework, the core values of sharia

banking, namely fairness, equity, transparency and

social responsibility, are in fact a rich source of values

applicable to all aspects of sharia banking operations

that can be used to spearhead marketing.

A communication and promotion strategy that

emphasizes the distinctive values of sharia banking

in language understandable by all will instill an

awareness of the differentiation of sharia banking

products from others. Furthermore, this strategy will

also work indirectly over time to shape the market

and build new preferences among the public for

products with a broader dimension than merely

the financial. For example, the principles of fairness

and social responsibility found in sharia banking

can be used to build public preferences for socially

responsible investment and ethical banking, as well

as community development banking. These three

characteristics are in fact specific to sharia banks,

and represent their comparative advantage. Having

considered all these angles, Bank Indonesia has

developed the Sharia Banking Development Grand

Strategy as primary guidance for public education and

dissemination activities and sharia bank expansion.

The grand strategy, which encompasses public

awareness/communication, branding strategy, product

development strategy and improved service quality, has

been prepared with the involvement of sharia banking

actors to ensure common ownership of the design

and a common drive to accelerate the growth of the

sharia banking industry in Indonesia. Since 2007, public

service advertising was launched in various media

in a public awareness campaign for sharia banking.

While continuing the public service advertising in 2008,

programmes held at the Sharia Economic Festival (FES)

in Jakarta and several other major cities presented

growth achieved in the real sector and industry with the

use of sharia-compliant financial and banking services.

The FES is envisaged as an annual programme.

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Halaman ini sengaja dikosongkan

148

Chapter 10

Payment System

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In payment system, Bank Indonesia has instituted various strategic policies to make payment system infrastructure more reliable, accurate, secure, effective, and faster in supporting private and government transaction activities nationwide. Such payment system characteristics are imperative in maintaining financial system stability as a whole. Regarding currency distribution, Bank Indonesia has successfully met the public demand for rising currency, which tended to increase. This was supplemented by efforts to distribute more currency that fit for circulation throughout the regions. Additionally, efficient and effective cash management by Bank Indonesia coupled with optimized bank’s cash management have helped improve the post-implementation of bank’s cash deposits scheme. This is clearly evidenced by the significant decline in currency outflow and inflow activities.With reference to non-cash payments, transaction activities in 2007 generally witnessed a surge in both volume and value. The primary factors that stimulated increased transaction activity were relatively strong economic growth and conducive economic conditions. Furthermore, the dynamics of transaction activities in the financial market, a shift in the preferred payment method and technological innovation in the payment system also served to catalyze transaction activity. Efforts taken by Bank Indonesia to improve non-cash payments began to bear fruit, as indicated by the growing trend of total non-cash transactions per capita, which rose by 18% per annum.

Chapter 10: Payment System

Payment Activity Performance

Cash Payment Instruments

The development of centers of economic growth in

a number of regions as well as the enduring societal

culture to use cash in transaction activities have boosted

the demand for currency in 2007. On average, the

amount of currency in circulation reached Rp174.8

trillion; an increase of 21.0% over the previous year,

which was higher than it was last year of 14.6%

(Chart 10.1). To support such growth, the realization

of additional currency demand in all regions arrived

at Rp115.4 trillion. Compared to the previous year,

additional money demand went down by 0.6%

attributable to efficiency measures taken since 2006;

principally through the optimization of currency stock

at Bank Indonesia Branch Offices (KBI) that have

experienced net inflows as well as improved bank’s cash

management. Based on its distribution, a larger portion

of curency was apportioned to East Indonesia: from

8.9% to 10.6%. This is mainly due to stronger economic

activity in the region.

The bank’s cash management was more optimized as

reflected by the significant decline in currency outflows

and inflows in 2007. The outflow and inflow of currency

was down by 42.1% and 29.4% respectively. Such a

decline is the direct result of the bank’s cash deposit

try out policy, which allow only currency unfit for

circulation is deposited at Bank Indonesia. The decrease

in currency outflow combined with a surge in currency

stock of 20.8% at the end of the reporting year drove

up Bank Indonesia’s cash ratio to approximately 3 to 4

months average outflow.

Currency in Circulation

Average growth of currency in circulation in 2007

surpassed its growth in the previous year, particularly

driven by fundamental factor of economic improvements.

In a quarterly basis, fluctuations in currency in circulation

were influenced by seasonal factors, such as religious

151

festivities, New Year’s celebrations, and school holidays.

This was clearly demonstrated by the amount of currency

in circulation which peaked during the fourth quarter of

2007; and reached Rp200.4 trillion (Table 10.1).

Bank Indonesia successfully fulfilled the soaring

demand for currency during natural disasters, such

as floods. Flooding in some areas of Jakarta at the

beginning of February 2007 spurred extraordinary

currency withdrawals, especially due to the shift in some

transactions that were usually performed using non-cash

instruments. Cash withdrawals from banks in Jakarta

during that period picked up from an average of Rp300

billion per day to Rp900 billion. In addition to sufficient

currency stock, the demand for currency was further

satisfied through the bank’s management and physical

safeguard of currency in accordance with disaster

management procedures at Bank Indonesia.

The position of currency went up after the

implementation of the bank’s cash deposit trial period.

Along with steps taken to optimize bank’s cash

management and the establishment of an inter-bank

currency transaction mechanism, currency position

gradually returned to normal. At the beginning of 2007,

the share of currency at banks reached 17.7% of

total currency in circulation; representing an increase

compared to 14.1% in 2006 and 15.1% in 2005. In order

to improve the efficiency of currency management, Bank

Indonesia encourages the establishment of an inter-bank

currency transaction mechanism. With this mechanism,

a bank with currency surplus of a particular denomination

may deal with another bank with a corresponding

deficit in the same area. This Bank Indonesia’s policy

also encourages banks to optimize cash management

by monitoring cash surpluses or deficits in their

working area to meet their operational requirement

and projected customer withdrawals. Through such an

array of endeavors taken since May, bank’s currency

has recovered and followed a similar pattern to that of

previous years (Chart 10.2).

During the last two years, the value and share of bank

notes in circulation have gone up. The share of bank

notes in circulation at the end of 2007 rose from 98.4%

to 98.8% of the currency in circulation. In term of value,

the majority of currency in circulation was denominated

in Rp50,000 and Rp100,000 bills, making up 45.0% and

42.6% of the currency in circulation respectively. Based

on the number of notes/coins in circulation, smaller

denominations (Rp10,000 and lower) was still dominant

Table 10.1

Developments of Currency in Circulation

trillions Rp

Period 2006 Growth (yoy) 2007 Growth (yoy)

Quarter-I 132.7 12.6% 160.8 21.2%

Quarter-II 135.9 15.2% 160.7 18.3%

Quarter-III 147.3 15.6% 176.7 20.0%

Quarter-IV 161.7 14.8% 200.4 23.9%

144.5 14.6% 174.8 21.0%

152

despite a declining share from 90.2% in 2006 to 86.3%

of the total.

Flow of Currency through Bank Indonesia

The efficiency of currency management by Bank

Indonesia and banks have improved subsequent to the

implementation of the bank’s cash deposit try out1. This

was reflected by a sharp decline in outflow and inflow by

42.1% and 29.4% respectively, to Rp195.9 trillion and

Rp154.3 trillion. The pattern of fluctuations in outflow and

inflow during 2007 was similar to that of 2005 but at a far

lower level (Chart 10.3 and Chart 10.4).

Analyzed by region, the decrease in the outflow and

inflow at BI regional offices was more pronounced than

the decline at head office. The main reason for this was

that the trial period of bank’s cash deposit scheme

was implemented at head office six months prior to

implementation at the regional offices (Chart 10.5).

The public’s growing demand for currency was reflected

in net outflow. Net outflow in 2007 totaled Rp41.6 trillion,

which represents an increase of 26.0% over the previous

year. The pattern of net outflow at head office remains

unchanged despite a drop from Rp34.0 trillion in 2006

to Rp24.2 trillion in 2007. Conversely, the pattern at BI

1 Discretion policy refers to Circular Letter No. 9/37/DPU dated 27th December 2007 on Rupiah Deposits and Withdrawals by Commercial Banks at Bank Indonesia, i.e. Bank Indonesia stipulates that a bank may deposit currency fit for circulation at Bank Indonesia if all predetermined conditions are met.

regional offices changed from net inflow to net outflow;

reached Rp17.4 trillion (Chart 10.6). Such conditions

indicate that the adjustment process for the currency

demand still continue at the branches, while in the head

office it already reflected the actual public demand

for currency.

Cash Position of Bank Indonesia

The cash adequacy ratio to average outflow improved

compared to the previous year, arrived at approximately

3-4 months of average outflow. This is primarily due

153

to waning outflows which allowed Bank Indonesia

to maintain a lower cash position. Bank Indonesia’s

lowest cash position in 2007 dropped to Rp47.2 trillion,

whereas the highest cash position was Rp83.7 trillion. In

addition to the public demand for currency, the majority

of cash held at Bank Indonesia was denominated in

Rp20,000 bills and above. In 2007, Rp50,000 and

Rp100,000 bills made up 51.3% and 34.6% of the total

cash held at Bank Indonesia respectively. Meanwhile,

based on its notes/coins, Rp1,000 and Rp50,000

bills were dominant, constituting 25.1% and 23.2%

respectively. With such composition, the availability of

large denomination bank notes (Rp20,000 and above)

was able to fulfill 3 to 4 months average outflow.

Furthermore, the availability of small denomination

bank notes was able to cover 5 to 6 months average

outflow while coins stock could provide 9 to 10 months

average outflow.

Currency Destroyed

The quality of money in circulation has shown signs

of improvement. This was evidenced by a 7.8% drop,

in nominal term, in currency destroyed despite the

growing amount of currency in circulation. In 2007, Bank

Indonesia destroyed 4.1 trillion bank notes, representing

a decrease of 14.6%. The majority of bank notes

destroyed were Rp1,000 and Rp50,000 denominations,

accounted for 38.3% and 17.7% respectively. In

accordance with the implementation of policy regarding

the deposit of currency unfit for circulation by banks, the

ratio of currency destroyed to inflow remained relatively

low despite a surge from 27.2% to 49.9%. This relatively

low ratio of currency destroyed to inflow was primarily

attributable to the discretionary policy related to bank’s

deposit procedure2. This discretionary policy made it

possible for the banks to also deposit the currency which

still fit for circulation.

Counterfeit Money

The ratio of counterfeit money found in 2007 slid due to

several factors. These factors included various endeavors

taken to bring down counterfeit money in circulation

as well as broader public knowledge regarding rupiah

money authenticity. The ratio of counterfeit money found

in 2007 was 8 counterfeit bank notes in each million

bank notes circulated. This denotes an improvement

compared to the previous year, when 17 counterfeit

bank notes were found per million bank notes circulated.

By region, the largest findings of counterfeit money were

in the Bank Indonesia Coordinating Office in Surabaya

(33.2%), Head Office (27.0%) and the Coordinating

Office in Semarang (13.4%).

Non-cash Payment Instruments

In general, payment transaction activity during 2007

picked up, both in volume and value. Strong economic

growth coupled with conducive economic conditions

were the key factors supported greater transaction

activity. Furthermore, a rising trading activities in the

financial markets, a shift in the preferred payment

method, as well as technological innovation in the

payment system also contributed towards surging

payment transaction.

Higher trading activity in the financial markets has

pushed up payment transactions with large value

(Rp100 million and above). Higher stocks and bonds

trading activities, including their various derivatives, in

the financial market have significantly contributed to

the rise in large-value payment transactions. Not with

standing, transaction activities in the banking industry,

large corporations, and government institutions, as well

as Bank Indonesia transactions related to monetary

management activity, also supported the increase in

large-value payment transactions.

2 The policy only allows banks to deposit money that is unfit for circulation. The bank’s cash deposit try out period for all currency denominations was implemented gradually; in May 2006 at head office and in December 2006 for all branch offices.

154

A shift in the preferred payment method as well as

technological innovation in the payment system

catalyzed growth in retail payment transactions (under

Rp100 million). During the last few years, the public has

tended to shift away from cash payments to non-cash

payment methods. Based on the survey conducted in

2006 and 20073, a change in payment instruments is

taking place, particularly in the cities, from paper-based

payment instruments, such as bank notes, cheques, and

checking accounts to card-based payment instruments,

such as debit cards/ATM, credit cards and electronic

money (e-money). In addition to the shift in preference,

various technological innovations in the payment

system also stimulated growth in non-cash payment

instruments. In the retail market, numerous financial

institutions have begun to utilize internet banking,

mobile banking, and phone banking technologies as an

instruments to transfer funds.

RTGS Transactions

The total transactions settled through the BI-RTGS

system in 2007 grew both in terms of value and volume.

The total value of transactions settled through BI-RTGS

was Rp42.4 thousand trillion in 2007; went up by 45.6%

relative to the previous year (Rp29.1 thousand trillion).

Meanwhile, the volume reached 8.5 million transactions;

3 Survey was related to the ‘Less Cash Society’ initiative, which comprises of a Survey on Public and Service Provider’s Perceptions, Preferences and Behavior towards the Non-cash Payment System (2006) and a Survey on the Deposit Composition Used for Payment Activity (2007).

22.5% higher than the previous year (6.9 million

transactions) (Chart 10.7). Therefore, the average

daily transaction value and volume settled through the

RTGS system reached Rp170 trillion and 34 thousand

transactions respectively. Transaction activity peaked

during the fourth quarter, known as the high season,

due to extraordinary transactions in line with religious

festivities as well as corporate and government year-

end payment.

155

The primary user of the BI-RTGS system for payment

transaction activity was the banking industry with a

volume share of 92.8% and 58.2% in terms of value. The

highest banking transaction activity came from customer

transfers with a share of 50%. This indicates that the

majority of bank customers were becoming accustomed

to transfers and transaction settlement through the

RTGS system. National Private Commercial Banks were

the biggest participants driven by their advantage in the

payment facility offered in terms of variety of products

and convenience. Transactions from this group of

banks represented 39.2% of the total value and 50%

of the total volume. The group of state-owned banks,

which comprises of just four banks was another biggest

participants constituted a significant share totaling 21.6%

of value and 28.9% of volume (Chart 10.8).

Based on its transaction type by banks, activities that

directly related to the public include settlements in

the stock market, foreign exchange, and customer

transfers. Highest growth was recorded for stock market

transactions which went up by 104.29% and 71.8% for

transaction value and volume respectively (Chart 10.9).

This growth indicated more mushrooming transactions

for stocks and bonds in 2007. This is consistent with the

transactions hike recorded by the Indonesian Securities

Insurance and Clearing Agency (KPEI), namely 94% with

reference to value and 89.5% for volume.

Table 10.2

BI-RTGS Transactions Based on Type of Transaction

Value (Trillions Rp) Volume

Type of Transaction 2006 2007%

Up/DownType of Transaction 2006 2007

% Up/Down

Interbank Money Market 4,206 5,816 38.26% Interbank Money Market 133,797 146,423 9.44%

Customer 5,088 7,401 45.45% Customer 5,362,485 6,776,777 26.37%

Foreign Currency Transaction

2,624 3,969 51.25% Foreign Currency Transaction

154,075 176,944 14.84%

Capital Market Settlement 1,238 2,530 104.29% Capital Market Settlement 37,241 63,980 71.80%

Government 986 1,178 19.49% Government 176,972 243,900 37.82%

Monetary Management 10,213 15,620 52.94% Monetary Management 54,441 46,497 -14.59%

Clearing Settlement 3,682 4,793 30.18% Clearing Settlement 470,232 365,033 -22.37%

Others 1,065 629 -40.93% Others 535,906 591,911 10.45%

Chart 10.9

Settlement of Stock Market Transaction in RTGS

156

Transactions by Bank Indonesia for monetary

management to safeguard monetary and financial

system stability were the main factor for higher RTGS

transaction value. Compared to the previous year,

transactions related to monetary management rose by

48.9%. The composition of these types of transaction

reached 60%; generally stemming from rupiah

intervention, purchases of SBI, SWBI and SUN as well

as other transactions related to monetary management.

Meanwhile, government transaction activity also grew

along with higher government expenditure (Chart 10.10)

BI-RTGS System Liquidity Management

Bank Indonesia’s concern to ensure the uninterrupted

settlement of payment transactions for RTGS

participants is evidenced through the use of the

RTGS’s participant liquidity monitoring system. During

the reporting year, liquidity in the money market was

satisfactory as no gridlock4 was recorded. To further

avoid potential gridlock, Bank Indonesia monitors

liquidity get an information on the participants’ ability to

meet their obligations at the end of the day. Moreover,

the throughput indicator also shown that the proportion

of settlement time was well preserved, 66.8% at the

early and mid settlement time period (Chart 10.11). This

indicates that the operational liquidity demand for the

BI-RTGS system to the end of the day is not tight and

evenly spread.

4 Gridlock is the cessation of the settlement system due to a bank’s inability to meet its payment obligations.

With reference to the operational time of the RTGS

system, most value of the transaction settlement occurs

in the morning period, prior to 7am (West Indonesia

Time); accounted for 21.4% of the daily transaction

value (Chart 10.12). The transactions that dominate the

morning period were rupiah intervention transactions

(45%), followed by SBI settlement transactions and

SBI (30.6%), as well as clearing pre-fund transactions

(17.7%). SBI and SWBI settlement transactions were

very effective in injecting liquidity in the financial market;

therefore, the subsequent liquidity demand from

157

Clearing Transactions

In line with RTGS transactions, clearing transaction

that reflects retail activity in society also posted growth.

Transaction value during the reporting period rose

by 13.1% to Rp1.389 trillion with an average daily

transaction of Rp5.6 trillion (Chart 10.13). With reference

to volume, the number of transaction also rose; by

7.12% to 79.5 million transactions with a daily average

of 319 thousand transactions. From the total amount of

transactions, the proportion of credit transfer activity and

debits clearing was relatively balanced. Credit transaction

volume recorded 37.6 million transactions whereas

debits clearing totaled 40.1 million transactions. With

regards to value, credit transfer transactions were worth

Rp365 trillion and debits clearing were Rp994 trillion. In

terms of the processing area, clearing activity in Jakarta

continued to dominate with a share of 52% (Rp718.9

trillion) and 60% (47.8 million transactions) for value and

volume respectively (Chart 10.14 and Chart 10.15).

Card Based Payment Instruments

Along with product innovation in the Card Based

Payment Instruments (CBPI), the CBPI industry also

experienced significant expansion: from the number

of cards issued, as well as the volume and value of

transactions. In 2007 the number of CBPI in circulation

was 44.6 million cards, providing a total transaction value

of Rp1,700 trillion and used for 1.2 billion transactions

(Chart 10.16 and Chart 10.17). CBPI industry growth

was primarily underpinned by the rapid expansion of

RTGS participants to be able to involve in transactions

throughout the day was met. Another busy time of

the day is from 4-5pm WIB, especially to cover the

participants’ liabilities in the clearing system. From

the activity side, the highest volume occurs in the

afternoon period, from 2-3pm WIB; constituting 14.98%

of total daily transaction volume. In that period, most

transactions came from customer transfers (83.6%), with

the remaining came from the inter-bank money market

as well as stock market transactions.

158

account based cards (ATM and ATM+Debit)5 which

dominate the share of cards used (77.4%), transaction

value (96%), and transaction volume (95.8%). The credit

card industry also enjoyed rapid growth; however, quality

suffered slightly. The number of credit cards in circulation

was recorded higher by 11.7% to 9.2 million cards.

Meanwhile, transaction value grew 26.9% (Rp72.8 trillion)

and transaction volume grew 13.7% (129.5 million).

However, the NPL of credit cards showed an upward

trend as illustrated in Chart 10.18.

In order to improve the quality of credit cards, Bank

Indonesia along with the card issuers were continuing

to evaluate the credit card industry as a whole while

also facilitating the establishment of self-regulatory

organization (SRO). These efforts were expected

to expedite the establishment of a sound, qualified

and independent credit card industry. Through the

SRO, issuers will be able to collaboratively agree on

standards and operational guidelines for credit cards,

such as: minimum qualifications for card applicants,

intermediation, fair competition and the regulation of the

minimum payment amount.

The CBPI industry also issued a new payment

instrument in 2007 known as e-money. The industry’s

5 The recording of transactions using account based payment card instruments is no longer based on the type of card (ATM, Debit and ATM+Debit), but based on the transaction function. This takes into consideration the function of payment cards, especially account based cards, which varies greatly and changes rapidly.

preference and appetite to issue e-money is expected

to continue growing. In 2007, 10 institutions have

applied to administrate e-money. E-money is generally

used for retail payment transactions and used with a

high frequency as well as fast processing time, such

as payments for transportation, toll roads and fuel

purchases.

To promote CBPI efficiency, Bank Indonesia has

facilitated the standardization of non-cash instruments

to encourage the use of single card for various payment

159

concerning rupiah deposits and withdrawals by

commercial banks.

