Chapter 1

Overview

2

The year 2007 witnessed a remarkable achievement of the Indonesian economy most notably in key areas despite mounting external pressures. For the first time since the crisis, the economy grew at a rapid level of above 6%, with macroeconomic stability kept in check. The favorable performances were reflected in significant surplus of balance of payments, reinforcing the international reserves, exchange rate stability, strong credit expansion and inflation under controlled. Soaring international commodity prices, led by oil, and the unfolding of the subprime mortgage crisis figured prominently among the challenges confronting the Indonesian economy during the year. In the face of these multiple adversities, the Indonesian economy had appeared to show a higher level of resilience in support of economic growth.

Indonesia’s improved economic resilience has been built upon a combination of macroeconomic and sectoral policies. Monetary and fiscal policy coordination has been markedly strengthened. The Government and Bank Indonesia have been in close collaboration in the delivery of economic stimulus and safeguarding economic stability. In the monetary sector, the pursuit of prudent and consistent policies responses have contributed to keeping inflation on a medium to long-term downward trend. Fiscal sustainability has also been safeguarded through appropriate control over strategic commodity prices. The banking system has seen steady progress as reflected in a raise in the intermediary function and strengthened institutions, including the accelerated development of Sharia banking. At the sectoral level, the government has sought to improve the quality of economic growth through improvements in the investment climate, accelerated construction of infrastructure, empowerment of MSMEs and the financial sector reform.

On the external front, the Indonesian economy is expected to encounter onerous challenges arising from global economy turbulence. Accordingly, economic growth is predicted to slow down in 2008 compared to 2007. Inflation is higher than the established target, while the rupiah exchange rate is expected to remain stable. Looking ahead, the synergy in monetary and fiscal policy will become more essential to mitigate the prevailing of risks. In this regard, Bank Indonesia will continue the pursuit of a consistent monetary policy directed in containing inflation so as to support sustainable economic growth. In the banking sector, Bank Indonesia will focus on improvement of the banking intermediary function and the institutional strengthening of the banking system. At the same time, the strengthening of economic competitiveness, including improvements to the investment climate and accelerated construction of infrastructure, will become increasingly important in paving the way for higher levels of growth in a structurally more robust economy.

Chapter 1: Overview

3

The beginning of the year was marked by buoyant

public optimism over the economic outlook. As

Indonesia entered 2007, macroeconomic stability was

back on track following the oil prices shock at the end

of 2005, the impact of which prevail until mid-2006.

This optimism was underpinned by strengthening public

confidence in the management of macroeconomic

policy, supported by consistent alignment in monetary

and fiscal policies for achievement of the inflation

target and a strong commitment to fiscal sustainability.

Rising confidence in the credibility of macroeconomic

policy was accompanied by improving international

confidence in the Indonesian economy as reflected in

the upgrading of Indonesia’s sovereign credit rating and

easing of investment risk premiums.

In the second half of 2007, the Indonesian economy

faced renewed global economic challenges, including

the knock-on effects of the sub-prime mortgage crisis,

as well as high oil and other international commodity

prices. World oil prices hovering near $100 per barrel1,

prompted higher demand for foreign currency to pay

for imports and increased fiscal burden, mainly for

covering the mounting fuel subsidy. The unfolding

impact of the sub-prime mortgage crisis triggered

pessimism over the world economic outlook, prompting

global investors to pull out of perceived high-risk

assets in a flight to quality. Most affected were assets

in emerging markets, including Indonesia. This also

triggered a round of capital reversal on the domestic

financial market, with Bank Indonesia Certificate (SBI),

government securities and stocks most affected.

The global economic turmoil has in turn undermined

the foundation of Indonesia’s macroeconomic stability.

In the second half of 2007, the rupiah came under

pressure with the monthly average of Rp9,372 to the

US dollar in August 2007. To address these challenges,

the Government and Bank Indonesia have introduced

a series of measures to maintain macroeconomic

stability while sustaining the momentum for economic

growth. These macroeconomic policy actions have

been implemented in a prudent and consistent manner

so as to build public and business confidence in the

rupiah. In addition, the high yields on the domestic

financial market encouraged renewed capital inflows

into Indonesia at a time of excess liquidity in the global

financial markets.

1 Intraday WTI oil price, 20 November 2007.

Despite the temporary pressure on the exchange rate,

the rupiah exchange rate remained relatively stable.

Among the factors contributing to stability in 2007

were positive developments in domestic economic

fundamentals consistent with the achievement of

internal and external equilibrium. Foreign Exchange

(Forex) market interventions to contain exchange

rate volatility were conducted on a limited scale. This

policy was reinforced by more robust communications

and improved effectiveness in prudential regulation

and monitoring of foreign currency movements.

The exchange rate was also bolstered by the strong

performance in the balance of payments. In 2007,

the balance of payments recorded another surplus

of $12.5 billion. The current account surplus reached

$11.0 billion or 2.5% of GDP, up from $10.8 billion in

2006, driven mainly by rising non-oil and gas exports.

Despite a temporary capital reversal in Q3-2007, the

capital and financial account booked a $2.8 billion

surplus for 2007, consistent with the continued

attractiveness of rupiah investment yields. Reflecting

the strong performance in the balance of payments

was increasing accumulation of international reserves

at $56.9 billion, equivalent to 5.7 months of imports and

official debt repayments and well ahead of the end-

2006 position of $42.6 billion.

The stability of the exchange rate also contributed to

keeping CPI inflation within the target. The success in

reigning in inflation also benefited from the subdued

volatile foods prices and low inflation in administered

prices. In this regard, the government commitment

to refrain from increases in administered prices for

strategic commodities (oil-based fuels and electricity

billing rates) played a vital role. Other government

contribution to contain inflation was the control of prices

in traded goods including non oil and gas. Furthermore,

improved policy credibility also has a beneficial effect

on public expectations on inflation.

With stability in place, economic growth accelerated

reaching a record high of 6.32% in 2007. Much of

acceleration of the economic growth was accounted

for buoyant demand for both private consumption

and investment. Private consumption escalated on

the back of rising purchasing power. At the same

time, investment growth was supported by improved

investor perceptions, higher returns on investment

and adequate availability of financing from banks and

financial markets in general. Exports continued to forge

4

ahead amid the slowdown in global economic growth.

Key to this was the ongoing diversification of export

destinations to high-growth economies such as China

and India. Thereby outweighing a decline demand from

developed countries. The acceleration of aggregate

demand was met with rapid expansion in production

across almost all economic sectors, most notably

manufacturing, agriculture and trade.

Economic performance also improved at the regional

level during 2007, as reflected in the strong growth and

relatively stable inflation in some regions. Analyzed by

contribution, the economies in the Java, Bali and Nusa

Tenggara (Jabalnustra) region and the Jakarta-Banten

region provided the strongest driving force for national

economic growth. Concerning prices, national inflation

was kept stable due to relatively low levels of inflation in

some of the most important regions contributing to the

national inflation figure. Despite the improved economic

performance in some regions, considerable disparities

persisted among regions in their levels of growth and

inflation.

In view of the stable outlook for various economic

indicators with projected inflation within the targeted

range, Bank Indonesia gradually lowered the BI Rate

to 8%, representing a cumulative reduction of 175

basis points from the end of 2006. These rate cuts

were followed by downward movement in market

interest rates, including rates for deposit funds and

credit. Lending showed significant expansion of

25.5%, ahead of the 22.0% target at the beginning

of the year. On the stock and bond markets, the BI

Rate reductions contributed to stock index gains

with positive response from buyers of bonds, even

in spite of the negative sentiment bearing down on

regional and global markets. These trends were also

accompanied by increased net asset value (NAV) in

mutual fund investments, and particularly the NAV per

unit for fixed income funds. Nevertheless, the BI Rate

was kept on hold from August to November 2007 to

anticipate risks from escalating inflationary pressure

from external shocks.

On the fiscal front, the policy has been targeted at

maintaining price stability for energy and staple needs,

while also delivering an economic stimulus. Escalating

world oil prices in combination with below-target

lifting of domestic oil led to a considerable pressure

in the budget deficit. To address this challenge, the

government pursued a series of anticipatory measures

for budget revenues and expenditures. On the revenues

side, the government strengthened the collection of tax

revenues and increased the target of dividends from

State Owned Enterprises (SOEs). On the expenditures

side, the government maintained domestic fuel prices

at steady levels through subsidy payments, leading to

higher than targeted government spending. In budget

financing, issuance of government securities ahead of

schedule to secure deficit funding enabled the deficit

funding target to be met before the recent turmoil in the

financial sector.

Looking ahead, after a thorough assessment on

economic performance, opportunities and risks,

Bank Indonesia forecasts economic growth in 2008

to reach 6.2%, somewhat lower than in the preceding

year. This growth will be driven primarily by private

consumption and investment. Key to the brisk growth in

private consumption are the planned increases in civil

servant salaries and provincial minimum wage levels.

Also providing momentum for higher consumption

will be adequate availability of consumer financing

from banking sources and other financial institutions.

Investment growth is also predicted to gather pace

partly in response to a conducive investment climate,

but also from the construction of government and

private sector-funded infrastructure projects, including

toll roads and power plants. With the world economy

heading for a slowdown, export performance is

predicted to decline.

Indonesia’s economic performance will remain firmly

underpinned by macroeconomic and financial system

stability. The rupiah exchange rate is forecasted to

remain stable in 2008 in view of attractive investment

returns and availability of foreign exchange from export

earnings and capital inflows. However, strong upward

pressures are predicted for CPI inflation, mainly from

imported inflation. An added source of inflationary

pressure is predicted to come from mounting inflation

expectations. Taking into account to these factors,

inflation is estimated to reach 6.0%-6.5% overall,

with the probability of tailing towards the upper limit.

Accordingly, measures to maintain prices and exchange

rate stability will gain increasing importance given that

the economic expansion in 2008 will mainly rest on

domestic demand, most notably private consumption.

5

In sum, the economic outlook for 2008 will be

reinforced by Government consistency in taking

the envisaged anticipatory measures (Box: Nine

Actions for Securing Fiscal Outcomes, including Tax

Reductions for Food Commodities and Added Food

Subsidies). In addition to this, the economic outlook

is contingent on Bank Indonesia’s consistency in

safeguarding macroeconomic and financial system

stability, particularly in the exchange rate, and

on further strengthening of fiscal and monetary

policy coordination.

Evaluation of the Indonesian Economy

in 2007

Against the backdrop of external turbulence, the

Indonesian economy demonstrated improved

performance during 2007. Underscoring this were

the robust balance of payments, higher economic

growth and more equitable income distribution,

thereby reducing unemployment and poverty although

remaining at high level. Macroeconomic stability

in combination with an array of sectoral policies

contributed to the favorable economic performance

as reflected in the stable exchange rate, subdued

inflation and a containment of fiscal deficit. With stability

in check, perceptions among investors and market

agents impoved.

Indonesia’s economic performance in 2007 was

supported by a series of consistent policies in building

domestic economic resilience against external and

domestic shocks. This range of policies included the

pursuit of monetary policy geared towards achieving

inflation target, fiscal sustainability, prudential banking

policies and sectoral policies for promoting investment

and export market expansion.

Macroeconomic Conditions

Indonesia’s economic growth in 2007 reached 6.32%,

having climbed from the previous year’s level of

5.5%. Accelerated growth momentum in 2007 came

largely from the strong growth recorded in household

consumption and investment. On the supply side,

the main contributors to economic growth were the

manufacturing, trade and agriculture sectors. The

high rate of economic growth was accompanied

by improvement in public prosperity indicators.

The percentage of the population living below the

poverty line fell from 17.7% in 2006 to 16.6% in 2007,

a reduction of 1.9 million persons. Besides higher

economic growth and stable inflation, the improvement

in poverty indicators is also supported by the

implementation of various social programmes targeting

the poor, including disaster relief.

On the demand side, economic expansion was

driven by 5.0% growth in household consumption,

well ahead of the 3.2% increase recorded in the

previous year. The accelerated growth in household

consumption came on the strength of improved

public purchasing power and adequate availability

of consumer financing. The improvement in public

purchasing power was the combined result of subdued

inflation, pay increases for formal sector employees

and laborers and high levels of remittance transfers

from Indonesians working overseas. Most sections

of society, including low-income groups, saw their

income levels rise. Improvement in middle-class

incomes was indicated in the findings of a survey of

executive salaries and the 10%-15% salary increase

awarded to civil servants. Among low-income groups,

the improvement in purchasing power benefited mainly

farmers and workers employed in the formal industrial

sector. Purchasing power among low-income groups

was also bolstered by the high volume of remittances

from Indonesians working overseas, recorded at

US$6.0 billion or 1.4% of GDP.

Investment grew by 9.2% in 2007 buoyed by strong

domestic demand and improving business optimism

over the condition of the domestic economy reflected in

various survey findings pointing to buoyant confidence

in the growth outlook for the domestic economy. The

upswing in investment was also accompanied by

improvement in capital productivity, reflected in the

downward trend in the Incremental Capital Output

Ratio (ICOR). The higher productivity of capital is

an indication of improvement in investment return

and efficiency.

On the financing side, while investors tapped sources

of credit and the capital market, indications pointed to

an increase in self-financing. This was borne out in the

financial statements published by stock-exchange listed

companies indicating greater use of retained earnings in

support of business expansion. More potential sources

of investment financing became available, as indicated

by the increase in the savings ratio. In 2007, the savings

ratio reached 26.8%, up from the previous year’s level

of 23.7%. Even so, this financing potential has not

6

been fully tapped for physical investment, as reflected

in the prevailing considerable savings-investment gap

at 2.6% of GDP. Analyzed by contributing source, the

surplus of savings over investment was generated in

the private sector, in contrast to the increased deficit

in the government sector. This is an indication of the

predominance of sources of private sector savings in

investments in the financial sector.

Despite the resurgent investment growth, complacency

should be avoided as Indonesia’s business

competitiveness lags behind the neighboring countries

- in terms of operations, corporate strategy and quality

of the business environment. Confirming this is a survey

by the World Bank (October 2007), in which Indonesia’s

competitiveness rating is essentially unchanged (54th

out of 131 countries), despite some improvement in

efficiency indicators in terms of market size, efficiency

on the market for goods and efficiency on the labour

market. Some key indicators of concern include

infrastructure shortages, inefficiency in bureaucratic

processes and difficulties in access to finance. In

consequence, the investment to GDP ratio remained at

about 24.9%, below the pre-crisis ratio of about 29%

and levels reached in other ASEAN countries.

In the midst of the global economic slowdown, real

exports continued to grow at 8.0%. This is explained

not only by steadily climbing world prices, but also

by strong demand from developing countries like

China and India. Analyzed by commodity, robust

export growth was driven by keen demand for coal,

palm oil and rubber. The large volume of palm oil and

coal exports is related to the energy diversification

programmes under way in developed countries to find

alternative sources of energy in response to soaring oil

prices.

Economic expansion resulted in an upsurge in

imports with growth at 8.9%, ahead of the preceding

year. Import growth benefited not only from relative

stability in the exchange rate, but also strong domestic

demand for consumption and investment. Analyzed by

component, imports of consumer and capital goods

registered exceptionally high levels of growth at 42.4%

and 23.1%.

On the supply side, the main contributors to GDP

growth, remain unchanged, which were manufacturing

sector, trade, hotels and restaurant sector, and

agriculture sector. Manufacturing growth during 2007

reached 4.7%, up slightly from 4.6% in 2006. In a

similar trend, the trade sector saw growth climb from

6.1% in 2006 to 8.5%. The high growth rates in both

sectors were attributable to rising domestic demand

and improved business confidence in the condition

of the economy. The agricultural sector also recorded

more vigorous growth alongside increased productivity,

particularly in the food crops subsector, as well as

robust export demand for rubber and palm oil. The rice

crop also reached its highest level in the past five years.

The upsurge in economic growth during 2007 also

improved the welfare of the population. This was

indicated in per capita income that reached $1,946

in 2007, up about 17% over 2006. In addition,

the economic growth generated employment for

approximately 4.5 million new entrants to the workforce,

bringing open unemployment down from 10.3% in

August 2006 to 9.1% in August 2007. Analyzed by

educational level, unemployment among those with

academy and university qualifications continued to

rise. However, unemployment eased among low

income groups, partly due to the reinvigorated role of

agriculture in driving economic growth.

Poverty indicators also improved, as reflected in the

downward movement in total numbers of people living

in poverty, the poverty gap index and the poverty

severity index. The March 2007 report issued by BPS

(Statistics Indonesia) cited 37.2 million living in poverty,

a reduction from 39.3 million in previous year. The

decline in numbers of poor was more pronounced in

rural areas at 1.20 million, while numbers of urban poor

fell by 0.93 million. Analyzed by rural-urban population,

rural poverty predominated, with 65% of Indonesia’s

poor living in rural areas. Nevertheless, improvement

took place in the average expenditure gap for the

poor, as reflected in the poverty gap index and poverty

severity index. Alongside the reduction in poverty levels,

income disparities also eased in 2007, as indicated by a

drop in the Gini coefficient.

The reduction in poverty levels was also accompanied

by improvement in quality of life. In a World Bank

report published in November 2007, the percentage

of population living with less than $1 per day was

8.5%, well inside the targeted 10.3% in the Millennium

Development Goals (MDG) for 2015. Improvement also

7

took place in other MDG indicators, including number of

children entering primary school, child mortality under

5 years and public access to clean water. The World

Bank also noted that Indonesia’s MDG programmes

were on target in almost all areas. Among the eight

MDGs, Indonesia has made significant progress in the

poverty alleviation program.

Table 1.1

Selected Macroeconomic Indicators

percent

Descriptions 2003 2004 2005 2006 2007

GDP Growth 4.7 5.0 5.7 5.5 6.3

CPI Inflation 5.1 6.4 17.11 6.60 6.59

Core Inflation 6.9 6.7 9.75 6.03 6.29

Average Exchange Rate (Rp/$) 8.572 8.940 9.713 9.167 9.140

SBI (1 month)/BI Rate since July 2005 8.31 7.43 12.75 9.75 8.00

Current Account/GDP 3.4 0.6 0.1 2.9 2.5

GDP by Expenditure

Consumption 3.9 5.0 4.0 3.2 5.0

Gross Fixed Capital Formation 0.6 14.7 10.9 2.5 9.2

Exports of Goods and Services 5.9 13.5 16.6 9.4 8.0

Imports of Goods and Services 1.6 26.7 17.8 8.6 8.9

GDP by Sector

Agriculture 3.8 2.8 2.7 3.4 3.5

Mining and Quarrying -1.4 -4.5 3.2 1.7 2.0

Manufacturing 5.3 6.4 4.6 4.6 4.7

Electricity, Gas, and Water Supply 4.9 5.3 6.3 5.8 10.4

Construction 6.1 7.5 7.5 8.3 8.6

Trade, Hotels, and Restaurants 5.4 5.7 8.3 6.4 8.5

Transportation and Communication 12.2 13.4 12.8 14.4 14.4

Finance, Rental, and Business Services 6.7 7.7 6.7 5.5 8.0

Services 4.4 5.4 5.2 6.2 6.6

Unemployment Rate 9.5 9.4 10.8 10.3 9.1

Poverty Rate 17.4 16.7 16.0 17.7 16.6

Real GDP per Capita, thousands Rp 9,574 10,506 12,700 15,000 17,600

Real GDP per Capita, $ 1,116 1,167 1,321 1,663 1,947

Monetary Aggregate

M2 Growth, End of Period 8.12 8.14 16.42 14.87 18.89

M1 Growth, End of Period 16.60 13.41 11.07 28.08 27.63

Base Money Growth, End of Period (test date) 20.42 19.81 20.22 23.90 27.77

Interest Rate

Interbank Money Market (overnight) 8.18 6.86 10.03 5.97 6.50

1-Month Time Deposit 6.62 6.43 10.43 8.96 7.19

Working Capital Loan 15.07 13.41 15.18 15.07 13.00

Investment Loan 15.68 14.05 14.92 15.10 13.01

Balance of Payments

DSR (Debt to Service Ratio) 34.1 27.1 17.3 24.8 19.2

International Reserves, in months of imports and foreign debt repayment

7.1 5.5 4.3 4.5 5.7

Sources: BPS-Statistics Indonesia Bank Indonesia

8

At the regional level, economic performance improved

during 2007, as reflected in brisk growth and

relatively stable inflation in some regions. Analyzed

by contribution, the economies in the Java, Bali and

Nusa Tenggara region and the Jakarta-Banten region

provided the strongest driving force for national

economic growth. At the same time, buoyant economic

growth in the Kalimantan, Sulawesi, Maluku and Papua

(Kali-Sulampua) region elevated the contribution of

this region to national growth. Concerning prices,

national inflation was kept stable due to relatively low

levels of inflation in some of the most important regions

contributing to the national inflation figure. Despite

the improved economic performance in some areas,

considerable disparities persist among regions in

growth and inflation. This calls for a common effort for

reduction in interregional income disparities.

Fiscal sustainability came under pressure from the

global economic turmoil. World oil prices, which

reached an average of $72.3 per barrel, and the low

lifting of domestically produced crude oil (899 thousand

barrels per day) combined to escalate expenditure on

the fuel subsidy while simultaneously reducing state oil

revenues. The rising burden of the subsidy was also

related to the government commitment to maintain

stability in domestic fuel prices, even as world oil prices

continued to soar. To mitigate pressure from rapidly

escalating world oil prices, government spending on the

fuel and electricity subsidies mounted significantly to

151% and 102% of budget planning. Exacerbating the

burden of the fuel subsidy was higher than predicted

consumption of subsidized fuels at 38 million kiloliters

instead of the targeted 36 million kiloliters.

Faced with these external shocks, the Government

pursued a series of policy actions to curb the fiscal

deficit. On the revenues side, the Government sought

to increase budget receipts by boosting taxation

receipts, including export tax on CPO and higher

dividend payments by SOEs. Otherwise, the absorption

of some budget expenditure components progressed

slowly due to administrative hurdles, which also helped

restrain the fiscal deficit. Through these actions,

the fiscal deficit was managed within safe limits at

1.3% of GDP, below the targeted 1.5% of GDP. The

consistency of government actions for maintaining fiscal

sustainability was also reflected in the decline in the

debt to GDP ratio to 31.2% in 2007.

Improvement in the domestic economy also was

reflected in the robust performance on balance of

payments during 2007, reflected in a $12.5 billion

surplus. Despite worries over the potential for a world

economic slowdown triggered by the subprime

mortgage crisis and high oil prices, at $11.0 billion

the current account surplus was nevertheless ahead

of the $10.8 billion surplus in the preceding year. The

increased surplus was bolstered by stronger export

growth in response to robust world demand and rising

export commodity prices. Analyzed by commodity,

export growth was driven primarily by manufactured

products and mining commodities. Imports also grew

at a faster pace in keeping with increased domestic

demand and exports.

The capital and financial account still managed a $2.8

billion surplus even in spite of negative sentiment on

global financial markets that set off a round of capital

reversal. Key to this was attractive yield on rupiah

investments, macroeconomic stability and improving

investor perceptions of risk. The improved performance

in the capital account is also explained by foreign direct

investment (FDI) that reached $1.2 billion. Alongside

this, portfolio transactions generated an increased

surplus at $7.0 billion, buoyed by high levels of excess

liquidity on global markets and improving investor

perceptions of risk. In response to these developments,

international reserves mounted to $56.9 billion at the

end of 2007, equivalent to 5.7 months of imports and

servicing of official foreign debt.

The dynamics of the rupiah exchange rate were

marked by an appreciating trend in 2007 accompanied

by reduced volatility. Average value of the rupiah

came to Rp9,140 to the US dollar, a gain of 0.3%

appreciation over Rp9,167 per dollar in the preceding

year. Appreciation in the rupiah was bolstered by the

balance of payments surplus, improvement in risks

and continued attractiveness of yields on rupiah

investments. Foreign capital kept flowing in response

to the attraction of investing in domestic financial

market instruments, despite temporary capital reversal

prompted by external shocks in the second half of

2007. Brisk capital inflows on the domestic forex market

during the first half of 2007 contributed to a significant

strengthening of the rupiah. However, the second half

of the year saw an escalation of global risks, with the

domestic forex market reporting excess demand for the

year overall. Point to point, the rupiah weakened 4.2%

9

to end-2007 level of Rp9,393 to the US dollar. The

downturn in the rupiah occurred late in 2007 triggered

by the unfolding of subprime mortgage crisis and a

hike of oil prices. Averaged over the year, the rupiah

underwent appreciation with volatility down from 3.8%

in 2006 to 1.4%.