Prime Cash Service

Steps taken by Bank Indonesia to support the prime

cash service include preparing a currency management

strategy by third parties through the continuation of

the trial of bank’s cash deposit. This scheme has

successfully reduced the number of bank’s cash

deposits and payments, which has improved the

efficiency and effectiveness of currency management

in Bank Indonesia and the banks. The preparation of a

cash centre was performed through reviews and analysis

that also consider aspects of effectiveness, demand from

each institution, geographic conditions, organization,

existing infrastructure and supervisory function. Other

measures include expanding the area of cooperation for

cash services with PT Posindo in seven regions, namely

Makassar, Mataram, Bengkulu, Medan, Jambi, Sibolga

and Manado to be able to meet demand for currency

in remote and border areas. The initiatives taken have

raised the index of Bank Indonesia’s cash service

satisfaction survey from 5.11 in 2006 to 5.16 in 2007.

High Quality Rupiah

Bank Indonesia’s policy to enhance the quality of the

rupiah is directed towards efforts to overcome the

distribution of counterfeit money, as well as enhancing

safety features and improving the quality of the materials

used to produce bank notes and coins. The policy

strategy to mitigate the distribution of counterfeit

money includes ongoing public education regarding the

characteristics of rupiah currency as well as improving

cooperation between the Coordinating Body for the

Eradication of Counterfeit Money (BOTASUPAL), the

police (POLRI) and other related parties. Other efforts

include continuing collaboration with other central

banks to establish Bank Indonesia Counterfeit Analysis

Center (BI-CAC) to formulate strategies to eradicate

counterfeit money. These measures taken have raised

the index from 4.79 in 2006 to 5.00. Bank Indonesia has

also reviewed the materials used to produce Rp1,000

bills through cost comparisons, protection against

counterfeiting, aesthetic appearance, usage profile as

well as customs and traditions.

Payment System

Policies instituted in 2007 continue to be aimed towards

improving security and efficiency of payment system

instruments, risk mitigation and customer protection.

service providers (interoperability). In particular for ATM

and debit cards, a memorandum of understanding has

been signed to formulate the technical standardization of

chip technology for ATM and debit cards. Meanwhile, to

promote the interoperability of e-money, Bank Indonesia

continues to facilitate meetings with e-money issuers and

potential issuers to standardize e-money.

Payment System Policy

Currency Circulation

Currency circulation policy in 2007 confirmed to the

dynamics of the internal and external environments.

Internally, economic growth, the size of the population,

and societal culture that dictates the preference to use

cash in transaction activity, were all appraised. Externally,

factors taken into consideration include the standard

practices of currency circulation management adopted in

various countries that tend to focus their activity on the

policy of currency circulation planning and supervision,

whereas the currency management is performed by

various institutions separate to the central bank.

By taking into account the dynamics mentioned above

and considering the mandate of Bank Indonesia in

currency circulation, such as fulfilling the demand for

currency in appropriate denominations, on time and in

good condition, Bank Indonesia has instituted an array

of policies referring to the three main pillars. The pillars

are: 1. Secure, reliable and efficient currency distribution;

2. Cash service improvement; and 3. Currency quality

improvement.

Secure, Reliable and Efficient Currency Distribution

Bank Indonesia strives to promote secure, reliable and

efficient currency distribution by optimizing supply and

distribution of currency which is sufficient, secure, and

punctual as well as in an appropriate denominations.

In terms of policy implementation, efforts to meet

demand for currency were conducted by boosting

stock of currency by 4.29% and distributing currency

exceeded the planned target (123.3%). Bank Indonesia

also promulgated a policy for large-amounts of cash

in transit at 13 Bank Indonesia branches to ensure

swift and punctual cash transfer. The measures taken

by Bank Indonesia have raised the index for rupiah

availability, which was based on survey, from 4.74 to

4.90. In addition, Bank Indonesia also issued regulations

to guarantee legal protection, such as regulations

160

Payment System Risk Mitigation

Risk mitigation during the reporting year was conducted

through safeguarding the operational reliability of

the payment system For systems operated by Bank

Indonesia, the safeguarding measure is routinely tested

through the preparedness of the primary and backup

systems in overcoming certain conditions that can

trigger operational failure in both systems. For the

clearing system in particular, the Bank Indonesia National

Clearing System (BINCS) uses the failure-to-settle (FtS)

mechanism for credit risk mitigation of fund transfers

through clearing. For systems outside Bank Indonesia,

such as APMK, persuasive measures were taken

through the National Payment System Communication

Forum (NPSCF) and the industry association.

Payment System Oversight

In fulfilling its mandate regarding oversight, Bank

Indonesia has prioritized oversight of the BI-RTGS

System, which is categorized as a Systemically

Important Payment System (SIPS) and Clearing System.

Unlike the concept of banking oversight which focuses

on an individual bank’s rating and performance,

payment system oversight focuses on payment system

implementation oversight in general, including the

licensing process, facilitation and consultation once

system development reaches the stage where payment

system participants fully comply with the agreed

regulations. Oversight is performed through assessments

of operational compliance for both systems, such that it

adheres to international standards (BIS-Core Principles

on Systemically Important Payment Systems).

Fostering Discipline of Cheques and Checking Accounts

Users

Regarding efforts to instill discipline in users of cheques

and checking accounts, in mid 2007, Bank Indonesia

issued a new regulation concerning the National Black

List (NBL). The regulation supplemented previous

corresponding regulations as well as represents

guidelines in administrating the NBL. Aspects considered

in the regulation include prudential principles, particularly

for customers using their cheques or checking accounts

to make payments. Having a nationally integrated black

list accessible by all banks at any location makes it

impossible for customers to draw on bad cheques in

different areas.

Policy on Money Remittances

Since its implementation started from the end of 2006,

prevailing regulation on Money Remittances activities has

prompted positive responses from related authorities,

such as the Financial Transaction Reporting and Analysis

Center (PPATK), the Department of Foreign Affairs, as

well as researchers from the World Bank and Asian

Development Bank. This is essentially associated with

Bank Indonesia’s efforts to prevent money laundering

and terrorist funding through remittances. Furthermore,

this regulation is an integral effort to provide simple,

secure and cheap services as well as legal protection

for foreign workers who transfer money to their families

in Indonesia.

Government Account Management Efficiency

In order to improve the efficiency of payment services

to the government, Bank Indonesia has developed

an application to assist the government in managing

their accounts. This application, known as Bank

Indonesia Government-eBanking (BIG-eB), covers the

administration of revenues, expenditure and transaction

settlement related to government’s account. The

operation of Big-eB also constitutes the implementation

of Act Number. 1/2004 regarding the State Treasury.

Moreover, BIG-eB strives to support overall TSA

implementation as well as coordination between the

fiscal and monetary authorities.

Improving Non-cash Payment Quality

In 2007, efforts to improve card-based retail payments

focused on the socialization of sagacious credit and

debit card use. This represents part of Bank Indonesia’s

endeavors to develop a card-based retail payment

system which emphasizes consumer protection. Various

socialization activities have been conducted in the

mass media, for instance in the form of public service

announcements in the press and electronic media.

Chapter 11

The Global Economy and International Cooperation

162

Compared to 2006, the global economy was sluggish in 2007, as reflected by decelerating growth and a slowdown in trade activity. This was principally attributable to a downturn in economic expansion in developed countries, particularly the USA, which continue to suffer from the subprime mortgage fiasco. However, slower growth in developed countries was offset by persistently high economic growth in emerging market countries. Against this propitious backdrop, the global economy recorded 4.9% growth; exceeding the long-term growth trend. The mortgage debacle in the US also triggered shocks in the global financial market. Meanwhile, the commodity market was affected by fuel price hikes followed by price increases in other commodities, mainly staple food commodities. Soaring commodity prices spurred intense inflationary pressures, further compounded by strong domestic demand in developing countries. As a result, global monetary policy stance remains relatively tight. Domestically, Indonesia has endeavored to improve competitiveness and financial system resilience by active involvement in international cooperation; through bilateral, regional and multilateral forums. Several noteworthy achievements include the agreement to form the ASEAN Economic Community in 2015 and the signing of economic cooperation with Japan. Meanwhile, the multilateralization process through the Chiang Mai Initiative has progressed and continues to anticipate various potential financial crisis scenarios.

Chapter 11: The Global Economy and International Cooperation

Global Economy

The pace of global economic growth slowed in

2007 compared to that of the previous year. Slower

economic growth was due to a downturn in developed

countries from 3.0% in 2006 to 2.6%, particularly in

the US, which experienced a drastic decline from 2.9%

to 2.2%. However, a group of developing countries

continued to perform well, reporting higher growth

(7.8%) than the previous year (7.7%). This prevented

a sharper decline in global economic growth. High

growth in developing countries was due to buoyant

expansion in China and India. Consequently, the global

economy grew by 4.9% in 2007 (Table 11.1). Compared

to the long-term growth trend, such growth is

relatively high; only slightly below that in 2006 of 5.0%

(Chart 11.1). In line with the lackluster global economy,

global trade activity of goods and services between

countries also demonstrated a declining growth trend.

Global trade volume only grew by 6.6% in the past year

of 2007, below the 9.2% recorded in 2006 (Chart 11.2).

Global economic performance was also marked by the

broadening subprime mortgage crisis originating in the

US and soaring global commodity prices. The subprime

mortgage turmoil began mid 2007, discernible by the

failure of several subprime mortgage lenders. The crisis

was triggered by an increasing number of borrowers

failing to repay their mortgages. Compounding the

problems of the subprime mortgage borrowers, many

investors, including global investors, who had invested

funds into subprime mortgages and their derivatives,

suffered huge losses. Such developments led to a

widespread crisis of confidence in financial assets

related to subprime mortgages among others, which

resulted in a credit squeeze. The crisis affected the

global financial market and caused prices on the U.S.

stock exchange and other global equity markets to

fall. Furthermore, the crisis effect multiplied to financial

markets in developing countries.

Separate to the shocks emanating from subprime

mortgages, global financial market performance,

163

in general, remained strongly influenced by excess

liquidity. Excess liquidity encouraged greater portfolio

investment in the global financial market, therefore

financial asset prices increased significantly, particularly

in the first semester of 2007. The perception of global

investors concerning investment risk in developing

countries also improved and consequently investment

to financial assets in emerging market economies

resurged. However, the bullish global financial market

quickly reversed following the subprime mortgage

catastrophe, which prompted capital flight to quality

and brought down exchange rates and financial

asset prices.

The global economy was also affected by the

rising oil price followed by the prices of other basic

commodities. The crude oil price soared and almost

broke the psychological barrier of $100 per barrel by

year end1. The current oil price trend has deviated from

its historical tendency, which generally witnessed a

decline in the fourth quarter. The escalating oil price

was due to the fundamental factor of growing demand,

yet the supply remained relatively limited. Furthermore,

increasing speculative transactions also exacerbated

the high oil price. Notwithstanding, the high oil price

also affected the prices of various commodities on the

international market, thus in general commodity prices

tended to rise too.

Sky-rocketing prices of various basic commodities

triggered relatively intense inflationary pressure, mainly

in developing countries. The inflation rate in developing

countries reached 5.9% from 5.1% in 2006. Meanwhile,

inflation in developed countries was relatively well

1 Price of WTI crude oil.

Table 11.1

Key World Economic Indicators

percent

Key Indicators 2005 2006IMF Estimation

2007

World Output1) 4.4 5.0 4.9

Developed Countries 2.5 3.0 2.6

United States 3.1 2.9 2.2

Euro Zone 1.5 2.8 2.6

Japan 1.9 2.4 2.1

Other Developed Countries 3.2 3.7 3.8

Developing Countries1) 7.0 7.7 7.8

Africa 5.9 5.8 6.0

Asia 9.0 9.6 9.6

China 10.4 11.1 11.4

Latin America 4.6 5.4 5.4

Middle East 5.6 5.8 6.0

World Trade Volume2) 7.5 9.2 6.6

Commodity Prices 29.3 14.3 29.0

Energy Commodities 41.1 7.2 43.6

Crude Oil 44.5 8.0 46.6

Non-energy Commodities 12.9 26.7 7.6

Inflation2)

Developed Countries 2.3 2.3 2.1

Other Developing Countries 5.2 5.1 5.9Source: IMF, CEIC, Bloomberg 1) WEO Update, January 2008 2) WEO October 2007

164

maintained despite strong inflationary pressures

stemming from soaring commodity prices by year end.

The tight monetary policy stance adopted over the last

several years by developed countries helped dissipate

the inflationary pressures affecting such countries.

Persistent inflationary pressures have encouraged

the continuation of tight monetary policy. Most

central banks raised their interest rates, as carried

out by the European Central Bank and the Bank of

England (Chart 11.3 and 11.4). However, in the second

semester, the intensity of the policy to raise interest

rates went down, with several central banks, including

the Federal Reserve (Fed), even beginning to lower

their rates (Chart 11.3). The Fed’s decision to cut its

rate was taken to stimulate economic growth that

had been sluggish due to the subprime mortgage

fiasco. Besides, the reduction of interest rates was

also aimed at minimizing instability and the relatively

tight financial market due to a crisis of confidence and

credit tightening.

US Economy

The state of the US economy, which has tended to

weaken over the past two years, deteriorated further

in 2007, primarily due to the subprime mortgage crisis.

Economic activities began to increase and expand

in the second and third quarter but lost momentum

because of the subprime mortgage failure in the third

quarter. This undermined growth in the fourth quarter

and, consequently, GDP growth reached just 2.2%; a

dramatic decline from the 2.9% achieved in 2006.

The economic slowdown was caused by waning

investment and weaker consumption. On top of the

subprime mortgage turmoil, weaker investment and

consumption were due to the policy to raise the interest

rate, which was implemented in 2004-2006. Weaker

consumption was evidenced by the lower consumer

confidence index. The index, which remained above

100 during the first semester of 2007 –indicating

consumer optimism and its implication on rising

consumption– quickly reversed to become pessimistic;

indicated by a drop in the index to 88.6 by year end.

Deteriorating consumer confidence was also the result

of rising unemployment, therefore, public expectations

for income and consumption tended to decrease.

The decline in consumption, however, did bare some

positive impacts, namely a reduction in imports which

narrowed the current account deficit. Nevertheless,

the shrinking current account deficit was also affected

by US dollar depreciation against other global hard

currencies. In turn, the smaller current account deficit

contributed positively to US economic growth, and

helped minimize the effects of global imbalance.

The subprime mortgage catastrophe ignited significant

shocks, thus aggravating U.S. financial market

performance. The crisis represented the nadir of the

165

deteriorating housing sector trend in the US, which has

been ongoing since mid 2005 and was followed by the

inability of borrowers to repay their subprime mortgages

due to the rising interest rate. As a consequence, a

number of lenders suffered huge losses, with several

prominent lenders closing down. In addition, the crisis

caused the share prices of companies related to

subprime mortgages to tumble. As a result, the stock

price index in the US plummeted. The Dow Jones

Industrial Average Index that had reached a level of

14,000 (July 2007) was sharply corrected to 12,846

(August 2007), which coincided with the subprime

mortgage debacle. Numerous foreign investors whom

had invested in subprime mortgages precipitated the

spread of the crisis to the global financial market.

Although domestic demand waned, inflationary

pressures remained strong originating from soaring

energy and international commodity prices. High

commodity prices triggered a significant rise in

consumer level prices, reaching 4.1% from 2.5% in

2006. However, core inflation decreased slightly from

2.6% in 2006 to 2.4%.

More conducive core inflation provided the Fed an

opportunity to reduce its rate and therefore stimulate

economic expansion. Unrelated to the persistently

intense inflationary pressures, the Fed began reducing

its Fed Fund Rate after maintaining it at 5.25% since

mid 2006. The decision to reduce the Fed Fund Rate

was taken to avoid a potential economic recession in

the US. At the FOMC Meeting in September 2007, the

Fed decreased its rate by 50bps to 4.75%. Further

reductions were made at FOMC meetings in November

and December (by 25 bps each month), therefore, by

the end of 2007 the Fed Fund Rate was 4.25%. To

mitigate the impacts of the subprime mortgage crisis

that tightened liquidity in the financial market, the Fed

–in cooperation with several central banks– injected

huge amounts of liquidity into the money market

including US dollars into the Euro Zone money market.

The efforts taken were effective and successful in

alleviating interest rate volatility in the money market.

The Euro Zone2

The Euro Zone economy is strongly influenced by

developments in the US, including the recent shocks

stemming from the subprime mortgage fiasco. The

2 Countries included in the Euro Zone are Austria, the Netherlands, Belgium, Finland, Ireland, Italy, Germany, Luxemburg, France, Portugal, Spain and Greece.

economic slowdown in the US was followed by a similar

downturn in the Euro Zone, where economic growth

in 2007 slumped to 2.6% from around 2.8% in the

previous year. Slower growth affected all countries in

the Euro Zone, with a significant decline in Germany,

which experienced a contraction in growth from 2.9%

in 2006 to 2.5%. Economic growth in the Euro Zone

slowed due to weaker consumption and exports. Weak

consumption was also reflected by declining consumer

confidence and retail sales figures. Falling export

growth was associated with lower demand for exports

from the US, as a main trade partner of the Euro Zone,

and appreciation of the euro meant that exports from

the zone became relatively expensive.

Inflation in the Euro Zone tended to increase in line

with the high oil price. Throughout 2007, the inflation

rate remained relatively stable at around 2.0% until

the third quarter. By the end of 2007 inflation had shot

up to 3.1%, which well exceeded the inflation rate in

2006 (1.9%). In addition to the record high oil price,

inflationary pressure also emanated from the significant

leap in food prices. By country, inflation increased

extraordinarily; form 1.4% in 2006 to 3.1% in Germany

and from 2.7% to 4.3% in Spain.

The ECB responded to relatively intense inflationary

pressure by continuing its higher interest rate policy,

however, the increase slowed somewhat compared

to 2006. In 2007, the ECB only raised its interest rate

twice by 25 bps each time: in March 2007 to 3.75%

and in June to 4.0%.

Japanese Economy

In line with the sluggish global economy, the Japanese

economic growth also slowed down. GDP grew by

just 2.1%; falling from 2.4% in 2006. Lackluster growth

was due to weaker consumption (not government

consumption) and exports. Weak exports were

associated with the slowdown in the US economy;

consequently, demand for Japanese products also

diminished. Meanwhile, investment experienced

contraction –despite less contraction than previously–

therefore undermining economic expansion. Only

government expenditure increased, which stimulated

some economic growth.

Prices in Japan indicated slight improvement. The

prices of domestic corporate goods showed a slight

increase, yet CPI inflation remained at around 0%.

166

The producer price index increased from 1.8% in

2006 to 2.6%, driven by high energy prices. However,

producers and the corporate sector did not fully

pass on the rising energy prices to their customers

as economic conditions remained inauspicious.

This caused CPI inflation to increase slightly, more

specifically to 0.7% compared to 0.3% in the

previous year.

In line with relatively weak economic activity, the

Bank of Japan continued its low interest rate policy.

The interest rate remained at a very low level, namely

0.50%, despite a 25-bps hike early in the year. The

relatively low interest rate in Japan has encouraged

carry trade by investors looking to gain profit from the

spread differential between Japan’s interest rate and

the interest rates in other countries.

Economic Performance in Latin America

The economy of the Latin America Zone maintained

strong growth despite its close linkages to the

weak U.S. economy. The Zone as a whole recorded

5.4% growth, the same as during the previous year.

Individually, several countries surpassed this aggregate

rate; however, a number of countries also began to

show signs of a slowdown. The countries with higher

growth rates include Brazil, Chile and Peru. Brazil is the

largest economy in the region and grew impressively

from 3.7% to 5.2%, meanwhile Chile and Peru grew

respectively from 4.0% to 5.3% and from 7.6% to 9.0%.

Robust growth in these three countries was driven

by consumption, investment and exports. Significant

export growth was encouraged by relatively high

demand for exports from China. The portion of exports

from these countries to China is dominant, with the

largest for Chile.

On the other hand, several countries, such as

Argentina, Colombia, Mexico and Venezuela,

performed sluggishly. The aggregate GDP of Argentina

slowed slightly from 8.5% in 2006 to 8.3% due to a

small decline in consumption and exports. Despite the

decline in GDP growth, economic growth in Argentina

remained relatively high. Meanwhile, the significant

decline in the Mexican economy was primarily

attributable to diminishing consumption expenditure, as

well as contracting investment and net exports. GDP

growth in Mexico dropped from 4.8% to 3.3%.

As transpired in most developing countries in general,

the inflation rate in the Latin America Zone also

soared. In fact in several countries, such as Argentina

and Chile, serious inflation issues arose. Inflation in

Argentina reached 8.5%, induced by strong domestic

demand. However, inflation improved compared to

2006, reaching 9.8%. Inflation in Chile sky rocketed

from just 2.6% to 7.8% due to price hikes in housing

and transportation. Another country in this zone that

experienced high inflation was Venezuela; sparked by

government social expenditure (welfare payments and

other social expenditure) which could not be balanced

by the required rise in commodity supply.