The stable, appreciating trend in the rupiah helped

to keep 2007 inflation within the targeted range. CPI

inflation for 2007 arrived at 6.59%, which was within

the government-set range of 6.0% ±1%. Inflation

during the year under review was influenced by

various fundamental and non-fundamental factors.

Fundamentals contributing to stable inflation included

subdued inflation expectations, stability in the exchange

rate and low inflationary pressure from the output

gap. Analyzed by non-fundamental factors, reduced

inflationary pressure in the CPI came from minimum

increases in administered prices and lower volatile

foods inflation.

Inflation expectations were relatively stable throughout

2007, as reflected in the findings of various surveys of

consumers, producers and financial markets. Stable

inflation expectations were largely attributable to a

combination of policy actions by Bank Indonesia and

the Government, particularly to fend off inflationary

pressures from high oil prices and the crisis on global

financial markets. Added to this, the absence of hikes

in administered prices for strategic commodities during

2007 also contributed to public expectations of stable,

low inflation. Externally, the stable movement in the

rupiah helped to mitigate rising imported inflation driven

by soaring international commodity prices. Through

these actions, core inflation for 2007 was held at

6.29%.

Volatile foods inflation reached 11.41%, well below the

15.27% recorded for the preceding year. Key to the

lower volatile foods inflation was reduced inflation in

rice due to adequate stocks and smooth distribution.

Increased rice production helped to keep rice stocks

at adequate levels, bolstered also by rice imported

by the National Logistics Agency (BULOG). Although

rice inflation eased, heightened inflation in other food

commodities from soaring international commodity

prices and natural disasters calls for vigilance. Among

the affected commodities are corn, cooking oil and

derivative products.

Inflationary pressure from administered prices was very

low, given the absence of price increases for strategic

goods such as subsidized fuels (gasoline, automotive

diesel, kerosene) and electricity billing rates. This

policy had a significant bearing on efforts to subdue

inflation during the year, given the sizeable weighting

of these items in the CPI basket and the considerable

magnitude of second round effects on other products.

Although considered low, inflation in administered

prices for the year under review mounted from 1.8%

(yoy) in the preceding year to 3.3% (yoy). This increase

is explained by decisions to raise the retail selling prices

for cigarettes by 7% in March 2007, the decision to

apply specific rates for cigarette excise as of 1 July

2007, water billing rate hikes in several cities, higher toll

road charges and increased prices for non-subsidized

fuels (Pertamax, Pertamax Plus and Pertamina Dex).

In view of the improving inflation outlook and relative

stability in macroeconomic conditions, Bank Indonesia

gradually lowered the BI Rate from 9.5% at the

beginning of 2007 to 8.25% in July 2007. In August,

the decision was made to keep the rate on hold

because of concerns over mounting future inflationary

pressure brought on by swelling world oil prices and

a wave of negative sentiment bearing down on the

exchange rate due to the subprime mortgage crisis

in the United States. However, in view of the lower

inflationary pressure and rising optimism in the future

of the economy, Bank Indonesia announced a 25 basis

point cut in the BI Rate in December. Thus at the end of

2007, the BI Rate reached a level of 8.0%.

The reductions in the BI Rate and accompanying

economic expansion also boosted performance on

the domestic financial market. Indonesia’s capital

market recorded an index gain of 52.1% in 2007 to

close at 2,745.8. Amid conditions of excess global

liquidity, mounting interest on investment on the stock

market was stimulated by the secure condition of

macro fundamentals, downward trend in the BI Rate

and improved micro-corporate performance reported

by stock exchange-listed companies in their financial

statements. Analyzed by sector, the index gains were

spurred most importantly by the mining, agriculture

and property sectors. Performance was also up on the

government securities and mutual funds markets. Yield

on government securities eased in response to growing

investor interest. On the mutual funds market, NAV

steadily mounted throughout the year to reach Rp92.2

10

trillion in December 2007, with growth driven mainly by

performance in equity-based and mixed funds.

The downward movement in the BI Rate was also

accompanied by improvement in the bank intermediary

function, with banks providing an increasingly

significant contribution to overall financing in the

economy. With the deposit rates declining, loan interest

rates began to ease although not to the same extent as

deposit rates. This change led to substantial expansion

in credit, surpassing the target set at the beginning

of the year. Total lending in 2007 mounted 25.5%

over the previous year to Rp1,045.7 trillion. Alongside

this, depositor funds widened by 17.4% to Rp1,510.7

trillion. The more robust expansion in credit compared

to depositor funds resulted in an improvement in the

banking system Loan to Deposit Ratio (LDR) to 69.2%,

the highest ever during the post-crisis period. Among

rural banks, this positive trend was also evident with

the LDR climbing to 109.7%. Micro Small Medium

Enterprises (MSMEs) lending widened to Rp502.8

trillion, an increase of 22.5% over the past year. Sharia

banks also achieved impressive performance, reflected

in expansion of service coverage, growth in depositor

funds and higher levels of financing compared to

past years.

The healthy performance in bank intermediation

was matched by improvement in risk management

capability. This was reflected in across the board

gains in various financial and operational performance

indicators, such as credit quality, earnings and capital.

Industry-wide non-performing loans (NPLs) were

lower, mainly in response to the restructuring of large

corporate loans at state-owned banks. Bank capital

held firm at a reassuring level, reflected in the bank

capital adequacy ratio (CAR) at a solid 19.2%.

Economic liquidity in 2007 was flush in comparison

to historical levels over the past 5 years. The narrow

measure of economic liquidity (M1) reached Rp460.8

trillion, representing growth of 27.6%. At the same

time, M2 widened by 18.9% to Rp1,643.2 trillion. This

movement in monetary aggregates is indicative of the

daunting challenge of managing economic liquidity.

Analyzed by influencing factors, the expansion in

liquidity is explained by a significant rise in lending

to the business sector, up Rp208.0 trillion or 26.4%

from the preceding year. Of this total, Rp154 trillion

comprised rupiah-denominated loans, while the

remaining Rp54 trillion, equivalent to $5 billion, was

extended in foreign currencies. Net Foreign Assets

(NFA) were also up 27.0% or Rp111.4 trillion over the

previous year’s position. This increase was dominated

by NFA at Bank Indonesia in line with the hefty rise

international reserves generated by increased oil and

gas revenues on the back of soaring world oil prices.

Despite this, the banking system reported a decline in

NFA, particularly in foreign assets held in call money

and demand deposits at overseas banks.

The improved economic performance in 2007 was also

reflected in mounting activity in the payment system.

Cash retained its place as a dominant instrument for

transactions, reflected in average volume of currency

in circulation at Rp174.8 trillion in 2007. At this level,

volume of currency in circulation was up 21.0%,

representing considerably higher growth than the

14.6% recorded in the preceding year. In non-cash

payments, average daily transaction volume in 2007

processed in the BI-RTGS system and the Bank

Indonesia National Clearing System (SKNBI) climbed

46.5% and 13.1% over the previous year. Alongside

this, there was considerable use of card-based

instruments, with volume dominated by account-based

cards at 77.6% and the remainder comprising credit

cards transactions. While part of this trend is explained

by economic growth, the increase is also the result of

financial market trading activity, changing preferences

in means of payment and technological innovations in

the payment system.

Macroeconomic and Sectoral Policy in 2007

The overall direction of Bank Indonesia policy in 2007,

covering monetary affairs, banking and the payment

system, focused on strengthening macroeconomic

stability as a basis for sustainable, quality economic

growth. The pursuit of prudent and consistent

monetary policy was directed at guiding inflation

expectations towards the established inflation target.

Banking policy was directed towards promoting

the bank role as an intermediary institution without

sacrificing prudential banking principles, in addition to

continuing the institutional strengthening of the banking

system. Payment system policy was directed at

supporting the effectiveness of monetary and banking

policies through the provision of a secure, fast, efficient

and reliable system for payments. On the government

11

side, fiscal policy was aimed at delivering a more

robust stimulus while maintaining fiscal sustainability,

while sectoral policy priorities targeted efforts to boost

productivity and economic growth in order to reduce

unemployment and poverty.

Monetary Policy

In monetary policy, Bank Indonesia (BI) again focused

on measures for achievement of low inflation in

the medium-term. To this end, Bank Indonesia has

consistently set the BI Rate, established as part of

the inflation targeting framework, on the basis of

inflation projections and comprehensive assessment

of macroeconomic conditions. At the implementation

level, the monetary policy stance in 2007 can be

divided into 2 periods, the period of decline in the

BI Rate (January-July 2007) and the period of flat

movement in the rate (August-November 2007). The

decision to lower the BI Rate was based primarily on

achievement of the inflation target and maintenance

of financial system stability. On the other hand, the

BI Rate was kept on hold in anticipation of potential

inflation risks brought about by the turbulence on global

financial markets beginning at the end of July 2007, as

well as the upward trend in world oil prices.

To strengthen monetary policy effectiveness, Bank

Indonesia has steadily improved the operating

framework for monetary policy, expanded the

range of monetary instruments and strengthened

communication and transparency in regard to monetary

policy. Improvements to the operating framework

include development of infrastructure to enhance the

effectiveness of open market operations through the

introduction of fixed rate tenders in the Bank Indonesia

Certificate auctions. Available monetary instruments

have been supplemented by the launching of fine tune

operations (FTOs) and progressive improvements in

liquidity projections and management. To strengthen

the credibility of monetary policy, Bank Indonesia

has revamped its monetary policy communications

and transparency with the use of press releases and

publication of monthly, quarterly and annual economic

reports, while also holding seminars and discussion

programmes (Box: Communications Strategy,

Monetary Policy and Central Bank Credibility).

In 2007, Bank Indonesia consistently applied a flexible

exchange rate policy, allowing the rupiah to move in

line with economic fundamentals. On one hand, this

alignment with fundamentals was aimed at sustaining

export competitiveness, while the management of

exchange rate volatility was also intended to safeguard

business certainty and minimize inflationary impact.

To manage volatility in the rupiah, Bank Indonesia

conducted forex market interventions on a limited scale.

Coordination of fiscal and monetary policy was

strengthened for further optimization of monetary

policy. The Inflation Control Team (TPI), consisting of

Bank Indonesia and relevant government agencies,

was made more effective in providing policy

recommendations for inflation control. Complementing

this, the Government also established the Staple Foods

Stabilization Coordinating Team tasked with stabilizing

prices for staple foods at affordable levels. This team

was made responsible for (i) planning and formulating

the stabilization policy for rice, sugar and cooking oil;

(ii) coordinating the operation of staple food stabilization

measures; and (iii) monitoring and evaluation of price

stability for staple food items.

Banking Policy

Banking policy in 2007 focused on improvement

in the intermediary function and the institutional

strengthening of the banking system, including

capacity building for the sharia banking industry. The

policy for strengthening the intermediary function was

implemented through changes in some regulations on

bank credit to promote lending to MSMEs and labor-

intensive sectors, without sacrificing prudential banking

principles. Measures for institutional strengthening of

the banking system included further action to promote

consolidation and an active role in the development of

financial markets and instruments aimed at building a

sound, robust financial sector in support of improved

economic resilience. In sharia banking, policy was

directed towards expanding the sharia banking role

in the economy through a more diversified offering

of sharia-compliant products and services and

strengthening the attractiveness of Islamic financial

instruments as an outlet for fund placements from

outside Indonesia.

The policy for further strengthening of bank

intermediation involves four key areas of action. First,

Bank Indonesia is actively engaged in providing the

data and information needed by banks and other

business actors. To do this, Bank Indonesia launched

the National Economic Database and Economic

12

Studies Information Centre on Bank Indonesia web

site and revitalized the roles and functions of Bank

Indonesia Regional Offices. Second is the revitalization

of the state bank role through strengthened

coordination and cooperation with the Government

in the restructuring of the national banking industry.

Third, amendments were made to series of regulations

to introduce revised procedures for assessment of

loan collectibility and other aspects of prudential

banking2. Fourth are efforts to strengthen the role and

contribution of rural banks in the MSME sector through

the linkage program. Reflecting progress made in these

four key actions was the launching of the Indonesia

Business Information Database (DIBI), establishment

of the Facilitation Team for Accelerated Economic

Empowerment of the Regions, operation of the linkage

program for commercial banks and rural banks, holding

of intermediation bazaars in various regions and efforts

to develop a more effective strategic partnership

with Regional Governments through a strengthened

advisory function at Bank Indonesia’s regional offices.

The policy for institutional strengthening of the banking

system is aimed at building the resilience of the national

banking system in the face of global competition. This

policy is divided into three key areas of action. First,

Bank Indonesia plays a facilitating role in the merger

process for the banking consolidation programme,

particularly for banks with potential to trigger instability

in the banking industry. Second, Bank Indonesia has

called on foreign banks to play a more optimum role in

the banking intermediation process as foreign banks

step up their lending to productive sectors. Third,

Bank Indonesia has taken on an increased role in the

development of financial markets and instruments

in order to create a sound, robust financial sector.

Reflecting the progress achieved in these three

areas is the strengthening of prudential regulations,

implementation of the Indonesian Banking Architecture

(API) and preparations for implementation of Basel II.

The launching of Basel II for the Indonesian banking

system is targeted for 2008.

In addition, Bank Indonesia has coordinated actions

with the Ministry of Finance and other agencies in the

development of an efficient and effective Financial

2 Bank Indonesia Regulation No. 9/6/PBI/2007 dated 30 March 2007 concerning Second Amendment to Bank Indonesia Regulation No. 8/2/PBI/2006 concerning Amendment to Bank Indonesia Regulation No. 7/2/PBI/2005 concerning Asset Quality Rating for Commercial Banks.

Sector Safety Net. To develop a comprehensive

framework for the financial sector, Bank Indonesia

worked in coordination with other relevant agencies to

develop the Indonesian Financial System Architecture

(ASKI) and lay the groundwork for the Financial Sector

Assessment Program (FSAP).

The policy for strengthening service capacity in the

sharia banking industry was aimed at accelerating the

growth of sharia banking. To this end, Bank Indonesia

formulated a plan for increasing service capacity in the

sharia banking industry, as envisaged in the Indonesian

sharia Banking Blue Print. This capacity expansion

was carried out simultaneously on the supply side and

demand side with the share of sharia banking targeted

to expand to 5% of total national banking volume by

end-2008. To provide the public with a wider range

of sharia banking services, the Codification of Sharia

Banking Products was prepared in 2007 to present

information on various Sharia banking products

available on the domestic market and as a reference

for sharia banks in expanding their range of financial

services.

Payment System Policy

The payment system policy is divided into policy for

currency circulation and policy for non-cash payments.

In 2007, currency circulation policy sought to improve

the security, reliability and efficiency of currency

circulation, quality of cash services and quality of the

currency itself. Alongside this, the policy for non-cash

payments is directed at mitigating payment system

risks, conducting oversight of the payment system,

reinforcing discipline in the use of cheques and

bilyet giro, regulating money remittances, efficiency

improvements in the management of government

accounts and promotion of non-cash payments.

The policy for secure, reliable and efficient circulation

of money was implemented through provision of cash

in adequate volume based on planned and realized

printing of currency, effectiveness and efficiency in

currency distribution, launching of large cash vaults at

13 Bank Indonesia regional offices and amendment of

regulations pertaining to the deposit and withdrawal of

rupiah currency by commercial banks in Indonesia.

Improvements in primary level cash services were

aimed at raising effectiveness and efficiency in

currency distribution to stakeholders. This policy

13

was implemented through measures that included

expanded areas for cooperation with PT Pos Indonesia

(Posindo) in provision of currency in border regions

and remote areas, further restrictions on bank cash

deposit and withdrawal transactions (or trial run for

bank deposits and withdrawals) and preparations for

outsourcing of currency sorting to third parties.

Efforts to improve the quality of currency in circulation

focused on reducing counterfeiting risks and

extending the lifetime of rupiah in circulation. At the

implementation level, practical actions included the

continuation of awareness campaigns and public

education programmes on the marks of authenticity

of the rupiah currency and development of the Bank

Indonesia-Counterfeit Analysis Center (BI-CAC).

Concerning the quality of materials used for currency,

Bank Indonesia conducted a study of the materials

used for production of the Rp1,000 denomination.

In the non-cash payment system, measures to mitigate

payment system risk include regular main system

and backup system testing to ensure the operational

reliability of the BI-Real Time Gross Settlement (BI-

RTGS) system. Similar testing was also conducted for

the Bank Indonesia National Clearing System (SKNBI),

including the introduction of the Failure to Settle (FtS)

mechanism designed to secure the clearing system

from potential credit risk by requiring all clearing

members to provide prefunding and securities through

the Bank Indonesia Scriptless Securities Settlement

System (BI-SSSS) as collateral for participation in

clearing throughout the day. Bank Indonesia also

revamped the infrastructure and regulation structure

for the payment system, in particular the use of Card-

Based Payment Instruments, provided facilitation for

launching of e-money and issued new regulations on

money remittances.

Oversight of the payment system also involves a

series of activities to test the operational quality of

the BI-RTGS system to ensure compliance with the

international quality standards established by the Bank

for International Settlements (BIS) in the Core Principles

on Systemically Important Payment Systems (CP

SIPS). Similarly, to mitigate settlement risk in securities

transactions, the Finality of Settlement principle

based on the recommendations of the International

Organization of Securities Commissions (IOSCO) has

been adopted for the BI-SSSS securities settlement

system. Under this principle, securities settlement is

final, and therefore does not accommodate unwinding

of settlements.

To reinforce discipline in the use of cheques and the

bilyet giro clearing payment orders, Bank Indonesia

issued a new regulation on the National Black List.

One fundamental difference with the former regulation

is self-assessment by banks of customers writing bad

cheques or bilyet giro, given that banks are better

informed as to whether a cheque or bilyet giro written

by customer is backed by sufficient funds.

As part of its effort to improve efficiency in the

management of Government accounts, Bank Indonesia

has developed the Bank Indonesia Government-

Electronic Banking (BIG-eB) application to simplify the

work of the Government in managing its accounts. In

the initial stage, the BIG-eB application will provide an

online, real time transaction information module. This

module will assist the Ministry of Finance in monitoring

transaction activity on an up to date and accurate

basis, thus expediting the process for preparation of

budget outcome reports.

Fiscal and Sectoral Policy

Fiscal policy in 2007 sought to deliver a more

robust economic stimulus while maintaining fiscal

sustainability. The heftier fiscal stimulus was reflected

in the increased budget deficit in comparison to the

preceding year, while fiscal sustainability was evident

from the steady decline in the ratio of official debt to

GDP and the surplus in the budget primary balance.

The economic stimulus was delivered not only through

government expenditures, but included a series

of limited tax incentives to stimulate activity in the

real sector3 in addition to continuation of social aid

programmes for the poor.

Confronted by the challenges of high oil prices and

low budget absorption, the government responded

with fiscal consolidation to curb the budget deficit

within the prescribed limit. On the revenues side, fiscal

consolidation involved revenue enhancement measures

through increases in dividend payments from SOEs

and tax on crude palm oil (CPO). On the expenditures

side, the consolidation involved economy measures

and efficiency improvements in government agency and

3 Government Regulation No. 1 of 2007 concerning Income Tax Facilities for Investment in Specified Business Lines and/or Specified Regions.

14

line ministry expenditures while retaining the policy for

payment of subsidies.

Sectoral policies aimed at enhancing the quality

of economic growth include improvements to the

investment climate, accelerated construction of

infrastructure, empowerment of MSMEs and the

strengthening and reform of the financial sector4. The

investment climate policy covers three main areas: (i)

institutional reforms aimed at reinforcing the institutional

basis for investment services and synchronizing the

regulations issued by central and regional governments,

(ii) smooth flows of exports and imports, including

improvements to cargo services and faster customs

processing, and (iii) tax reforms including revamped tax

administration and protection of taxpayer rights. The

primary objective of this package is to boost economic

growth beyond the 6% level by promoting investment

as a driving force for this growth.

The Financial Sector Reform Policy is a continuation

of the Financial Sector Policy launched in mid-2006

covering five main areas: (i) financial system stability,

including reinforcement of financial sector coordinating

mechanisms and strengthening of financial institutions,

(ii) banking institutions, including improved banking

policy coordination and facilitation for Sharia banking

expansion, (iii) non-bank financial institutions,

including development of export financing and laying

the groundwork for risk-based supervision of multi

finance companies, (iv) the capital market, including

improved efficiency and liquidity on the capital market

and more robust liquidity and stability on the bond

market (debt securities), and (v) other policies, including

diversification of development financing sources. The

main objectives of this package are to build financial

sector stability and diversify sources of business

funding, including sources from the banking system,

the capital market and other financial institutions.

To strengthen the quality of economic growth and

increase employment, the policy for accelerated

construction of infrastructure was continued during the

year under review. This policy covers three key areas:

(i) improvements to the legal and regulatory framework

with fast-tracked work on completion of infrastructure-

related regulations, (ii) institution building, including

4 Presidential Instruction (Inpres) Number 6 of 2007 concerning Policy for Accelerated Real Sector Growth and Empowerment of Micro, Small and Medium Enterprises (MSMEs) dated 12 June 2007.

capacity building for contracting agencies in projects

undertaken in private sector partnerships under

Presidential Instruction No. 67/2005 and division of

central and regional government powers and functions

in infrastructure development, and (iii) improvement

management of infrastructure construction, including

a process for accelerated land expropriation in the

public interest and preparation of standard operating

procedures for public-private partnership under

Presidential Instruction No.67/2005. This policy is

essentially a consolidation of coordinated strategic

measures designed to bring about reforms in the policy,

regulatory and institutional framework for provision of

infrastructure.

To reduce poverty levels, the policy for empowerment

of MSMEs aims to strengthen productivity and

effectiveness in programme implementation. The

MSME Empowerment Policy covers the four key

aspects of: (i) improved MSME access to financing

sources, (ii) development of entrepreneurship and

human capital, (iii) increased market opportunities for

MSME products and (iv) regulatory reform. The primary

target of this package is to raise MSME productivity

and strengthen the effectiveness of programmes and

activities related to empowerment of MSMEs. The

policy is also intended to send a more positive signal

of the importance of joint commitment in support of

measures for empowerment of MSMEs.

Economic Outlook and Policy Direction

in 2008

The Indonesian economy is predicted to face major

challenges in 2008 with heavy pressure from high

international commodity prices in tandem with the

risk of slumping world economic growth. On one

hand, economic growth is forecasted lower than the

preceding year. Slowing world economic expansion

will dampen export performance. Furthermore,

the Government policy emphasis on maintaining

macroeconomic stability to fend off external pressures

augurs for a reduced economic stimulus compared

to the previous year. External shocks will also stoke

inflationary pressure. CPI inflation is predicted at

the upper limit of the established inflation targeting

range. The economic outlook will remain daunted by

risks from external and domestic factors. To address

this, various policies will be pursued to bolster the

performance of the economy. Bank Indonesia policy in

2008 will be consistently directed towards safeguarding

15

macroeconomic stability in support of sustainable

national economic growth.

Global Economic Forecast

The global economy is predicted to grow by 4.1% in

2008, reflecting a slow down performance compared

to 4.9% in the preceding year. World economic

expansion in 2008 will be constrained by a range of

issues stemming largely from the spreading impact the

subprime mortgage crisis in the United States. Despite

repeated actions by the United States Federal Reserve

and the Bank of England, there is still a risk that the

problems currently besetting the financial sector are far

from over. The unfolding of the turmoil are predicted

to impact investment activity, consumer spending and

international trade. Global economic disturbances will

also be exacerbated by soaring world crude oil prices

predicted to hamper economic growth and inflation

control during the coming year. The combination of

these problems is expected to produce slowed growth

in developed countries. On the other hand, developing

countries are predicted to maintain reasonably high

growth buoyed by domestic demand despite the

inevitable negative impact from the world economic

slowdown.

Despite the expected slow down in world economic,

there is a downside risk of higher inflation. High

international commodity prices are expected to intensify

global inflationary pressures. The lack of adequate

growth in production capacity, continued high demand

from China and India, geopolitical conditions and

climatic disturbances are forecasted to keep oil prices

high throughout 2008. Upward pressure on oil prices

is also likely to originate from speculative actions by

financial market agents on commodity markets. On

the other hand, non-oil and gas commodity prices

are predicted to ease in comparison to the past year.

However, unrelentingly high oil prices will encourage

more intensive development of alternative energy

sources, which in turn will ensure continued high

demand for food commodities such as corn, crude

palm oil and sugar.

With the world economy forecasted to enter a

slowdown, developed nations are expected to follow

a loose bias monetary policy in 2008. Despite the

predicted rise in inflationary pressure, the potential for

more abrupt decline in global economic expansion will

prompt many central banks in developed economies

to adopt a loose bias policy stance. In contrast, central

banks in most emerging market countries are likely

to adopt a tight bias monetary policy to fend off high

inflationary pressures.

Capital inflows to emerging markets are predicted

to ease from the previous year’s levels. However,

the excess global liquidity and positive outlook for

economic fundamentals support the outlook for

emerging markets to continue benefiting from capital

inflows, most notably in the form of FDI and portfolio

investments. The improving economic outlook is key to

investor decisions to pour capital into FDI on emerging

markets. Portfolio capital inflows are also predicted to

rise, drawn by continued attractive investment returns

and subdued economic risks.

Economic Growth Forecast

Economic growth in 2008 is forecasted at 6.2%,

down slightly from the preceding year. The intensity

of external pressures is expected to slow economic

expansion. Export performance will weaken in

comparison to the preceding year due to the effect

of less vigorous world economic expansion. The

persistently high level of international commodity prices

has prompted the Government to make adjustments to

expenditure patterns in the Draft Revised 2008 Budget,

reflecting efficiency improvements in consumption and

investment spending, as well as increased subsidy

payments. These expenditure cutbacks designed to

free up funds for subsidies will in turn lead to reduced

government expenditures on consumption and

investment during 2008.

The driving force for economic growth in 2008 is

predicted to come mainly from private consumption

and investment. Rising public purchasing power

resulting among others from increases in provincial

minimum wages and civil servant salaries, combined

with price stabilization policies for staple goods,

will pave the way for increased public consumption.

Also providing added boost to consumption will be

consumer optimism in the outlook for improvement

in the economy, bolstered by availability of lower-cost

financing with interest rates at more attractive levels.

Optimism for the economic outlook will also provide

added momentum for investment. Construction

investment is predicted to rise with growing number of

infrastructure projects implemented by the government

and private sector. Government efforts to resolve

16

various roadblocks to infrastructure construction

are expected to provide an added boost to this

investment activity. Similar growth is also forecasted

for non-construction investment. Growing demand

and optimism for the economic outlook will stimulate

business interest in expanding economic capacity.

The launching of a range of investment policies will

also provide incentives for investment activity, as

also indicated by the surge in approvals for domestic

investment projects and FDI.

Export growth is forecasted to taper off in comparison

to the preceding year, a result of the world economic

slowdown. Accordingly, Indonesia has sought to

diversify export destinations with focus on China,

India and Eastern Europe, and therefore it is possible

to mitigate the adverse effects of softer demand

from developed nations caused by the economic

slowdown. At the same time, imports of goods and

services are expected to mount in keeping with rising

domestic demand.

This economic growth forecast also has support

from the fiscal stimulus, even though less than in the

previous year. In the Draft Revised 2008 Budget, the

Government targets a deficit at 2.0% of GDP, up from

the Revised 2007 Budget deficit at 1.3% of GDP.

The increased deficit in 2008 is largely explained by

the Government role in maintaining domestic price

stability. To protect public purchasing power amid

the forecasts of pressure from persistently high

international commodity prices, the Government has

decided to increase budget spending on the fuel and

electricity subsidies and on the price stabilization

program for strategic food commodities. Added to

this, fiscal policy in 2008 is still aimed at delivering

a stimulus for the economy. The Government plans

increases in both routine and capital expenditures,

although not to the same extent as in the past year.

Higher routine expenditures are partly explained by

the drive to improve the welfare of civil servants in a

planned increase in basic salaries of about 20%. At the

same time, government capital expenditures will flow

into infrastructure projects, such as roads, bridges and

irrigation channels. These Government policies will in

turn contribute to economic growth during 2008.

Analyzed by economic sector, the economic growth

forecast for 2008 relies heavily on performance in

manufacturing sector, trade, hotels and restaurants

sector and the transport and communications

sector. Rising demand will strengthen manufacturing

performance. Mounting public consumption will

stimulate increased growth in the food, beverages

and tobacco subsector and in the transportation

equipment manufacturing subsector. Furthermore,

infrastructure projects will strengthen performance

in the basic metals, iron and steel subsector, cement

industry subsector and non-metal quarrying subsector.

Manufacturing growth is set to improve not only from

growing demand, but also a series of Government

incentives designed to strengthen that sector, including

the rescinding of import duties on hot rolled steel and

reduction in luxury goods tax on electronic products.

Rising economic activity will in turn generate added

momentum in services sectors, such as transportation

and communications sector, as well as trade sector.

Investment financing in 2008 will be provided mainly

from equity, bank financing and government capital

expenditures. Sources of equity funds, include self-

financing and reinvestment of profits, are expected to

dominate investment financing with more than 50%

of the total. On the domestic front, the Government,

banking system and capital market are expected to

provide about 30% of needed investment financing. A

further 10% will be provided from external sources.

Balance of Payments Forecast

The balance of payments in 2008 is predicted to record

a $11.3 billion surplus, bringing international reserves

at end of year to $68.2 billion or equivalent to 6.2

months of imports and servicing of official foreign debt.

The forecasted balance of payments surplus is down

from the preceding year, with reduced surpluses in the

current account and the capital and financial account.

The current account in 2008 is predicted to chart a

respectable surplus, although not as high as before.

Amid the slowdown in world economic expansion,

export performance is predicted to decline. However,

a deeper slowdown can be avoided to some extent

by diversification of export destinations, with softer

demand from developed countries compensated by

robust demand from developing economies such as

China, India and Eastern European countries. Export

performance will also be bolstered by international

prices for oil and non-oil commodities, which is

predicted to remain strong. At the same time, the

upward trend in domestic economic activity will

continue to fuel brisk growth in imports.

17

The capital and financial account is predicted to register

a more modest surplus compared to the past year.

Nevertheless, performance will be supported by a rise

in long-term capital inflows in response to the improving

investment climate in Indonesia. FDI is predicted to

climb significantly over the previous year. Portfolio

capital inflows are also forecasted to be strong,

although not as high as before. Continued attractive

yields amid conditions of excess global liquidity will

stimulate keen investor interest in emerging market

countries. Increased capital inflows will be invested

primarily in government securities.

Exchange Rate Forecast

The rupiah exchange rate is expected to remain stable

during 2008. Stability in the rupiah will be reinforced

by improvements in fundamentals as reflected in the

continued high balance of payments surplus and

attractive yields on rupiah investments when compared

with the region. Demand for international reserves is

estimated to increase due to higher volume of non-oil

imports and higher prices of oil in international markets.

Nevertheless, the increased foreign currency demand

is expected to be offset by adequate supply. Hence

rupiah stability can be maintained.

Inflation Forecast

CPI inflation in 2008 is predicted at 6.0%-6.5%, above

the targeted range. Global economic conditions marked

by persistently high international commodity prices will

bring considerable pressure to bear, with CPI inflation

forecasted at the upper limit of the inflation targeting

range. Steep world commodity prices are expected

to boost imported inflation and fuel public inflation

expectations. These conditions will in turn drive up core

inflation. Nevertheless, these external factors can most

likely be mitigated by the stable exchange rate and

support from government policy support for domestic

price stability. Demand-side pressure is predicted to

be adequately balanced by higher investment in added

economic capacity. In the volatile foods category,

inflationary pressure will ease with the support of

government commitments to safeguard supplies of

food under the agricultural intensification programme

and greater flexibility for imports by the National

Logistics Agency (BULOG). In the administered prices

category, price increases are predicted to be minimal

in keeping with the government policy of not raising

administered prices for strategic goods.

Forecast for the Banking System

In 2008, bank lending growth in support of economic

expansion is forecasted to reach 22%-24% alongside

improvement in credit quality (NPLs gross below 5%)

and strengthening in the LDR to 72%. The continued

robust economic expansion in tandem with conducive

interest rate movements are expected to provide added

momentum to bank lending. The improving condition

of the banking system, reflected in the rising strength

of bank capital, will also contribute to the accelerated

lending growth. The more vigorous credit expansion will

be supported primarily by lending in the infrastructure

sector, which is expected to generate multiplier effects

in other economic sectors. Added support for credit

expansion will also come from growth in depositor

funds, forecasted at 16%-18%.

Sharia banking is also predicted to keep forging ahead,

with its share of the national banking system expanding

to 5% of total national banking assets in 2008. Growth

in sharia-compliant financing is predicted to outpace

credit growth in the conventional banking system.

This forecast is related to the potential for increased

mobilisation of depositor funds in the sharia banking

system in keeping with the buoyant outlook for the

economy and growing competitiveness of investment

products offered by sharia banks. On the financing

side, stronger economic expansion is expected to

generate increased demand for sharia bank financing.

The types of financing provided by sharia banks will be

dominated by sale-and-purchase based financing for

the services and trade sectors.

Risks to the Indonesian Economy in 2008

The economic forecast described above also entails

eminent downside risks that could potentially change

the projected outcomes. Higher than predicted

international prices for both oil and non-oil commodities

represent the most serious risk factor to be monitored.

Persistent strong demand, limited production capacity

and various sentiment factors, including geopolitical

issues, are expected to keep international oil prices

at high levels throughout 2008. On the other hand,

unabated high oil prices have prompted more

vigorous efforts to develop alternative energy sources.

International prices for foodstuff commodities such as

corn and soybeans are projected to soar in response

to biofuel production. In addition, climate change

caused by global warming will also notch up pressure

in food commodity prices due to crop failures. The high

18

commodity prices will benefit the balance of payments

of exporting countries, but on the other hand these

prices will have a significant bearing on economies

through increased inflationary pressure.

High world oil prices coupled with uncertainty over the

end of the global financial market turmoil brought on by

the spreading subprime mortgage crisis are predicted

to impact world economic performance. The economic

slowdown in developed countries, most importantly

the United States, is set to continue and thus erode

optimism for global economic expansion, which may

in turn hurt Indonesia’s exports. Uncertainty over the

global financial market turbulence could also derail

macroeconomic stability. Since the risk associated with

the reversal of capital inflows remain, given the share

of short term capital inflows and the shallowness of

domestic financial market.

In addition to international crude oil prices soaring

beyond the budget assumption, potential pressure

on the fiscal deficit will also come from increased

demand for domestic consumption of oil-based fuels

triggered by such factors as the price disparity between

subsidized and non-subsidized fuels and the failure to

achieve targeted levels of domestic oil production. Any

increase in the budget deficit could potentially derail

fiscal sustainability, which in turn may fuel negative

sentiment and impact the overall economic outlook.

This negative sentiment could set off another round

of portfolio capital reversal. This in turn would reduce

the balance of payments surplus and in so doing

undermine the strength of the rupiah.

Investment activity could potentially become hampered

by various hurdles preventing the completion of

infrastructure projects, including lack of clarity of

regulations on land expropriation and inadequate

synchronisation of central government and regional

government policies. Furthermore, the lack of

significant improvement in infrastructure and risks of

natural disasters could hamper the supply of goods,

which might give raise to inflationary pressure. Risk of

price increases may also arise from difficulties in the

kerosene to LPG conversion programme, which could

lead to shortages of these commodities and drive up

kerosene prices.

Policy Direction

In the monetary sector, Bank Indonesia policy will

directed at maintaining macroeconomic stability by

consistently containing inflation expectations towards

the established target. Monetary policy will continue to

emphasize consistency and commitment in managing

inflation in line with the government-set target for 2008.

This monetary policy stance not only requires support

from interest rate policy, but also policies restraining

volatility in the rupiah. In this regard, the maintenance

of safe levels of international reserves is consistent

with the safeguarding of macroeconomic stability.

Reinforcing this are standby measures established

through the ASEAN+3 cooperation under the Chiang

Mai Initiative, 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 the future economic

and financial stability of the region.

This monetary policy will require support from an

improved operational framework. To this end, Bank

Indonesia will launch a series of tactical measures to

enhance the effectiveness of monetary instruments in

absorbing excess liquidity in the banking system. Open

Market Operations (OMOs) will use instruments with

a broader range of tenors to maintain stability in the

overnight (O/N) interbank market. Also enhancing the

use of OMOs will be fine tuning operations (FTOs), repo

transactions with underlying government securities

and Forex swaps. On the financial market, the strategy

for financial market deepening and expansion of

the financial instrument base will take on increasing

importance. The reactivation of existing instruments

and transactions is one measure for financial market

development that is expected to improve effectiveness

in the management of liquidity held by financial market

players.

To promote economic growth, the primary thrust

of banking policy in 2008 will be on quality lending,

improved MSME access to financing, expansion in the

direction of universal banking and further consolidation

of the banking system. Higher quality lending will involve

such actions as increased lending to productive sectors

and exploration of possibilities for reestablishment of a

policy bank concentrating on mobilisation of long-term

funds for financing infrastructure projects. To improve

MSME access to financing, Bank Indonesia is pressing

forward with expansion of the linkage program,

19

development of a loan guarantee scheme for MSMEs,

reduction in the risk-weighted asset calculation for

people’s business loans (KUR) and MSMEs credit,

and redefinition and redirection of the rural bank role in

local economic empowerment. Greater room has been

created for banks to expand operations into universal

banking as a response to the mounting demand for

innovative bank products integrated with other products

from the financial industry. The adoption of universal

banking within the banking system will not only help

ensure provision of needed financing, but also support

financial market deepening.

The drive to optimize the bank intermediary function

must be accompanied by measures for strengthening

the resilience of the banking industry, Bank Indonesia

will keep moving forward with bank consolidation,

including the launching of regulations pertaining to the

criteria for High Performing Banks and Anchor Banks,

as well as examining the effectiveness of the increase

of minimum bank capital to Rp80 billion. Preparations

for implementation of Basel II, primarily in relation to

the three pillars of capital adequacy, supervisory review

process and market discipline, will continue.

Banking policy will also focus on strengthening banking

transparency towards the public and the launching of

Banking Education Year. By mid-2008, all banks will

be expected be fully compliant with good corporate

governance (GCG) including disclosure of their GCG

in reports to the public. The Banking Education Year

in 2008 will mark the launching of a comprehensive,

integrated public education programme on banking

in coordination with all banking industry stakeholders.

This programme is envisaged as empowering the

public with greater ability to choose and make more

carefully planned, considered use of banking products

and services. The banking system is also expected to

play a community social role under the corporate social

responsibility (CSR) programme. The banking industry

CSR may focus on strategic efforts in education as a

contribution to the nation’s social and human capital.

To support economic activity and the effectiveness of

monetary and banking policy, the currency circulation

policy will continue to focus on improvements in

the security, reliability and efficiency in currency

circulation; improved primary level cash services; and

enhanced quality of currency. Existing policies will be

continued, including the strategy for secure, effective

and efficient currency distribution and measures to

combat the circulation of counterfeit currency through

the strengthening of infrastructure at Bank Indonesia

and enhanced anti-counterfeiting collaboration with

other agencies. Bank Indonesia will also launch the

pilot implementation of cash centres at the Bank

Indonesia Head Office and some Bank Indonesia

Regional Offices as part of the strategy for outsourcing

cash management to third parties. In addition, Bank

Indonesia plans to issue a new Rp20,000 denomination

in 2008 for reasons of cost efficiency and longer

retention in circulation.

Policy for non-cash payments is aimed at curbing

risks, raising efficiency, ensuring equitable access and

enhancing consumer protection. Actions to mitigate

risk in the payment system and thus support financial

system stability include the ongoing trials of disaster

recovery planning to safeguard the operational reliability

of the payment system (RTGS and national clearing

system) and a study exploring possibilities for operation

of a payment versus payment (PVP) mechanism for

foreign exchange transactions and development

of a risk mitigation model for funds transfers.

Efficiency improvements include the introduction of

interoperability in the card-based payment instrument

networks, while the principle of equitable access is set

out in the system operating regulations by emphasizing

Bank Indonesia’s position as regulator, operator and

member. Consumer protection will be strengthened

through the introduction of a regulation on e-money

and broader coverage of application of the rules on

money remittance activities.

To optimize policy effectiveness, Bank Indonesia

will continue to strengthen coordination with other

macroeconomic policies. The drive to safeguard

macroeconomic stability and promote more robust,

more healthily structured economic growth is integral

to overall economic policy. A key prerequisite is

greater competitiveness in the economy through

improvement in the investment climate and accelerated

construction of infrastructure. Work will continue on

the harmonization of a range of policies for these

objectives. Further strengthening will take place in the

coordination and synergy established between Bank

Indonesia and the Government. Policy coordination

for inflation control, in addition to the Inflation Control

Team (TPI) and Coordinating Team for Stabilization of

Food Staples, will also involve the Coordinating Forum

20

for Inflation Control coordinated by the Office of the

Coordinating Minister for the Economy. At the regional

level, the Bank Indonesia Regional Offices will take on

a strengthened role in local economic empowerment

and accelerated economic development, among others

through establishment of Regional Inflation Control

Teams for coordination between Bank Indonesia

Regional Offices and relevant agencies. In the payment

system, Bank Indonesia will launch the government

e-banking application (BIG-eB) to complement the

implementation of the Treasury Single Account. The

BIG-eB application will offer a range of modules for

conducting transactions and providing information on

Government financial transactions. In a further move

to safeguard and reinforce financial system stability,

coordination will be strengthened further in the Financial

System Stability Forum (FSSK) for collaboration

between the Ministry of Finance, Bank Indonesia and

the Indonesian Deposit Insurance Corporation (LPS)

under the auspices of the Coordinating Minister for the

Economy. In 2008, the FSSK plans to finalize the Crisis

Management Protocol and the Macro Early Warning

System while taking forward a series of programmes

under the Indonesian Financial System Architecture

initiative.

21

One interesting feature of Bank Indonesia in the past

several years is public transparency, particularly in

regard to monetary policy. In the past, monetary policy

decisions were made in closed sessions with outcomes

not announced to the general public. Now, the public

can easily access information on monetary policy and

the decisions adopted in the Board of Governors’

Meeting held at Bank Indonesia each month. Bank

Indonesia has also opened itself to members of

the public interested in learning and understanding

monetary policy. Other means of communications, such

as the web site, workshops, seminars, student visits

and formal and informal meetings have been organized

to improve public understanding of monetary policy and

the national economy. Bank Indonesia is now working to

bring itself closer to the public.

The drive to bring Bank Indonesia closer to the public

is integral to the monetary policy framework adopted

in 2005. The launching of the Inflation Targeting

Framework (ITF) as a working framework for monetary

policy in Indonesia has influenced the operation of

monetary policy itself. The ITF introduced the public to

a new logic in the policy actions taken by the central

bank. The ITF also brought structural change to the

communications approach previously followed by the

central bank1. Central bank policy is now consistently

steered towards achievement of a future inflation target,

established for the medium and long-term. To achieve

the target, communication represents the front line of

the drive to build the credibility of the central bank.

Central bankers now understand that credibility is one

of the most important elements in monetary policy

effectiveness. In the 1960’s and 1970’s, policy makers

1 Initial reference came from Leiderman and Svensson (1995) and basic thoughts came from Svensson (1999). Several general view could be found in Bernanke et al (1998), Loayza and Soto (2001), Mishkin and Schmidt-Hebble (2001) and Gjedrem (2001). Each country’s experiment had been evaluated by Kohn (2000) for England, Svensson (2001) for New Zealand, and Svensson et al (2002) for Norway.

did not yet fully understand the correlation between

determinants of credibility and policy outcomes.

However, in 1977, Finn Kydland and Edward Prescott

published their dissertation, “Rules Rather than

Discretion: The Inconsistency of Optimal Plans” (Kydland

and Prescott, 1977), which presents a cogent analysis

of the credibility of decision making authorities. Kydland

and Prescott specifically pointed out how economic

indicators in many situations will show better results if

policy makers are able to make credible statements or

promises on specific aspects of their envisaged policies.

“Credible” in this context means that the public believes

that policy makers will honour their promises even when

tempted to do otherwise.

Much has now been written on the relationship between

central bank communications and the operation of

the ITF. Early references are found in Leiderman and

Svensson (1995) and the basic line of thought in

Svensson (1999). General viewpoints are also found in

Bernanke et. al. (1998), Loayza and Soto (2001), Mishkin

and Schmidt-Hebbel (2001) and Gjedrem (2001).

Evaluations of individual country experiments have also

been prepared by Kohn (2000) for the United Kingdom,

Svensson (2001) for New Zealand and Svensson et. al.

(2002) for Norway.

More specifically, Kydland and Prescott cite examples

in which central banks will tend to announce or publicly

commit themselves to low inflation targets. If the public

trusts these statements (the central bank has credibility),

the public will place their confidence accordingly. As a

result, demands for wage increases and even prices

will moderate, adjusting to the expectations in place.

This public behavior will then ease the task of the

central bank in fulfilling its commitment to maintaining

low inflation. Conversely, if the public is sceptical of

the central bank commitment to low inflation (e.g., the

public believes that the central bank will be tempted

to take a more populist approach at the expense of

Communications Strategy, Monetary Policy and Central Bank Credibility

22

long-term objectives), public expectations of inflation

will mount. The public expectations of higher levels of

future inflation will in turn drive up prices and ultimately

increase the difficulty and expense for the central bank in

achieving and maintaining low, stable inflation. It is here

that the credibility of the central bank plays a major role in

achievement of the inflation target.

From a theoretical standpoint, the importance of central

bank credibility is supported by a number of views, such

as the school of new macroeconomics of monetary policy

with its new neoclassical synthesis (NNS) or the New

Keynesian Economics approach. The benchmarks of

the NNS approach include some features from classical

economics, such as the real business cycle (RBC),

intertemporal optimization and rational expectations.

The NNS approach also has Keynesian features such as

monopolistically competitive firms, a markup of price over

marginal cost and sticky prices (costly price adjustment).

The understanding of these theories has helped central

banks to grasp and to explain to the public how monetary

policy builds and maintains the credibility of a low inflation

outlook and why inflation targeting can achieve balanced

improvement in the stability of inflation and output.

In Indonesia, inflation is influenced by three main factors.

First is volatile foods, in which inflation is customarily

determined by the harvest season, tight supply,

distribution bottlenecks or even natural disasters. Second

are administered prices, such as fuel prices and electricity

billing rates. Third is the core inflation, comprising inflation

generated by the output gap, inflation from external

factors, such as the exchange rate and rising international

commodity prices, and public expectations of inflation.

Among these inflation determinants, one of the most

dominant factors in Indonesia is the persistently high level

of public inflation expectations.

Public expectations are shaped by two factors. The

first is adaptive or backward looking expectations, in

which inflation is determined by the subjective views

of economic actors based on past economic data and

events. This subjective view still predominates in the

expectations formed by the public in Indonesia. Second

are rational or forward-looking expectations in which

inflation is based on monetary scenarios projected by

the central bank, which in this case has an inflation

target. It is these forward monetary projections that are

envisaged for further development to guide the behavior

of economic actors. To achieve this, the credibility of the

central bank is essential, as well as mutual trust between

the central bank and the public.

It is here that a communication strategy is key to

strengthening the effectiveness of monetary policy. On

a structural level, monetary policy communications at

Bank Indonesia form part of the overall Bank Indonesia

communications strategy. This strategy is formulated

as a guide for Bank Indonesia in communicating with

the public, influencing expectations and ultimately

strengthening the credibility of the central bank. Various

monetary policy communications were put into place

beginning in 2005 and subsequently in 2007 were

incorporated permanently into the strategy for monetary

policy communications.

The monetary policy communications strategy has been

formulated down to the operational level. The strategy

sets out the main objectives, target groups (stakeholders)

and communication tools. Communications are conveyed

in a transparent, comprehensive and predictable manner.

Transparency in monetary policy communications is

upheld through timely provision of factual information.

Identification of stakeholders is a vital prerequisite to an

effective communications strategy. Bank Indonesia’s

communications or even the monetary policy education

itself is focused on the media, financial market and

banking system actors, economic analysts, industry

(business associations, Chamber of Commerce and

Industry, etc.), academics, students, politicians, members

of parliament, NGOs and the general public.

Looking ahead, monetary policy communications in

Indonesia remain daunted by formidable challenges.