Asia Pacific (excluding Japan)

The economy in the Asia Pacific region (excluding

Japan) improved relatively. Developing countries in Asia

experienced a slight rise in growth from 7.7% in 2006

to 7.8%. China, with a robust growth rate, was once

again the main catalyst of growth in the region. China’s

GDP grew by 11.4% in 2007, higher than previous year

of 11.1%. Economic growth in China was driven by high

domestic demand and exports.

Economic growth continued in Australia, New Zealand

and the ASEAN-4 group of nations (Indonesia,

Malaysia, Thailand and the Philippines). The

economies of ASEAN-4 grew from 5.4% in 2006 to

5.6%. With the exception of Thailand, the ASEAN-4

nations successfully recorded increased economic

growth. Regarding Australia and New Zealand, they

recorded growth from 2.8% to 3.9% and 1.6% to 3.0%

respectfully. Strong economic growth in the ASEAN-4

nations, Australia and New Zealand was chiefly spurred

by consumption and investment. Particularly for the

ASEAN-4 group, economic growth was also supported

by burgeoning exports.

Newly industrialized Asian economies, including

South Korea, Singapore, Hong Kong (SAR) and

Taiwan (Province of China), reported an economic

downturn with their economies slowing from 5.3% in

2006 to 4.9%. Slow growth in this group was mainly

due to sluggish economic growth in Hong Kong and

Singapore. Lackluster economic growth in Hong

Kong was caused principally by dwindling investment,

meanwhile in Singapore the slowdown was due to

stagnant exports. Economic growth in South Korea

remained relatively stable compared to previous

167

years, while higher economic growth was successfully

recorded in Taiwan.

Inflation in the Asia Pacific region tended to increase

due to the high prices of international commodities as

well as strong domestic demand. Immense inflationary

pressures befell China, where the economy grew

rapidly, as well as affecting the newly industrialized

Asian economies. The highest leap in inflation occurred

in China (from 2.8% in 2006 to 6.5%), followed by

Singapore (from 0.8% to 4.4%), Taiwan (From 0.7%

to 3.3%), South Korea (from 2.1% to 3.6%) and finally

Hong Kong (from 2.6% to 3.8%). Amid the rising

inflation rate trend in the region, inflation in other

economies, such as Australia and the ASEAN-4

countries, declined.

To curb the inflation rate, monetary policy in the Asia

Pacific region tended to be tight. The People’s Bank of

China adopted a tight monetary policy stance by raising

the interest rate and minimum reserve requirement.

The interest rate of working capital credit with a 1-year

tenure was raised six times from 6.12% to 7.47% (an

increase of 135 bps); meanwhile the minimum reserve

requirement was raised 10 times so by the end of 2007

it was up to 14.5% from around 9.0%. The Bank of

Korea increased its interest rate twice –each time by 25

bps– up to 5.0%, and in Taiwan the interest rate was

raised four times from 2.75% to 3.38%.

Financial Market

In 2007 the global financial market moved dynamically

amid the shocks stemming from the subprime

mortgage crisis in the US. In general, the condition

of the global financial market remained conducive

(bullish), supported by abundant global liquidity and

better perceived risk for developing economies. Such

conditions encouraged global investors to diversify their

portfolios into financial assets in emerging economies.

Investment in emerging economies became a more

attractive alternative along with improving economic

performance and stability. This brought capital inflows

–in the form of FDI, portfolio and loans– into emerging

market countries.

Capital inflows to emerging market economies

increased in 2007, reaching $620 billion, which

represents a $48 billion increase over the previous

year (Table 11.2). Investment in the form of equity

investments was dominated by surging FDI, whereas

portfolio investment decreased slightly when compared

to the previous year. Such was the impact of subprime

Table 11.2

International Capital Flows

billion $

Description 2005 2006 2007

Current Account Balance 274.1 380.2 419.5

External Financing, net:

Private Capital Flows, net 519.6 572.8 620.3

Equity Investment, net 254.3 229.3 265.1

Direct Investment, net 200.6 167.3 212.9

Portfolio Investment, net 53.7 62.0 52.2

Private Creditors, net 265.3 343.6 355.2

Commercial Banks, net 145.7 202.3 188.5

Non Banks, net 119.5 141.3 166.6

Government Capital Flows, net -64.2 -65.0 3.3

IFIs -38.6 -32.9 1.9

Bilateral Creditors -25.6 32.1 1.3

Resident Lending/Other, net -287.3 -334.1 -286.8

Reserves (- = increase) -442.2 -554.0 -756.2Source: IIF, Capital Flows to Emerging Market Economies, 21st October 2007.

Table 11.3

Developments in Major Global Currencies

percent

Country - CurrencyChanges from year 2006 Average

2007*ptp Average

European Union - Euro 10.54 9.10 1.37

Canada - Dollar 14.37 5.30 1.07

UK - Poundsterling 1.33 8.59 2.00

Sweden - Crown 5.57 8.34 6.76

Japan - Yen 6.18 -1.24 117.78

Denmark - Crown 9.53 8.39 5.44

Argentina - Peso -2.91 -1.33 3.12

Brazil - Real 16.69 10.55 1.95

Chile - Peso 6.64 1.57 522.21

Mexico - Peso -0.83 -0.20 10.93

China - Yuan 6.51 4.58 7.61

Hong Kong - Dollar -0.28 -0.43 7.80

India - Rupee 10.95 8.76 41.35

Korea - Won -0.65 2.67 929.30

Malaysia - Ringgit 6.27 6.29 3.44

Philippines - Peso 15.87 10.09 46.09

Singapore - Dollar 6.15 5.16 1.51

Taiwan - Dollar 0.50 -1.01 32.86

Thailand - Baht 15.94 14.74 32.32

South Africa - Rand 2.05 -4.14 7.05Source: Bloomberg(+) Appreciation(-) Depreciation* Each currency is quoted against $, except UK-Poundsterling and Euro which are GBP/USD and

EUR/USD.

168

mortgage turmoil which shocked the global capital

market. Furthermore, a shift in the direction of capital

flows occurred in 2007 with more capital flowing to

emerging market economies in Europe than in Asia.

Foreign Exchange Market

The foreign exchange market was affected by the

weaker US dollar exchange rate against other global

hard currencies (Table 11.3). This was associated with

weaker fundamentals in the US economy. Besides, the

currencies of developing countries appreciated due to

high capital inflows from global investors to countries

offering relatively more interesting returns on investment

compared to the industrial countries. Moreover, the

role of developing countries in contributing to global

economic growth has become more important and is

supported by the larger trade volume among emerging

market countries.

Despite some depreciation, the US dollar did appreciate

on several occasions. Ironically, significant appreciation

eventually transpired at the same time as the subprime

mortgage catastrophe developed in the US, when

global investors shifted their investment portfolio to low-

risk assets, namely U.S. Government Securities. This

triggered a capital reversal in the US, therefore, the US

dollar strengthened against almost all global currencies,

except the yen. The yen strengthened against the US

dollar as investors intensified their carry trade activity

(withdrawals of loans in Japan with low interest rates to

be invested in other economies providing higher returns

on the investment) and withdrew their funds back to

Japan, thus strengthening the yen. After volatility had

subsided, the US dollar returned to its depreciatory

trend, yet with relatively higher volatility in accordance

with increased uncertainty surrounding the upcoming

fallout of the subprime mortgage debacle and the

increasing trend of oil price.

Financial Market

Abundant global liquidity brought positive impacts

on the global financial market, particularly the capital

market. The share price index of various global equity

markets, particularly in emerging market economies,

increased impressively despite global financial market

shocks stemming from the subprime mortgage crisis.

The significant increases in the share price index of

developing countries were also attributable to the

improved risk perception of global investors towards

developing countries. A sharp increase was recorded in

China’s (Shanghai) share price index that leapt almost

100% in 2007 to reach 5266. Furthermore, this was

followed by a sharp increase in the share price index

in Indonesia, Hong Kong, South Korea and Malaysia

that increased by 51.5%, 41.3%, 32.3% and 30.7%

respectively. Meanwhile, the price indices of key global

stock exchanges also recorded an increase –except for

the Japan Stock Exchange– even though the increase

was not as high as in the emerging market countries.

169

Singapore, Indonesia, Malaysia, Thailand and the

Philippines were corrected by between 14% and 24%3

(Chart 11.6).

The performance of the global bonds market was

influenced by a shift in yield that followed different

directions in developed and developing countries. The

yield of government bonds in developing countries

tended to decrease –its price went up– in the first

semester, caused by strong flows of foreign investment

to government bonds. The subprime mortgage failure

struck in the second semester, which sparked a capital

reversal preceded by domestic bonds sales by foreign

investors, therefore, bond yield increased (Chart 11.7).

Conversely, the reverse occurred on the government

bonds yield in developed countries. A more attractive

yield in developing countries was one reason that

investors reduced their placements on bonds in

developed countries, consequently, during the first

semester the yield of bonds in developed countries

tended to increase. However, as the market was beset

by the subprime mortgage debacle and risks increased

bonds issued in developed countries, for which the

risk is relatively lower, became once again investors

preference and thus causing the yield to go down

(Chart 11.8).

3 The level of share price index correction as an impact of the subprime mortgage crisis, which peaked at the end of July 2007, was calculated by comparing the highest index in July 2007 (pre-crisis) to the lowest index in the period of July-August 2007.

As the subprime mortgage crisis developed in July

of 2007, the share price indices of key global stock

exchanges were corrected sharply. This was preceded

by tumbling share prices in the U.S. –the Dow Jones

Industrial Average index was corrected by around

8.2%. The share price indices in Europe and Japan

also declined (Chart 11.5); in Europe declining by

10%-14% in less than two months (July-August 2007).

The share price indices in France, UK and Germany

were corrected respectively by 14.0%, 12.8% and

10.3%; meanwhile the Dow Jones Stoxx 50 index was

corrected by 10.9%. Other key global exchanges, i.e.

Japan, were also affected with the Nikkei 225 index

falling by 16.4%.

Heavier impacts were eventually felt in the financial

markets of developing countries with relatively smaller

exposure to subprime mortgages. Aside of being

impacted by negative sentiment regarding falling share

prices on key global stock exchanges, share price

correction in developing economies was triggered

by portfolio adjustments made by global investors in

reaction to the subprime mortgage crisis. Generally,

global investors shifted riskier assets –including

financial assets issued by developing economies– to

safer assets to correct their investment risk profile and

also practiced profit taking to cover their investment

losses in other locations. As a consequence, Asian

share price indices dropped. From July-August 2007,

the share price indices in South Korea, Hong Kong,

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Meanwhile, the performance of the inter-bank money

market was influenced more by interest rate policy.

Along with the Fed’s decision to reduce the interest

rate in the second semester of 2007, the US dollar

denominated London Inter-bank Offered Rate (LIBOR)

interest rate also trended downward. The euro

denominated LIBOR rose in line with the interest rate

policy set by the ECB (Chart 11.9). However, the rising

interest rate was not transmitted to the long-term

interest rate, which tended to decline.

A noteworthy issue in the performance of the money

market was the significant jump in the interest rate in

August 2007. The subprime mortgage turmoil tightened

market liquidity and drove up the interest rate. The rise

in the interest rate of the money market occurred while

the interest rate policy remained unchanged. In addition

to the rise, the dynamics of the interest rate became

relatively more volatile. However, the interest rate

returned to normal after several central banks jointly

injected liquidity to reduce shocks in the money market.

Commodity Market

Commodity market performance was characterized

by a price dynamic that tended to rise in the past year

of 2007. Escalating commodity prices were triggered

by the soaring global price of crude oil in accordance

with the fundamental factor of imbalanced supply and

demand as well as speculative transactions. The record

high oil price also pushed up the prices of natural gas

and coal, which are included in the energy commodities

group. The price index of energy commodities

increased by 43.6% over the previous year (point-to-

point), but on average rose just 10.4%. Spiraling energy

commodity prices also drove up the prices of non-

energy commodities, primarily food commodities. In

fact, the rising price index of non-energy commodities,

which averaged 14%, exceeded the escalation in

energy commodity prices (Chart 11.10).

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Moreover, geopolitics risk in the Middle East remains an

ongoing issue.

In addition to fundamental factors, the soaring oil

price was also the result of speculative transactions

that benefited from oil price fluctuations. Speculative

transactions are likely to increase, as indicated by

the performance of non-commercial contracts (Chart

11.13), the diminishing potential investment profit in the

financial market and US dollar depreciation. Another

factor that encouraged speculative transactions

was the subprime mortgage catastrophe that

intensified investment risk in the financial market.

Such transactions are a causal factor of the continued

increase in the oil price at year end, which shifted the

dynamics of the oil price from its historical pattern

(Chart 11.13).

The oil price increased both on average and point-to-

point. The price of WTI oil spiraled from $61 per barrel

at end of 2006 to $98.7 per barrel in November 2007;

the highest on record. By the end of 2007, the oil price

closed at $96 per barrel, indicating a point-to-point

increase of 57.2%. In terms of the annual average, the

price of WTI oil rose from 9.5% from $66.1 per barrel

in 2006 to $72.3 per barrel. The prices of OPEC oil and

Minas oil also followed a similar trend as WTI oil. In line

with the oil price trend, the gas price, which is also an

Oil & Gas Commodity Market

The price of oil sky rocketed in 2007 reaching record

highs of $98,9 per barrel. This price trend -principally

at year end– shifted the oil price dynamic from its

historical pattern which generally witnessed a decline at

the end of a year. The high oil price was due to strong

demand –chiefly from China– which was not balanced

by a sufficient boost in supply. In effect, efforts to raise

supply to satisfy the strong demand reduced the spare

capacity. Consequently, the oil price was vulnerable to

negative sentiment and increasing risk (Chart 11.11).

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energy commodity, increased by 25.7% (point-to-point)

and by 3.0%4 on average (Chart 11.14).

Non-oil/gas Commodity Market

The prices of non-oil/gas commodities rose in 2007,

among others, driven up by the soaring oil price. Prices

in the manufacturing industry were pushed up as the

intrinsic production process is directly linked to oil,

which is a production input. Other commodities that felt

the direct impacts of the high oil price were agricultural

commodities; in particular food prices (Chart 11.15).

Rising food commodity prices were mainly the result of

greater alternative energy utilization. The high oil price

accelerated the conversion of energy sources from

oil to alternative fuels such as biofuel and biodiesel,

for which the main ingredients are food stuffs, such

as corn, sugarcane, CPO and soybean. With the

increase in biofuel/biodiesel usage, demand for the

related food stuffs also increased, therefore their

prices went up too. Furthermore, growing demand

for agricultural commodities stimulated production of

the respective commodities. One such effort included

supplemental plantation land; even at the expense of

other commodities, such as wheat. As a consequence,

the supply of wheat decreased and its price increased.

Furthermore, extraordinary weather –droughts triggered

by global warming– has constrained agricultural

production, decimated crops and hampered the supply

4 Based on LNG export price from Indonesia to Japan.

of agricultural commodities, which have intensified

inflationary pressures on related prices.

The prices of metal commodities also increased,

mostly in the first semester of 2007. Higher prices were

induced by stronger demand –mostly from China– to

support production activities. However, during the

second semester prices of metals declined owing

to waning demand in accordance with a slowdown

in production activity in developed countries. Such

a decline was also caused by the termination of

numerous tenure trading contracts as risks magnified

following the shocks in the financial market due to

the subprime mortgage fiasco. Falling prices helped

compensate the price hikes that occurred in the first

semester. Therefore, taken holistically for the year there

was little change (Chart 11.16).

International Cooperation

The increasing dynamics of the global economy

necessitated closer international cooperation to

boost the competitiveness of economies in the

region and maintain financial stability. In 2007,

international cooperation noted remarkable progress

and produced several critical initiatives, which are

currently ongoing. To raise competitiveness, important

bilateral and regional cooperation has been agreed,

such as the signing of the Indonesia-Japan Economic

Partnership Agreement (IJ-EPA) and the agreed

formation of the ASEAN Economic Community (AEC)

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incorporated in the IJ-EPA include the discontinuation

of major import duties on Indonesian exports to

Japan. The agreement is also expected to foster

investment from Japan and also strengthen the reform

process ongoing in Indonesia’s human resources,

particularly capacity building. This will also be made

possible through Japan’s aid program, such as though

technical assistance for skills and technology from

various aspects, especially associated with product

standardization. Meanwhile, for Japan, the IJ-EPA is

considered important due to Indonesia’s position as the

largest economy in ASEAN and, furthermore, Indonesia

has abundant natural resources that are highly coveted

by Japan.

ASEAN Economic Community 2015

Regionally, in its 40th anniversary year, ASEAN

embarked upon a new historical pillar in economic

cooperation. On 13th January 2007 in Cebu, the

Philippines, ASEAN leaders agreed to expedite the

formation of the ASEAN Economic Community (AEC);

brought forward from 2020 to 2015. This reflects

ASEAN determination to rapidly improve regional

competitiveness in the global economy. To support

this goal, in November 2007, ASEAN leaders signed

two key documents to support the formation of AEC,

namely the ASEAN Charter and the AEC Blueprint,

including a strategic achievement schedule for each

element. In addition to the Blueprint and ASEAN

Charter, the ASEAN Baseline Report (ABR) was also

developed to monitor the achievements towards AEC

2015 (Box: AEC 2015: Opportunities and Challenges for

Indonesia).

The formation of AEC is expected to improve regional

competitiveness in the global economy through the

achievement of four strategic frameworks, including

a single market and international production base,

economic zone with high competitiveness, evenly

distributed economic growth and global economic

integration. Efforts to achieve a single market and

international production base are performed by

deepening regional integration through the liberalization

of products and production factors to achieve optimal

economies of scale. The liberalization process will

demand national economic strengthening by ASEAN

nations in order to boost their competitiveness and

narrow the economic development gap. Consequently,

the bargaining position of ASEAN will strengthen in the

face of global competition. The high competitiveness

in 2015. Meanwhile, to bolster financial stability in

the region, efforts to improve network effectiveness

have been agreed such as through the Bilateral

Swap Arrangement (BSA) as well as efforts towards

multilateralization through the Chiang Mai Initiative

(CMI) and strengthening the surveillance system. These

measures taken are aimed at improving cooperation

effectiveness as part of a regional self-help mechanism

to prevent and manage future potential crises. In the

multilateral forum, efforts to maintain financial stability

focused on strengthening international financial

institutions through the implementation of institutional

reforms and good governance.

Boosting Economic Competitiveness in the

Region

Efforts to improve competitiveness through bilateral and

regional cooperation have been implemented including

the liberalization of regulations on trade and other

related sectors. Such endeavors were materialized

through the IJ-EPA and the planned formation of

AEC in 2015. IJ-EPA is the first comprehensive

bilateral agreement implemented by Indonesia.

Meanwhile, commitment to AEC aims to improve

the competitiveness of the ASEAN Zone through the

formation of single market and production base.

Indonesia-Japan Economic Partnership

Agreement (IJ-EPA)

Bilateral cooperation reached an important historical

turning point through the signing of an economic

partnership between Indonesia and Japan in August

2007. IJ-EPA was initially developed in 2005 and has

placed Indonesia on an even keel with other rival

nations in the Japanese market5. The IJ-EPA covers a

wide range of topics, for which the ultimate objective

is to strengthen economic partnership between the

two countries, namely through capacity building,

liberalization and reinforcing relationships in terms of

trade and investment. The contract encompasses

various sectors, such as the trade of goods and

services, as well as investment and the movement of

natural persons, including intellectual property rights.

To Indonesia, Japan is a trading partner and a key

source of enormous direct foreign investment. The

potential advantages to Indonesia from the cooperation

5 The EPA agreement between Indonesia and Japan was relatively protracted compared to other ASEAN nations like Singapore (2002), Malaysia (2005), the Philippines (2006), and Thailand (April 2007).

174

of ASEAN will also improve its bargaining position in

various free-trade area negotiations with ASEAN trading

partners, such as China, South Korea, Japan, Australia,

New Zealand and India.

In achieving a single market and international

production base, the liberalization of products and

production factors will establish ASEAN as a free-

flow zone for goods, services, investment and skilled

workers as well as freeing up capital flow by 2015. A

free-flow zone for goods will be achieved by reducing

tariffs and non-tariff trade barriers. Meanwhile,

improved market access and the implementation

of non-discriminatory treatment between local and

foreign business owners will lead to the free flow of

services. The ASEAN cross-border free-flow zone for

goods and services will raise production efficiency in

the global supply chain. This will subsequently open

more opportunities for cross-border investment in the

region and, therefore, ASEAN will become an attractive

investment target for global and regional investors.

Advanced investment activities are going to require

production factors, to be met through the cross-border

free-flow of skilled workers and freer capital flows.

Conversely, greater productivity from the increasingly

sophisticated investment activities will also stimulate

the flow of goods and services to be used as inputs or

traded as end products.

AEC Blueprint

The AEC Blueprint comprises of a master-plan

to achieve the four strategic frameworks of AEC

2015 by identifying elements, action plans and the

implementation schedule. ASEAN as a single market

and production base will be achieved through a

gradual liberalization process. Competition regulations,

consumer protection, intellectual property rights,

infrastructure development, taxation and e-commerce

are important elements in the establishment of ASEAN

as a region with strong economic competitiveness.

Regulation and policy development will be executed at

the national level and also through regional cooperation,

such as through standardization and synchronization.

ASEAN as a region with equally distributed economic

development will be accomplished through the

development of small and medium enterprises, as well

as by means of the Initiative for ASEAN Integration

for CLMV (Cambodia, Lao PDR, Myanmar and

Vietnam) countries, which aims to improve technology

and capacity building for economic development.

A coherent approach in economic relations beyond

the region and a more significant role in the global

production network are two important elements in the

attainment of ASEAN as a region fully integrated with

the global economy. The action plan will be executed

through negotiation on free-trade area agreements

that should bare mutual benefits to the various ASEAN

trade partners.

The schedule for the action plan is organized into four

stages, namely 2008-2009, 2010-2011, 2012-2013 and

2014-2015. In the implementation of the AEC Blueprint,

ASEAN also focuses attention on the differences in

development level and member preparedness. In order

to ensure agreed commitment, the principle of no

back-loading of commitments has also been applied,

and flexibility must be proposed at the beginning of the

negotiations and universally agreed upon (pre-agreed

flexibility).

In order to monitor and evaluate the implementation

progress of the AEC 2015 Blueprint, the ASEAN

Baseline Report (ABR) was established. Through the

ABR, ASEAN leaders are aware of the achievement

status of economic integration and are able to offer

guidance to resolve any challenges to be overcome.

The challenges in developing ABR include the lack of

availability of a database for statistical economic and

financial indicators of the liberalized economic sectors

from all ASEAN country members.

ASEAN Charter

The ASEAN Charter represents the organization of the

fundamental constitution of governmental cooperation

among ASEAN member countries. The basic

transformation executed through the ASEAN Charter

is the provision of legal personality status for ASEAN

cooperation; therefore, ASEAN may have a different

identity to the identities of its member countries.

Furthermore, the organizational structure of ASEAN

has improved, as well as ASEAN’s mandate and

decision making mechanism. The refinements made

include the formation of a Committee of Permanent

Representatives to ASEAN that represent the member

countries of ASEAN, and the formation of an ASEAN

National Secretariat that is a national focal point whose

purpose is to conduct coordination at the national level.

With the transformation of the ASEAN Charter, ASEAN

is expected to implement the agreement and better

respond to various issues in the region in terms of

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Through the EMEAP forum, regional surveillance was

strengthened by establishing MFSC in April 2007.

MFSC is expected to support regional efforts in

maintaining monetary and financial stability through

the betterment of surveillance activities. Through

MFSC, coordination and cooperation initiatives relating

to crisis management on a regional scale were also

implemented. In support of such implementation,

EMEAP member countries agreed to complement

surveillance in each country member with crisis

management. Crisis management will focus on three

categories, namely: (i) major operational disruptions

(MOD); (ii) distressed financial institutions; and (iii)

financial market disruptions. Crisis management

was regionally integrated in November 2007, as an

anticipatory step against impacts of externalities to

the region, such as the subprime mortgage failure in

the US. Furthermore, in the long term, cooperation

will be underpinned through various international

financial institutions and inter-regional coordination in

accordance with crisis management.

Institutional Reform and Governance in the IMF

Globally, the IMF has been actively involved in

discussions related to institutional reform and

governance in the organization. IMF reforms are based

on the Medium-term Strategy (MTS) that describes

various strategies to improve IMF’s role in the global

economy. Implementation of MTS includes several key

topics such as a new direction for surveillance, quota

and vote representation for developing countries,

as well as the role of IMF in developing and low-

income countries.

New Direction for Surveillance

As a step to improve surveillance, IMF has refined the

surveillance framework and placed focus on crises

happening around the world. The crisis in the late

90s as well as various external shocks in the region

up to 2007, indicate sub-optimal surveillance as a

core function of IMF in detecting crises and external

shocks. One reason is due to the implementation

of the Decision on Surveillance over Exchange Rate

Policies framework in 1977. In fact, in the last 30

years there have been significant changes in capital

flows and integration in the financial market, such

that the surveillance framework requires refinement.

Consequently, in June 2007, a New Decision on

Bilateral Surveillance was adopted to anticipate

exchange rate management issues. Crucial changes

AEC and global issues that will become more complex

in future.

Maintaining Financial Stability

To maintain financial stability, a comprehensive array

of endeavors to strengthen organizational governance

has been implemented regionally and globally. At

the regional level, efforts include the betterment of

liquidity assistance availability and strengthening

surveillance. Efforts to enhance the effectiveness of

liquidity assistance incorporate CMI multilateralization.

Whereas regional surveillance will be enhanced through

the establishment of a Monetary Financial Stability

Committee (MFSC) at the EMEAP forum. Multilaterally,

the implementation of an organizational reform agenda

at the Bretton Woods institutions (IMF and World Bank)

remained the key focus in the reporting year.

Boosting the Effectiveness of Regional Liquidity

Assistance and Surveillance

A decade on since the Asian Crisis in 1997 represents a

critical moment for the East Asia region (ASEAN+3)6 to

evaluate the role of regional cooperation in maintaining

financial stability in order to support sustainable

economic growth. Reflected by experience gleaned

from the crisis, ASEAN+3 have enhanced effective

cooperation regarding a regional self-help mechanism

to prevent and deal with future potential crises.

Additionally, heavy losses due to the crisis and deeper

financial integration in the region have encouraged

ASEAN+3 to boost the effectiveness of surveillance

cooperation and liquidity assistance through CMI

multilateralization. However, it should be noted that

such efforts are supplementary to the global liquidity

assistance scheme instituted by the IMF.

CMI multilateralization is one endeavor to strengthen

and ensure the availability of liquidity assistance,

raise assistance value and simplify the withdrawal

mechanism. Through multilateralization, it is expected

that the region will jointly agree upon stronger

commitment to initiatives to maintain regional stability.

Commitment is on regional policy cooperation and

coordination through improved surveillance in order

to facilitate evolutionary regional financial cooperation.

Currently, efforts to implement multilateralization are in

the preparatory stages.

6 ASEAN+3 countries include the ten ASEAN member countries (Brunei Darussalam, the Philippines, Indonesia, Cambodia, Lao PDR, Malaysia, Myanmar, Singapore, Thailand, and Vietnam) plus China, Japan and South Korea.

176

include additional principles that stipulate member

countries must avoid promulgating domestic exchange

rate policy that could lead to external instability.

In addition to providing guidelines for surveillance

activities, the new framework is expected to improve

quality, transparency and the impartiality of surveillance

implementation. The new framework follows three

key principles, namely: (i) the absence of any new

obligations to be met with persuasive dialogue

remaining as primary key; (ii) attention given to the

specific conditions of member countries; and (iii)

flexibility regarding future economic development.

Quota and Vote Representation

Efforts to reform the quota and vote representation

of member countries are crucial to improve the

governance of IMF. Quota reforms are based on the

desire to increase the vote representation of developing

and low-income countries, particularly developing

countries with an increasing role in the global economy.

Reform issues were discussed and agreed upon at the

G-20 meeting in September 2007.

Quota reform to accommodate the vote representation

of low-income countries is achievable by raising

the basic votes. The newly agreed upon formula

for quota setting should be simple, transparent and

accommodative relative the each member country’s

position in the global economy, which will precipitate a

larger quota for developing countries. Several proposals

for new formulae brought up several key aspects,

such as using a filtration approach to determine the

countries eligible to receive a quota increase, raising

the basic vote to protect low-income countries, as well

as foregoing any quota increase for underrepresented

developed countries. Despite basic support from IMF

member countries for the proposal to increase the

quotas of developing countries, as of year-end 2007 no

consensus had been reached.

Role of IMF in Emerging Market Countries and

Low-Income Countries

One commitment included in MTS is IMF support to

low-income country members. To this end, the IMF

wrote off the debt of Liberia, which was included in

the group of countries known as General Resource

Account (GRA) protracted arrears7 (Liberia, Sudan

and Somalia) using the voluntary assistance funds of

member countries (SCA-1/deferred charges8). The

initiative was based on the consideration that funds

sourced from Poverty Reduction and Growth Facility-

Heavily Indebted Poor Countries (PRGF-HIPC) and

the Multilateral Debt Relief Initiative (MDRI) Trust9 are

insufficient to write off the debts of such countries.

A decision was later made by the IMF to write off the

debts of Liberia considering the country’s policies being

more conducive compared to that of other countries.

Also taken into consideration is the fact that Liberia has

a Gross Domestic Product of less than $120, a foreign

debt ratio of more than 760% and a foreign reserve of

only $4.2 million. Indonesia as a member of the IMF

took part in this initiative.

7 Countries that have been behind schedule on their obligations to the IMF for more than six months.

8 SCA-1 is an account formed by IMF to anticipate and protect against the possibility of negative financial impacts due to a delay by member countries in repaying their obligations for more than six months (protracted arrears).

9 PRGF-HIPC Trust is a trust formed in February 2007 to allocate special assistance for eligible HIPC member countries, whereas the MDRI Trust was formed in accordance with 100% debt write off for Low-Income Countries, funded by three multilateral institutions (IDA, AfDF and IMF).

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ASEAN Economic Community (AEC) 2015: Opportunities and Challenges for Indonesia

In November 2007, ASEAN entered a new era in regional economic cooperation through the signing of the ASEAN Charter and Blueprint of steps towards AEC 20151. That declaration legislated the definite commitment to ASEAN economic integration. In summary, AEC will represent the transformation of ASEAN into an economic zone where goods, services and skilled workers are free to move without borders and supported by freer flows of capital. The impact of the change is the formation of a new distribution configuration for production outputs and production factors in an intra-ASEAN economy.

Theoretically, economic integration provides the promise of better welfare for the countries within, through broader market access, greater efficiency and superior economic competitiveness, as well as more opportunities for the employment of human resources. This is further supported by various empirical research that shows a positive correlation between regional economic integration and economic growth. However, there are also several conflicting suggestions, where economic integration is often viewed as providing advantages only to certain countries.

In order to reap optimum benefits from integration, a comprehensive study is required to estimate the implications of integration on the national economy. The study is required to enable the government and all relevant national elements to develop the required strategic steps to be taken to ensure Indonesia can be actively involved as a ‘player’ and not merely as a ‘marketing field’ for other countries. In general, the opportunities and challenges of AEC for the national economy are described in the following paragraphs.

Opportunities for Indonesia In terms of trade, AEC will bring numerous potential opportunities as an integrated ASEAN region will expand the market for Indonesian products. In 2006, the total population of ASEAN was 567.6 million with

1 On 13th January 2007, ASEAN leaders agreed to bring forward the formation of AEC from 2020 to 2015.

a total Gross Domestic Product (GDP) of $1.1 trillion (growth of 5.7%). An optimistic growth outlook has elevated ASEAN to a large market opportunity and potential production base. One prospective sector is electronics, which includes information technology and the communications industry. The electronics sector has a high level of industrial integration in ASEAN. This means that electronic products produced in ASEAN are processed among ASEAN member countries. This will make ASEAN a production base for electronic products. For Indonesia, among the eight priority sectors other than services2, Indonesia has five leading sectors including agriculture, wood products, fisheries, rubber and electronics. Mapping these leading sectors is required in order to produce guidelines to improve Indonesia’s competitiveness.

In terms of direct capital investment, regional cooperation to improve infrastructure (gas pipelines and information technology) will open more opportunities for Indonesia to improve its investment climate, particularly in expediting domestic infrastructure improvement programs.

With reference to attracting foreign capital, freer capital flows among ASEAN member countries will provide more opportunities for Indonesia to attract foreign capital inflows to the ASEAN region, invested in rupiah denominated assets.

Besides the opportunities outlined above, one critical aspect in the establishment of AEC is that integration will allow capacity building and higher quality institutions, regulations, and improved human resources in Indonesia, which will improve the competitiveness and efficiency of the domestic economy. Various ASEAN regional cooperation programs implemented in accordance with AEC are related to the need for synchronization, standardization and adherence to

2 Eight priority sectors include agriculture, fisheries, health service products, rubber products, wooden products, textiles and textile products, electronics, information technology and communication as well as automobiles.

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universally agreed Mutual Recognition Arrangements (MRA). For instance, the liberalization of skilled workers in ASEAN has to comply with standardized certification and competence for professionals in ASEAN. This will eventually lead to improvements in human resources in various Indonesian business sectors.

Challenges facing IndonesiaEfforts to benefit from the various opportunities offered by the emergence of AEC are not straightforward due to several challenges that require immediate attention.

Similar Comparative Advantage throughout the Region. Based on the mapping of comparative advantage in ASEAN member countries for goods in the priority integration sectors3, almost all countries have similar primary commodities in terms of agriculture, fisheries, rubber products, wood and electronics. Such similarity lowers the intra-ASEAN trade share, ranging from just 20%-25% of total ASEAN trade. Thus, a strategy to boost added value is required for Indonesian exports compared to other ASEAN countries. This also constitutes an impact assessment on import substitutes that might increase in line with the reduction of trade barriers in ASEAN. For intra-ASEAN trade, Indonesia’s share is relatively low (26%) compared with Singapore (31.8%) and Malaysia (29%).

Several challenges also confront the services sector, for instance tourism. Tourism is one of the four service sectors that have been prioritized in the AEC Blueprint, along with airlines, health and e-ASEAN. Currently, tourism in ASEAN is dominated by Malaysia, Thailand, Singapore and Indonesia or ASEAN-4. Viewed from the competitiveness of the tourism industry, based on the “Travel and Tourism Competitiveness Table”, it is evidenced that Singapore is the highest in ASEAN, followed by Malaysia, Thailand and then Indonesia. Development of intra-ASEAN tourism, dominated by ASEAN-4, indirectly stimulates tight competition among the four countries, particularly in terms of attracting tourists from ASEAN and non-ASEAN, as the four countries share similar characteristics regarding their tourism destinations. Based on the “Travel and Tourism Competitiveness Table”, it is also clear that one limitation of tourism in Indonesia is inadequate marketing management, in terms of budget

3 There are 12 Priority Integration Sectors, for which integration has been brought forward to 2010, including agricultural products, airlines, automobiles, e-ASEAN, electronics, fisheries, health, rubber products, textiles and apparel, tourism, wooden products and logistical services.

(promotion cost) and the establishment of a tourism promotion center4.

High Non-Tariff Barriers. Among ASEAN countries, Indonesia has the most non-tariff barriers. Non-tariff barriers are partially evidenced by the numerous parties involved in export/import activities, particularly related to permits. In terms of permits, more than 22 government agencies issue more than 40 documents. In order to make the most of ASEAN economic integration, Indonesia should reduce the various barriers which cause inefficiency and high economic costs, therefore, lowering competitiveness. Inter-sector and agency coordination, particularly in terms of harmonizing the perceptions of the government and business players, as well as coordinating policy at the national and regional levels, should be improved.

Adjusting the National Agenda to AEC Commitments. Due to the obligations inherent with the commitment according to the AEC Blueprint, Indonesia will have to adjust its national agenda, roadmap as well as domestic regulations in line with AEC commitments. This is required so that the strategic schedule of implementation can be applied according to domestic preparedness, as AEC implementation will be assessed through an AEC balanced scorecard with key performance indicators for all liberalization sectors (goods, services, investment, capital and skilled workers).

Improving the Awareness of Stakeholders regarding the Strategic Schedule towards AEC 2015. Hitherto, the understanding on AEC commitment and the implementation stages to be applied by Indonesia remains incomplete. Consequently, supplemental knowledge will allow the preparation process to be executed jointly by the relevant authorities as well as all stakeholders. The possible negative impacts of integration in the short term should be clearly socialized to the affected sectors in order to assist them through retraining, skill enhancement, or a gradual shift to different work. Intensive consultation with the affected group should avoid unwanted reactions.

4 One current promotional activity used is the ‘Visit Indonesia Year 2008’ program conducted through the creation and organizing of tourism events in the region based on the niches and image of tourism resources in each region.

Chapter 12

Economic Outlook and Policy Direction for 2008

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Amid the turbulence in the global economy, Indonesia’s economic growth is forecasted to reach 6.2%, a decline from 2007. On one hand, domestic demand in the form of household consumption and investment will play a stronger role in driving the wheels of the economy. On the other hand, exports will play a more moderate role in consequence to adverse global conditions. The effect of the external shocks also reflected in lower surpluses in the current account and overall balance of payments. External challenges will bear down heavily on domestic macroeconomic stability. These pressures are predicted to fuel inflation, while exchange rate is forecasted to be stable. Synergy of monetary and fiscal policy will take on even greater importance in mitigating the negative impact of external shocks on the economic outlook. Bank Indonesia will maintain a consistent monetary policy stance to achieve inflation target in support of sustainable economic growth. The Government will stay the course with maintaining fiscal sustainability while delivering a fiscal stimulus. Furthermore, to stimulate activity in the real sector, the Government will make further improvements to the investment climate and accelerate the pace of infrastructure construction. In the banking sector, Bank Indonesia will maintain a strong focus on improvement of the banking intermediary function and institution building in the banking system. Accompanying this will be payment system policies to support increased economic activity, effectiveness of monetary and banking policy and safeguarding of financial system stability.

Chapter 12: Economic Outlook and Policy Direction for 2008

Economic performance in 2008 is daunted by

predictions of adverse global economic developments.

In the global economy, international commodity prices

are running at high levels. World economic growth

is predicted to slow in comparison to the previous

year due to the impact of the high oil price and the

prolonged US subprime mortgage crisis. Despite

the likelihood of rising inflationary pressure fuelled

by high commodity prices, global monetary policy

will maintain a loose bias to counter a weakening in

global economic expansion. Foreign capital inflows

into emerging markets, including the Asia-Pacific,

are therefore expected to remain strong. Domestic

factors supporting economic growth will include the

stable exchange rate, availability of financing and

continued robust public purchasing power. On the fiscal

side, policy will be consistently implemented within

sustainable fiscal deficit while providing room for fiscal

stimulus.

In view of the global and domestic outlook, economic

growth in 2008 is predicted to ease slightly to 6.2%.

On the demand side, the economy will be buoyed by

private consumption. The implementation of a series of

investment policy packages and work on infrastructure

projects will stimulate a higher level of investment

growth. The optimization of the budget expenditures

will also provide an added boost to government

investment. On the other hand, the forecasted

slowdown in world economic growth will affect the

economy, most importantly in exports, while imports

are set to rise in 2008 in response to higher domestic

demand. Analyzed by sector, economic activity is

forecasted to mount, most importantly in sectors linked

to consumption activities. Manufacturing, the trade,

hotels and restaurants sector and the transport and

communications sector are forecasted to be the main

contributors to economic growth.

181

In 2008, the balance of payments is predicted to

post a healthy surplus, albeit less than in 2007. Softer

performance in the balance of payments will be

reflected in the current account and the capital and

financial account. The reduced current account surplus

will result from declining performance in non-oil and

gas exports in keeping with the outlook for global

economic slowdown. At the same time, a slightly lower

financial account surplus is predicted in response to

smaller inflows of portfolio capital.

The rupiah exchange rate is predicted to remain stable.

During 2008, rupiah stability will be bolstered by solid

performance in the balance of payments reinforced by

consistency, prudence and coordinated management

of macroeconomic policy. Attractive yields on rupiah

investments compared to regional neighbors will keep

attracting capital inflows that in turn will keep the

equilibrium in forex market.

Strong upward pressure is predicted for CPI inflation in

2008, mainly from external factors. Imported inflation

is seen likely to mount in response to external shocks.

An added source of inflationary pressure is predicted to

come from rising inflation expectations. Nevertheless,

it is expected that the higher inflationary pressure

can be mitigated by the stable exchange rate. In the

administered prices category, inflationary pressure will

remain low in line with the government commitment

to hold back from raising administered prices for

strategic items. However, pressure from volatile food

inflation is predicted to remain strong despite some

decline. Overall, the effort to achieve the inflation target

in 2008 will face challenges, most importantly from

external factors. Inflation is predicted to reach 6.0%-

6.5%, tending towards the upper limit of the forecasted

range. This is consistent with the figure proposed

by the Government in the Revised 2008 Budget,

which assumes inflation to reach 6.5%, above the

Government-set inflation target.

Further improvements are predicted in banking

performance during 2008. Bank lending is forecasted

to expand in line with the healthy outlook for the

economic prospects and underpinned by financial

system stability. Credit expansion is expected to reach

22%-24%, supported by bank funds mobilisation at

16%-18% over the preceding year. Accompanying

this will be improvement in credit quality reflected in

declining NPLs.