These challenges are exacerbated by widely varying

levels of public understanding, public expectations

of future inflation and the economic outlook and the

struggling credibility of the central bank itself. Low,

stable inflation cannot be achieved in a simple, one-

off undertaking, but instead demands a long series of

complex measures. A key factor in this is the credibility of

the central bank. In the absence of credibility, low public

confidence will engender public behavior detrimental

of the economy. In this modern age, a key task for

central banks is the management of expectations. For

this reason, a common effort among all the constituent

elements of our society in maintaining the credibility of

the central bank is of strategic importance in building our

nation’s economic stability.

Chapter 2

Macroeconomic Conditions

24

During 2007, the Indonesian economy showed overall improvement. This was reflected in the highest economic growth rate achieved during the post-crisis period, underpinned by increasingly robust, carefully managed macroeconomic stability. On the demand side, accelerated growth was driven by vibrant public consumption and investment in keeping public purchasing power and economic prospects. Despite some slowing, export growth remained strong in the face of the threat of world economic slowdown. Demand-side expansion was also reflected in increased capacity utilisation across almost all economic sectors. Key sectors supporting overall economic growth, such as manufacturing, agriculture, and trade, as well as hotels and restaurants, forged ahead at a faster rate compared to the preceding year. Robust economic growth was also followed by higher employment levels, rising per capita income and reductions in poverty gap index and poverty severity index.

Chapter 2: Macroeconomic Conditions

Economic growth in 2007 surpassed that of 2006,

reaching its highest level since the outbreak of the

economic crisis. Overall, the economy emerged in

better condition despite challenges arising from global

and domestic issues. Indonesia was able to minimise

the impact of soaring oil prices and the subprime

mortgage crisis and in so doing maintain the stability

of the rupiah and inflation while safeguarding fiscal

sustainability. The achievement of macroeconomic

stability coupled with stronger public purchasing power

paved the way for reinvigorated economic growth

in 2007. After slipping to 5.5% (yoy) in 2006, growth

mounted significantly in 2007 to 6.3% (yoy) (Chart 2.1).

On the demand side, the impressive gain in economic

growth was reflected in surging domestic demand and

relatively strong exports. In the first half of 2007, public

purchasing power, which had weakened in 2006 after

fuel price hikes in 2005, managed a gradual recovery

to provide added stimulation for private consumption.

Investment began to show significant improvement

following a downturn brought on by slackened

domestic demand. Exports maintained their rapid

expansion at the beginning of the year, buoyed by world

demand and high international prices for resource-

based commodities. Imports also continued to expand

rapidly in keeping with strengthened domestic demand

and exports. In the second half, the recovery in public

purchasing power helped to stimulate rapid growth in

private consumption. Investment growth maintained

an upward trend, driven mainly by rising domestic

demand. Export growth began to taper off towards the

end of the year in response to slowing global demand.

However, import growth remained strong at year end

due to robust domestic demand.

25

All economic sectors reported higher levels of growth

compared to the preceding year. Leading growth

sectors were transport and communications, electricity,

gas and water supply sector, construction, financial

sector and trade, hotels and restaurants sector.

As alluded previously, manufacturing, trade and

transportation were the main sectors driving the growth

of the economy. However, the composition of major

economic sectors in the GDP, led by manufacturing,

agriculture and trade, as well as hotels and restaurants

sectors remained unchanged.

On the policy front, real sector policy was directed

at strengthening economic growth. To this end, the

Government launched a policy package for revamped

growth in the real sector and empowerment of

MSMEs. The policy package, which strengthens

existing cross-sectoral policies while introducing

new policies, is divided into the following key areas:

i) improvement of the investment climate; ii) reform

of financial system; iii) accelerated construction of

infrastructure; and iv) empowerment of MSMEs. As of

November 2007, the Government had achieved most

of the targets set out in the Presidential Instruction.

Policies were also introduced to improve welfare by

strengthening poverty alleviation under the Regional

Poverty Alleviation Coordinating Teams , continuing the

School Operational Assistance programme for aid to

underprivileged students and other actions.

Improved economic growth in 2007 was also

accompanied by a general reduction in numbers of

unemployed and the poor. The economic expansion

in 2007 succeeded in absorbing larger numbers of

workers than new entrants to the workforce. As a

result, open unemployment in 2007 fell to 10.5 million,

compared to the 11.1 million recorded in 2006. The

reduced unemployment in turn lowered the numbers

of people living in poverty from 39.30 million (17.8% of

the population) in 2006 to 37.17 million (16.6% of the

population) in 2007. This improvement in welfare had

a positive impact on some of the targeted indicators

in the 2015 Millennium Development Goals, most

importantly with reduction in poverty and hunger, lower

child mortality rate and more children receiving primary

and secondary education.

Aggregate Demand

On the demand side, improved public purchasing

power and robust world demand for Indonesian export

products were key factors driving economic growth

in 2007. In the first half of 2007, stronger purchasing

power fuelled by consumer confidence in rising

incomes resulted in significantly increased growth in

Table 2.1

GDP Growth and Distribution by Expenditures

percent

Items 2004 2005 2006*2007**

2007**I II III IV

Total Consumption 4.9 4.3 3.9 4.6 4.6 5.3 5.1 4.9

Private Consumption 5.0 4.0 3.2 4.7 4.7 5.1 5.6 5.0

Government Consumption 4.0 6.6 9.6 3.7 3.8 6.5 2.0 4.0

Investment1 14.2 10.8 2.9 7.0 6.9 10.4 12.1 9.1

Domestic Demand 9.1 5.3 3.3 -0.8 3.4 4.4 9.6 4.2

Net Export -23.1 13.6 15.6 6.8 25.0 6.7 -14.2 6.1

Exports of Goods and Services 11.1 16.4 9.2 8.1 9.8 6.9 7.3 8.0

Imports of Goods and Services 25.2 17.1 7.6 8.5 6.5 7.0 13.6 8.9

GDP 4.9 5.7 5.5 6.1 6.4 6.5 6.3 6.3

Distribution of GDP (%)

Total Consumption 68.2 67.3 66.3 64.4 65.2 63.8 68.2 65.4

Private Consumption 60.6 59.6 58.3 57.8 57.3 56.3 58.9 57.6

Government Consumption 7.6 7.7 8.0 6.5 7.9 7.4 9.3 7.8

Investment1 21.4 22.5 21.9 21.5 22.0 22.5 23.6 22.4

Exports of Goods and Services 41.1 45.2 46.8 47.0 48.0 46.9 49.1 47.8

Imports of Goods and Services 32.8 36.3 37.0 36.8 38.2 38.8 40.2 38.5

Sources: BPS-Statistics Indonesia1 Gross Fixed Capital Formation.

26

private consumption. Exports, buoyed by strong world

demand for agricultural and mining commodities,

continued to come to the fore. Investment showed an

upward growth trend, consistent with more vigorous

private consumption. Imports, comprising mainly

consumer goods and raw materials, also grew at a high

rate alongside rising domestic demand and exports.

During the second half of the year, vigorous expansion

in domestic demand continued to provide the main

driving force for growth. However, export-driven growth

began to taper off as the slowdown took greater hold

in the world economy. This period was also marked by

surging import growth.

Private consumption expanded at the rate of 5.0% in

2007 on the back of renewed public purchasing power.

Public purchasing power mounted a gradual recovery

during the year, following a period of weakened

purchasing power in 2006 brought on by earlier fuel

price hikes. Reflecting this was the sustained upward

trend with private consumption growth reaching 5.0%

(yoy) in 2007, well ahead of the previous year’s growth

at 3.2% (yoy). This recovery in purchasing power was

experienced at almost all levels of society. Middle and

upper income employees in the formal sector saw their

salaries rise by an average of 13% (yoy) during 2007

(Table 2.2). At the same time, wages for informal sector

workers, representative of purchasing power among

lower income groups, improved further albeit on a

modest scale (Chart 2.2 and 2.3).

Analyzed by component, growth in both food and

non-food consumption mounted higher in comparison

to 2006 (Chart 2.4). Non-food consumption climbed

5.8%, well ahead of the 4.1% recorded in 2006.

Increased non-food consumption was reflected in

the significant rise in sales of durable goods, such as

motor vehicles and electronic products. Motor vehicle

sales were up 36.3% in 2007, a vast improvement

over the negative 40.2% growth in the previous year

(Chart 2.5). Alongside this, the previous negative

12.8% growth in motorcycle sales improved to 5.8%.

Purchases of electronic items, including televisions and

washing machines, advanced by 21.3% and 33.3% in

2007 (Table 2.3). Also reflecting the escalating trend

in consumption was the accelerated real growth in M1

during 2007 (Chart 2.6).

Table 2.2

Salary Increase by Management Levelpercent

Management LevelAverage Increase

2005 2006 2007*

Blue Collars 9.9 12.3 12.7

Clerk 9.8 13.1 13.8

Junior Management 9.8 13 13.7

Middle Management 9.6 12.8 13.9

Senior Management 9.4 12.8 13.6

All Level 9.7 13 13.8Source: SWA, February 2007* projection

27

Consumer confidence in the condition of the economy

also bolstered private consumption. Consumer

confidence indicators showed steady improvement

from the beginning of 2007, as borne out in the Bank

Indonesia Consumer Survey, which shows an upward

trend from early in the year. The consumer confidence

index components in the BI Consumer Survey have

registered steady gains (Chart 2.7). This improvement

is mainly attributable to a number of factors, including

current income levels, economic conditions and

availability of employment. Income expectations

identified in the Consumer Tendency Survey by the

Central Statistics Agency (BPS) were also upbeat, due

largely to improved forecasts for household incomes

(Chart 2.8). In addition, the downward movement in

loan interest rates to the middle of the year is also

believed to have boosted private consumption.

From the financing side, support for accelerated growth

in private consumption came from consumption credit

and non-bank financing. Consumption credit and

non-bank financing expanded at a faster rate with

interest rates in decline. Disbursements of consumption

credit mounted 17.5% in 2007, ahead of the previous

year’s growth of 16.8%. Average growth in consumer

financing during 2007 also surpassed the average

expansion recorded in preceding years (Chart 2.9 and

Chart 2.10).

Unlike private consumption, government consumption

manifested a slowing growth trend. Growth in

government consumption reached 4.0%, down from

Table 2.3

Electronic Products Sales Growth

percent

Product 2005 2006 2007

Television -4.10 -3.77 21.26

Refrigerator 21.07 -11.76 23.27

AC 26.03 -13.48 34.85

Washing Machine 16.71 4.24 33.34

Source: Electronic Marketing Club.

28

the 9.6% recorded in the previous year in keeping with

reduced budget expenditure outcomes. Analyzed by

component, the slowdown in expenditures took place

mainly in personnel expenditures and the General

Allocation Funds and Special Allocation Funds for the

regions. On the other hand, miscellaneous expenditures

and the Profit Sharing Fund recorded negative growth.

Investment responded to rising demand with more

robust expansion compared to the preceding year.

In 2007, investment expanded by 9.2% (yoy), a

considerable improvement over the 2.5% growth

in 2006. Driving this performance was escalating

domestic and external demand in the first half of

2007 and rapid expansion in private consumption to

the end of the year. Investment growth was recorded

in both construction and non-construction sectors.

Also contributing to investment performance was

improved efficiency in use of capital as more investment

flowed into technology-intensive sectors. In 2007,

the Incremental Capital Output Ratio (ICOR) eased

reflecting improvement to 3.8, down when compared

to 4.2 in 2006 (Chart 2.11) and the average for the past

4 (four) years1. Accordingly, the ratio of investment to

real GDP edged slowly upwards to 22.4%, albeit still

below the all-time 29% high during the pre-crisis period

(Chart 2.12).

1 ICOR is the ratio of the incremental increase in capital to incremental increase in output, or the level of investment required to generate one unit of output.

Disaggregated by component, accelerated investment

growth was driven mainly by the 10.1% rise in non-

construction investment (Chart 2.13). The surge in

non-construction investment was reflected in renewed

growth trend in heavy equipment sales in 2007

(Chart 2.17). In contrast, construction investment was

stable with growth at 8.6% (yoy). At this level, growth

in construction investment was on par with the stable

trend in cement sales during 2007 (Chart 2.15).

29

Rising investment bolstered expansion in economic

capacity, as reflected in the upward trend in capital

accumulation. Progress was achieved in the resolution

of various infrastructure-related problems affecting

production in keeping with the gradual improving

trend in capital accumulation (Chart 2.16). Stronger

investment growth is also expected to boost economic

capacity and thus minimise inflationary pressure from

the output gap.

Also fuelling renewed investment growth was an upbeat

trend in business sentiment over the condition of the

economy. The BPS survey points to improvement in

business sentiment over future economic conditions,

especially in relation to domestic demand and demand

for input goods (Chart 2.17). Consistent with the BPS

survey, the BI Business Survey, which is related to

realized investment levels, indicated a gain in realized

investment value in the second half of 2007 compared

to the first half (Chart 2.18).

30

The upward investment trend was reflected in the

savings-investment gap. With investment growing at a

faster rate, the savings-investment gap narrowed from

2.7% in 2006 to 2.5% in 2007. However, the reduced

surplus in the savings-investment gap was attributable

more to the widening of the fiscal deficit from -0.9%

to -1.2%. At the same time, the private sector surplus

climbed from 3.6% to 3.8% despite more robust

expansion in private investment.

Despite this, investment activity was still hampered

by an inadequately conducive investment climate

compared to competing countries. This is explained

by several reasons, among others lack of infrastructure

and problems with investment-related regulations. In

the Doing Business 2008 survey by the International

Finance Corporation, Indonesia’s competitiveness

rating improved from the 133rd to the 123rd spot in

2007 (Table 2.5), while still lagged behind neighboring

countries such as Thailand, Malaysia and even Vietnam.

Aside from this survey, Indonesia’s rating by the World

31

The buoyant export growth was driven by exports of

mining extraction commodities such as coal and nickel

(Chart 2.20) and agricultural commodities, notably

palm oil and rubber (Chart 2.21). At the same time,

the leading manufactured exports were chemicals and

rubber products (Chart 2.22). World demand for coal

and palm oil mounted sharply in 2007 due to the effect

of energy diversification spurred by soaring oil prices.

With economic activity gathering pace, imports of

goods and services also grew more vigorously than

in 2006. The 8.9% (yoy) growth in these imports was

attributable largely to robust expansion in imports of

consumer goods and raw materials (Chart 2.23). The

Economic Forum was also unchanged. Compared to

neighboring countries, Indonesia’s competitiveness

ranked ahead only of that of Vietnam and the

Philippines (Table 2.6).

Exports of goods and services forged ahead, driven

by high world demand. Export registered strong 8.0%

growth (yoy) in 2007, despite some slowing compared

to the preceding year. The major factor fuelling export

growth was robust world demand in the first half of

2007 (Chart 2.19). Towards the end of 2007, external

conditions began to deteriorate global demand from

the effects of the ongoing US subprime mortgage

crisis. However, at this point, the crisis had brought no

significantly impact on export growth.

Table 2.4

Saving – Investment Gap

2005 2006 2007

Ratio to GDP (%)

Government

Saving 2.4 2.2 2.2

Investment 2.9 3.1 3.4

Deficit/Surplus -0.5 -0.9 -1.3

Private

Saving 21.3 24.6 25.2

Investment 20.7 21.0 21.5

Deficit/Surplus 0.6 3.6 3.8

Total

Saving 23.7 26.8 27.4

Investment 23.6 24.1 24.9

Deficit/Surplus 0.1 2.9 2.5

Note:

GDP (Trillion Rp), base year 2000 2,774.3 3,339.5 3,957.4

Current Account (Millions of $) 278 10,836 11,009

Average Exchange Rate (Rp/$) 9,713 9,167 9,140Source: BPS-Statistics Indonesia, Ministry of Finance

Table 2.5

Indonesia’s Rating - Investment Climate Survey

Countries

Ease of Doing Business

Starting a Business

Dealing with Licenses

Employing Workers

Registering Property

Enforcing Contract

Closing a Business

2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007

Indonesia 133 123 163 168 117 99 154 153 49 51 142 141 137 136

Malaysia 21 24 74 74 102 105 43 43 4 4 14 63 53 54

Vietnam 94 91 90 97 62 63 82 84 175 165 41 40 119 121

Thailand 17 15 27 36 11 12 49 49 32 33 26 26 41 44

China 92 83 128 135 175 175 86 86 81 83 20 20 76 57

Philippines 130 133 135 144 75 77 122 122 141 141 113 113 147 147

Singapore 1 1 11 9 5 5 1 1 2 2 5 4 0.8 2Source: International Finance Cooperation

32

upsurge in consumer goods imports came in response

to invigorated private consumption fuelled by rising

purchasing power. Imports of raw materials and capital

goods also mounted higher in support of rising levels of

production and investment (Chart 2.24). Import growth

was especially strong during the second half of 2007, in

line with the upward trend in domestic demand.

Aggregate Supply

On the supply side, almost all sectors reported

improved growth over 2006. Supporting this were

indicators of increased capacity utilisation in nearly

all sectors (Chart 2.25). The leading growth sectors

in 2007 were all non-tradable, i.e. transport and

communications, the electricity, gas and water

supply sector, construction and the trade, hotels and

restaurants sector. At the same time, manufacturing

and agriculture, the major pillars of the economy,

reported improved growth compared to 2006.

Rising domestic demand and strong exports stimulated

renewed growth in manufacturing. Manufacturing

growth in 2007 reached 4.7% (yoy), slightly ahead

of the 4.6% growth (yoy) recorded in 2006. Key to

this growth was performance in the transportation

equipment, machinery and tools subsector and the

food, beverages and tobacco subsector. Stronger

manufacturing growth was reflected in the upward

Table 2.6

Rank of Competitiveness

Countries2007-2008

(131 countries)2006-2007

(122 countries)

Indonesia 54 54

Malaysia 21 19

Vietnam 68 64

Thailand 28 28

China 34 35

Philippines 71 75

Singapore 7 8

Source: WEF

33

In 2007, the heavy equipment, machinery and machine

tools manufacturing subsector grew 9.7%, outstripping

the 7.6% growth of 2006. This performance was driven

primarily by rising domestic demand from private

consumption and growing investment as demonstrated

by the rise in motor vehicle and electronics production

during 2007 (Chart 2.28 and 2.29). Car production

reached 411.6 thousand units in 2007, an increase

of 98.4% (yoy) over only 207.5 thousand units in the

previous year. At the same time, total electronics

sales (televisions, refrigerators, AC units and washing

movement in the annual manufacturing production

indices released by Bank Indonesia and BPS, which

gathered pace since the beginning of the year (Chart

2.26 and 2.27). Nevertheless, it is important to note the

slowing trend in quarterly manufacturing growth near

the end of the year, with flagging growth reported in

some subsectors.

Manufacturing sector growth was strengthened

by continued high growth in the heavy equipment,

machinery and machine tools manufacturing subsector.

34

machines) reached 7.9 million units, up 24.8% over the

same period in 2006.

Contrasting this was loss of momentum in the

subcategories of food, beverages and tobacco and

textile, leather goods and footwear manufacturing

compared to 2006. The food, beverages and tobacco

category charted 5.1% growth, down from 7.2% in

the previous year. Analysed by quarterly performance,

growth in the food, beverages and tobacco industry

slowed towards year-end following a brief surge at the

beginning of the year. Performance was even more

disappointing in the textile, leather goods and footwear

subcategory, which recorded -3.7% (yoy) growth in

contrast to positive 1.2% (yoy) one year before. Factors

contributing to flagging performance in the textile

industry included market penetration by low-priced

imports, especially from China, and slow progress in

the textile industry machinery restructuring programme

supported by subsidized bank credit2.

The trade, hotels and restaurants sector grew at a

brisk rate on the strength of rising public consumption.

Growth in this sector reached 8.5% in 2007, up from

the 2006 level of 6.4%. The higher growth is explained

mainly by mounting performance in the trade subsector,

with growth up from 6.6% in 2006 to 8.9% in 2007.

One indicator of strengthening public consumption was

2 The textile industry availed only 60.2% of the total Rp255 billion interest subsidy.

Table 2.7

GDP Growth and Distribution by Sector

percent

Items 2004 2005 2006*2007**

2007**I II III IV

Growth (%)

Agriculture 2.8 2.7 3.4 -1.7 4.7 7.6 3.1 3.5

Mining and Quarrying -4.5 3.2 1.7 6.2 3.2 1.0 -2.1 2.0

Manufacturing 6.4 4.6 4.6 5.2 5.1 4.5 3.8 4.7

Electricity. Gas and Water Supply 5.3 6.3 5.8 8.2 10.2 11.3 11.8 10.4

Construction 7.5 7.5 8.3 8.4 7.7 8.3 9.9 8.6

Trade. Hotels and Restaurants 5.7 8.3 6.4 9.2 7.6 7.9 9.1 8.5

Transportation and Communication 13.4 12.8 14.4 13.0 12.7 14.1 17.4 14.4

Finance. Rental and Business Service 7.7 6.7 5.5 8.1 7.6 7.6 8.7 8.0

Services 5.4 5.2 6.2 7.0 7.0 5.2 7.2 6.6

GDP 5.0 5.7 5.5 6.1 6.4 6.5 6.3 6.3

Distribution of GDP (%)

Agriculture 14.9 14.5 14.2 13.8 14.4 15.1 11.9 13.8

Mining and Quarrying 9.7 9.4 9.1 9.1 8.8 8.4 8.6 8.7

Manufacturing 28.4 28.1 27.8 27.5 27.3 27.1 27.6 27.4

Electricity. Gas and Water Supply 0.7 0.7 0.7 0.7 0.7 0.7 0.7 0.7

Construction 5.8 5.9 6.1 6.1 6.1 6.1 6.5 6.2

Trade, Hotels and Restaurants 16.4 16.8 16.9 17.1 17.1 17.2 17.7 17.3

Transportation and Communication 5.8 6.2 6.8 6.9 7.1 7.2 7.9 7.3

Finance. Rental and Business Service 9.1 9.2 9.2 9.4 9.3 9.1 9.6 9.4

Services 9.2 9.2 9.2 9.3 9.3 9.0 9.5 9.3Source: BPS-Statistics Indonesia

35

In 2007, agricultural sector growth reached 3.5%, up

slightly from the 2006 growth of 3.4%. This upturn

came largely from stronger performance in the food

crops subsector, and especially the paddy crop, a

major factor in agricultural sector growth (Table 2.8).

Paddy production was up in response to improved

productivity in Java and expansion of agricultural land

outside Java. Increased rubber and oil palm production,

on the other hand, came in response to robust export

demand during 2007 (Chart 2.34).

the upswing in trading activity reported in the Bank

Indonesia retail survey (Chart 2.30). Added to this,

loading and unloading data for the four major ports

(Belawan, Tanjung Priok, Tanjung Perak and Makassar)

pointed to increased activity (Chart 2.31). The hotels

and restaurants subsector also forged ahead with

growth reflected in higher hotel occupancy rates and

foreign tourist arrivals (Chart 2.32 and 2.33).

Increased production and rising export demand

provided added momentum for the agricultural sector.

36

The mining and quarrying sector registered increased

growth at 2.0% in 2007, mainly on the strength of the

non-oil and gas sector. The major growth commodities

in this subsector were coal and nickel ore (Chart 2.35).

In the oil and gas subsector, growth was negative due

to low levels of investment, falling productivity and

closure of some oil wells.

The transport and communications sector grew by a

robust 14.4%, as in the preceding year. Growth in the

communications subsector was again strong, providing

the main driving force as competition mounted among

telephone operators. This has led to more aggressive

innovation and business expansion that has in turn

fuelled growth in numbers of telephone subscribers,

with cellular telephones in the lead. At end-2007, the

number of cellular telephone subscribers in Indonesia

reached 80 million (Chart 2.36). The transportation

subsector, however, underwent more subdued growth

because of the spate of accidents involving various

modes of transportation at the beginning of the year

(Chart 2.37).

Growth was also up in the construction sector. With

construction investment on the rise, the construction

sector take the lead at 8.6% (yoy), up from 8.3%

(yoy) in 2006. Key to the resurgent construction was

investor confidence in rising public purchasing power

and the various measures taken by the Government

for implementation of infrastructure projects. Renewed

expansion in the construction sector was reflected

in high growth in commercial properties, including

shopping centres, apartments and condominiums

(Table 2.9).