Economic activity in 2008 will again be daunted by

risks. The most important risks are from external

factors, namely a steeper downturn in the world

economy, higher than forecasted international

commodity prices and continued turbulence on global

financial markets. These factors could bear down on

the Government budget, the balance of payments

and the overall economy. Domestic challenges to the

economy will come from lower than predicted lifting

of oil and micro-level issues hampering improvement

in the investment climate and holding back progress

on infrastructure projects. The lack of optimum policy

response could potentially blunt economic growth

and employment. These conditions combined with

the inadequate state of infrastructure, disruptions

to supply of goods and distribution of staple needs

could spur inflation. Failure to address these risks

properly could cause economic growth to disappoint

predictions, while inflation could potentially surge ahead

of forecasted levels.

To respond to these challenges, the Government and

Bank Indonesia will intensify their policy synergy. Fiscal

policy will consistently target the safeguarding of fiscal

sustainability while delivering an economic stimulus.

Monetary policy will stay the course for achievement of

the medium-term inflation target. This policy synergy

will help build confidence among economic agents in

the maintenance of macroeconomic stability, which

will provide a vital basis for achieving sustainable

economic growth. In the banking system, Bank

Indonesia will move forward with the consolidation

programme designed to bring about a sound, strong

and competitive banking system while taking further

actions to strengthen the banking intermediary function.

In the payment system, policy for cash and non-

cash payments will focus on meeting public needs,

supporting monetary and banking policy effectiveness

and maintaining financial system stability.

Key Assumptions

The Global Environment

The global economy is predicted to grow by 4.1% in

2008, reflecting slowing performance compared to

4.9% in the preceding year (Graph 12.1). The world

economic slowdown will bear down most severely on

developed countries due to the impact of the prolonged

US subprime mortgage crisis. In its January 2008

revision of the World Economic Outlook (WEO), the

182

International Monetary Fund (IMF) revised downward

the growth forecast for developed nations such as

the United States, Euro zone and Japan (Table 12.1).

Nevertheless, this slowdown can still be offset by

economic expansion in developing countries. Under

these conditions, economic growth is predicted to

remain fairly high, albeit below the long-term growth

trend. The flagging growth in the world economy

augurs for a slowdown in volume of world trade.

Non-oil and gas commodity prices are predicted to

decline in the face of the world economic slowdown,

while remaining on the higher end of the scale. The

steep 14% rise in 2007 will be followed by the onset

of price correction in 2008. Major decline is especially

likely for basic metal commodities in response to

improvements in market supply delayed since mid-

2007. Improvement is expected following various

difficulties at the producer level previously constricting

supply, ranging from natural disasters to labour and

machinery capacity. However, high prices for some

food commodities, such as corn, CPO and sugar, are

again forecasted due to robust demand stimulated by

ongoing efforts to develop alternative energy sources.

Crude oil prices are predicted to remain high

throughout 2008. Concerning fundamentals, the

current level of world oil prices is the result of an

ongoing lack of spare production capacity, geopolitical

and climate factors and robust oil demand from China

and India. Upward pressure on prices has also come

from speculation by financial market players on the

commodity market. This switch to commodity markets

is triggered by depreciation in the US dollar that has

lowered the value of US dollar-denominated assets.

Looking ahead, the world economic slowdown augurs

an easing in world oil prices. In addition, the recovery

on world financial markets following the decision by

central banks to increased liquidity will encourage

a shift away from speculative activity. According to

several institutions, world oil prices in 2008 will average

about US$75-90 per barrel (Table 12.2).

Unrelentingly high world commodity prices portend

mounting world inflationary pressure in 2008. As

predicted by IMF in the WEO October 2007, inflation in

developed economies would edge upwards to 2.2%

while inflation in the developing could reach 4.8%.

However, latest developments shows that both core

inflation and CPI inflation are on an upward trend, and

therefore forecasts are now suggesting inflation at

above the IMP-predicted level.

Table 12.2

Oil Price Projection

2008 Description

IMF 75.0 Average of WTI, Brent, Dubai

Consensus Forecast 78.5 End of December 2008

EIA 86.0 Energy Inform. Adm. US-Feb 08

Bloomberg, 13 Feb 08 80.0 27 Respondents

World Bank 84.1 January 2008 Publication

Table 12.1

World Economic Outlook

2005 2006 2007Projection

2008

World Output 4.4 5.0 4.9 4.1

Developed Countries 2.5 3.0 2.6 1.8

– United States 3.1 2.9 2.2 1.5

– Europe 1.5 2.8 2.6 1.6

– Japan 1.9 2.4 2.1 1.5

– Others 3.2 3.7 3.8 2.8

Developing Countries 7.0 7.7 7.8 6.9

Africa 5.9 5.8 6.0 7.0

Eastern and Central Europe 5.6 6.4 5.5 4.6

Commonwealth 6.6 8.1 8.2 7.0

Developing Asia 9.0 9.6 9.6 8.6

– China 10.4 11.1 11.4 10.0

Middle East 5.6 5.8 6.0 5.9

Latin America 4.6 5.4 5.4 4.3Source: IMF, WEO, January 2008.

183

In view of the forecasts for slowdown in the world

economy, the global outlook is for a loose monetary

policy, particularly in developed countries. This policy

course will be taken to anticipate a more pronounced

economic slowdown, despite the upward trend in

inflationary pressure. The likely outcome of this global

monetary policy is that capital inflows will continue to

pour into emerging markets, although not at the same

rate as in the previous year (Table 12.3). Increased

capital flows will consist primarily of FDI and portfolio

investments.

Fiscal Policy Scenario

In 2008, fiscal policy will focus on maintaining fiscal

sustainability while also delivering a fiscal stimulus.

This fiscal policy includes such actions as the food

price stabilization programme. Fiscal policy will operate

through a twin-track process of fiscal consolidation

through control of the fiscal deficit and a budget

financing strategy aimed at reducing the government

debt burden and associated risks. To augment the

fiscal stimulus, early in the year the Government

targeted the 2008 budget deficit at 1.7% of GDP.

Looking ahead, the 2008 Budget will face external and

internal pressures. Externally, the unrelenting climb

in world commodity prices could potentially drive up

domestic prices. To ensure macroeconomic stability,

the Government will subsidise energy and strategic

food commodities on a considerable scale. Internally,

the government faces the risk of oil lifting falling short

of the budget assumption. These two conditions are

set to expand the budget deficit in 2008. However, the

government will pursue a range of fiscal consolidation

measures to curb the deficit in the Revised 2008

Budget at 2% of GDP (Graph 12.2). (Box: Nine

Measures for Securing the 2008 Budget.)

Fiscal policy on the revenue side will seek to increase

state revenues while continuing to provide limited fiscal

incentives1. Consolidation of taxation is targeted at

increasing the tax ratio in the GDP through broadening

of the tax base, intensified tax collection and tax

administration reforms. Key non-taxation policies will

also be introduced, including measures to increase

crude oil lifting volume, optimized collection of non-oil

and gas natural resources revenues, intensified efforts

to combat illegal logging, illegal mining and illegal

fishing, application of Good Corporate Governance at

SOEs and improved oversight of collection of non-tax

revenues at various line ministries and state institutions.

On the expenditures side, the Government will give

greater emphasis to quality of expenditures. This

is a response to the mounting constraints on state

revenues, especially from taxation. Actions will include

improved remuneration for state officials, fulfilment

of interest payment obligations, improvement in the

quality, efficiency and effectiveness of government

services and administration, increased budget for

infrastructure, support for price stability through

subsidies, increased budget allocations for education

and continuation of education and health assistance

targeting the poor.

On the financing side, the Government will prioritize

financing from domestic sources (Table 12.4). The

higher deficit will be funded through an increase in the

net issuance of Government Securities from Rp91.6

trillion in the 2008 Budget to Rp116.6 trillion in the draft

Revised 2008 Budget (Table 12.4). Building on the

strategy in 2007, the Government in 2008 will again

1 Fiscal incentives for 2008 include Minister of Finance Regulation No. 122/PMK.011/2007 dated 28 December 2007, effective retroactively from 16 July 2007, concerning Import Duties Exemptions for Goods Used in Upstream Oil, Natural Gas and Geothermal Activities, Minister of Finance Regulation No. 178/PMK.011/2007 dated 28 December 2007, valid 1 January 2008-31 December 2008, concerning Government-Paid VAT for Goods Imported for Upstream Oil, Natural Gas and Geothermal Exploration, Minister of Finance Regulation No. 179/PMK.011/2007 dated 28 December 2007, effective 1 January 2008, concerning Import Duties for Floating or Submerged Drilling or Production Platforms.

Table 12.3

Capital Flow to Emerging Markets

billions of $

2005 2006 2007* 2008**

Current Account 274.1 380.2 419.5 374.0

Net External Financing

Net Private Investment 519.6 572.8 620.3 593.1

Net Equity Investment 251.3 228.3 265.1 277.3

Net Direct Investment 200.6 167.3 212.9 223.2

Net Portfolio Investment 53.7 62.0 52.2 54.0

Net Private Creditor 265.5 343.6 355.2 315.9

Net Commercial Banks 145.7 202.3 188.5 145.8

Net Non Banks 119.5 141.3 166.6 170.0

Net Government Capital Flow -64.2 -65.0 3.3 9.5

International Financial Institution -38.6 -32.9 1.9 6.8

Bilateral Creditor -25.6 -32.1 1.3 2.7

Net Resident Borrowings/others1 -287.3 -334.1 -286.8 -269.0

Foreign Reserve -442.2 -554.0 -756.2 -707.0* estimated figure** IIF Projection1 Including net lending, monetary gold, and errors and omissions.

184

issue Government Securities in a range of tenors to

broaden the investor base. Included in this is a plan

for issuing rupiah and foreign currency-denominated

Sharia Government Securities. On the other hand, the

targeted receipts from PT PPA (Asset Management

Indonesia) and SOE privatization are minimal at

about Rp2 trillion. As envisaged in the long-term debt

management strategy directed towards domestic

borrowing sources, a net repayment of foreign debt

is again predicted for 2008. The Government will also

provide Rp2.8 trillion funding for infrastructure projects

under the Public-Private Partnership (PPP).

The fiscal consolidation pursued by the government

is predicted to ensure a continued fiscal surplus

through positive growth in government consumption

and investment. The rise in the Revised 2008 Budget

deficit is attributable to a doubling in almost all subsidy

items compared to the 2008 Budget in order to

maintain public purchasing power. At the same time,

consumption and investment will continue to expand

but at a slower rate. At the central government level,

increased government consumption will be driven

mainly by the approximately 20% rise in basic pay

for civil servants. Increased material expenditures

are linked, among others, to unit reorganization and

establishment of new units. The increase in other

expenditures, which includes higher budgeting for

policy measures, covers budget allocations for the

2009 national election and procurement of Government

rice stocks, social and security emergency relief funds

and other supporting expenditures. In a parallel move,

investment expenditures will be boosted by larger

budget allocations for infrastructure. The two line

ministries receiving sizeable budget allocations for

infrastructure are the Ministry of Public Works and the

Ministry of Communications.

An increased fiscal contribution is also predicted at the

regional level. Regional government consumption and

investment will be marked by increased expenditure

allocations for regions in line with the strengthening

of domestic revenues, as reflected in the rise in the

tax ratio to 14% of GDP in the Revised 2008 Budget.

Higher budget allocations for social aid and subsidies

will also result in increased transfers to the real sector.

The more robust social aid budget contains higher

budget funding for disaster relief, increased social

assistance channelled through line ministries/statutory

agencies and social aid programmes in operation for

the past several years. These programmes include the

Operational Assistance for Schools (BOS), free health

services at community health centres (Puskesmas),

class III government hospitals and appointed private

hospitals and the Families with Hope programme

that has taken over from the Direct Cash Transfers

programme. At the same time, increased subsidies are

explained by higher energy subsidies necessitated by

forecasts of further escalation in crude oil prices, as

well as subsidies for strategic food staple commodities.

185

Table 12.4

State Budget and Revised State Budget for 2008trillions of Rp

ItemState Budget 2008 Revised State Budget 2008

Trillions of Rp % GDP Trillions of Rp % GDP

A. Total Revenue and Grants 781.4 18.1 839.4 19.6

I. Domestic Revenue 779.2 18.1 836.7 19.5

1. Tax Revenue 592.0 13.7 601.5 14.0

2. Non-Tax Revenue 187.2 4.3 235.2 5.5

Oil and Natural Gas 117.9 2.7 152.2 3.6

II. Grants 2.1 0.0 2.7 0.1

B. Expenditures 854.7 19.9 926.2 21.6

I. Central Government Expenditures 573.4 13.3 641.4 15.0

1. Line Ministries and Agencies Expenditure 311.9 7.2 272.1 6.3

2. Non Line Ministries and Agencies Expenditure 261.5 6.1 369.3 8.6

– Interest Expenditure 91.4 2.1 94.2 2.2

i. Domestic Debt 62.7 1.5 65.0 1.5

ii. Foreign Debt 28.6 0.7 29.1 0.7

– Subsidies 97.9 2.3 208.6 4.9

i. Energy Subsidies 75.6 1.8 161.2 3.8

ii. Non Energy Subsidies 22.3 0.5 47.4 1.1

– Other Expenditures 25.0 0.6 19.3 0.5

II. Regional Government Expenditures 281.2 6.5 284.8 6.6

1. Balancing Fund 266.8 6.2 274.8 6.4

a. Profit Sharing Fund 66.1 1.5 74.1 1.7

b. General Allocation Fund 179.5 4.2 179.5 4.2

c. Special Allocation Fund 21.2 0.5 21.2 0.5

2. Special Autonomy and Balancing Fund 14.4 0.3 10.1 0.2

C. Primary Balance 18.1 0.4 7.4 0.2

D. Budget Surplus/(Deficit) (73.3) (1.7) (86.8) (2.0)

E. Financing 73.3 1.7 86.8 2.0

I. Domestic Financing 90.0 2.1 104.2 2.4

1. Domestic Bank FInancing 0.3 0.0 (11.7) (0.3)

2. Domestic Non-Bank Financing 89.7 2.1 115.9 2.7

a. Privatization (net) 1.5 0.0 1.5 0.0

b. Assets Recovery 0.6 0.0 0.6 0.0

c. Net Government Bond Sale 91.6 2.1 116.6 2.7

d. Government Investment Fund (4.0) (0.1) (2.8) (0.1)

II. Net Foreign Financing (16.7) (0.4) (17.4) (0.4)

1. Gross Drawings 43.0 1.0 44.2 1.0

a. Program Loan 19.1 0.4 23.8 0.6

b. Project Loan 23.9 0.6 20.4 0.5

2. Repayment of Principle of Foreign Loan (59.7) (1.4) (61.6) (1.4)

Assumptions:

Economic Growth (%) 6.8 6.4

Inflation (%) 6.0 6.5

Average Exchange Rate (Rp/$) 9,100 9,150

Average 3-month SBI Rate (%) 7.5 7.5

International Oil Price ($/barrel) 60 83

Indonesia Oil Lifting (million barrel per day) 1,034 0.910Source: Ministry of Finance

186

Accordingly, the fiscal impulse2 indicator points to

a fiscal policy commensurate to the needs of the

economy.

Sectoral Policy

The Government will implement a series of policies to

boost investment and sectoral economic performance.

The fiscal stimulus will be aimed at strengthening

the real sector, in part through increased capital

expenditures. Besides reinforcing investment policy

implementation, government policy will also seek to

accelerate the completion of infrastructure projects.

Part of this will include development of several schemes

for land expropriation, which represents one of the

major roadblocks to infrastructure projects. A range

of sectoral policies is designed to provide incentives

and promote growth in particular economic sectors.

These incentives include income tax relief for some

investments, exemption and reduction of import duties

and VAT on capital goods, machinery or equipment

for production purposes that cannot yet be produced

in Indonesia and favorable land and property tax

treatment for specified lines of business and selected

regions. In an added move, the Government has

also launched Visit Indonesia Year 2008, which will

stimulate economic activity in areas related to the

services sector and hotels and restaurants. Activity in

the communications sector is also set to climb further

following the announcement of new interconnection

rates in 2008.

Policy will be strengthened in support of inflation

control. To ensure adequate market supply, the

Government has allocated subsidies for fertilizers,

low interest loans and seeds, in addition to budget

funds for construction and restoration of agricultural

infrastructure and eradication of pests and diseases.

The Ministry of Agriculture targets the opening of new

land for rice paddy cultivation in 2008 to offset the

conversion of existing paddies to other use, with new

rice paddies to be developed outside Java on the

islands of Sumatera, Sulawesi, the Moluccan islands

and Papua. The Government has also delegated

greater powers to the State Logistics Agency (Bulog) to

import rice. In further actions, the government will lower

the import duty on rice by Rp100 to Rp450/kg in 2008.

To boost public purchasing power, the Government

will also strengthen the social safety net through such

2 For explanation of the fiscal impulse, refer to the chapter on Government Finances.

actions as increasing the volume of rice allocated

for the poor (the raskin programme) and operational

assistance for schools.

Forecast for Aggregate Supply and Demand

Economic growth in 2008 will be chiefly driven by

increased domestic demand. Improvement in public

purchasing power from the planned pay rise for

civil servants and increases in provincial minimum

wage levels (Graph 12.4) will spur growth in private

consumption. The downward trend in interest rates in

2007 will also generate added momentum for private

consumption from the financing side. Investment will

grow in response to escalating domestic demand

and improvement in the investment climate. The

external shocks taking place in the global economy are

expected to slow exports, although the impact will be

limited. At the same time, imports will rise to keep pace

with mounting domestic demand.

Forecast for Aggregate Demand

Economic growth in 2008 will be driven more by

increased domestic demand. Improvement in public

purchasing power from the planned pay rise for

civil servants and increases in provincial minimum

wage levels (Chart 12.4) will spur growth in private

consumption. The downward trend in interest rates in

2007 will also generate added momentum for private

consumption from the financing side. Investment will

grow in response to escalating domestic demand

and improvement in the investment climate. The

external shocks taking place in the global economy are

predicted to slow exports, although the impact will be

limited. At the same time, imports will rise to keep pace

with mounting domestic demand.

Private Consumption

Private consumption is predicted to maintain robust

expansion in 2008 on the strength of buoyant

purchasing power and availability of financing.

Table 12.5

Economic Growth Outlook by Expenditure

Component (percent, yoy) 2007 2008*

Gross Domestic Product 6.3 6.2

Private Consumption 5.0 5.4

Government Consumption 3.9 3.8

Gross Fixed Capital Formation 9.2 9.3

Export of Goods and Services 8.0 7.9

Import of Goods and Services 8.9 9.4* Bank Indonesia Projection.

187

Investment

Investment activity in 2008 is predicted to show slightly

increased growth. Improvements in the investment

climate are expected to boost investment expansion

in 2008. The fiscal stimulus through government

investment will also have a role in strengthening

investment levels in 2008, despite reduced growth

compared to the preceding year (Chart 12.5). At the

same time, private investors are expected to play an

increased role in promoting investment.

Analyzed by type of investment, construction

investment is predicted to advance at a rapid pace

in 2008, driven by work on a range of government

and private sector infrastructure projects. One of

the largest of these is the construction of a toll road.

Although these projects are predicted to fall behind

their original schedules, Government actions to resolve

various obstacles in the field, particularly in relation to

land expropriation, are expected to pave the way for

construction investment on a larger scale.

Alongside this, investment in non-construction

investment is on a positive growth track. The expected

improvement in the investment climate will stimulate

investor activity in Indonesia. In data from the

Investment Coordinating Board (BKPM), applications

for domestic and foreign investment approvals were

up in 2007 compared to 2006 (Chart 12.6 and 12.7).

Investment interest has focused more on business

investment in secondary sectors, such as food

Purchasing power will be reinforced by real increases

in incomes, including gains from the approximately

20% pay rise for civil servants and higher provincial

minimum wage levels. The surge in the capital

market, which offers opportunities for capital gains,

has also strengthened public purchasing power

in the middle and upper classes. Looking ahead,

Government fiscal policies are expected to provide

added boost to purchasing power. In addition,

preparations for the elections in 2008 and the election

of regional government heads will generate even more

private consumption. On the financing side, higher

consumption will be supported through financing from

banks and other financial institutions. The resurgent

growth in consumption credit extended by banks and

in financing from financial institutions since mid-2007 is

predicted to continue.

Government Consumption

Government consumption is predicted to expand

further in 2008, although at a slower rate. Despite the

significantly increased deficit, the direct contribution

of the fiscal sector to the real sector will narrow due to

increased allocations for subsidies. Central government

and regional government consumption will expand at

a slower rate, commensurate with reduced growth in

personnel expenditures, material expenditures and

General Allocation Funds for the regions.

188

processing, paper and printing and the chemical and

pharmaceutical industries.

Exports and Imports of Goods and Services

Export growth is likely to slow in 2008 compared to

the preceding year. The potential for less vigorous

export performance arises from the downturn in world

economic growth with flagging world demand for

Indonesian products. However, a steeper downturn

will be avoided through greater diversification of export

destinations. The share of non-oil and gas exports

to the US is steadily declining, while non-oil and gas

exports to emerging markets, led by China and India,

are on the rise (Box: Emerging Markets Intra Trade). In

addition, future exports will continue to be dominated

by resource-based products. The buoyant demand

for the commodities in emerging market countries and

sustained high prices will prevent further decline in

export performance.

Real import growth for goods and services in 2008

is still predicted to forge ahead on the strength of

continued high domestic demand. The ongoing

economic expansion is expected to generate increased

imports. Raw material imports are predicted to rise in

line with more vigorous demand for domestic economic

activity. Alongside this, expanding domestic investment

activity will stimulate imports of capital goods.

Forecast for Aggregate Supply

Analyzed by sector, economic growth in 2008 will

be driven by growth in manufacturing, the trade,

hotels and restaurants sector and the transport and

communications sector (Table 12.6).

An upsurge is predicted in manufacturing, the

most important contributor to sectoral growth,

with redoubled performance in the non-oil and gas

manufacturing subsector. Higher production will come

in response to increased demand generated by robust

public purchasing power.

Activity in the trade, hotels and restaurants sector is

also predicted to climb. Rising public consumption is

expected to boost activity in the wholesale and retail

trade subsector. Added to this, mounting business

activity and the government’s launching of Visit

Indonesia Year 2008 will generate increased added

value in the hotels and restaurants subsector.

The transport and communications sector is

predicted to maintain high growth, fuelled mainly

by the communications subsector. The impressive

performance in the communications subsector, like

before, will be bolstered by strong public purchasing

power. Rising demand for communications has been

followed by higher supply capacity following the

investment made by telephone operators in recent

years. While cellular services have improved, calling

rates have also become more affordable. According

189

major role in this sector, albeit with reduced growth

compared to 2007.

Financial sector performance is predicted to remain

strong in 2008. The high level of economic activity will

boost demand for financial intermediary services. The

outlook for improvement in the financial sector is borne

out in bank business plans for lending and plans by

some non-bank financial institutions to issue bonds in

2008 to finance future business expansion. Increased

leasing, primarily for heavy equipment purchases,

is also predicted in line with the ongoing work on

government-sponsored infrastructure projects.

Balance of Payments Forecast

In 2008, the balance of payments is predicted to post

a healthy surplus, albeit less than in 2007 (Table 12.7).

The reduced balance of payments surplus will result

from softer performance in the current account and

the capital and financial account. Despite this decline,

direct investment is predicted to mount higher with

support from Government policy actions in support

of the real sector and improvement in the investment

climate. In the current account, slowing global

economic growth with reduced volume of world trade

will bear down on Indonesia’s export performance. At

the same time, imports will maintain vigorous growth in

line with the vibrant activity in the domestic economy.

This forecast augurs for a reduced current account

surplus, albeit still at a healthy level. The balance of

payments in 2008 is predicted to chart a US$11.3

billion surplus, bringing international reserves at end of

year to US$68.2 billion or equivalent to 6.2 months of

imports and servicing of official debt..

The Current Account

The current account surplus in 2008 will be slightly

less than in 2007. The reduced surplus will result

mainly from slowing growth in non-oil and gas exports

in keeping with the global economy slowdown and

an escalating services and income deficit. However,

Indonesia is expected to avoid a steeper decline in

the surplus due to support from increased oil prices

and restraint in non-oil and gas import growth. The

current account is also predicted to benefit from higher

numbers of foreign tourist arrivals under the Visit

Indonesia Year 2008 programme.

The non-oil and gas trade balance is forecasted to

post about the same surplus as in 2007. The outlook

to Indonesia’s Telecommunications Regulation

Agency, subscriber calling rates are set to come down

significantly during 2008.

Agricultural sector growth for 2008 is forecasted

above the historical post-crisis average. Performance

in agriculture will be strengthened mainly by the food

crops and estates subsectors. In the food crops

subsector, high output will be driven by increased

productivity, particularly for rice. This projection is

consistent, among others, with the First Quarter 2008

Forecast Figures released by the Central Statistics

Agency (BPS). The 2008 rice crop is projected at 58.27

million tons of dry unhusked rice, up 2.13% from the

2007 output of 57.05 million tons. Increased production

is also forecasted for corn and soybeans. In the estates

subsector, the forecast is for sustained high production

driven mainly by output from oil palm estates. Key

factors in this are high estate productivity and the

incentive of attractive international market CPO prices.

Weaker performance is predicted for the mining and

quarrying sector. The slowing volume of world trade

in 2008 is expected to produce some softening in

demand for Indonesian mining products, such as nickel

and copper.

Construction sector growth is predicted to mount

in 2008. Infrastructure construction with private

sector participation is expected to generate

considerable growth momentum in this sector. In

addition, construction of commercial property in

Jakarta is forecasted to rise, providing added boost

to construction sector performance. Government

investment in infrastructure projects will also play a

Table 12.6

Economic Growth Projection by Sectors

Component (percent) 2007 2008*

Gross Domestic Product 6.3 6.2

Agriculture 3.5 3.5

Mining and Quarrying 2.0 1.2

Manufacturing 4.7 5.0

Electricity, Gas and Water Utilities 10.4 11.4

Construction 8.6 9.3

Trade, Hotels and Restaurants 8.5 8.7

Transportation and Communication 14.4 14.6

Finance, Leasing and Services 8.0 8.1

Services 6.6 3.3* Bank Indonesia Projection.

190

for a world economic slowdown will dampen non-oil

and gas export performance. Non-oil and gas imports

will maintain vigorous growth in keeping with vibrant

domestic demand. However, the oil and gas balance

of trade is set for an increased surplus compared to

2007. Oil and natural gas exports will grow at a slower

pace due to declining production of LPG and LNG. At

the same time, growth in oil and natural gas imports

is similarly projected to ease in keeping with the

government policy to cut back oil imports.

The service and income deficit is predicted to rise in

2008, while transfers will remain largely unchanged.

High oil prices and imports will lead to an increased

deficit in the services account, particularly for freight

services used for imports. Similarly, the income deficit

is predicted to rise as a consequence of added foreign

capital entering Indonesia. Overall, the surplus in the

transfers account will be largely unchanged

The Capital and Financial Account

The capital and financial account is predicted to chart

a reduced surplus due to falling portfolio investment

and growth in investment assets. On the other hand,

the outlook is for increased long-term capital inflows in

the form of FDI in keeping with the improved domestic

investment climate. Investor interest is expected to

mount in the oil and natural gas sector, stimulated

by high oil prices and tax incentives offered by the

Government. In 2008, a smaller surplus is forecasted

for short-term capital inflows (portfolio capital). This

decline comes in response to the impact of the

subprime mortgage crisis in the US, the full extent

of which has yet to be revealed. Capital inflows are

Table 12.7

Forecast for Indonesian Balance of Paymentsmillions of $

Description 2007 2008*

I. Current Account 11,009 10,102

A. Goods, net (Trade Balance) 33,083 33,550

– Exports, fob. 118,014 128,918

– Imports, fob. -84,930 -95,368

1. Non-Oil/Gas 27,048 27,109

– Export 93,142 102,456

– Import -66,094 -75,347

2. Oil/Gas 6,036 6,440

– Export 24,872 26,461

– Import -18,836 -20,021

B. Services, net -11,103 -11,586

C. Income, net -15,875 -16,737

D. Current transfers, net 4,903 4,875

II. Capital and Financial Account 2,753 1,225

A. Capital Account 530 192

B. Financial Account 2,223 1,003

1. Direct Investment 1,164 3,055

2. Portfolio Investment 6,981 6,050

3. Other Investment -5,922 -8,072

III. Total (I+II) 13,726 11,328

IV. Errors and Omissions -1,220 0

V. Overall Balance (III+IV) 12,543 11,328

VI. Monetary Flows1) -12,543 -11,328

A. Changes in International Reserves -12,543 -11,328

B. IMF 0 0

Notes:

International Reserves 56,920 68,249

(In month of imports and official debt repayment) 5.7 6.21) - (minus ) indicates surplus and + (plus) indicates deficit.* Bank Indonesia projection

191

commodity prices and rising inflation in trading partner

countries. Also contributing to inflationary pressure

will be escalating inflation expectations. However,

the stable value of the rupiah is expected to mitigate

these inflationary pressures. In the administered

prices category, inflationary pressure will remain low

in line with the government commitment to hold back

from raising administered prices for strategic items.

However, pressure from volatile foods inflation is

predicted to remain high despite some decline. The

strong inflationary pressure in volatile foods is related

to persistent high international food commodity prices.

Taken together, CPI inflation in 2008 is predicted to

come within the 6.0%-6.5% range, tending towards the

upper limit of the range or above the Government-set

5%±1% target.

Fundamentals

Rising inflationary pressure from fundamentals is

predicted for 2008, mainly from external factors.

Mounting pressure in externals is explained by

escalating inflation in trading partner nations and high

international commodity prices. An added source of

inflationary pressure will be rising inflation expectations.

With public purchasing power fairly strong, for example,

due to the increase in provincial minimum wage

levels (Table 12.8), public inflation expectations are

predicted to mount. Confirming this are the results of

predicted to mount only gradual recovery, with inflows

in 2008 falling short of the level reached in 2007.

Forecast for the Rupiah

The rupiah exchange rate is predicted to maintain

stable movement throughout 2008. This prediction

is supported by carefully managed domestic

macroeconomic fundamentals and especially the

healthy condition of the balance of payments. Overall,

demand and supply on the forex market will remain

adequately balanced. Demand for foreign currency will

be spurred mainly by growing economic activity that will

in turn stimulate imports. On the supply side, foreign

currency sources are predicted to remain adequate,

bolstered by non-oil and gas export earnings and

capital inflows, comprising mostly portfolio investments.

Export earnings will remain a major source of foreign

currency, despite slowing growth in non-oil and gas

exports. Under these conditions, the current account

surplus will provide a cushion for mitigating possible

external shocks in the capital and financial account

related to portfolio investments. This is expected to

provide key support for maintaining stability in the

rupiah.

Inflation Forecast

Strong pressure is predicted for CPI inflation in 2008,

principally from the external factors of high international

Chart 12.8

Inflation Expectation – Consumer and Retail Sales Survey

192

the Retail Sales Survey (SPE) and Consumer Survey

(SK) (Chart 12.8). Nevertheless, it is expected that

mounting inflationary pressure can be mitigated by the

stable exchange rate. Added to this, the Government is

committed to hold back from raising prices for strategic

items, such as fuel and electricity billing rates, and this

will also ease pressure from inflation expectations. On

the demand side (the output gap), inflationary pressure

is predicted to remain low in view of measures to

secure supplies and distribution. Contributing to secure

supplies will be increased production capacity in

response to stronger investment growth. Furthermore,

the envisaged improvements to infrastructure are

expected to support the smooth distribution of goods

and in so doing minimise the possibility of shortages.

Non-fundamentals

Inflationary pressure from administered prices will

be kept at a subdued level throughout 2008. The

government commitment to hold back from hikes in

administered prices for strategic items, such as fuel

and electricity billing rates, is predicted to minimise

pressure from rising administered prices on CPI

inflation. Pressure from rising prices in this category is

expected from non-strategic items, including cigarette

excise, water billing rates, river and waterway transport

fares, toll charges and intercity and interprovincial bus

services. Improvements in supply and distribution

of goods are also expected to minimise inflationary

pressure from administered prices. The kerosene

shortages of the second half of 2007 are not expected

to repeat themselves in 2008.

Pressure from volatile foods inflation is set to remain

high, despite a downward trend. Inflationary pressure

will come from strong international food prices.

However, the mounting pressure may be mitigated by

adequate supply of foodstuffs, most importantly rice.

Factors safeguarding rice stocks include increased

production and flexibility in rice imports. Higher rice

production is closely linked to government efforts

for further improvement of agricultural infrastructure,

such as irrigation systems and use of hybrid seeds

capable of lifting farmer productivity. On the supply

side, procurement of imported rice will be made more

effective with BULOG given wider powers to import

rice. To keep rice prices under control, the Government

has also issued a ruling on import duty reduction for

rice. In 2008, the government will lower the rice import

duty from Rp550 to Rp450 per kilogram in support of

the price stabilization programme for domestic rice.

Banking Forecast

Further improvement in bank performance is predicted

for 2008 in keeping with the continued upbeat outlook

for the economy, with support from growing financial

system stability. The combination of a buoyant

economic outlook for 2008 and conducive trend in

interest rates offers a vital opportunity for business

and banks to promote activity in the real sector. With

support from improving financial system stability and

banking system resilience, bank lending is predicted

to expand by 22%-24% on the back of funding growth

at 16%-18%, bringing the LDR to as much as 72%.

Accompanying this expansion will be improvement in

credit quality reflected in relatively low NPLs gross at

less than 5%. Growth in bank lending will be supported

primarily by ongoing infrastructure projects, which in

turn are expected to boost credit expansion in other

productive sectors through multiplier effects.

Like the overall forecast for the banking system,

the Sharia banking system is predicted to chart

further performance gains. The upbeat outlook for

the Indonesian economy in 2008 coupled with the

programme for accelerated expansion of Sharia

banking is expected to boost industry volume and

funds mobilisation by Sharia banks. Contributing

to the expansion is the potential for establishment

Table 12.8

Provincial Minimum Wage Increase

Province2007 (Rp)

2008(Rp)

Increase(%)

NAD 850,000 1,000,000 17.65

North Sumatera 761,000 822,205 8.04

West Sumatera 750,000 800,000 6.67

Jambi 658,000 724,000 10.03

Bengkulu 644,838 683,528 6.00

West Java 447,654 568,193 26.93

DKI Jakarta 816,100 972,605 19.18

Banten 661,613 837,000 26.51

Central Java 500,000 547,000 9.40

DI Yogyakarta 460,000 586,000 27.39

East Java 448,500 500,000 11.48

Bali 622,000 682,650 9.75

West Nusa Tenggara 550,000 730,000 32.73

East Nusa Tenggara 600,000 650,000 8.33

Central Sulawesi 615,000 670,000 8.94

South Sulawesi 673,200 740,520 10.00

Papua 987,000 1,105,500 12.01

193

External risks consist of the potential for a more drastic

world economic slowdown, higher than predicted

international commodity prices and persistent lack of

stability in financial markets. In addition, domestic risks

include the possibility of below-forecasted domestic

oil production, delays in ongoing implementation of

infrastructure projects and persistence of distribution

bottlenecks for staple goods.

External Risks

Higher than predicted international prices for both oil

and non-oil commodities represent the most serious

risk factor. The impact of the rise in world oil prices

is visible in the balance of payments. High oil prices

may exacerbate world inflation, which in turn will affect

Indonesia’s export performance due to mounting prices

for imported raw materials. In addition, high oil prices

could widen the price disparity between subsidized and

non-subsidized fuels, encouraging higher consumption

of oil-based fuels. The increased consumption in turn

could cause oil imports to rise beyond the forecasted

level. High world oil prices, potential for production

shortfalls and continued high domestic demand for

oil could spur increased demand for foreign currency

to pay for oil imports, which could subsequently

influence future movement in the exchange rate. High

international commodity prices could send prices

climbing further in trading partner countries, resulting in

imported inflation that will increase prices for imported

raw materials that could potentially be passed on to

selling prices on foreign and domestic markets. On the

consumption side, the rise in imported inflation could

dampen growth in private consumption, particularly for

non-food items.

Another external risk is that of a steeper downturn in

the world economy. World economic growth in 2008

is predicted to slow in comparison to 2007 primarily in

response to flagging economic growth in the US. The

US economy still has potential for lower than forecasted

growth in view of the situation in the housing sector,

which has yet to recover from the knock-on effects of

the US subprime mortgage crisis. Any sharper decline

in the US economy could put further brakes on world

economic growth, in turn sapping the volume of world

trade. In consequence, Indonesian exports could fall

short of the growth forecast.

At the same time, prolonged instability in global financial

markets could slow the rate of portfolio capital inflows

of new Sharia banks in 2008 and the increasingly

attractive profit sharing returns that have raised the

competitiveness of Sharia bank investment products.

Improving conditions in the real sector and expansion in

the Sharia banking network will also stimulate demand

for financing. Financing, like before, will be dominated

by sale-and-purchase based financing, with focus

on the services and trade sectors. Given their limited

financing capacity, Sharia banks will pursue a strategy

of syndicated financing to boost financing growth.

With a target established for Sharia banking assets to

expand to 5% of total national banking assets, support

extended by the Government, finalization of the Sharia

Banking, Taxation and Sharia Government Securities

laws, asset growth at Sharia banks is expected to

outpace that of the national banking system. Under

these conditions, steady growth is forecasted for asset

volume, depositor funds and financing extended by

Sharia banks in 2008.

Payment System Forecast

In view of the continued healthy growth projection for

the Indonesian economy and the high rate of worn

currency in public circulation, added demand for cash

outside banks in 2008 is predicted to reach Rp109.2

trillion. This added demand for currency outside banks

is 5.4% lower than the realized additional currency

outside banks in 2007. A range of efficiency measures

put into place since 2006 to optimize the provision of

cash at BI Regional Offices with inflowing cash trends

combined with more effective cash management

at banks has reduced added volume in the cash

distribution plans.

Concerning non-cash payments, the continued high

economic growth projection for 2008 is expected to

promote increased transaction activity by the public.

Payment transaction activity is forecasted to reach

about Rp51,000 trillion. Most of the transactions (about

93% or Rp47,500 trillion) will take place in the BI-

RTGS system, a further 3% (about Rp1,500 trillion) in

clearing and the remaining 4% (about Rp2,000 trillion)

with the use of card-based payment instruments and

other payments.

Risks

Indonesia’s economic outlook for 2008, like before, is

daunted by various risks in relation to external shocks

and domestic conditions, while also challenged by

the high level of permanent component of inflation.

194

to emerging market countries, including Indonesia. This

in turn may impact the capital and financial account.

The secondary effects of the subprime mortgage crisis

in the US are predicted to bear down on Indonesia’s

foreign capital inflows. In addition, the predominance

of short-term (portfolio investment) capital in the

structure of Indonesia’s capital inflows and the shallow

condition of the domestic financial market render the

market more susceptible to global risks compared to

other countries in the region and will therefore influence

exchange rate fluctuation.

Domestic Risks

In view of oil lifting in 2007 at only 899 thousand

barrels per day and the lag in tangible results from

the tax incentives offered to the oil and gas sector, oil

production in 2008 could well fall below the assumed

level. Lower domestic oil production will necessitate

higher imports of oil, which may affect the balance

of payments (Box: Sensitivity of Indonesia’s 2008

Balance of Payments to Changes in Oil Prices and

Production Levels).

Delays in infrastructure projects also represent a

risk factor on the domestic front. The potential for

delays is related to the current limitations of the legal

and regulatory framework, with its shortcomings

in transparency and effectiveness at the sectoral

and intersectoral levels. This is reflected in such

conditions as obscurity in the regulations on land

expropriation and the weak synchronisation of central

government and regional government policies. Other

factors hampering progress in infrastructure projects

include limited project planning and risk management

resources, domestic financing and lack of clarity in the

cost recovery mechanism.

The difficulties with progress on infrastructure and

conditions in some regions prone to natural disasters

are factors with potential for disruption in the

distribution of goods, and particularly staple items.

Any disruption in staple goods distribution will drive up

prices for these items, which may trigger heightened

expectations of price increases that in turn could

fuel inflation.

All of these risks, if not managed carefully, will

exacerbate the potential for flagging economic

performance. Economic growth could drop below

the forecasted level. Upward pressure on prices may

lead to higher than forecasted inflation. (Box: Moving

Towards Quality, Sustainable Economic Growth:

Opportunities and Challenges).

Policy Direction

Monetary Policy Direction

The monetary policy pursued by Bank Indonesia will

remain focused on building macroeconomic stability

in support of sustainable economic growth through

application of the Inflation Targeting Framework (ITF).

Monetary policy direction will focus on achievement of

the Government-set inflation target, taking into account

economic forecasts and risks. This commitment

and consistency in monetary policy is expected to

engender a shift in the perceptions and expectations

for economic actors in favour of more forward looking

expectations of inflation. However, achievement of the

inflation target is daunted by the challenge posed by the

considerably high level of permanent inflation-forming

components. For this reason, coordination of monetary,

fiscal and real sector policies will be continued to ease

the level of these permanent components.

In actions related to achievement of the inflation

target, monetary policy will focus on deepening of the

domestic financial market. A deeper, more robust and

liquid financial market will strengthen the resilience

and stability of the financial system and ultimately

minimise the negative impact of global financial market

turmoil on the domestic economy. The revitalization

and enrichment of monetary instruments is vital to

this objective. Measures include the issuance of Bank

Indonesia Certificates (SBIs) in longer tenors of 6 and

9 months and the activation of repurchase agreements

(repo) with underlying government bonds to support

liquidity management. The use of government bonds

in repo transactions is also envisaged as a means

of encouraging greater activity and liquidity on the

government bonds market, thus improving market

efficiency and resilience to potential shocks. Liquidity

management will also be supported by the use of

foreign exchange swaps (FX swaps). This policy is

expected to help market actors achieve more effective

liquidity management and improve risk diversification.