Labor

The upswing in economic growth during 2007 was

accompanied by increased absorption of labor that

produced some reduction in unemployment. In the

latest BPS data, Indonesia’s workforce in August

2007 stood at 109.9 million, up 3.6 million compared

to August 2006 (Chart 2.38). This expansion in the

workforce was accompanied by higher numbers of

workers in employment. In August 2007, the total

employed population mounted by 4.5 million compared

to August 2006. Of this working population, 69.1%

were employed in the informal sector and the remainder

in the formal sector (Chart 2.39). The steeper increase

in numbers of employed compared to the workforce

contributed to a downward trend in the percentage of

open unemployment to 9.1% in August 2007 compared

to 10.3% in August 2006.

Table 2.8

Paddy Harvested Area and Production

Harvested Area (Ha)

Harvest/Ha(Ku/Ha)

Product (ton)

2005 11,839,060 45,74 54,151,097

2006 11,786,430 46,20 54,454,937

2007* 12,124,827 47,05 57,051,679Source: BPS-Statistics Indonesia* Provisional figures

37

are employed in agriculture, trade and industry at

41.0%, 20.6% and 12.4% respectively (Table 2.10).

As in the past, the prevailing low educational levels

in the workforce affected productivity. Over 35%

of Indonesian workers have only primary school

education, followed by workers with junior high

school, senior high school and no school education

at all (Chart 2.40). As a result, unemployment fell

among the lesser educated, in contrast to the upward

unemployment trend among more highly educated

The composition of the Indonesian workforce remained

unchanged, with agriculture providing the largest

source of employment. During 2007, the labour-

intensive sectors of agriculture, trade and industry

were able to absorb new workers at the rate of 2.7%,

7.0% and 4.0%. At the same time, higher employment

levels in high-growth sectors, such as transport and

communications, financial and business services

and the construction sector were insufficient to bring

about a change in the composition of the workforce in

Indonesia. The largest numbers of workers, like before,

38

members of the workforce (Table 2.11). The relatively

unchanged proportion of workers by educational

background has affected worker productivity, which

has shown no significant improvement since 2000.

Measured by GDP output (millions of rupiahs) per

worker, labour productivity has changed little, edging

up by a thin margin from Rp19.4 million per worker in

2006 to Rp19.6 million in 2007 (Chart 2.41).

Welfare

The number of Indonesians living in poverty fell in

2007 as unemployment eased. Measured annually,

the total population living below the poverty line fell to

37.2 million (16.6%) from 39.3 million (17.8%) in 2006,

representing an improvement of 2.1 million (Table 2.12).

The reduction in poverty was more pronounced in

rural areas at 1.2 million, while numbers of urban poor

fell by 0.9 million. This improvement is closely linked

to the robust growth in the agricultural sector during

the year under review, which generated increased

employment for rural workers and thus contributed to

poverty reduction in rural communities. Despite this,

the ratio of rural poor to total impoverished citizens

in Indonesia remained high at 63.4%. In percentage

terms, the proportion of urban poor and rural poor

eased to 12.5% and 20.4% from 13.4% and 21.9% in

the preceding year.

The poverty gap index3 and poverty severity4 index

eased in 2007 despite a surge in 2006 due to the effect

of the fuel price hike in October 2005. The poverty gap

index showed an improving trend over the 1999-2005

period with a narrowing in the average gap between

spending by impoverished citizens and the poverty

line. Alongside this, the poverty severity index, which

mounted in 2006, pointed to a prevailing increase in

3 This is a measure of the average gap in spending by the poor compared to the poverty line.

4 The higher the poverty index, the greater the spending disparities among the poor.

expenditure disparities among the poor. The year 2007

saw a lessening in both the poverty gap index and

poverty severity index, with the poverty gap index falling

to 3.0 and poverty severity index to 0.8 (Table 2.13

and Table 2.14).

Analyzed by distribution, the poverty gap and poverty

severity indices were more pronounced in rural rather

than urban areas. On a more detailed level, the

magnitude of poverty gap in rural areas was more

pronounced than in urban areas, a condition that saw

little change from 1999 to 2007. This indicates that

average spending by the rural poor is still markedly

below the rural poverty line. A similar condition was

also evident in the higher poverty severity index for rural

areas compared to urban centres. This indicates that

spending disparities among the rural poor are far more

severe than for the urban poor.

Table 2.9

Growth of Commercial Property

Property TypesCumulative by Quarter II-2005

Cumulative by Quarter II-2006

Cumulative by Quarter II-2007

Yearly Growth on Quarter II-2006 (%)

Yearly Growth on Quarter II-2007 (%)

Office (million m2) 5.15 5.19 5.41 0.78 4.24

Shopping Center (million m2) 2.00 2.43 2.56 21.50 5.35

Apartment (unit) 16,304 19,601 28,371 20.22 44.74

Condominium (unit) 36,694 44,204 54,284 20.47 22.80

Industry (ha) 7,166 7,246 7,304 1.12 0.80Source: Procon Indah Research, Q2-2007.

39

Per capita income mounted in 2007, consistent with

the improvement in welfare indicators. During the year,

per capita income reached US$1,947.1, a rise of 15%

over 2006 (Table 2.15). The stronger per capita income

was closely tied to rapid economic growth in nominal

terms during 2007 alongside moderate population

growth. Despite this, income distribution showed little

improvement. Based on BPS calculations, the Gini

coefficient in 2007, which measures income disparities,

mounted slightly compared to 2006 (Table 2.16). This

is indicative of a worsening trend in income disparities,

marked by rising incomes in high income brackets in

contrast to a deteriorating trend for middle and low

income earners.

The improved welfare in 2007 contributed significantly

to the progress achieved towards the Millennium

Development Goals (MDGs) for 2015. The World

Bank in its MDGs report for 2007/2008 lists Indonesia

as having reached most of the targets set out in

the 8 MDGs. In the area of poverty and hunger, the

proportion of population living on US$1 per day has

been reduced to 7.5%, below the targeted 10%.

Despite this, the World Bank noted lack of significant

improvement in other poverty indicators, such as

poverty depth and the proportion of consumption by

the poor. Other indicators of progress are the drop

Table 2.10

Growth of Labor Force and Labor Force by Sector

Sector

2005 2006 2007 Growth of Labor Force

February November February August February August2005-2006 2006-2007

Nominal (%) Nominal (%)

Agriculture 41,814.2 41,309.8 42,323.2 40,136.2 42,608.8 41,206.5 -1,173.6 -2.84 1,070.2 2.67

Mining 808.8 904.2 947.1 923.6 1,020.8 994.6 19.4 2.14 71.0 7.69

Manufacturing 11,652.4 11,953.0 11,578.1 11,890.2 12,094.1 12,368.7 -62.8 -0.53 478.6 4.02

Electricity, Gas and Water

Supply

186.8 194.6 207.1 228.0 247.1 174.9 33.4 17.17 -53.1 -23.30

Construction 4,417.1 4,565.5 4,374.0 4,697.4 4,397.1 5,252.6 131.9 2.89 555.2 11.82

Trade 18,896.9 17,909.1 18,555.1 19,215.7 19,425.3 20,554.7 1,306.6 7.30 1,339.0 6.97

Transportation 5,552.5 5,652.8 5,467.3 5,664.0 5,575.5 5,958.8 11.2 0.20 294.9 5.21

Finance 1,042.8 1,141.9 1,153.3 1,346.0 1,252.2 1,399.5 204.1 17.88 53.4 3.97

Services 10,576.6 10,327.5 10,572.0 11,355.9 10,962.4 12,020.0 1,028.4 9.96 664.1 5.85

Total 94,948.1 93,958.4 95,177.1 95,456.9 97,583.1 99,930.2 1,498.5 1.59 4,473.3 4.69

Source: BPS-Statistics Indonesia

40

in the child mortality rate and the increased numbers

of children enrolled in primary and junior high school

education.

Pro-Growth Policies

In 2007, real sector policy implemented through an

integrated combination of policies was focused on

accelerating economic growth in pursuit of the 6%

average economic growth target envisaged in the

2004-2009 Medium Term Development Plan (RPJMN).

The importance of achieving higher, sustainable

economic growth has prompted the Government to

redouble its commitment and effort in the planning and

implementation of each policy. In 2007, the Government

launched Presidential Instruction (Inpres) No. 6 of 2007,

a policy package for accelerated real sector expansion

and empowerment of MSMEs. This package builds

on previous intersectoral policies by accelerating

the implementation of past policies5 and introducing

some new measures. The policy package consists

of 141 individual policies grouped by: i) improvement

of the investment climate; ii) financial system reform;

iii) accelerated construction of infrastructure; and iv)

empowerment of MSMEs. As of November 2007, the

Government achieved most of the targets laid down in

the Inpres while work on 47 further policy actions was

ongoing (Table 2.17).

The Government has launched a range of initiatives to

promote more vigorous investment growth. To address

the combination of a lack of comprehensive resolution

of domestic problems and mounting competition with

neighboring countries, improvements to the investment

climate became one of the main priorities in policy

implementation throughout 2007. Government actions

5 Mainly Inpres No. 3 of 3006 concerning Improvement of the Investment Climate.

for improvement of the investment climate covered

3 main areas: institutional provisions, expeditious

movement of goods and customs processing and

tax administration reform. From the institutional

side, one effort to promote investment involved the

promulgation of Act No. 25 of 2007 concerning

Investment. Important breakthroughs in the law aimed

at promoting investment include expansion in the

scope of investment categories, investor criteria, lines

of business and licensing. Concerning the expeditious

movement of goods and customs processing, the

Table 2.11

Unemployment by Education

(percentage of total unemployment)

Education August 2006 August 2007

Not Attending Formal Education 1.6 0.9

Not Finished Elementary School 5.6 4.4

Elementary 23.7 21.8

Junior High School 25.0 22.6

High School 38.0 40.7

Diploma 2.5 4.0

University 3.6 5.7

Total 100 100Source: BPS-Statistics Indonesia

41

Government issued several regulations that essentially

slashed import tariffs on several commodities used in

investment and development of productive sectors.

In addition, the Government has streamlined customs

clearance procedures, reducing average processing

time to 30 minutes in the green channel and 3 days

for the red channel. In the area of tax reform, new

regulations provide income tax and VAT relief for

investment-related activities.

In 2007, the Government also emphasized financial

sector reform with the strengthening of financial system

stability covering the full range of banks, non-bank

financial institutions and the capital market. Policy

actions included strengthening of the coordinating

mechanism for financial institution authorities and

preparation of the financial system safety net. Added

to this, the Government successfully accomplished

the resolution of bad debt at some state banks, a

move expected to boost public confidence in banking

institutions and in so doing bolster overall financial

system stability.

Empowerment of MSMEs is another measure designed

to promote higher economic growth and reinforce the

structure of the economy. During 2007, empowerment

of MSMEs included actions for improved MSME access

to financing, entrepreneurship and human resources

development, market expansion for MSME products

and regulatory reform. To ensure greater access to

financing, the Government issued 13,000 land titles in

various regions for use as collateral in MSME loans.

The Government also completed the initial stage of

recapitalizing the MSME loan guarantee institution and

issuing regulations on the operation of the warehouse

receipt system as an instrument for MSME financing.

Table 2.12

Poverty Line and Number of People Living in Poverty

Area/Year

Poverty Line (Rp/capita/month) People Living in Poverty

(millions of people)

Percentage Food Non-Food Total

Town

2005 103,992 46,807 150,799 12.40 11.37

2006 126,527 48,797 175,324 14.29 13.36

2007 132,258 55,683 187,942 13.56 12.52

Village

2005 84,014 33,245 117,259 22.70 19.51

2006 103,180 28,076 131,256 24.76 21.9

2007 116,265 30,572 146,837 23.61 20.37

Town + Village

2005 91,072 38,036 129,108 35.10 15.97

2006 114,619 38,228 152,847 39.05 17.75

2007 123,992 42,704 166,697 37.17 16.58Source: BPS-Statistics Indonesia, Susenas Panel Data on February 2005, March 2006 and 2007.

Table 2.13

Poverty Depth Index

Year Town Village Town + Village

1999 3.52 4.84 4.33

2000 1.89 4.68 3.51

2001 1.74 4.68 3.42

2002 2.59 3.34 3.01

2003 2.55 3.53 3.13

2004 2.18 3.43 2.89

2005 2.05 3.34 2.78

2006 2.61 4.22 3.43

2007 2.15 3.78 2.99Source: BPS-Statistics Indonesia, February 2007

Table 2.14

Poverty Severity Index

Year Town Village Town + Village

1999 0.98 1.39 1.23

2000 0.51 1.39 1.02

2001 0.45 1.36 0.97

2002 0.71 0.85 0.79

2003 0.74 0.93 0.85

2004 0.58 0.9 0.78

2005 0.6 0.89 0.76

2006 0.77 1.22 1

2007 0.57 1.09 0.84Source: BPS-Statistics Indonesia, February 2007

42

obstacles hampering construction of infrastructure are

difficulties with land expropriation. To resolve this, the

Government has issued a regulation providing clarity on

land expropriation in the public interest. A related action

for institutional strengthening was the establishment

of a Rp2 trillion guarantee fund in the 2007 budget

dedicated for land expropriation and infrastructure

project loan guarantees. At the same time, ten pilot

projects commenced in 2006 were approaching the

stage for actual construction.

The policy for accelerated economic growth is

also supported by measures to strengthen public

purchasing power, particularly among low-income

groups. In 2007, the Government continued the

provision of direct and indirect subsidies and transfers

to low-income groups. Although no longer providing

direct cash transfers, the Government operates other

aid schemes such as school operational assistance,

educational bursaries and food subsidies for poor

families.

Table 2.17

Inpres No. 6/2007 Target Achievement

Program Planning Realization

Investment Climate Repair 49 40

Financial Sector Reformation 36 28

Infrastructure Development Acceleration

40 13

MSMEs Empowerment 34 28Source: Office of Coordinating Minister for the Economy

Table 2.16

Gini Ratio

Category of Citizen

2002 2003 2004 2005 2006 2007

40% lowest 20.92 20.57 20.80 18.81 19.75 19.10

40% middle 38.89 37.10 37.13 36.40 38.10 36.11

20% highest 42.19 42.33 42.07 44.78 42.15 44.79

Gini ratio 0.33 0.32 0.32 0.36 0.33 0.37Source: BPS-Statistics Indonesia

Table 2.15

Income per Capita

GDP Nominal(billions of $)

GDP per Capita($/person)

2000 165.6 807.2

2001 164.5 791.2

2002 198.9 944.0

2003 237.3 1115.7

2004 256.7 1116.6

2005 288.4 1256.6

2006 369.4 1662.6

2007 438.1 1947.1Source: BPS-Statistics Indonesia

A conducive investment climate also depends on

adequate quality and quantity of infrastructure, and

for this reason, the Government pursued a series

of actions in 2007 to accelerate the construction of

infrastructure. To this end, new policies were issued to

improve regulatory framework, reinforce institutional

structures and strengthen management. Among the

43

Contrary to the prevailing opinion that a loose, expansive

monetary policy is the right choice for promoting

economic growth and rescuing the poor, research1

indicates that a prudent monetary policy targeting low

inflation and stable macroeconomic conditions in fact

will bring down poverty levels in the long run. Using a

regional database covering 26 provinces in Indonesia for

the 1984-2005 period, this study offers empirical proof

that prudent monetary policy is pro-poor.

In theoretical terms, a relaxed monetary policy will

reduce unemployment and boost output and inflation

in the short-term. However, the benefits of such a

policy are short-lived because of the existence of

business cycle and the aversion to high inflation, and

therefore a loose monetary policy cannot produce

a permanent boom. On the contrary, a prudent,

consistent and credible monetary policy is able to

maintain low inflation over the long-term and stabilize

fluctuations in aggregate demand. Low inflation in the

long run and macroeconomic stability both represent

positive conditions that encourage investment, and

can therefore be relied on to generate higher levels

of economic growth. Higher economic growth can

in turn bring permanent improvement in the welfare

of the poor. A study by Easterly and Fischer (2001)

demonstrates a correlation between poverty reduction

and lower inflation. Subsequently, Romer and Romer

(2002) successfully disaggregated the short run and

long run effects of inflation on poverty. In the short

run, there is no guarantee that high inflation will have

a positive effect poverty reduction, but in the long run,

this inflation will inevitably have a negative bearing on

poverty. In regard to macroeconomic stability, Agenor

(2004) demonstrates that policy-driven improvement

in macroeconomic stability tends to increase savings

and investment and is therefore conducive to economic

growth and poverty reduction.

1 Munandar, Kurniawan, and Santoso (2007), Working Paper “In Search of a Pro-Poor Monetary Policy: Study Using Regional Data from Indonesia”.

Short Run Analysis

The research draws on annual national and regional

data for Indonesia over the past two decades (1984-

2005). Monetary policy performance is measured by the

unemployment rate and short-term inflation (measured

with the annual GDP deflator). The short-term regression

specifications are built on the belief that the annual

change in poverty levels is correlated to the dynamics of

unemployment or the level of inflation during that year. In

more formal terms, the specifications of the short-term

regression model are as follows:

∆yt=a1+b1∆x1t+∑djdj+e1t

∆yt=a2+b2∆x2t+∑djdj+e2t

∆yt=a3+b3∆x1t+b4∆x2t+∑djdj+e3t

in which:

∆yt=yt–yt-1 : change in poverty level during year t,

∆x1t=x1t–x1,t-1 : dynamics of unemployment levels

in year t,

∆x2t=x2t–x2,t-1 : Inflation during year t,

dj : dummy variable for sub-sample j.

The estimates show that in the short run (1 year),

change in the unemployment rate is significantly

correlated (0.992) with change in the poverty level

(Table 1). At the same time, a negative correlation

was observed between inflation and the poverty level

(-0.130). Rising inflation brought about by a loose

monetary policy will stimulate aggregate demand and

in turn have a positive effect in reducing poverty. The

second finding above confirms the widely accepted

theory in which an expansive (contractive) monetary

policy will stimulate (depress) economic activity.

In Search of a Pro-Poor Monetary Policy

44

Long Run Analysis

The long run analysis uses cross-sectional data from

provinces in 2005 in conjunction with panel data for all

provinces for the 1984-2004 period. Long-term inflation

is calculated using average annual inflation (GDP

deflator) over that period. Macroeconomic instability is

determined in using a standard deviation from nominal

GDP growth during 1984-2004. The poverty level is

determined by the proportion of a specified population

(national or regional) living in poverty2. Monetary policy

performance uses an approach involving long-term

inflation and macroeconomic instability. The model

used is as described below, in which the independent

variables refer to a specific reference year (2005), while

explanatory variables are formed from long-term data

(20 years) over the preceding period (1984-2004):

y1=r1+g1x1i+∑fjdj+x1i

y2=r2+g2x2i+∑fjdj+x2i

y1=r3+g3x1i+g4x2t+∑fjdj+x3i

in which: y1 – poverty level in province i during 2005.

2 Data obtained from the Central Statistics Agency (BPS).

x1i – long-term inflation rate in province i

(calculated from average inflation in

1984-2004)

x2i – macroeconomic instability in province

i (standard deviation in nominal GDP

growth, 1984-2004).

The regression (Table 2) indicates that long-term high

inflation and unstable macroeconomic conditions are

positively correlated with poverty (with coefficients of

3.132 and 1.295 respectively). The two correlations are

statistically significant, except when both variables are

included together. Alongside this, dummy variables

are used for provinces with different characteristics

(outliers). These provinces are Aceh and Maluku, both

regions of past or present conflict. Added to these are

the provinces of Jakarta, East Kalimantan and East

Nusa Tenggara, which are differentiated from other

regions by endowment. Jakarta and East Kalimantan

are blessed with an abundance of natural resources,

while resources in East Nusa Tenggara are scarce. The

Table 1

Short Term Regression

Changes of Poverty Rate and Macroeconomics

Model 1 Model 2 Model 3

C -0.922 -0.551 -0.808

-3.024 -1.896 -2.494

0.009 0.077 0.026

Changes of Poverty Rate 0.992** 0.744

2.378 1.545

0.031 0.145

“Changes of Inflation” -0.130* -0.074

-1.99 -1.021

0.065 0.325

1997 5.117** 4.815** 5.235**

4.144 3.813 4.227

0.001 0.002 0.001

1998 2.602* 12.803** 7.918

1.954 2.818 1.474

0.07 0.013 0.163

1999 -0.036 -10.302* -5.759

-0.031 -2.005 -1.005

0.976 0.063 0.332

R2 0.666 0.636 0.689

S.E.E 1.141 1.191 1.139Note: ** Significant at level 5% * Significant at level10%Dependent variable is poverty rate.Three numbers on each variables is estimated coefficient, absolute value of t-statistic and p-value.

Table 2

Long Term Regression

Poverty Rate and Macroeconomics

Model 1 Model 2 Model 3

C -0.205 0.009 -0.174

-1.166 0.213 -1.239

0.258 0.833 0.231

Long Term Inflation 3.132** 1.691

2.139 1.36

0.046 0.191

Macroeconomics Instability 1.295** 1.141**

4.039 3.426

0.001 0.003

NAD 0.153** 0.136** 0.155**

2.177 2.441 2.75

0.042 0.025 0.013

Maluku 0.200** 0.190** 0.209**

2.823 3.386 3.689

0.011 0.003 0.002

DKI Jakarta -0.180** -0.120* -0.153**

-2.442 -2.163 -2.573

0.025 0.044 0.019

East Kalimantan -0.071 -0.116** -0.122**

-1.029 -1.985 -2.127

0.317 0.062 0.048

NTT 0.198** 0.226** 0.253**

2.602 3.705 4.023

0.018 0.002 0.001

R2 0.511 0.674 0.704

Adj. R2 0.357 0.57 0.589

S.E.E. 0.066 0.054 0.053

45

coefficient estimates of dummy variables confirm the

view that conflict zones and poorly endowed regions

tend to have higher levels of poverty than regions with

more robust economic capacity.

The conclusion from these findings is that in the long

run, monetary policy that safeguards macroeconomic

stability and consistently maintains low inflation over

the long-term will have significant impact in reducing

poverty levels.

Policy Implications

An expansive monetary policy may achieve poverty

reduction in the short run. However, business cycle

fluctuations and aversion to high inflation mean that any

positive effect is only temporary. In the long run, low

inflation and macroeconomic stability are significantly

correlated with lower poverty levels. A prudent monetary

policy (maintaining stable prices and macroeconomic

conditions) has a permanent positive effect in reducing

poverty. The findings in this research support the

conclusion that a prudent monetary policy is a pro-poor

monetary policy.

46

Halaman ini sengaja dikosongkan

46

Chapter 3

Regional Economic Developments

48

At the regional level, economic conditions improved during 2007 with adequately strong growth and relatively stable inflation in some regions. Analyzed by contribution, the economies in the Java, Bali and Nusa Tenggara (Jabalnustra) region and the Jakarta-Banten region provided the strongest driving force for national economic growth. At the same time, brisk economic growth in Kalimantan, Sulawesi, Maluku and Papua (Kali-Sulampua) strengthened that region’s contribution to national growth. On the demand side, regional economic growth was generated by vigorous expansion in consumption and exports. Investment growth also gathered momentum, particularly in the mining and plantations sectors. Concerning prices, national inflation was kept stable due to relatively low levels of inflation in some of the most important regions in the national inflation figure. While some regions have made considerable strides in economic performance, substantial disparities in growth and inflation remain. This calls for a common effort for reduction of interregional income disparities.

Chapter 3: Regional Economic Developments

Economic Performance at the Regional Level

Regional economies demonstrated improved trends

in 2007, reflected in high economic growth and

stable inflation in a number of regions. Analysed

by contribution, the most important regions for

national economic growth were Jakarta-Banten

and Jabalnustra. With growth at 6.4% and 6.2%,

respectively Jakarta-Banten and Jabalnustra

contributed 4.0% of national economic growth. At the

same time, the Kali-Sulampua and Sumatera regions

took on an expanded role in the growth of the national

economy. Kali-Sulampua contributed 1.0% to national

growth, following the brisk 6.8% economic growth

in that region. Similarly, the Sumatera contribution to

national economic growth widened to 1.3%.

On the demand side, consumption again provided the

main driving force for growth in all regions. Expanding

consumption was fuelled by more robust purchasing

power in line with the increase in real incomes.

Also key to the high regional growth were mounting

exports, particularly in the Kali-Sulampua, Jabalnustra

and Jakarta-Banten regions. In Sumatera and Kali-

Sulampua, economic growth was also driven by

resurgent investment activity.