The direction pursued in monetary policy also aims

to strengthen the effectiveness of the ITF. To improve

operation of the ITF, actions will be pursued to maintain

overnight rates stability in the interbank money

195

market, which serves as a vehicle for monetary policy

transmission and a mechanism for forming more

consistent short-term yield curves (Box: Improvements

to the Monetary Policy Operational Framework).

These measures will be pursued to strengthen the

effectiveness of monetary policy transmission in

order to manage public expectations and promote

an expanded financial sector role in support of the

economy. To this end, liquidity conditions and overnight

rates on the money market will be monitored on a daily

basis, enabling quick response in the event of any

disruptions with the use of the Fine Tuning Operations

(FTO) mechanism, repo transactions with SBIs or

government securities and FX swap transactions.

The monetary policy direction will also be supported by

exchange rate policy. Bank Indonesia will consistently

apply a flexible exchange rate policy, allowing the

rupiah to move in line with economic fundamentals. To

manage volatility in the rupiah, Bank Indonesia will also

conduct forex market interventions. These exchange

rate support measures are expected to dampen

inflationary pressure from exchange rate movement

and guide inflation expectations of economic agents

consistent with inflation target. Reinforcing this are

standby facilities under the ASEAN+3 cooperation in

the Chiang Mai Initiatives, in which Bank Indonesia has

concluded bilateral swap arrangements with Japan,

Korea and China. These regional self-help measures

are of strategic importance in maintaining future

economic and financial stability in the region.

Actions for strengthening monetary policy will also be

reinforced by a communications and dissemination

strategy. Press releases and publication of monthly,

quarterly and annual economic reports will continue.

In addition, seminars, discussions and other events for

educating the public on monetary policy and economic

developments will be organized on a consistent basis.

These actions are expected to strengthen monetary

policy transparency in the eyes of the public and thus

support actions to guide public expectations towards

the prescribed inflation target.

Further measures in support of achievement of the

inflation target and macroeconomic stability will be

pursued through policy and strategic partnerships

coordinated with the Government and other economic

actors. Coordination and synchronisation of monetary,

fiscal and sectoral policies has been established in

various coordinating meetings between Bank Indonesia

and the Government. In addition, the Inflation Control

Coordination Forum has been established for policy

coordination in steering inflation towards target. The

primary task of this forum is regular monitoring of

inflation control-related activities. At the technical level,

the work of the Inflation Control Team in support of

securing the supply and distribution of major staple

goods will be intensified through implementation of the

inflation control road map. In a parallel action at the

regional level, the role of the Bank Indonesia Regional

Offices will be strengthened for empowerment and

acceleration of local economic development and

operation of local inflation control measures. Among

these is the establishment of Regional Inflation

Control Teams to coordinate actions between Bank

Indonesia Regional Offices and relevant agencies. In

the envisaged actions, inflation levels will be managed

through coordination of comprehensive price controls

at the central and regional levels designed to guide

public inflation expectations towards the established

inflation target.

Concerning the financial system, interagency

coordination with Bank Indonesia has been pursued

through establishment of the Financial System

Stability Forum (FSSK). The objective of the FSSK is

to strengthen and maintain financial system stability3

through regular meetings. In 2008, the FSSK plans to

finalise the Crisis Management Protocol and the Macro

Early Warning System (EWS) while taking work forward

on programmes under the initiatives in the Indonesian

Financial System Architecture (ASKI).

Policy Direction for the Banking System

In the area of banking, Bank Indonesia will continue

pressing forward with the consolidation programme

for a sound, strong and competitive banking system.

Added to this will be further strengthening of the bank

intermediary function to ensure that business financing

needs are met without sacrificing attention to prudential

banking. The policies for strengthening the resilience

of the banking system consist partly of continuation of

the banking consolidation policy, improvement of good

corporate governance, customer education and the

envisaged launching of Basel II. In further moves, the

banking intermediary function will be reinforced through

policy for promotion of productive business ventures,

3 The financial system consists of the banking system, capital market, insurance companies and other financial institutions.

196

expanded credit to MSMEs, introduction of universal

banking, optimized role for foreign-owned banks and

exploration of possibilities for establishment of a policy

bank. Rural bank development will focus on building

rural banks as a pillar of strength for local economic

activity with focus on local economic potential and

social capital. This policy will involve such actions as

mapping of the rural bank profile, strengthening of

quality and competence in oversight of rural banks,

capacity building for rural bank personnel and

establishment of a centre of micro-financial institution

studies. In other moves, Sharia banking policy will

focus on various actions to accelerate the growth of the

Sharia banking industry, including a public awareness

programme, improvement in quality of human

resources, product enrichment and finalization of three

underlying laws: Sharia Banking, Taxation and Sharia

Treasury Notes.

Strengthening the Bank Intermediary Function

The strengthening of the bank intermediary function will

be pursued in several areas. First is technical guidance

for productive business, which requires each bank to

provide guidance to productive business actors within a

specific region or sector with unrealized potential. One

compliance indicator in this area is the ratio or portion

of total credit and debtors with reference to a range of

indicators, such as the comparison with consumption

credit in the bank portfolio.

Second is promotion of economic development through

micro, small and medium-scale credit, which involves

four main policies. Commercial bank loans for MSME

customers will be channelled through rural banks under

the Linkage Program. This programme is organized for

the reason that commercial banks have greater funding

capacity than rural banks, but are constrained in their

outreach to MSME customers by the limitations of their

operating networks and analysis capability.

A loan guarantee scheme will also be established

to support access to credit for feasible but not

yet bankable MSME customers. This scheme

involves regional governments, commercial banks

and especially Regional Development Banks,

relevant sectoral offices in the regions, Business

Development Service Providers (BDSPs) and loan

guarantee institutions.

There will also be a study of possibilities for reduction

in the Risk-Weighted Assets calculation for People’s

Business Credit (KUR). With the backing of loan

guarantees from Askrindo, risk-weighted assets

may be lowered about 30%-40%. This reduction

is also possible for credit guaranteed by insurance

companies other than Askrindo, insofar as they satisfy

requirements to be established at a future date.

Third is incorporation of universal banking into the

Indonesian banking system to support financial market

deepening. This will bring a positive contribution to

financial stability and economic growth. Universal

banking using the in-house model is planned for

launching at end-2010, with the expectation that the

amendment to the Banking Act will be finalized no later

than the end of 2008.

Fourth is the policy for strengthening the bank

intermediary function at the 49 commercial banks

with majority foreign ownership (46% of total banking

assets). This policy includes actions to promote higher

quality lending by channelling funds to productive

MSME ventures, promoting active involvement in

training for productive business ventures in a particular

region or sector and strengthening the role of these

banks under the corporate social responsibility

programme.

Fifth is exploration of possibilities for establishment of a

policy bank, in view of the limited availability of long-

term financing to support infrastructure development.

The limited national budget funds for infrastructure

projects and the long-standing predominance of

short-term funds in the bank financing structure have

kept financing for infrastructure projects at a relatively

limited level. The funds mobilized by the policy bank

will be channelled into various projects and long-term

development programmes, with infrastructure an

important focus.

Strengthening Bank Resilience

Actions for strengthening bank resilience will involve

a range of policies. First, to establish the direction of

bank consolidation, the criteria for High Performing

Banks and Anchor Banks will be defined in a regulation.

Added to this will be an audit of the effectiveness of the

increase in bank capital to Rp80 billion.

197

Second is implementation of Basel II, covering Pillar

1 (minimum capital adequacy), Pillar 2 (supervisory

review process) and Pillar 3 (market discipline). In

Pillar 1, there will be an assessment of accurate

use of internal models in the calculation of capital

charge for market risk taking account of (i) general

requirements, including the management of the bank

risk management system; (ii) qualitative requirements,

such as active oversight by the board of commissioners

and board of directors, possession of internal validation

standards and periodic internal audit of the use of

the internal model; and (iii) quantitative requirements,

such as daily calculation of Value at Risk (VaR) and

use of data for one year (250 working days). For Pillar

2, the work programme for 2008 is still in the stage

of translation of the four principles of the system for

risk-based bank supervision. The implementation of

Principle 1 (Internal Capital Adequacy Assessment

Process – ICAAP) by means of clearer regulations

to guide banks in the capital adequacy calculation,

implementation of Principle 2 (Supervisory Review

Evaluation and Process – SREP), Principle 3 (CAR

above minimum) and Principle 4 (early intervention)

will take place through improvements to the existing

formal bank supervisory actions, including clarification

of the regulation that supervisors may order banks

to add capital commensurate to the risk profile. For

Pillar 3, the work programme continues to be directed

towards improvements to the bank published report

framework in keeping with the approach used in

Pillar 1 of Basel II and other international standards,

including International Accounting Standards (IAS).

The implementation of Pillar 3 will also be followed

by broader outreach and intensification in the public

education process.

Third, a circular letter was issued on Good Corporate

Governance (GCG) on the technical guidelines for

bank GCG, requiring banks with assets exceeding

Rp10 trillion or publicly listed banks to implement GCG

by the end of June 2007. Banks with less than Rp10

trillion in assets or not listed on the stock exchange are

required to comply with the full GCG regulations by end

of June 2008, so that in mid-2008, GCG will be fully

implemented at all banks (self-assessment basis).

Fourth, the public education programme marked

by the launching of Banking Education Year 2008 is

aligned with efforts to promote financial deepening by

building public awareness of the benefits and risks of

banking products.

Fifth is the Corporate Social Responsibility programme

for the banking industry, aimed at providing strategic

assistance in education.

Rural Bank Development

Rural bank development will aim at providing support

for empowerment of local economic actors, the target

and focus of their business. For this purpose, the

redefinition and redirection of future policy for rural bank

development will take place as follows:

First, move forward with the implementation of the

rural bank blue print for strengthening the strategic role

and contribution of rural banks as community banks in

support of local economic development.

Second, prepare a stratification (grouping) of rural

banks in order to optimize their role and contribution.

This stratification is based on Tier 1 capital as

appropriate to the capacity and risks carried by

the rural banks and parallels the banking structure

envisaged in the Indonesian Banking Architecture (API).

In future actions, changes will be to the regulation and

supervision system for different strata of rural banks.

Third, conduct research for mapping the rural bank

profile based on capacity, customer needs and risks.

It is envisaged that these issues will be identified

according to rural bank strata, enabling solutions to

be found. Furthermore, a comprehensive study will be

performed for the rural bank regulatory policies and

supervision systems commensurate to the capacity and

risks of each strata of rural bank, which will be set out

in the rural bank blue print.

Fourth, launch Rural Bank Apex institutions operating

at the regional level. This will involve an awareness

campaign for establishment of regional Apex

institutions in other regions. Preparations will also

follow for establishment of an Apex institution capable

of operating on a national scale. Reflecting the results

of an Apex pilot project and borrowing from best

practices in some countries, the envisaged form of

the national Apex institution is a commercial bank or

unit of a commercial bank committed to operating

as an umbrella for member rural banks with a policy

commitment in MSME development.

198

Fifth, build the quality and competence of rural bank

supervisors in keeping with advancement in rural bank

products and services and to anticipate a range of

cases involving rural bank operations.

Sixth, build the quality and competence of rural bank

personnel to maintain competitiveness against other

institutions offering MSME credit and strengthen rural

bank capacity for financing productive sectors.

Seventh, found a micro finance institution with the aim

of refining a range of measures undertaken by the

Government and other parties in order to promote the

economic development and empowerment of low-

income populations in isolated regions and rural areas.

Sharia Banking

The expansion policy for sharia banking for

achievement of a 5% share of total banking assets

will face challenges from limited capital, inadequately

qualified human resources and thin service coverage.

These challenges can be essentially addressed

from two sides: the expansion policy pursued by

the authorities and the expansion strategy on the

part of banking institutions. For the authorities,

the development policy includes regulation of

establishment and office networks, operations and

technical assistance. For banking institutions, the

expansion strategy involves marketing approaches,

provision and development of product variety and

organizational management. Sharia banking policies will

be guided as follows.

First, provide incentives or facilities to attract new

investors, involving the establishment of an investor

forum with stakeholders. This is envisaged as a move

to bring added capital into the sharia banking system.

Besides the establishment of the investor forum,

an entry point for new investors will come with the

finalization of the revised Taxation Act. At the same

time, the upward trend in ROA and ROE among sharia

banks is expected to stimulate entry by new investors.

Second, conduct public awareness campaigns for

sharia banking to inform the public and encourage

the use of sharia bank financial services. Public

awareness campaigns will apply an approach

stressing the advantages and unique characteristics of

banking operations that uphold the values of fairness,

community and benefit. The campaigns will include

public service advertising in various media and the

organization of Sharia Economic Festival in the first

month of the Islamic calendar year (Muharam).

Third, provide training for MSE business consultants

and Sharia bank account officers to build

understanding of the real sector. This is expected to

pave the way for expanded financing by Sharia banks.

The programme will involve government agencies,

and in particular, regional governments, consultancy

firms or educational institutions and companies with

corporate social responsibility programmes targeting

MSE development.

Fourth, broaden Sharia banking involvement in

government projects, both in financing of government

projects and opportunity for management of

government sources of funds. In addition, the

Sharia banking system will also be involved in a

deposit insurance programme for MSE customers

in cooperation with government agencies, banking

institutions and guarantee institutions.

Fifth, issue or amend various regulatory provisions

in support of accelerated growth of Sharia banking,

among others with the completion of the Sharia

Banking Act, the National Sharia Securities Act and

amendment to the Taxation Act.

Sixth, strengthen human resources quality through

technical assistance programmes for banks aimed

at building competency and expertise, including

certification for Sharia bank directors, cooperation

with educational institutions in building the expertise of

Sharia bank managers, curriculum recommendations

and provision of literature on Islamic economics,

finance and banking for higher educational institutions.

Seventh, enrich the selection of financial products and

services offered by Sharia banks through preparation of

a book codifying international sharia-compliant banking

products with information on various Sharia bank

products in the international community. This book is

envisaged as a reference for domestic Sharia banks to

broaden their financial products.

199

Policy Direction for the Payment System

Payment system policy continues to focus on meeting

public demand for payment instruments and services,

supporting monetary and banking policy effectiveness

and maintaining financial system stability. In the area

of currency circulation, policy in 2008 will represent a

continuation of the preceding year, built around three

pillars: (i) increasing the circulation of secure, reliable

and efficient circulation of currency, (ii) cash service

excellence, and (iii) improvement in the quality of

currency. In the area of non-cash payments, payment

system policy will maintain a consistent focus on 4 (four)

key principles: risk mitigation, efficiency improvements,

equitable access and consumer protection.

The strategy for meeting demand for cash currency will

involve the provision of currency in adequate quantities

and outsourcing of currency distribution to third parties.

To supply the need for currency, Bank Indonesia will

arrange for procurement of 5.86 billion bank notes and

1.16 billion coins. The currency distribution strategy will

be implemented through dispatch and return from Bank

Indonesia Regional Offices receiving net inflow and

expanded cooperation with transportation operators.

The policy for primary level cash services will involve

pilot implementation of cash centres and evaluation

of outsourcing of cash services. To improve currency

quality, Bank Indonesia plans to issue and circulate

bank notes in the Rp2,000 denomination.

To ensure the reliability and operational continuity of the

payment system while mitigating risks, Bank Indonesia

is involved in ongoing testing of the main and backup

systems at both the operator and among members.

Added to this, a study will examine the operation of

foreign currency transfers using the payment versus

payment (PVP) mechanism and progress in the funds

transfer risk mitigation model at Bank Indonesia,

accommodated into the Second Generation RTGS

development. This is to anticipate growing interest

among foreign investors in need of improved settlement

efficiency in multi currency settlement within the

expanded scope of cross border settlement. Parallel

with the development of the Second Generation RTGS,

development of the Second Generation BI-SSSS

will accommodate the market need for securities

transactions with government bonds and SBIs as

underlying instruments, such as securities lending and

borrowing and collateral management. To improve

efficiency primarily in the retail payment system, the

interoperability principle will be implemented in the

card-based payment instrument industry. The principle

of equitable access will be set out in the regulation

specifying the system operating procedures, with

emphasis on Bank Indonesia’s position as regulator,

operator and member. This regulation will also enable

the operation of payment system functions by non-bank

institutions. Alongside this, consumer protection will be

strengthened through the introduction of a regulation

on e-money and industry-wide application of rule on

money remittances. To reinforce policy coordination

between Bank Indonesia and the Government, the

payment service infrastructure operated through the

BIG-eB facility will be equipped with additional modules

for rupiah transactions, foreign currency transactions

and foreign currency transaction information. The BIG-

eB facility will act as a support for the Treasury Single

Account (TSA) mechanism slated for launching at all

State Treasury Offices.

200

Sensitivity of Indonesia’s 2008 Balance of Payments to Changes in Oil Prices and Production Levels

Oil prices and production levels have an important

bearing on the balance of payments, mainly in the oil

and natural gas trade balance. The conclusion reached

from simulations of changes in both assumptions in the

2008 balance of payments projection is that change

in oil production exerts greater influence on the oil

and natural gas trade balance compared to change

in oil prices. Each 1 percent rise (fall) in oil prices will

increase (diminish) the oil and natural gas trade surplus

by US$80 million. On the other hand, each 1 percent

rise (fall) in oil production will increase (diminish) the oil

and natural gas trade surplus by US$248 million.

The change in the assumed oil price in the balance of

payments forecast will be transmitted to Indonesia’s oil

exports and imports. In addition, movement in oil prices

will also influence gas exports and imports, given the

inclusion of an oil price component in the formulation

of the gas selling price. At the same time, the change

in the assumed domestic oil production in the balance

of payments forecast is transmitted to oil export and

import volume. If oil production falls below the assumed

level, export oil volume will decline and conversely

import volume will rise1.

In this regard, the outlook for the 2008 balance of

payments depends on such factors as the outlook for

oil prices, which have recently surged, and the declining

capacity of domestic crude oil producers in the past

few years. The table below indicates the sensitivity of

the oil and natural gas balance of trade when oil prices

rise and production falls, both in comparison to the

assumptions used in the 2008 balance of payments

projection2.

1 Assuming cateris paribus, including but not limited to no change in domestic oil fuel consumption levels.

2 Note: the assumed price and production levels are averages over one year.

Table of BOP Sensitivity to Changes in Price and Oil

Production to 2008 BOP Projection

Detail

Impact on BOP (in million $)

Price 1%

Production 1%

Price 1%Production 1%

Oil Transaction:

– Oil Exports (fob) 136 -131 3

– Oil Imports (fob) -190 -117 -308

Oil Trade Balance -54 -248 -305

Gas Transaction

– Gas Exports 134 0 134

– Gas Imports –

Gas Trade Balance 134 0 134

Oil & Gas Trade Balance 80 -248 -171

201

In recent developments, crude oil prices, domestic

lifting of oil and escalating international commodity

prices have swollen the 2008 Budget deficit. Crude

oil prices steadily climbed since Q1/2007, reaching

an average of US$72.30 per barrel for 2007. At this

level, crude prices were above the assumed US$60

per barrel price used in the Revised 2007 Budget and

the 2008 Budget. The surge beyond the assumed

oil price has boosted the 2008 budget deficit mainly

because of developments in the various parameters for

calculating the subsidies for fuel and electricity billing

rates, resulting in a soaring expenditure burden for the

fuel subsidy and electricity subsidy. These parameters

include the increased estimated quota for subsidized

fuel consumption; increased proportion of fuel used in

power generation; and failure to achieve the target for

energy conversion from kerosene to LPG. In addition,

oil lifting in 2007 reached only 899,000 barrels per day,

below the 950,000 barrels per day assumption in the

Revised 2007 Budget. In 2008, lifting is forecasted

at less than 1 million barrels per day, below the 2008

Budget assumption of 1.034 million barrels per day. In

addition, the upward trend in some international prices

for foodstuff commodities such as soybeans, wheat

and corn, brought on by rising world demand and

energy conversion, also carries the risk of expanding

the 2008 Budget deficit through increased subsidies for

these commodities to maintain domestic price stability.

The combination of these factors could push the deficit

in the Draft Revised 2008 Budget to 4.2% of GDP.

To address the risk of a spiralling deficit, the

Government is adopting a series of policies for

securing the Draft Revised 2008 Budget deficit level

while reducing the burden to the public and sustaining

growth momentum. The policies are set out in the Nine

Actions for Securing the 2008 Fiscal Deficit Outcome,

which provide fiscal incentives for the real sector and

incentives for stabilization of foodstuff prices. The nine

actions involve state revenues, state expenditures and

Table 1

Factors Escalating 2008 Budgets Deficits

Factors

Oil Price Above $80/barrel

Oil Lifting Below 1 million barrel/day

Quota for subsidized Fuel

Consumption

Up from 35,8 million kilo liter to 39 million kilo liter partly due to only 50% of

the 2 million kilo liter target of conversion of kerosene to LPG was achieved

and talking into account the high 2007 realization of fuel consumption (38,2

million kilo liter).

Food SubsidiesHigher subsidies allocation to rice for the poor program, cooking oil market

operation and program for direct assistance to soybean cakes producers.

Package for Stabilization of

Strategic Food Commodity Price

Partly including the lowering of rice import tariff; government covering for

cooking oil VAT; lowering of flour import tariff; government covering of wheat

and flour VAT; reducing of soybean import tariff; lowering of income tax on

soybean import; increase of bea keluar CPO, biofuel

Tax Revenue

Reduction of non oil and gas income tax resulting from a lower 2007

realization than targeted in the revised 2007 budget that is applied as

the base calculation for the 2008 budget and a lower economic growth

assumption.Source: Ministry of Finance, February 2008

Nine Measures for Securing the 2008 Budget

202

deficit financing. The fiscal incentives extended to the

real sector include expansion of the scope of sectors

benefiting from income tax incentives (Government

Regulation No. 1 of 2007), reduced income tax rates

for companies listing on the stock exchange and

fiscal facilities for specified sectors (including tax and

import duty incentives for investment in oil, natural

gas and geothermal production and in capital goods

not produced in Indonesia). The Government will

also maintain budget support for the infrastructure

programme, albeit with a reduction from Rp4 trillion in

the 2008 Budget to Rp2.8 trillion in the Draft Revised

2008 Budget.

These actions will enable the Government to keep the

Draft Revised 2008 Budget deficit at a level consistent

with fiscal sustainability while still contributing to the

real sector. Accordingly, the Government expects to

control the deficit in the Draft Revised 2008 Budget to

2% of GDP, representing an increase of Rp14 trillion

over beginning of year target of 1.7% of GDP. This

enlarged deficit will also be accompanied by growth in

Government consumption and investment, although

at a slowing rate. Budget cuts for line ministries and

agencies will result in slower growth in Government

consumption and investment compared to initial

targets. On the other hand, transfers to the real sector

will run ahead of target due to rising subsidies. The

increased subsidies are expected to sustain public

purchasing power and domestic demand to offset

slowing growth in Government consumption and

investment. On the financing side, constraints in deficit

financing sources mean that the increased deficit will be

followed by greater volume of T-Note issues compared

to the plan at the beginning of the year. Neither of

these are expected to disrupt the outlook for fiscal

sustainability, given the surplus in the primary balances

and the ongoing decline in the official debt ratio.

Table 2

2008 State Budget Outlook With and Without Security Measures

trillions of Rp

ExplanationState Budget

2008

State Budget

without

security

measures

Security

Measures

Revised Draft

State Budget

2008

Changes

State Revenues 781.4 806.8 32.6 839.4 58.0

of which

Non Oil & Gas Tax 550.3 534.3 20.4 554.7 4.4

SOE Dividends 23.4 23.4 8.0 31.4 8.0

Other Non Tax Revenues 37.6 39.1 3.4 42.4 4.8

State Expenditures 854.7 985.6 (59.3) 926.2 71.6

Central Government Expenditures 573.4 697.2 (55.8) 641.4 68.0

Line Ministries/Agencies Expenditures 311.9 311.9 (39.9) 272.1 (39.9)

Non Line Ministries/Agencies Expenditures of

which

261.5 385.3 (16.0) 369.3 107.8

– Fuel Subsidies 45.8 116.2 (10.0) 106.2 60.4

– Electricity Subsidies 29.8 65.0 (10.0) 55.0 25.2

– Non Energy Subsidies 22.3 39.5 7.9 47.4 25.1

Transfer to Regions of which 281.2 288.3 (3.5) 284.8 3.6

Oil and Gas Profit Sharing Fund 23.6 28.5 28.5 4.9

Infrastructure Fund 4.6 4.6 (4.6) 0.0 (4.6)

Budget Deficit (73.3) (178.8) 91.9 (86.8) (13.5)

(Share to GDP) (1.7) (4.2) (2.0) (0.3)

Budget Financing 73.3 71.2 15.6 86.8

Domestic Financing 90.0 90.3 13.9 104.2

Foreign Financing (16.7) (19.1) 1.7 (17.4)

Source: Ministry of Finance, February 2008.

203

Table 3

Nine Measures for Securing the 2008 Budget

A. Revenue Optimalization

1. Optimalization of Tax, non

tax revenues and SOE

dividends

• AdjustmenttoFixedIncomeTaxtariff:30%forcorporate,35%forindividuals

• Intensificationsoftaxfor“booming”sector(miningandplantation)

• Intensificationofexciserevenues

• AdditionalexporttaxforCPOanditsderivatives

• Exporttaxforminingproducts(coal,gold,nickel,tin)

• InterimdividendfromSOE(PertaminaandNonPertamina)

B. Expenditure Savings

2. Use of Budget Reserve

Fund

• Policymeasuresinotherexpenditures

3. Savings and Prioritization

of Line Ministries/Agencies

Expenditures

• 15%deductionfromLineMinistries/AgenciesExpenditures(MinisterofFinanceDecreeNo.

S-1/MK 02-2008 dates 2 January 2008)

• EliminationofinfrastructureAdjustmentFund

• SavingsinLineMinistries/Agenciesprojectloan

4. Improvement of Fuel and

Electricity Production and

Consumption

• Optimalizationofoilproduction/lifting;taxandexcisetaxincentiveshadbeenprovidedto

the investment/exploration of oil and geothermal; 2008 oil lifting higher than 2007 realization

• ConversationprogramfromkerosenetoLPGcanbecarriedoutbyeliminatingoperational

barriers, provision of infrastructure and regional licensing

5. Energy Conversation and

Efficiency Program in

Pertamina and PLN

• Fuelsubsidies:alphaloweredby1%from13.5%to12.5%;limitationonsubsidized

premium and solar consumption through the use of smart card and kerosene consumption

through the use of a control card

• Electricitysubsidiaries:5%alphaforthesalepriceofHighSpeedDieselfromPertamina

to PLN; PLN network loss maintained at 11.4%; electricity subsidiaries savings through

incentives and disintensives; as certain a 27% maximum on the ratio of fuel use for

electricity generator

C. Widening of Deficit and Optimalization of Financing

6. Use of Windfall Gains in

Oil and Gas Producing

Regions through the Use of

Debt Instrument

• CashSurplusofoilandgasproducingregionsplacedinrisk-freeinstrumentssuchas

between government securities.

• Tosaveonintermediationcost,regionsdirectlypurchaseSBNanddirectlygainthe

benefits.

7. Widening of deficit

through bond issuance,

optimalization of program

loan and acceleration of

investment fund repayment.

• Upsizingofshariabonds(governmentshariasecurities),indonesiaretailbondsandtreasury

notes

• Optimalizationofprogramloan

D. Price Stabilization Program

8. Reduction of Tax burden on

strategic food commodities.

• Rice:loweringofimporttariff(Rp550/kgtoRp450/kg)

• CookingOil:ContinuationofandwideningofcoverageofgovernmentborneVAT;

application of export tax to CPO above $1050, biofuel and other CPO derivatives.

• Flour:loweringofimporttariff;VATforwheatandflourundergovernmentcoverage.

• Soybean:loweringofimporttariff(10%to0%);loweringofincometaxforsoybeanimport

(2,5% to 0,5%).

9. Additional food subsidies. • Increasingvolumeofriceforthepoorfortargetedhouseholds,5kgperpoorhouseholds.

• Continuationofcookingoilmarketoperation.

• DirectAssistancetosoybeancakeproducers.Source: Ministry of Finance, February 2008.

204

Quality, sustainable economic growth is a vital

prerequisite for building a more prosperous society.

In terms of potential, Indonesia’s geographical and

demographic conditions offer fertile ground for high

growth, supported by abundant natural resources and

a large workforce. Indonesia’s huge population also

underpins the enormous potential of the domestic

market. In addition, the open Indonesian economy

offers wide open opportunities for imports and exports

and for tapping capital inflows. However, this vast

growth potential cannot yet be harnessed for optimum

benefit. During the last 5 years, economic growth was

still hovering around 5% per annum, the long-term

growth trend1 for virtually the last three decades. At

this level, growth is far from sufficient to absorb the

ever expanding workforce. The issue of low absorption

into the workforce is exacerbated by the deteriorating

elasticity of economic growth towards employment.

At the same time, inflation, while being brought more

under control, still runs at an average above the pre-

crisis level while also registering higher volatility.

The marks of quality, sustainable economic growth

are a high growth rate accompanied by low, stable

inflation, with new employment exceeding the growth of

the workforce. How does an economy achieve this? In

growth theory, analysis of sources of growth lead to an

evaluation of the production side of the economy, which

involves study of the adequacy and efficiency of input

factors in production processes. In simple terms, in the

long run it is only expanded production capacity in an

economy that will bring about higher economic growth.

In the short run, it is possible for a growth surge to

be driven by increased aggregate demand. However,

in the long run, only demand-side growth matched

by supply-side expansion will enable the economy to

achieve higher growth without sacrificing price stability.

1 The long-term trend was obtained by calculating average economic growth for the Q1/1981 to Q2/2007 period. For full information,see“EconomicStructureandImplicationsforthe2008-2009InflationTarget,”Affandi,Yoga(2007).

Furthermore, expansion of production capacity is also

expected to create greater demand for labour, which

will increase employment.

Going from there, the question arises as to whether

in the next five years the Indonesian economy will

be capable of growing beyond the current level of

long-term growth? Is this direction supported by

developments in production factors?

Developments in Growth Production Factors

The condition of economic capacity is showing an

improving trend, although still far short of the conditions

preceding the economic turmoil of 1997-1998. In the

aftermath of the crisis, capital accumulation began

to improve, despite some levelling in 2005 due to

the slowdown in economic activity in the wake of the

fuel price hike. The increased capital accumulation is

borne out by indicators of improved efficiency in use

of capital. This is reflected in the downward trend in

the ICOR since 2004 (see Chapter 2, Macroeconomic

Conditions). However, the efficiency gains in use

of capital are thought to be driven more by higher

production capacity utilisation taking advantage of

existing under used capacity.

Unfortunately, these gains on the capital side have not

been supported by improvement in worker productivity.

Growth in the workforce2 has not been matched by

improvement in human capital, as reflected in stagnant

worker productivity3 at the national level (Chart 2)

and lack of significant improvement in the proportion

of educated workers since the crisis. Added to this,

educated workers are still concentrated in particular

2 As of August 2007, the workforce had expanded by 3.55 million workers from one year earlier.

3 Calculated with the ratio of output value (Rp millions) to workers. Forfullinformation,seeWorkingPaper,“SectoralGrowth,StrategyforQualityEconomicGrowth,”Permata,Meiliy(2007)andResearchNotes,“Studying2007EconomicGrowth,ReviewfromtheProductionSide,”Yanuarti,TriandKurniati,Yati(2007).

Moving Towards Quality, Sustainable Economic Growth: Opportunities and Challenges

205

sectors, namely the financial sector, electricity, gas and

water utilities and the services sector.

Indonesia’s Medium-Term Economic Outlook:

Can Growth Rise Above the Long-Term Trend?

To answer this question, it is necessary to examine the

factors that have a role in long-term economic growth.

According to the Formel-G model4, long-term economic

growth is driven by four major factors: population

growth, ratio of investment to GDP, human capital and

trade openness.

Data reveals that the post-crisis ratio of investment to

GDP (average only 21% in 2003-2006) was well below

the pre-crisis level. The low level of investment is one

reason for the low post-crisis economic growth rate.

In regard to trade openness, Indonesia is in a better

position to seize advantage from the open global

economy, as reflected in the significant rise in the ratio

of exports and imports to GDP from 27% (1993-1996)

to 38% (2003-2006). Concerning population growth,

the high growth rate has unfortunately not been

matched by improvement in human capital.

Referring to the growth formula in the Formel-G model,

there is still chance of achieving higher medium to

long-term growth as long as Indonesia is able to keep

improving the investment to GDP ratio, strengthen

external performance and build human capital.

4 Formel-G: Foresight Model for Evaluating Long-term Growth, developed by Deutsche Bank Research, 2005.

Increased investment must be supported by a

conducive investment climate. It is true that in the

short-term, investment activity can be stimulated solely

by domestic demand. However, without improvement

in the investment climate, investment activity becomes

almost impossible to sustain over the long-term. The

Global Competitiveness Report 2007-2008 reveals that

the investment climate remains the most problematic

factor in conducting business in Indonesia. For this

reason, the agenda for improvement in the investment

climate is a key prerequisite for future economic

development. The combination of large market

potential and a healthy investment climate will stimulate

FDI. Inflows of FDI will not only result in expanded

business capacity, but also bring in new technology

and innovations that will ultimately strengthen the

productivity of the economy5. Growth theory states

that long-term sustainable economic growth can only

be created through improvement in TFP, while the

contributions from capital accumulation and human

resources will ultimately lessen due to the decline in

incremental productivity in the two factors. Besides

more robust TFP, human capital is also assumed to

see significant improvement, and thus the human

contribution to production processes will also increase.

Indonesia’s economic outlook is closely linked to

forecasts for world economic developments. World

oil prices are predicted to subside as more supply

5 Dollar et. al. 2003 offers empirical proof of the linkage between the quality of the investment climate and growth through improved TFP (productivity).

206

comes on stream. Domestically, relaxation in world

oil prices will ease pressure on fiscal conditions,

affording the Government opportunity to refocus

on maintaining fiscal sustainability. Reflecting this

will be a steady reduction in the fiscal deficit. These

actions provide assurance of added reinforcement

of macroeconomic stability. With oil prices on the

way down, a fairly upbeat outlook for world demand6

also promises considerable headroom for export

growth. This improvement in external capacity is also

supported by increased investment in machine capacity

expansion. Stronger FDI in line with improvement of the

investment climate will also provide a safety valve for

the overall condition of the balance of payments, and

as a result, the exchange rate will remain on a stable

trend. The synergy between exchange rate stability and

supply-side improvement will provide greater room in

capacity utilisation, which in turn will engender a steady

downward trend in the inflation outlook and promote

private consumption. If these various assumptions

hold, the Indonesian economy could be pushed to

approximately 8% growth within the next three years.

6 The WEO Update for January 2008 downgraded the world economic growth forecast from 4.9% (WEO October 2007) to 4.1%, but this decline is predicted to take place mainly among developed nations.

Policy Implications

The above scenario analysis leads to the conclusion

that the Indonesian economy can be taken to a higher

level in the future as long as various prerequisites

can be met, such as higher investment to GDP ratio

and improvement in human capital. The commitment

and hard work of all stakeholders will be essential to

this objective. Essential policies for achieving higher

economic growth are:

• Macroeconomic Policy (Monetary and Fiscal)

Monetary policy will stay a prudent, consistent

course in order to safeguard macroeconomic

stability. Fiscal policy will be directed towards

improving the condition of infrastructure, refinement

of the education programme and monitoring the

effectiveness of education budget expenditures.

The refinements to the education programme are

aimed at strengthening human capital. Besides

these actions, it is necessary to bolster fiscal

and monetary coordination so that policies are

complementary (mutually supporting) and not

substitutionary (mutually obscuring).

• Microeconomic (Sectoral)

Policy Construction of infrastructure is key to

accelerating the pace of activity in the real sector.

Good infrastructure will ensure the smooth flow

of capital goods and inputs in order to support

smoothly operating production processes capable

of flexibly responding to market demand and

ensuring expeditious distribution of commodities

and industrial products. In addition, revamping

of government institutions related to supply-side

improvements must also be given high priority.

These improvements are related to investment

(licensing, security and certainty of business),

human capital development (skills, education and

health), production efficiency and productivity.

Table 1

Medium Term Economic Outlook

2007 2008* 2009* 2010*

Growth of Components (%)

Gross Domestic Product 6.3 6.2 6.2-6.8 6.8-7.4

– Private Consumption 5.0 5.4 5.6-5.9 5.6-6.0

– Government Consumption 3.9 3.8 4.0-5.0 7.0-9.0

– Investment 9.2 9.3 10.5-10.8 11.0-13.0

– Exports of Goods & Services 8.0 7.9 8.1-9.1 10.5-11.5

– Imports of Goods & Services 8.9 9.4 10.4-10.7 12.5-13.5

Others

Income per Capita ($) 1.947.1 1980-2005 2145-2180 2375-2410

Unemployment (%) 9.1 9.0-10.0 9.0-10.0 8.5-9.5

Inflation (%) 6.41) 6.0-6.5 4.5±1%2) 4.0±1%2)

* Bank Indonesia Projection1) Yearly Average2) Inflation Target

207

Improvements to the Monetary Policy Operational Framework

An interest rate-based monetary policy operational

framework has been implemented under the Inflation

Targeting Framework since early July 2005. Over time,

changes have been necessary to the implementation

of the framework for better adaptation to current

developments. In 2008, improvements will emphasise

the operational aspects of monetary policy. As formally

explained by the Governor of Bank Indonesia at the

annual bankers’ dinner, these improvements take

into account the magnitude of daily fluctuation and

steep short-term yield curve on the money market.

These conditions lead to uncertainty in both liquidity

and interest rates, and encourage the proliferation

of transactions aimed solely at profiting from short-

term interest rate differentials. This is not a conducive

environment for financial institutions to manage assets

over a longer-term horizon1.

1 Keynote Speech by the Governor of Bank Indonesia at the Annual Bankers’ Dinner, 18 January 2008.

In addition, the underlying thought in improvements

to the monetary policy operational framework is that a

properly functioning, efficient interbank money market

is essential to the effectiveness of the monetary policy

transmission mechanism for influencing the formation

of longer-term yield curves relevant to economic

activity in the real sector. In this regard, monetary policy

operations will focus on implementing the monetary

policy stance (BI Rate) on the money market. Within this

context, Bank Indonesia will maintain stable rates on

the overnight interbank market at a level consistent with

the BI Rate2. This is not in any way intended to modify

the policy stance reflected in the level of the BI Rate3.

2 “Monetarypolicyoperatingframeworkestablishthemeansbywhich central banks implement the desired monetary policy stance ... the liquidity management operations that support the stance by seeking to ensure that a short term market rate isconsistentwiththepolicyrate.”(Borio,ClaudioandWilliamNelson, BIS Quarterly Review, March 2008).

3 The BI Rate is set in the monthly Board of Governors’ Meeting and changes only when Bank Indonesia sees movement in indicators that demand a response to safeguard achievement of the inflation target.

208

On a technical level, the fine tuning of the monetary

policy operational framework will take place through

liquidity management operations on the money market.

To achieve this, Bank Indonesia will bring into operation

a range of regular and non-regular OMO instruments,

supported by standing facilities. The regular OMOs will

be conducted using instruments with a broader range

of maturities (1, 3, 6 and 9 months), traded with the

variable rate tender mechanism. Accompanying this will

be non-regular OMOs involving fine tuning operations

(FTOs)4 and FX swaps at the discretion of Bank

Indonesia. Overnight standing facilities will operate as

second-tier instruments. These will consist of standing

deposit facilities and standing lending facilities that

will form a narrower interest rate corridor compared

to the present, established in symmetry with the BI

Rate5. These liquidity management tools will operate

with or without the use of securities as underlying

assets. These securities may comprise SBIs or other

instruments, such as government securities6.

4 May be contractionary or expansionary with a tenor of 2-14 days.5 Press Release, Keynote Speech by the Governor of Bank

Indonesia at the Annual Bankers’ Dinner, 18 January 2008.6 Since 21 January 2008, there has been more intensive use

of FTOs. In early February 2008, the SBI auction system was changed back to a fully variable rate tender system with weekly auctions for the 1 and 3 month tenors. Window time for standing facilities was changed to 15:00-17:00 for SBI Repos and the FASBI. In addition, underlying assets for repo transactions were expanded with 100% ceiling for SBIs and government securities.

The existence of a more diversified range of monetary

instruments and their underlying assets will also

support the financial market deepening process. The

issuance of SBIs with tenors beyond 1 and 3 months

will not only absorb structural excess liquidity, but also

strengthen the effectiveness of liquidity management in

the banking system. A further benefit is that the longer

tenor instruments will be conducive to pricing of other

short-term financial assets and banking products.

At the same time, the use of Government Securities7

will boost activity and liquidity, thus strengthening the

resilience of the Government Securities market in the

face of potential shocks. The FX Swaps are an OMO

instrument designed to assist liquidity management on

the rupiah money market.

In practice, the improvements to the monetary policy

operational framework will involve measured, phased

actions. To this end, communications with stakeholders

will be intensified through various forums and media. At

a suitable time, Bank Indonesia will publicly announce

the full implementation of these improvements, taking

account of various factors reflecting the readiness and

stability of the money market.

7 In repo transactions.