On the supply side, the major contributing sectors to

regional economic growth were trade, manufacturing

and agriculture. Growth in the trade and industry

sectors was especially strong in Jabalnustra. Further

impetus for economic expansion in Jabalnustra,

Sumatera and Kali-Sulampua came from growth in

the agricultural sector. Despite this, agriculture growth

did not fully reflect a fundamental improvement in

that sector, given ongoing problems related to the

diminishing area of arable land and limited productivity

(Box: Agricultural Sector Role in Decline). National

economic growth was also supported by robust

expansion in the non-oil and gas mining subsector in

the Kali-Sulampua region and the communications

subsector in Sumatera.

The stable national inflation during 2007 owes much

to the low levels of inflation in key contributing regions,

most importantly Jakarta-Banten and Jabalnustra. In

both regions, low foodstuffs inflation in the absence

of distribution problems helped keep overall inflation

down. However, some cities registered above national

inflation levels. In 2007, inflation surpassed the national

average in 25 cities, up from 23 cities in the previous

year. Banda Aceh reported the highest inflation for any

city (10.44%), while inflation was lowest in Pangkal

Pinang (2.60%). The widely varying level of inflation

among different cities is explained mainly by differences

in foodstuffs and housing inflation. Strong deviation

in the two inflation categories is partly the result of

supply shocks involving shortages and distribution

bottlenecks.

49

The improving trend in regional economic growth and

inflation had a positive impact on prosperity indicators.

Unemployment fell in all regions, while per capita

incomes increased. The relatively stable inflation,

declining unemployment and higher nominal wage

levels in some regions produced an overall increase in

public purchasing power. Further support for improved

purchasing power came from strong price increases for

plantation commodities, particularly in regions where

the plantations subsector plays a predominant role in

the local economy.

Regional economic performance was again marked

by growth disparities. The main growth centres have

historically been concentrated in Java, with the largest

growth contribution generated in Jakarta, followed

by West Java and East Java provinces. Economic

growth in some provinces lagged behind others, with

average growth above 5.95%. These provinces include

Aceh, East Kalimantan, West Nusa Tenggara, Bangka

Belitung and Riau, where growth was recorded at

0.04%, 2.5%, 3.1%, 3.5% and 4.3%, respectively.

Compared to the previous year, the deviation in

provincial economic growth widened from 1.7% to

1.8%. One factor explaining the low growth rates in

these provinces is limited infrastructure.

Inflation in some regions was again relatively still high,

above the national level. In these regions, inflation

was spurred by escalating prices in the foodstuffs,

processed foods and housing categories caused by

supply shocks. Disparities in welfare were also evident

with varying per capita income among provinces,

particularly between the Jakarta-Banten and Kali-

Sulampua regions due to significantly different

economic growth levels in provinces.

Sumatera

Economic growth in the Sumatera region reached

5.5% in 2007, up from the previous year’s growth at

4.6%. On the demand side, consumption was the main

driving force for growth in this region. Sumatera also

recorded significantly increased investment activity,

making it a leading region in investment growth. On the

supply side, the most important contribution to growth

came from the agriculture, trade and construction

sectors. Key to this performance was expanding role

of bank financing in line with bank credit expansion.

Concerning prices, inflation showed a declining trend,

despite relatively high inflation in some cities. Lower

inflation in Sumatera was the result of falling inflation in

the foodstuffs category.

The resurgent economic growth in Sumatera was

propelled by higher growth rates in most provinces

with growth forging ahead particularly in the southern

and central zones of the island (Table 3.1). Analyzed by

administrative region, the provinces of North Sumatera,

West Sumatera and South Sumatera were the leading

contributors to the improved economic performance

in the Sumatera region. Higher growth was generated

mainly by buoyant performance in the plantations

50

subsector, which represents one of the primary

growth engines in the two provinces. Other provinces,

notably Aceh and Riau, recorded only low growth

due to sluggish performance in the mining sector and

specifically in the oil and natural gas subsector, the

main source of growth in both provinces. At the same

time, Aceh has received only limited stimulus for the

local economy from the post-tsunami rehabilitation and

reconstruction. There, the ongoing rehabilitation and

reconstruction programme has not fully functioned as a

force for turning the wheels of the local economy.

On the demand side, more vibrant economic growth

in the Sumatera region was driven by consumption

and investment (Table 3.2). Consumption mounted

considerably during 2007. Increased household

consumption followed improvement in farmer terms

of trade and real increases in the provincial minimum

wage in most provinces (Chart 3.1 and 3.2). Gross fixed

capital formation advanced at a brisk pace in Sumatera.

Key to investment growth was improvement in

infrastructure, such as the construction and repair work

to the eastern Sumatera highway, as well as redoubled

investment in plantations. Sumatera also reported more

robust export growth during 2007 on the strength of

mounting demand for plantation commodities, such

as crude palm oil (CPO) and derivative products, in

addition to rubber and rubber products (Chart 3.3).

Disaggregated by sector, the most important

contribution to growth in Sumatera came from the

agriculture, trade and construction sectors. Agriculture

sector growth forged ahead at a brisk clip during 2007,

driven by robust growth in the plantation subsector

(rubber and palm oil). One factor boosting rubber

and palm oil production was the expansion of land

under cultivation for estate crops. In addition, soaring

world rubber and CPO prices spurred efforts to boost

output of palm oil and rubber. In the trade sector,

higher growth was closely linked to more vigorous

consumption and growth in trade-related sectors,

including construction and industry. Among factors

prompting renewed construction growth was the post-

tsunami reconstruction programme and expansion of

land under cultivation for oil palm estates.

Table 3.1

Regional GDP Growth in Sumaterapercent

2005 2006 2007

Sumatera Zone 4.8 4.6 5.5

North Sumatera 4.9 5.7 5.2

Central Sumatera 4.7 4.1 5.4

South Sumatera 4.6 4.5 5.7Source: Regional BPS-Statistics Indonesia.

Table 3.2

Regional GDP Growth by Expenditure in Sumaterapercent

2005 2006 2007

Sumatera Zone

Consumption 4.9 5.1 6.0

Gross Fixed Capital Formation 6.3 6.1 8.2

Net Exports 4.6 4.1 5.1Source: Regional BPS-Statistics Indonesia.

51

Opportunity for economic advancement in the

Sumatera region has come with the enactment of the

Act on the Batam-Bintan-Karimun Free Trade Zone

(FTZ-BBK) in October 2007. Under this act, the islands

of Batam, Rembang and Galang are designated free

trade zones in their entirety, while Bintan and Karimun

are designated as enclave zones. With the Free Trade

Zone in force, accelerated economic activity and

employment will not benefit only the Riau Islands

province, but also nearby areas through multiplier

effects leveraging the economic interdependencies

among these regions. Another factor supporting

economic advancement in Sumatera is financing.

Banks operating in the Sumatera region have steadily

improved their performance with depositor funds

reaching Rp203.2 trillion, up 19.6% from the preceding

year. Depositor funds are almost evenly divided among

demand deposits, saving deposits and time deposits.

Loan disbursements are also on the rise. Lending in

2007 climbed to Rp127.2 trillion, representing 28.6%

expansion over the year before. The steep rise in credit

compared to depositor funds has strengthened bank

performance, reflected in improvement in the Loan to

Deposit Ratio (LDR) (Table 3.4).

In regional fiscal management, the absorption rate in

regional budgets in the Sumatera region remains on

the lower end of the scale. In Aceh province, budget

absorption reached Rp1.4 trillion, or 35.4% of the

Rp4.0 trillion budget ceiling1. In the provinces of South

Sumatera, Bangka Belitung and Lampung, locally-

generated revenues and regional expenditure realization

averaged more than 70%. The low absorption rate is

explained by several different factors, including the

delay of launching of Regional Government projects in

the year.

Inflation in the Sumatera region reached 6.95% in 2007,

lower than in the preceding year. The falling inflation in

Sumatera is explained by a drop in foodstuffs inflation.

However, in regions such as North Sumatera and South

Sumatera (Chart 3.5 and 3.6), inflationary pressures

persisted as a result of supply shocks, which were

reflected in high volatile foods inflation. Inflation in

Sumatera, as in previous years, surpassed the national

average. Seven out of 14 cities in the Sumatera region

recorded above national levels of inflation. In the city of

Banda Aceh, inflation reached 10.44%, the highest level

for any city in Indonesia. Sumatera is heavily dependent

on goods supplied from outside the island and

between provinces on Sumatera itself, and the island

is highly susceptible to price shocks because of lack of

improvement in infrastructure.

Jakarta-Banten Region

In 2007, the Jakarta-Banten region charted 6.4%

economic growth, unchanged from the previous year.

On the demand side, consumption played a role as

1 November 2007.

52

the main driving force for growth in this region. On the

supply side, the most important contributions to growth

came from trade, financial services and construction.

In regard to financing, economic performance was

underpinned by more rapid bank credit expansion

alongside relatively high realization of regional

budget. Inflation in the Jakarta-Banten region eased

in comparison to 2006. Additionally, Jakarta-Banten

inflation was below the national average. Lower inflation

was recorded in almost all categories of goods and

services.

On the demand side, economic growth in Jakarta-

Banten was supported by rising consumption and

investment (Table 3.5). Factors spurring increased

consumption were improvement in public purchasing

power, particularly for middle and upper income

earners, and public expectations of improvement in

the economy. Investment recorded increased growth

with brisk construction of property and transportation

infrastructure in Jakarta and nearby areas.

On the supply side, economic growth in the Jakarta-

Banten region was driven by trade, financial services

Table 3.4

Banking Indicators in Sumatera

2004 2005 2006 2007

Depositor Funds

Position (Rp Trillions) 118.1 135.5 173.2 203.2

Growth (%) 15.7 19.9 21.9 19.6

Demand Deposits (Rp Trillions)

28.1 40.2 56.5 62.6

Savings Deposits (Rp Trillions)

52.6 50.9 61.7 74.8

Time Deposits (Rp Trillions)

37.5 44.4 55.0 65.8

Credit (total)

Position (Rp Trillions)** 68.5 84.8 100.9 127.2

Growth (%) 29.2 25.9 17.4 28.6

Working Capital (Rp Trillions)

30.9 39.7 47.6 61.3

Investment (Rp Trillions) 16.8 19.2 22.6 26.0

Consumption (Rp Trillions) 20.8 25.9 30.7 39.9

MSMEs (Rp Trillions)*** 44.2 57.3 69.0 86.0

Loan to Deposit Ratio 57.6 60.5 58.2 62.6

Non Performing Loan Ratio 2.4 6.8 5.8 4.7

** based on distributor bank location*** based on project location

Table 3.3

Regional GDP Growth by Sector in Sumatera

percent

2005 2006 2007

Sumatera Zone

Agriculture 2.4 2.2 4.3

Mining & Quarrying 1.6 1.6 1.5

Manufacturing 4.6 4.0 4.4

Electricity, Gas & Water 5.9 5.8 3.3

Construction 8.3 7.0 7.3

Trade, Hotels, & Restaurants 6.8 9.0 7.1

Transportation & Communication 9.7 9.7 10.2

Finance, Rental 7.0 7.7 8.2

Services 4.7 5.0 8.7Source: Regional BPS-Statistics Indonesia

53

and construction. Growth in the trade sector was

consistent with mounting consumption. Reflecting

the stronger performance in trade was the volume

of loading and unloading at the ports of Tanjung

Priok, Banten and Sunda Kelapa. In the financial

sector, resurgent growth in credit and depositor

funds improved bank performance. Vibrant growth in

the construction sector was fuelled by property and

transport infrastructure development.

In the Jakarta-Banten region, bank performance

reached new heights in 2007. Depositor funds mounted

to Rp725.7 trillion, an increase of 13.6% over the

preceding year. Time deposits comprised the largest

share of bank funding at Rp401.8 trillion, or 55.4% of

total depositor funds. Loan disbursements were also

up 26.4%, bringing total credit outstanding to Rp503.8

trillion. Improved banking performance in 2007 was

also reflected in the stronger LDR and falling NPLs

(Table 3.7).

Regional fiscal management in 2007 was marked

by quite high realization rates in regional budgets for

Jakarta and Banten provinces. In Jakarta, realized

capital expenditures at the end of 2007 stood at 81.7%

of budget allocations, significantly improved from the

outcome one year before. Nevertheless, the largest

share of realized budget expenditures was recorded

in recurrent expenditures at 87.4%. In the province of

Banten, realized capital expenditures in 2007 reached

87.8% of budget, down from the 2006 outcome.

Inflation in Jakarta-Banten eased to 6.05% for 2007

from the 2006 level of 6.15% in response to falling

inflation in the foodstuffs and housing categories. One

factor contributing to reduced inflation was the plentiful

supply of goods to Jakarta, including rice and cooking

oil. Inflation in the Jakarta-Banten region was below the

national inflation rate.

Java-Bali-Nusa Tenggara (Jabalnustra)

Economic growth in the Java, Bali and Nusa Tenggara

(Jabalnustra) region reached 6.2% in 2007, well ahead

of the previous year’s growth of 5.4%. Demand-

side growth was fuelled mainly by consumption.

On the supply side, growth impetus came from

the heavyweight sectors of trade, agriculture

and manufacturing. Availability of financing in the

Jabalnustra region improved through bank credit

expansion that arrived at 20.9%, while regional budget

realization in some provinces also improved over the

preceding year. Inflation in Jabalnustra was down

in comparison to 2006 and also below the national

inflation rate. The downward trend is a result of

Table 3.5

Regional GDP Growth by Expenditure in Jakarta-Banten

percent

2005 2006 2007

Consumption 6.5 6.7 7.2

Gross Fixed Capital Formation 5.2 4.4 5.6

Exports 8.6 9.4 5.6

Imports 5.6 4.2 11.4Source: Regional BPS-Statistics Indonesia

Table 3.6

Regional GDP Growth by Sector in Jakarta-Banten

percent

2005 2006 2007

Jakarta-Banten Zone

Agriculture 2.3 2.4 1.2

Mining & Quarrying 1.6 0.4 2.2

Manufacturing 5.8 5.5 4.3

Electricity, Gas & Water 5.6 5.1 2.4

Construction 6.0 7.6 8.1

Trade, Hotels & Restaurants 7.1 6.3 7.9

Transportation & Communication 11.2 12.7 14.1

Finance, Rental 4.7 4.3 5.4

Services 5.6 5.2 6.6Source: Regional BPS-Statistics Indonesia

Table 3.7

Banking Indicators in Jakarta-Banten

2004 2005 2006 2007

Depositor Funds

Position (Rp Trillions) 529.8 582.5 628.7 725.7

Growth (%) 8.2 16.9 5.0 13.6

Demand Deposits (Rp Trillions)

146.8 160.1 175.9 200.6

Savings Deposits (Rp Trillions)

95.6 85.9 99.2 123.3

Time Deposits (Rp Trillions) 287.4 336.4 353.5 401.8

Credit (total)

Position (Rp Trillions)** 299.7 356.1 409.5 503.8

Growth (%) 26.4 24.0 8.1 26.4

Working Capital (Rp Trillions)

158.0 190.0 225.8 275.6

Investment (Rp Trillions) 74.7 83.0 93.4 114.1

Consumptions (Rp Trillions) 67.0 83.1 90.4 114.2

MSMEs (trillions Rp)*** 63.5 85.2 97.8 131.7

Loan to Deposit Ratio 57.2 60.6 62.4 69.4

Non Performing Loan Ratio 6.0 8.7 6.8 4.9

** based on distributor bank location*** based on project location

54

declining inflation in almost all categories of goods and

services.

The accelerated growth in Jabalnustra is powered

mainly by West Java province, which enjoys the highest

growth rate and is also the most important contributor

to growth in Jabalnustra overall. The East Java zone

ranked second as an engine of growth, followed by

the Central Java zone. The robust growth in the three

zones of Java is an indication that flooding on the island

has not significantly impacted economic growth in the

Jabalnustra region.

On the demand side, household consumption

and exports again provided the economic growth

momentum in the Jabalnustra region. Increased

consumption came on the back of rising purchasing

power commensurate with the real increase in the

provincial minimum wage in all provinces (Chart 3.9)

and stronger farmer terms of trade in Central Java,

East Java, Bali and West Nusa Tenggara provinces

(Chart 3.10). Exports forged ahead in West Java, led

by textiles and textile products profiting from sharply

ascending foreign demand.

Disaggregated by sector, the primary sources of

economic growth in the Jabalnustra region are trade,

Table 3.8

Development and Realization of Regional State Budget in Jakarta-BantenRp billions

DescriptionsBudget 2006

Realization up to Q4-

2006%

Budget 2007

Realization up to Q4-

2007%

DKI Jakarta

Locally - Generated Revenues 8,666.7 7,771.8 89.7 10,084.3 8,819.8 87.5

Primary Balance 6,661.0 6,459.9 97.0 7,572.1 7,445.9 98.3

Administration & Operational Expenditures 11,974.8 10,993.4 91.8 13,929.1 12,171.8 87.4

Capital Expenditures 5,828.2 4,348.6 74.6 6,142.7 5,019.3 81.7

Banten

Locally - Generated Revenues 1,126.4 1,118.0 99.3 1,306.9 1,306.2 99.9

Primary Balance 480.1 465.4 96.9 590.7 574.3 97.2

Administration & Operational Expenditures 7,021.5 651.5 92.9 828.6 626.8 75.6

Capital Expenditures 396.7 390.1 98.3 443.2 389.2 87.8

55

the back of increased output at the Cilacap refinery and

a number of oil drilling blocks.

Bank performance in the Jabalnustra region showed

steady improvement in 2007. Depositor funds reached

Rp373.1 trillion at end-2007, an increase of 13%. At

Rp149.8 trillion, time deposits represented the most

important component of bank funding (40.1% of the

total). Similarly, loan disbursements came to Rp245.7

trillion, following 20.9% expansion, with working capital

credit accounting for the largest share. Improved bank

performance was also evident in the more robust LDR

and falling NPLs ratio in the Jabalnustra region.

agriculture and manufacturing. Growth picked up in

the trade sector in line with rising consumption. One

indication of performance in this sector was the heavier

volume of goods transported out of the Jabalnustra

region. In agriculture, growth resulted from higher

production of rice and corn, both leading agricultural

commodities in this region (Table 3.10), as a result of

improved productivity. Climate change and flooding had

little effect on agricultural performance in Jabalnustra.

Alongside this, stronger performance was reported

in manufacturing, also one of the mainstay sectors of

Jabalnustra. In the West Java zone, manufacturing

growth was bolstered by strong performance in the

transportation equipment, machinery and textiles and

textile products subsectors. In the East Java zone,

manufacturing growth was recorded mainly in the

food, beverages and tobacco subsector, as well as the

paper and printed goods subsector. In the Central Java

zone, manufacturing sector performance was driven by

vigorous growth in the oil and gas refining subsector on

Table 3.10

Paddy and Corn Production in Java and Non-Java

2005 2006 2007Growth

2007 (%)

PADDY

Production (thousands ton)

Java 29,767.0 29,961.0 30,628.7 2.2

Non Java 24,389.6 24,495.6 26,413.9 7.8

Indonesia 54,156.5 54,456.6 57,042.6 4.7

CORN

Production (thousands ton)

Java 7,455.0 6,689.0 7,457.4 11.5

Non Java 5,068.7 4,921.3 5,822.0 18.3

Indonesia 12,523.7 11,610.3 13,279.4 14.4Source: BPS-Statistics Indonesia* ARAM III

Table 3.9

Regional GDP Growth in Jabalnustra

percent

2005 2006 2007

Jabalnustra Zone 5.6 5.4 6.2

West Java Zone 5.6 6.0 6.4

Central Java Zone 5.3 5.2 5.5

East Java Zone 6.0 5.8 6.0Source: Regional BPS-Statistics Indonesia.

56

Regional fiscal management in Jabalnustra was

marked by generally improved realization in 2007

regional budgets compared to the previous year. In

the province of West Java, realized direct expenditure

components reached more than 90% of budget

allocations. This high rate of realized expenditure is

explained by implementation of development projects

mainly for improvement of local government offices and

infrastructure. In Central Java, spending was dominated

by personnel expenditures at 51.9%, while capital

expenditures for public services accounted for only

10.9% of the total (Table 3.12).

The Jabalnustra region was also marked by falling

inflation, below even the national inflation figure. The

decline in inflation came in response to lower prices for

rice and other foodstuffs. Adequate supply and smooth

distribution of staple needs in the region were among

the key factors easing foodstuff inflation.

Kalimantan, Sulawesi, Maluku and Papua

(Kali-Sulampua)

The year 2007 saw brisk economic growth in the

Kalimantan, Sulawesi, Maluku and Papua (Kali-

Sulampua) region, albeit with strong inflation. Growth

in Kali-Sulampua reached 6.8%, ahead of other

regions. On the demand side, growth was driven by

consumption, exports and investment. Analysed by

sector, the largest contributions to growth came from

trade and agriculture. On the other hand, the Kali-

Sulampua region sustained a high rate of inflation at

7.77%, significantly higher than the national inflation

Table 3.12

State Expenditures Realization in Central Java

Rp billions

Description2007

Quarter I Quarter II Quarter III Quarter IV

1 Personnel Expenditures 2,123.92 2,407.30 2,501.19 2,658.47

2 Material Expenditures 423.81 706.49 720.59 724.56

3 Official Travel Expenditures 64.95 100.81 104.75 104.75

4 Maintenance Expenditures 141.31 242.75 252.22 235.49

5 Other Expenditures 1.27 1.27 1.30 1.40

6 Capital Expenditures 149.75 296.26 444.39 546.24

7 Profit Sharing and Financial Assistance Expenditure 217.49 683.54 615.19 724.68

8 Unexpected Expenditures 0.00 133.04 140.89 128.80

Total 3,122.51 4,571.44 4,780.50 5,124.3

Distribution (percentage)

1 Personnel Expenditures 68.02 52.66 52.32 51.88

2 Material Expenditures 13.57 15.45 15.07 14.14

3 Official Travel Expenditures 2.08 2.21 2.19 2.04

4 Maintenance Expenditures 4.53 5.31 5.28 4.60

5 Other Expenditures 0.04 0.03 0.03 0.03

6 Capital Expenditures 4.80 6.48 9.30 10.66

7 Profit Sharing and Financial Assistance Expenditure 6.97 14.95 12.87 14.14

8 Unexpected Expenditures 0.00 2.91 2.95 2.51

Total 100.00 100.00 100.00 100.00

Table 3.11

Banking Indicators in Jabalnustra

2004 2005 2006 2007

Depositor Funds

Position (Rp Trillions) 265.1 278.7 324.5 373.1

Growth (%) 3.4 15.1 13.8 13.0

Demand Deposits (Rp Trillions)

54.2 57.6 68.0 78.9

Savings Deposits (Rp Trillions)

109.8 105.4 123.9 144.4

Time Deposits (Rp Trillions)

101.0 115.7 132.5 149.8

Credit (total)

Position (Rp Trillions) ** 150.8 185.9 207.0 245.7

Growth (%) 24.1 25.1 10.3 20.9

Working Capital (Rp Trillions)

80.8 99.4 113.0 131.5

Investment (Rp Trillions) 17.8 20.1 21.9 25.7

Consumption (Rp Trillions) 52.2 66.5 72.1 88.5

MSMEs (Rp Trillions)*** 128.9 168.1 191.4 206.1

Loan to Deposit Ratio 58.4 63.5 61.6 65.9

Non Performing Loan Ratio 2.9 4.6 5.0 4.3

** based on distributor bank location*** based on project location

57

and international market. Alongside this, investment

gathered momentum particularly in the plantations

and mining sectors and in construction of rail links for

transporting coal.

Analysed by sector, the main sources of growth

were trade and agriculture, while mining, one of

the primary sectors in Kali-Sulampua, contributed

relatively little. Growth in trade was spurred by rising

consumption and performance in trade-linked sectors.

Agriculture sector performance improved, buoyed by

increased production in the foodcrops and plantations

subsectors. Key to this was expansion of cultivated

land and improved productivity levels. At the same time,

the mining and quarrying sector reported higher growth

compared to the previous year. Mining sector growth

picked up in the Sulawesi zone with higher levels of

nickel ore and gold production following the expansion

in underground mining operations by Papua’s largest

mining company.

Banks charted performance gains in the Kali-Sulampua

region. Bank funds mobilisation reached Rp132.9

trillion, with savings deposits comprising the largest

share at Rp55.4 trillion or 41.7% of total depositor

funds. At the same time, loan disbursements reached

Rp77.5 trillion, dominated by consumption credit.

Improved banking performance was reflected in the

steady rise in the LDR. Added to this, NPLs recorded

rate. This inflation was driven by escalating prices for

consumer goods, with foodstuffs and housing prices

most affected.

The economy in Kali-Sulampua recorded significant

growth in 2007. Driving this performance was robust

economic growth in the Sulampua region at 11.1%. In

contrast, Kalimantan recorded only moderate growth

at 3.8%. Most provinces in the Sulampua zone were

high growth performers, with the exception of North

Maluku and Maluku provinces where growth reached

5.2% and 5.1%, respectively. In the provinces of South

Kalimantan and East Kalimantan in the Kalimantan

zone, growth was similarly low at 5.3% and 2.5%,

respectively. The modest growth in East Kalimantan

and South Kalimantan is explained by slowing

performance in the mining sector.

On the expenditure side, household consumption,

exports and investment were the main growth factors

in the Kali-Sulampua region. Growth in household

consumption was buoyed by strengthened public

purchasing power, reflected in the increased provincial

minimum wage levels and farmer terms of trade in

some provinces (Chart 3.13 and 3.14). Farmer terms of

trade in Kali-Sulampua improved in response to rising

plantation commodity prices. Exports in the region

also mounted higher in line with the upward trend in

exports of primary commodities, such as coal, rubber

and CPO, fuelled by vibrant demand on the domestic

58

decline, although the NPLs ratio in the Kali-Sulampua

region was the highest compared to other regions

(Table 3.14).

Regional fiscal management was marked by strong

performance in local government budget realization.

In East Kalimantan province, realized local government

budgets at end of year reached 80%. In Central

Kalimantan, regional budget realization were at 64% of

2007 budgets. Budget administration and excessively

long tendering processes are two factors hampering

budget realization.

Inflation mounted significantly in the Kali-Sulampua

region in 2007, climbing above the national inflation

rate. Rising inflation was spurred by price movements in

the foodstuffs, housing and transportation categories.

Inflation in 12 out of the 14 cities in the Kali-Sulampua

region surpassed the national inflation rate. The high

rate of inflation is explained by supply shortages in

parts of the Kali-Sulampua region due to difficulties

with distribution and dependence on supply from

other regions and especially from Java. Reflecting

this were high rates of volatile foods inflation in some

cities, including Banjarmasin (Chart 3.15) and Manado

(Chart 3.16).

Regional Demographics

Stronger economic growth and stable inflation in

most regions helped bring gradual improvement

in the prosperity of the local population. Regional

unemployment levels eased alongside improvement

in per capita income. Welfare also improved in

response to a series of Government programmes,

including the Askeskin health insurance scheme for

impoverished families and operational assistance for

schools (BOS). Despite this, the regions have not

undergone a significant improvement in welfare, as

evident in the relatively small drop in unemployment

and poverty levels and the continued income disparities

among regions.

Labor conditions in the regions saw improvement

during 2007. Labor intake was up in all regions in line

with economic growth at the local level. The highest

increase in employed workers was recorded in the

Sumatera region, followed by Java and Sulawesi

(Table 3.15). However, the higher numbers of workers

entering employment was not followed by significant

reductions in unemployment, with intake of workers

insufficient to offset the growth in the workforce.

In Jakarta-Banten, Java, Sumatera and Sulawesi,

unemployment remains high. However, unemployment

levels are low in Bali, Nusa Tenggara, Kalimantan,

Maluku, Papua and Sumatera, and also below the

national average.

With stronger regional economic growth and low

population growth2, per capital incomes have improved.

Per capita income was up in all regions, with highest

levels recorded in Jakarta and East Kalimantan

(Chart 3.17). However, this improvement was still

marred by regional income disparities, particularly

between Jakarta-Banten and Kali-Sulampua.

These disparities are the result of several factors,

including different rates of economic growth and

population growth.

2 Source: Key Socio-Economic Indicators for Indonesia, March 2007, BPS.

Table 3.14

Banking Indicator in Kali-Sulampua Zone

2004 2005 2006 2007

Depositor Funds

Position (Rp Trillions) 75.6 85.4 111.0 132.9

Growth (%) 16.3 20.6 25.7 20.7

Demand Deposits (Rp Trillions)

16.8 23.0 36.7 42.2

Savings Deposits (Rp Trillions)

39.5 39.2 49.1 55.4

Time Deposits (Rp Trillions)

19.3 23.2 25.3 35.3

Credit (total)

Position (Rp Trillions) ** 43.4 52.6 62.0 77.5

Growth (%) 39.2 24.0 16.4 27.5

Working Capital (Rp Trillions)

17.2 20.5 24.9 31.6

Investment (Rp Trillions) 8.2 9.8 11.2 12.7

Consumption (Rp Trillions)

18.0 22.3 25.9 33.2

MSMEs (Rp Trillions)*** 33.9 43.3 51.3 64.5

Loan to Deposit Ratio 58.0 59.7 55.2 58.3

Non Performing Loan Ratio 2.7 7.1 6.1 6.0

** based on distributor bank location*** based on project location

Table 3.13

Regional GDP Growth in Kali-Sulampua Zone

percent

2005 2006 2007

Kali-Sulampua Zone 5.5 6.2 6.8

Kalimantan Zone 3.9 3.7 3.8

Sulawesi Zone 8.1 9.9 11.1Source: Regional BPS-Statistics Indonesia

59

Regional Economic Issues

Regional economies continue to be daunted by various

problems, including regional disparities in economic

growth and the growing number of cities reporting

inflation above the national average. These two

problems have led to disparities in quality improvement

in regional economies. Nevertheless, these issues

will be gradually addressed through improvements to

infrastructure and inter-agency coordination.

Higher rates of economic growth and greater

employment have helped ease poverty levels. In 2007,

the number of population living in poverty was down

in all regions compared to 2006. The steepest fall

in numbers of poor was recorded in the Sumatera

region (8.1%), followed by Jakarta-Banten (6.0%)

(Chart 3.18). However, this reduction carried less

significance, as indicated by the relatively unchanged

proportion of population in poverty to the populations of

individual regions.

60

The national economy is overwhelmed by disparities

in regional economic growth, with the steepest

differences occurring in the Kali-Sulampua and

Sumatera regions. GDP growth in some of these

provinces is well below the national growth rate.

Even in some resource-rich regions, notably Aceh,

Riau, Papua and East Kalimantan, growth is below

the national average. Compared to the previous year,

the deviation in economic growth among provinces

widened from 1.7% to 1.8%. Reasons for the sluggish

growth performance in some regions include limited

infrastructure, regional regulations that discourage

investment and overwhelming dependence of the local

economy on one particular primary sector (mining).

Inflation in most cities in Indonesia is above the national

inflation rate. According to observations over the

past 4 years, 34 cities recorded inflation above the

national rate. In these cities, inflation is fuelled mainly

by escalating inflation in the foodstuffs, processed

foods and housing categories. One underlying cause of

high inflation in these regions is the problem of supply

shocks on the market for goods (Box: Inflation Control

in the Regions). These supply shocks are caused by

such problems as supply shortages, poor infrastructure

for distribution, long span of distribution, hoarding,

charging of illegal levies and seasonal influence.

Table 3.15

Employment and Unemployment Rate by Region

Labor (millions of people)

Employment (millions of people)

Unemployment Rate (%)

August 2006 August 2007 August 2006 August 2007 August 2006 August 2007

Sumatera 21.08 21.66 18.95 19.73 10.10 8.91

Jabalnustra 61.72 64.15 55.74 58.61 9.69 8.64

Java (non Jakarta-Banten) 55.59 57.91 49.99 52.67 10.07 9.05

Bali and Nusa Tenggara 6.13 6.24 5.75 5.94 6.20 4.81

Jakarta-Banten 8.29 8.42 7.05 7.22 14.96 14.25

Kali-Sulampua 15.26 15.72 13.71 14.36 10.16 8.65

Kalimantan 6.10 6.13 5.53 5.67 9.34 7.50

Sulawesi 7.00 7.35 6.21 6.62 11.29 9.93

Papua and Maluku 2.16 2.24 1.97 2.07 8.80 7.59

Indonesia 106.39 109.94 95.46 99.93 10.28 9.11Source: BPS-Statistics Indonesia

61

Low, stable inflation is a prerequisite for sustainable

economic growth. When inflation is low and stable,

economic agents are able to engage in economic

activity on a more carefully measured basis. Producers

can set more affordable selling prices, while consumers

are able to obtain needed goods appropriate to the

purchasing power. Stable inflation and the sustainable

economic growth that it supports also help to boost

prosperity levels in the long-term, as indicated in more

robust public purchasing power, greater absorption

of manpower and stronger private incomes. These

conditions also help to improve the quality of life for

the local population, as envisaged in the mission

for regional governments in the Medium-Term

Development Plan.

National CPI inflation represents the aggregate

movement in prices of goods and services in 45 cities

across Indonesia. Analysed by weighting on a per city

basis, Jakarta is the largest contributor to national

inflation. However, if analysed by region, all regions

have a sizeable weighting in the national inflation rate

(Table 1).

Urban inflation figures for the past 4 years show that

34 cities almost consistently report inflation above the

national CPI inflation rate. The high rate of inflation in

these cities is fuelled mainly by escalating inflation in the

foodstuffs, processed foods and housing categories.

Analysis of causative factors reveals a consistent

pattern in urban inflation, with the main source of

inflationary pressure coming from fundamentals

(exchange rate pressure, high expectations and output

gap) and administered prices. However, the behavior

of price movements in the regions can be specifically

differentiated by supply and distribution of goods,

which can give rise to different levels of supply shocks

in individual areas. Shocks are attributable to various

causes, including supply shortages, poor distribution

infrastructure, long distribution lines, hoarding, illegal

levies and seasonal influence.

Table 1

Inflation Weight by Cities

Sumatera Jakarta-Banten Jabalnustra Kali-Sulampua

Lhokseumawe 0.25 Jakarta 27.66 Tasikmalaya 0.7 Pontianak 1.36

Banda Aceh 0.66 Serang/Cilegon 2.18 Bandung 6.76 Sampit 0.26

Padang Sidempuan 0.31 Cirebon 0.87 Palangkaraya 0.52

Sibolga 0.24 Purwokerto 0.69 Banjarmasin 1.93

Pematang Siantar 0.68 Surakarta 1.58 Balikpapan 1.31

Medan 5.98 Semarang 4.36 Samarinda 1.55

Padang 2.07 Tegal 0.83 Manado 1.27

Pekanbaru 1.95 Yogyakarta 1.22 Palu 0.68

Batam 1.72 Jember 0.92 Makassar 3.06

Jambi 1.31 Kediri 0.86 Kendari 0.5

Palembang 3.98 Malang 2.05 Gorontalo 0.46

Bengkulu 0.76 Surabaya 8.9 Ternate 0.32

Bandar Lampung 2.25 Denpasar 1.94 Ambon 0.58

Pangkal Pinang 0.44 Mataram 1.07 Jayapura 0.4

Kupang 0.61

Total 22.6 Total 29.84 Total 33.36 Total 14.2

Regional Inflation: Issues and Control Measures

62

The creation of stable CPI inflation is the task

and responsibility of Bank Indonesia. To fulfil this

responsibility, Bank Indonesia formulates monetary

policy on the basis of the inflation targeting framework.

Within this framework, the central bank influences

inflation on the fundamentals side, particularly in

order to shape public expectations. However, on the

non-fundamentals side, Bank Indonesia is unable to

influence inflation given that administered prices are

the competence of the Government and supply shocks

are determined by availability of supply and smooth

distribution. In the post-regional autonomy era, regional

governments play a central role in issues related to

supply and distribution. For this reason, control of

supply shocks demands close attention from Bank

Indonesia through efforts to strengthen cooperation

between the Government and regional institutions

concerned with addressing problems in the production

and distribution of goods and policy formulation.

Inflation control in the regions involves collaborative

action with local stakeholders using multiple

approaches as follows: a. Reinforcement of institutional

linkages between Bank Indonesia at the regional level

and local governments, most importantly for building

a common commitment among the relevant parties

to curbing inflation in the region, given the common

need for low, stable inflation; b. identification of reasons

for shortages of staple needs in the region, with the

strategic goal of ensuring the smooth distribution of

staple goods, shortening distribution lines, improving

regional infrastructure and eradicating hoarding

practices and illegal levies; c. holding dissemination

activities to build public awareness among the local

population of the condition and outlook for the

economy and risks of inflationary pressure.

On the institutional side, Bank Indonesia will

work for more effective cooperation with regional

governments through the BI Regional Offices. Two

forms of cooperation will be developed and put into

action in 2008 through optimization of Focus Group

Discussions (FGDs) and establishment of the Regional

Inflation Control Teams (TPID). The objective of the

strengthened institutional arrangements is to convey

concerns over inflationary pressure in individual

regions and communicate actions for mitigating

these pressures. The focus of inflation control at

the regional level is three-fold: (i) ensuring adequate

supply; (ii) minimizing price shocks arising from regional

regulations (user charges and taxes); and (iii) building

understanding of the condition and outlook of the

economy and the risks of inflationary pressure at the

regional level.

63

Over the past 20 years, the role of agriculture as an

engine for the economy has been in declining trend.

This is borne out in the diminishing share of agriculture

in the national economy, down from about 20% in

1990 to only about 15% (Chart 1). The declining role is

explained by the more modest growth of the agricultural

sector, with the slowdown most apparent in the food

crops subsector. Commodities in the food crops

subsector include rice, corn, wheat and potatoes.

Within this subsector, the most important crop is rice.

Growth in paddy production has tapered off during

the past 20 years (Chart 2). This slowing growth

is explained by rice production in Java, which has

fallen behind production growth in other areas. Java

is the most important centre for paddy cultivation

in Indonesia, accounting for 57.6% of the national

crop, followed by Sumatera and Sulawesi at 22% and

9%, respectively.

Two factors are responsible for slow rate of growth

in paddy cultivation: low productivity and loss of

arable land. The low productivity has several causes,

ranging from the deteriorating condition of agricultural

infrastructure to the still limited use of seed technology

and poor procurement and distribution of fertilizers

and agricultural chemicals. Agricultural infrastructure

networks have deteriorated significantly with 17.5%

of networks damaged or unusable (Table 1). The

most serious damage has been sustained in irrigation

networks and water reservoirs. The distribution system

for labelled seeds is unable to guarantee quality control

and crops yields are therefore below optimum levels

despite farmer attempts to cultivate crops with the

use of these labelled seeds. Fertiliser shortages have

emerged because of limited domestic production

caused by decline in capacity (Chart 3). Indonesia also

suffers from loss of land used for paddy cultivation,

particularly in Java due to conversion of rice paddies to

other use (Chart 4).

The diminishing role of agriculture portends a decline in

the supply of foodstuffs and employment. Indonesia’s

growing population and limited rice production

Agricultural Sector Role in Decline

64

Table 1

Condition of Irrigation Infrastructure

Infrastructure Constructed Quantity UnitsCondition Water Supply Reliability

Heavy Damage Light Damage Reservoir Non-Reservoir

Irrigation Network 6,771.83 km341.33 1,178.55 719.17 6,052.65

(0.05%) (17.4%) (10.62) (89.38)

Dam 1,154 location1

– – –(0.24%)

Reservoir 273 location14 5

– –(5.1%) (1.8)

Source: Ministry of Agriculture

underscores the necessity of rice imports to secure

food supplies (Table 2). Indonesia has imported rice

every year except for a brief period of self-sufficient

rice production in 1993. Concerning employment, the

low rate of growth in agriculture also means a low rate

of absorption of workers in this sector. This is very

unfortunate, given that agriculture is a very important

source of employment for the population.

Chapter 4

Exchange Rate

66

Chapter 4: Exchange Rate

During the past year of 2007, the rupiah exchange rate on average remained stable and strengthened, compared to the previous year bolstered by improving domestic macroeconomic fundamentals amidst volatility in the global economy and turbulent financial markets. The subprime mortgages crisis in the United States, which expanded globally, coupled with the soaring oil price during the second half of 2007 triggered depreciatory pressures on the rupiah exchange rate. However, the adoption of consistent and prudent monetary and fiscal policies, along with currency stabilization policy measures, had minimized such pressures and accordingly maintained exchange rate stability.

The rupiah exchange rate during 2007, in general,

was stable with decreasing volatility. On average the

rupiah strengthened against the US dollar by 0.3%

from Rp9,167/$ in 2006 to Rp9,140/$ (Chart 4.1). The

rupiah exchange rate stability was further reflected by

decreasing volatility from 3.9% in 2006 to 1.4%1 (Chart

4.2). However, in terms of point to point, the rupiah

depreciated by 4.2% from Rp8,995/$ at the end of

2006 to Rp9,393/$ by the end of 2007, in particular as

a result of external pressures during the second half

of 2007. Rupiah exchange rate stability was supported

by greater public confidence, amid a sluggish global

economy and inauspicious money markets, both

domestically and internationally, in the Indonesian

economy and the high yielding domestic financial

market. Pressures on the rupiah exchange rate during

the second half of 2007 stemmed primarily from the

subprime mortgage debacle in the US that expanded

globally (Box: Impacts of the Subprime Mortgage Crisis

on Indonesian Financial Markets) and the dramatic hike

in the global oil price. However, prudent and consistent

monetary and fiscal policies as well as measures taken

by Bank Indonesia to stabilize the currency were able to

mitigate a further rupiah exchange rate slide.

In the first semester of 2007, the rupiah tended to

appreciate as foreign portfolio capital inflows to

the domestic financial market increase. This was

1 Rupiah volatility is an indicator to measure rupiah fluctuations by calculating the deviation of daily rupiah exchange rate from the annual average (250-day moving average).

buttressed by improving macroeconomic fundamentals

as reflected by the balance of payments which ran an

increasing surplus, lower inflation, robust economic

growth and well-controlled fiscal sustainability. Such

developments are inextricably linked to the prudent

and consistent macroeconomic policy management

pursued to boost public confidence, both domestically

and internationally, in the rupiah. In addition, amid

burgeoning liquidity excess in the global financial

system, the high yielding domestic financial market also

played a role in attracting such foreign portfolio capital

inflows. Against this propitious backdrop, the rupiah

appreciated, peaking in May 2007 at a monthly average

of Rp8,838/$.

However, global risk increased and put pressure on

the rupiah exchange rate during the second semester

of 2007. The subprime mortgage crisis in the USA

triggered volatility in the global financial market,

encouraging global investors to avoid assets regarded

as high risk, including emerging market assets. The

crisis also precipitated capital reversal in the domestic

financial market which sparked pressures on the

rupiah. Meanwhile, the soaring global oil price raised

the need for foreign exchange to import oil. As a

result the rupiah began to depreciate in the second

half of 2007, reaching its lowest in August 2007 with

a monthly average of Rp9,372/$. Thus, the rupiah

dynamically strengthened during the first half of 2007

67

but subsequently fluctuated in the second semester

(Chart 4.2).

Factors Affecting the Exchange Rate

Domestic Factors

Domestic macroeconomic fundamentals remained

conducive to support rupiah exchange rate stability.

Sustainable domestic economic growth during

2007, relatively well-controlled inflation in line with its

specified target, as well as consistent and prudent

macroeconomic policies all helped boost market

confidence in the rupiah. In the midst of a series of

external shocks, economic growth in 2007 reached

6.3% with inflation at 6.59%, while fiscal conditions

remained sustainable. Furthermore, the current account

and the overall balance of payments ran a sufficiently

large surplus in 2007 and foreign exchange reserves

increased significantly. Well-maintained economic

fundamentals preserved foreign investor confidence

in domestic economic conditions as well as in the

economic outlook in the midst of external turbulence.

This, combined with the relatively high yield on rupiah

investments, ensured that the global portfolio capital

inflows during 2007 remained high, despite limited

capital reversal due to several external shocks.

Solid balance of payment performance increased the

potential supply of foreign exchange and reserves,

which underpinned rupiah exchange rate stability. In

2007, the current account balance recorded an $11-

billion surplus, exceeding that of 2006 which totaled

$10.8 billion. The large surplus played as a buffer in

balancing the decline in capital account surplus, which

was principally due to capital reversal mainly in the

third quarter of 2007. Still, as a whole the balance

of portfolio investment transactions had managed

to record a $10-billion surplus in 2007. Such a solid

balance of payments was also reflected by the increase

in foreign exchange reserves and net foreign assets.

Foreign exchange reserves swelled from $42.6 billion in

2006 to $56.9 billion in 2007. Whereas, the net foreign

assets –as an indicator of potential foreign exchange

supply in the domestic foreign exchange market–

increased from $45.9 billion in 2006 to $55.71 billion in

2007 (Chart 4.3).

Investment risk in Indonesia improved in line with

preserved economic fundamentals. Investment risk

on rupiah financial assets reduced, owing to this

strong economic fundamentals. Several risk indicators

improved in 2007, reflected by the elevated Indonesian

sovereign credit rating as well as improved Country

Risk Index. Favorable economic fundamentals coupled

with consistent and prudent macroeconomic policy

management were considered in the awarding of

Indonesia’s sovereign credit rating by Moody’s, Rating

and Investment Information (R & I) and Japan Credit

Rating Agency (JCRA). Moody’s raised Indonesia’s

rating from ‘B1’ to ‘B1+’ on 1st August 2007, and again

68

to ‘Ba3’ on 18th October 2007. As well, R&I raised

Indonesia’s rating from ‘BB’ to ‘BB+’ on 31st October

2007 while JCRA moved the rating up from ‘BB-‘

to ‘BB’ on 6 September 2007. Indonesia’s rating is

currently approaching ‘investment-grade’ and nearing

that of the pre-crisis level.

In addition to the credit rating, other risk indicators such

as the Country Risk Index issued by the International

Country Risk Guide also indicated a gradual

improvement from 68 in 2006 to 70.5 in October 2007

(Chart 4.4). Yield spread between Indonesian global

bonds and US T-notes also showed an upsurge.

However, the increase was due more to a decline in

US T-note yield stemming from an increase in global

investment funds to this instrument as a result of the

subprime mortgage fiasco in the US (Chart 4.5).

The investment yield on rupiah assets throughout 2007

was still attractive. Despite the decline in BI Rate from

the end of 2005 to November 2007, the Indonesian

interest rate continued to remain competitive regionally.

The yield of rupiah investments tended to decline, both

measured by the uncovered interest rate parity (UIP)2

as well as the covered interest rate parity (CIP) which

incorporated risk factor, that is the UIP minus the yield

spread between the Indonesian global bonds and the

US T-notes. UIP decreased dramatically from 4.16%

at the end of 2006 to 2.70% (Chart 4.6). The decrease

was attributable to the 175-bps drop in the BI Rate

in 2007. Conversely, CIP decreased to 0.45% by the

end of 2007, which was far below the previous year’s

2.94%. Despite its declining trend, the domestic interest

rate remained relatively higher than that of several

countries in the region. This implies that investments in

rupiah assets were still more profitable. Investments in

rupiah bonds also offered attractive yield, as reflected

by the highest yield spread between domestic bonds

2 The domestic interest rate is calculated using the 1-month Jakarta Inter Bank Offered Rate (JIBOR) denominated in rupiah and the foreign interest rate applies the 1-month Singapore Inter Bank Offered Rate (SIBOR) denominated in US dollars.

69

and US T-notes in the region (Chart 4.7). The high

yield on rupiah investments guaranteed the Indonesian

money market as an attractive destination for global

portfolio inflows.

International factors

In the first half of 2007, the global financial market was

marked by excess liquidity and US dollar depreciation

as part of the adjustment process for ongoing global

economic imbalances. Such conditions boosted

carry trade transactions, particularly in emerging

market countries, including Indonesia. Risk taking by

global investors in the financial markets of emerging

market countries also arose in line with improving

macroeconomic fundamentals in these countries.

This was reflected by the narrowing of emerging

market bonds yield to that of US government bonds

as a measure of the risk appetite of global investors

(Chart 4.8).

Global risks intensified during the second half of 2007,

undermined by the subprime mortgage crisis. The

crisis triggered volatility in the global financial market

commencing at the end of July 2007 and forced global

investors to reprice risk on investment in emerging

market assets. Such developments provoked capital

outflows from emerging market assets (flight to quality),

including rupiah assets. Further pressures emanated

from the soaring oil price that peaked at $98.9 per

barrel3 in the second semester of 2007. Despite the

greater demand for foreign exchange to pay for imports

due to the rising oil price, the resultant pressure on

the rupiah was minimal. Oil price pressure against

the rupiah was transmitted through of limited foreign

portfolio adjustments in the SUN market as uncertainty

intensified due to inflationary pressures. Against such

an ominous backdrop, the rupiah tended to depreciate

against other hard currencies during the second half of

2007 (Chart 4.9 and Chart 4.10).

3 WTI oil price as of 20th November 2007.

70

Transactions in Foreign Exchange Market

Foreign capital inflows drove the performance of the

foreign exchange market, and balanced the supply and

demand for foreign exchange. The developments of

domestic foreign exchange market was characterized

by the increasing volume of transactions as recorded

in the spot, forward and swap markets. Total volume

of foreign exchange transaction in the spot market for

2007 arrived at $561 billion, 43.5% higher than the

$391 billion reported in 2006 (Chart 4.11). Meanwhile,

the volume of foreign exchange transactions in both

the forward and swap markets in 2007 increased

by 19.1% and 45.1% respectively to $28 billion and

$192 billion. The spot market structure remained

relatively unchanged. Spot transactions continued to

be dominated by exchanges between US dollars and

rupiah as has occurred in previous years.

The volume of spot transactions became more

dominant vis-à-vis forward and swap transactions, as

indicated by the increasing share of spot transactions

(y-o-y) (Chart 4.12). The surging share of spot

transactions was partly attributable to the restrictions

applied on derivatives transactions from July 20054.

This reduced speculative transactions, which, in

general, supported the rupiah exchange rate.

4 Through PBI no 7/14/PBI/2005 on the Restrictions on Rupiah Transaction and Extension of Foreign Exchange Credit by Banks

Most foreign funds were invested at the beginning of

the year prior to the subprime mortgage crisis in USA,

which began at end of July 2007. Despite significant

foreign capital inflow, excess demand for foreign

exchange persisted. Throughout 2007, net foreign

capital inflow to the domestic foreign exchange market

reached $4.0 billion, slightly below the net inflows

of 2006, which topped $4.3 billion. On the other

hand, the demand for foreign exchange by domestic

players totaled $4.4 billion, higher than the $4.2

billion demanded in 2006. Hence, in 2007, the foreign

71

exchange inter-bank market experienced excess

demand of $372 million, contradictory to the previous

year which recorded an excess of supply amounting

to $181 million (Chart 4.13). This evidences greater

pressure on the rupiah, leading to depreciation against

US dollar on a point to point basis, albeit appreciating

in terms of annual average.

Foreign capital inflows in 2007 were placed in several

rupiah assets, namely stocks, government bonds (SUN)

and Bank Indonesia Certificates (SBI). Placement in

stocks dominated foreign capital inflows amounting

to Rp32.6 trillion ($3.6 billion). Stock placements

became investors’ preference amid declining interest

rate trend and narrowing bond yield spread. Still, the

yield spread of Indonesian bonds remained relatively

higher than that found in other countries. Meanwhile,

placements in SUN reached Rp23.2 trillion ($2.6 billion)

for the year; the second largest after stocks. As such,

foreign entitlement on SUN increased with a total value

of Rp78.2 trillion ($8.4 billion), whereas the foreign

placements in SBI rose by Rp9.9 trillion ($1.2 billion).

Consequently, the total value of foreign entitlement in

SBI moved up to Rp28 trillion or $3 billion (Chart 4.14).

Policies Taken

Rupiah stability in 2007 was buoyed by the exchange

rate management policy undertaken, which was

directed to achieve equilibrium between the economy’s

internal and external balance. In this regard, a

measured policy of intervention in the foreign exchange

market was continuously pursued in order to control

exchange rate volatility. As such, rupiah volatility eased

from 3.9% in 2006 to 1.4% in 2007. In addition to the

intervention policy, Bank Indonesia also strengthened

their communications strategy, enhanced the

effectiveness of prudential regulations and monitored

the flows of foreign exchange.

72

Chronology of the Subprime Mortgage Crisis

The low interest rate in the US from 2000 to 2004,

loosened requirements for mortgages, coupled with

competition among lenders had increased loans

to borrowers with low creditworthiness (subprime

borrowers). The extension of subprime mortgages to

subprime customers totaling just $213 billion in 2002

had sky-rocketed to $665 billion in 2005. In addition,

securitization based on subprime mortgage collateral

continued to elevate through financial engineering

in the form of Asset Backed Securities (ABS) and

Collateralized Debt Obligation (CDO).

The magnitude of potential profit obtainable through

subprime mortgage securitization encouraged a

number of major financial institutions to enter this

business segment including Bear & Sterns, HSBC and

Citigroup. The CDO product became more attractive

as it received high ratings from ratings agencies like

Standard and Poor’s as well as Moody’s. High yields

also attracted investors from numerous countries

to purchase CDO. From 2003-2007, issuances of

ABS and CDO collateralized by subprime mortgages

increased sharply reaching over $450 billion in 2006.

Why did the subprime mortgage related businesses

quickly develop into a global crisis? Most mortgages

were Adjustable Rate Mortgages (ARM), for which the

interest rate was fixed during the first few years but

subsequently followed market interest rates. Due to the

high risk inherent with subprime mortgage borrowers,

the interest rate imposed was ARM plus a specified

margin.

In line with the rising interest rate trend since mid 2004,

the burden of repayment installments by subprime

borrowers became heavier, rendering them unable to

repay their loans and leading to increased cases of

defaults (Figure 1). Almost simultaneously, property

sector prices plummeted. As a result, subprime

mortgage lenders suffered catastrophic losses, several

even came to closure. In the middle of 2007, the

accumulation of non-performing loan in the US housing

sector peaked and ultimately triggered turbulence in the

global financial markets. Surging non-performing loans

forced investors to reconsider their investments in CDO

due to the falling collateral value of the securities. The

price of CDO plunged. Whereas, the series of losses

endured by subprime mortgage lenders resulted in a

dramatic slide in share prices in the US, which quickly

spread to all shares in the financial sector, particularly

banks.

The drop in share prices in the US quickly spread on a

global scale, particularly to the share prices of financial

institutions outside the USA with exposure, be it direct

or indirect, to CDO. Global investors who realized

their exposure to CDO simultaneously reconsidered

their investment risk (repricing of risk). As a result,

a significant shift from high risk financial assets to

relatively safe assets occurred, for example to US

government bonds (flight to quality).

Impacts of the Subprime Mortgage Crisis on Indonesian Financial Markets

73

The crisis of confidence in CDO continued to

propagate, causing greater difficulties for subprime

mortgage lenders and issuers of Asset Backed

Commercial Papers (ABCP) to obtain funds in the

credit market. This happened because most investors

refused to extend their investment funds in ABCP.

Consequently, the banking sector, as the guarantor of

ABCP, was forced to resume control of the supply of

funds to subprime mortgage lenders, which burdened

the bank balance sheet. Such developments resulted in

a tight inter-bank money market, particularly of 3-month

tenures. The actions taken by the Federal Reserve to

cut its interest rate in August 2007 and inject huge

amounts of liquidity through coordination with a number

of other central banks could only temporarily cool

financial market volatility.

The continuing drop in property prices, financial market

instability and tight mortgage lending standards,

pressurized public consumption in the US. In addition,

the manufacturing sector also began to feel the impacts

of weaker consumption, which triggered a wave of

layoffs. On the other hand, a number of financial

institutions, including prominent US investment banks,

reported significant losses from the CDO business,

which at the end of 2007 had went beyond $100 billion.

Approaching year end 2007, the US economy fell under

the shadow of recession, therefore, pressures on global

financial markets continued.

Volatility in the global financial market due to the

second-round effects of the subprime mortgage

crisis compelled global investors to reprice risk on

their investments. The withdrawal of funds from

their investments in the financial markets of ‘risky’

developing countries intensified pressures on most

of the countries’ currencies. The withdrawal of global

investors’ funds was, in itself, an effort to cover their

losses from the bearish financial markets in developed

countries.

Impacts on the Domestic Financial Market

Financial institutions in Indonesia were identified

as having no exposure to the commercial papers

collateralized by subprime mortgages. Nevertheless,

volatility in the global financial markets triggered by

the subprime mortgage turmoil raised volatility and

uncertainty domestically, which encouraged capital

outflows from rupiah investment instruments. In a

turbulent global financial market, investors tend to save

their money by avoiding risky investment instruments

(risk aversion), including instruments issued in emerging

markets like Indonesia.

During the subprime mortgage crisis, the risk appetite

of global investors for emerging market assets went

down, as reflected by the widening spread of Emerging

Market Bond Index Global (EMBIG) against US Treasury

Bonds. Risk appetite was also highly correlated to

the rupiah exchange rate. This was reflected by the

broadening spread of EMBIG followed by depreciatory

pressure on the rupiah (Chart 2).

Foreign capital outflows escalated from June 2007

until August 2007; which exacerbated pressures on

74

the rupiah exchange rate (Chart 3). The withdrawal

of foreign investments from the Indonesian financial

market originated in part from Bank Indonesia

Certificates (SBI) and government bonds. However,

foreign investment in the stock market continued to flow

in (Chart 4). Subsequently, capital outflows diminished

and inflows even began to resurge significantly following

The Fed’s decision to discount its Fed Fund Rate by 50

bps on 18th September 2007.

The subprime mortgage turmoil has become

deeper and wider than most experts predicted. In

November 2007, the financial market again suffered

from turbulence since the housing sector crisis had

developed into liquidity and credit crises that pushed

the US economy closer towards a recession, and

a series of losses was reported by major financial

institutions. Coupled with the soaring world crude

oil price, which approached $100 per barrel, foreign

capital outflows began once again. As a result, the

rupiah exchange rate refaced immense pressure, albeit

fading towards the end of 2007.

Although Indonesian financial markets suffered from

the fall out created by the US subprime mortgage

crisis, the impacts were, however, well minimized.

Economic fundamentals, duly supported by improved

macroeconomic policy management, have rendered

the Indonesian economy better resilience to external

shocks. Such conditions were absent a few years ago

when external shocks triggered prolonged volatility

necessitating Bank Indonesia to raise its BI Rate

significantly and the government to reduce its fuel

subsidies.

The improvement in Indonesian economic

fundamentals was reflected by a number of key

indicators, including among others, the large surplus

in the balance of payments, the well controlled inflation

rate to year end 2007 and sustainable economic

growth. In addition, rupiah investment instruments

continue to promise attractive yields; the highest in

Southeast Asia. Against this opportune backdrop,

Indonesian financial markets remain an attractive global

investment destination.

Chapter 5

Inflation

76

Chapter 5: Inflation

The Consumer Price Index (CPI) touched 6.59% in 2007, in line with the target of 6.0%±1.0% set by the Government. Stable exchange rate, adequate supply of food, and modest increases in administered prices contributed to the relatively stable inflation in 2007 compared to the previous year, when the CPI reached 6.60%. This achievement also stemmed from the support of the Government in controlling factors that influenced inflation, especially those which originated from increases in the prices of commodities in international markets. This condition, in turn, increased policy credibility, thereby giving a positive contribution toward efforts to keep the public’s inflationary expectations in line with the inflation target.

Inflation Developments

In general, prices of goods and services at the

consumer level were relatively under control in 2007.

The reasonably stable inflation was the result of the

fairly low inflation in the first half of 2007. The CPI in the

calendar year up to June 2007 was recorded at 2.08%

(ytd), including deflation of 0.16% (mtm) in April. The

inflation rate in the first half of 2007 was lower than in

the corresponding period of the previous year of 2.87%

(ytd). A breakdown of inflation by component1 showed

that nearly all components of the CPI experienced lower

inflation compared to the previous year with the biggest

decline occurring in the foodstuffs component, edging

down from 5.16 % (ytd) in the first half of 2006 to 2.45%

(ytd) in the same period of 2007. Moving into the second

half of 2007 (July-December), however, inflationary

pressures elevated fairly substantially. Increases in the

prices of international commodities, such as crude oil,

crude palm oil (CPO), wheat, and gold, combined with

the weakening rupiah, were behind the higher inflation in

the second half of 2007.

In addition, seasonal factors such as religious festivities,

the start of the new academic year, and the year-end

1 According to the COICOP (Classification Of Individual Consumption by Purpose), 744 CPI commodities are grouped by the BPS into 7 groups of goods and services. They are (1) the foodstuffs group, (2) the processed foods, drinks, cigarettes, and tobacco group, (3) the housing, electricity, water, gas, and fuels group, (4) the clothing group, (5) the health group, (6) the education, recreation, and sports group, along with the (7) transportation, communications, dan financial services group.

holidays resulted in further inflationary pressures. With

such developments, CPI inflation climbed in the second

half of the year to around 4.51%. The higher inflation

rate reflected price increases in nearly all types of goods,

especially foodstuffs. Overall in 2007, CPI inflation

retained its stability at 6.59% compared to 6.60% in the

previous year.

Factors Affecting Inflation

Based on the influencing factors2, the relatively stable

inflation in 2007 was mainly attributable to improvements

in non-fundamental factors, with inflation from

fundamental factors being reasonably controllable. From

the non-fundamental side, lower volatile food inflation3

coupled with government policy in leaving administered

prices unchanged4 for strategic goods, such as

subsidized fuel and electricity tariffs, were the two main

reasons for the improved inflation conditions. From the

fundamental side, the fairly stable core inflation5 was

mainly attributable to inflationary expectations remaining

2 Based on the characteristics of developments in commodity prices, CPI inflation can be grouped into volatile food inflation, administered prices inflation, and core inflation.

3 Volatile food inflation is inflation in the group of food commodities whose prices are highly fluctuates because of certain factors such as the time of the harvesting season, distribution bottlenecks, natural disasters, and plagues.

4 Administered prices inflation is inflation in the group of commodities whose prices are set by the government.

5 Core inflation is commodity inflation whose movements are influenced by economic developments in general (fundamental factors such as inflation expectations, the exchange rate, and aggregate demand and supply balances) which will have an impact on price changes in general and which tend to be permanent in nature.

77

in-check and the minimal pressures from the interaction

between aggregate demand and supply. Meanwhile,

amidst a pick-up in imported inflation, pressure from the

external side remained subdued as the average rupiah

exchange rate strengthened in 2007 (Chart 5.3).

These inflation dynamics indicated that the role of

lower volatile food inflation was reasonably important in

safeguarding the stability of CPI inflation in 2007. The

lower volatile food inflation meant that its contribution

in forming inflation experienced a decline from 2.75%

in 2006 to 2.09% in 2007. The lower inflation from the

volatile food group was able to offset the increased

inflation contribution coming from core inflation and

administered prices such that, overall, the yearly inflation

was relatively stable (Table 5.1).

Non-fundamental Factors (Shocks)

Volatile Food

The year 2007 witnessed a drop in volatile food inflation

to 11.41% from 15.27% in 2006. The decline was mainly

attributable to the fall in the prices of rice , underpinned

by adequate supply and smooth distribution. Aside from

increased production, efforts to safeguard sufficient

supplies of rice were also achieved through imports

conducted by the State Logistics Agency (Bulog). The

Inflation of rice commodity, which has the largest weigh

in calculating the CPI, fell sharply from 32.0% in 2006

to 8.49% in 2007. This decline started to be apparent in

April after the government allowed Bulog to import rice,

as part of the efforts to safeguard stocks of rice. Overall,

the contribution of rice toward the overall inflation moved

down from 1.58% in 2006 to 0.52% in 2007 (Table 5.2).

Although, in general, volatile food inflation in 2007

experienced a decline, inflation of a number of

commodities in this group increased due to rising prices

of a number of commodities in international markets

and the occurrence of some natural disasters. The

surging prices of CPO in global markets had a significant

impact on volatile food inflation through higher prices of

cooking oil which rose 41.40% (Table 5.2). The upsurge

in cooking oil inflation was followed by increases in prices

of products made from CPO such as margarine and

butter which mounted 14.28% and 29.81%, respectively

(Table 5.4).

Meanwhile, the soaring price of corn in international

markets which were accompanied by surges in the

prices of livestock feed pushed up the prices of chicken

meat and eggs by 12.30% and 19.04%, respectively.

The occurrence of flood also put pressures on volatile

food inflation, as reflected in higher inflation of red

onions, hiking sharply to 124.50%, or far higher than

in 2006 when deflation of 18.8% was recorded (Table

5.2). Seen from its contribution to inflation, rice gave the

largest contribution amounting to0.52%. Meanwhile,

cooking oil and red onions – which both experienced

high inflation – also contributed quite significantly

78

toward volatile food inflation, that is 0.49% and 0.47%

respectively (Table 5.2).

Administered Prices

During 2007, pressures from administered prices inflation

was relatively minimal given that the government did

not raise the price of strategic administered goods such

as subsidized fuel (premium, diesel, and kerosene)

and electricity tariffs. The impact of this policy was

reasonably significant in efforts to safeguard the stability

of inflation this year considering the fairly large weighting

of administered goods in the CPI basket of goods, and

given that the knock-on impact on other commodities is

quite high.

Although relatively subdued, inflation of administered

goods in 2007 experienced a slight increase compared

to 2006, from 1.84% to 3.30%. This rise was mainly due

to policies taken in regard to a number of non-strategic

goods (Table 5.3), among others the 7% increase in

the retail selling prices of cigarettes in March 2007, the

adoption of specific excise taxes on cigarettes on 1 July

20076, increases in drinking water tariffs in a number

of cities, toll road tariff hikes, and upsurges in the prices

of non-subsidized fuel (Pertamax, Pertamax Plus, and

Pertamina Dex).

In addition to that, administered prices inflation was

also influenced by supply shortages of kerosene and

Liquefied Petroleum Gas (LPG) although the government

did not make adjustments (at the agents’ level). The price

of kerosene saw increases at the retail level, especially

in the third quarter of 2007. This occurred as a result

of problems in the implementation of the government’s

program to get consumers to convert from kerosene

to LPG sold in 3 kg canisters. Under such conditions,

kerosene inflation in 2007 rose to 2.7% and contributed

6 Based on Minister of Finance (PMK) Decree Number 118/PMK.04/2006 concerning Fiscal Policy, the government imposed two Policies in relation to cigarette excise taxes, that is increases in the retail selling prices (HJE) and the imposition of specific excise taxes on group I cigarettes of Rp7/stick, group II by Rp5/stick, and group III by Rp3/stick.

0.07% to inflation. Besides kerosene, the price of LPG

also climbed as a result of a scarcity of supplies in a

number of regions due to distribution difficulties. LPG

inflation was recorded at 2.1%, contributing 0.01%

toward inflation (Table 5.3).

Fundamental Factors

Core Inflation

From the fundamental side, developments in core

inflation were still relatively under control although

core inflation showed an increase compared to the

previous year. Core inflation was recorded at 6.29%, or

higher than the previous year’s 6.03%. The higher rate

of core inflation stemmed from escalating pressures

from imported inflation as the prices of a number of

international commodities such as crude oil, CPO, gold,

and wheat moved up.

Nonetheless, these imported inflation pressures

were mitigated somewhat by the relatively stable

rupiah exchange rate. At the same time, other factors

Table 5.1

Core and Non-Core Inflation and Its Contribution

percent

YearCore Volatile Foods Administered Prices

CPI InflationInflation Contribution Inflation Contribution Inflation Contribution

2006 6.03 3.48 15.27 2.75 1.84 0.37 6.602007 6.29 3.75 11.41 2.09 3.30 0.75 6.59

Source: BPS-Statistics Indonesia

79

influencing core inflation, that is the interaction between

aggregate demand and supply (the output gap), along

with inflationary expectations, indicated relatively stable

developments.

Broken down by each type of product, the impact of

hikes in international prices can be seen in gold and

various types of food. Gold jewelry contributed the most

to core inflation, with inflation of this product arriving

at 27.50% and giving a contribution of 0.33%. Various

foods also showed higher inflation, especially various

types of noodles, various types of cake and bread, as

well as soybean cake (Table 5.4).

Inflation Expectations

The public’s inflation expectations were relatively stable

at around 6%-7% in 2007. In general, market players

were still convinced that inflation in 2007 would be

around 6%-7%, or still in the range of 6%±1% targeted

by the government. Based on the Consensus Forecast

survey, inflation estimates for 2007 from a number of

institutions demonstrated that inflation expectations

in 2007 were relatively stable at around 6.3%-6.7%

(Chart 5.4). This result was also confirmed by the results

of a survey conducted by Bank Indonesia, that is the

Market Perceptions Survey (SPP), which showed that

the majority of respondents expected inflation in 2007

to be around 6%-7%. Even the number of respondents

who believed that inflation would be in the range of

6%-7% experienced an increase, while the number of

respondents who said inflation would rise (in the range

of 7.1%-8.0%) declined further (Chart 5.5). The stability

in inflation expectations reflects the confidence of the

majority of market players that the Government and

Bank Indonesia were consistent in implementing policies

to reach the predetermined inflation targets.

Although relatively stable, the level of inflation

expectations going forward still needs to be scrutinized.

This is related to the rise in expectations of price

increases ahead, especially at the end of 2007. The

consumer survey at the end of the year showed that

consumer expectations for prices 3 months and 6

months ahead intensified (Chart 5.6). This may be the

result of soaring prices of international commodities

which, it is feared, will push up production costs and,

ultimately, the prices of domestic goods. Additionally, the

higher inflation expectations also reflect the dominance

of backward looking reasoning in the formation of

inflation expectations such that it took longer for inflation

to be brought down.

Table 5.2

Volatile Foods Inflation and Several Volatile Foods

Commodities Contribution to Inflation

percent

Commodities2006 2007

Inflation Contribution Inflation Contribution

Rice 32.00 1.58 8.50 0.52Cooking Oil 6.70 0.08 41.40 0.49Shallot -18.80 -0.09 124.50 0.47Broiler Chicken Meat 10.40 0.14 12.30 0.17Broiler Chicken Egg 4.90 0.04 19.00 0.13Source: BPS-Statistics Indonesia

Table 5.3

Several Administered Prices Commodities Contribution

to Inflation in Year 2007

percent

Commodities2006 2007

Inflation Contribution Inflation Contribution

Filtered Clove Cigarettes

7.10 0.16 1.02 0.24

PAM Drinking Water Tariff

7.80 0.08 12.90 0.14

Clove Cigarettes 6.90 0.09 0.00 0.12Fuel 0.10 0.00 2.90 0.10Kerosene 1.80 0.04 2.70 0.07Cigarettes 5.60 0.02 7.10 0.03Toll Road Tariff 11.20 0.01 24.10 0.02LNG 1.10 0.01 2.10 0.01Parking Fee 3.20 0.01 3.10 0.01Source: BPS-Statistics Indonesia

Table 5.4

Contribution of Several Food Commodities in Core

Inflation to Inflation in Year 2007 and Its Developments

percent

Commodities2007

Inflation Contribution

1 Gold 27.50 0.33

2 CPO

Margarine 14.28 0.01

Butter 29.81 0.00

3 Wheat

Flour 35.92 0.03

Varieties of Noodles 16.19 0.06

Biscuit 7.52 0.02

Varieties of Cakes and Bread 9.81 0.20

4 Soybean

Moulded Soybean 18.60 0.09Source: BPS-Statistics Indonesia

80

External Factors

In 2007, inflationary pressures from external factors

were primarily the result of higher imported inflation,

emanating from upsurges in the prices of international

commodities, especially crude oil, CPO, and wheat.

This condition heightened inflationary pressures in a

number of countries, leading to higher inflation rates

in Indonesia’s trading partners (Chart 5.7). This higher

inflation was then transmitted to domestic inflation,

as reflected in WPI imported inflation which rose from

7.01% in 2006 to 25.60%. Nonetheless, the increase

in WPI imported inflation was not fully transmitted to

the prices of domestic goods at the consumer level.

This was indicated by the fact that the increase in the

inflation of imported commodities was not as large as the

increase in WPI imported inflation. The rate of inflation

of CPI imported commodities rose slightly from 5.83%

in 2006 to 7.20% in 2007 (Chart 5.8). The phenomenon

of lower inflation of imported commodities compared

to WPI imported inflation may be attributable to several

factors: (1) a number of imported goods formed the

input components in the production process such that

81

the proportion in the increase in the final price of goods

will be lower than the proportion in the increase in the

price of imported goods; (2) there were indications

that producers tried not to pass on all the increases of

prices in input goods onto consumers after considering

conditions related to consumer demand and business

competition.

On the other front, the relatively stable exchange rate

lessened pressures arising from imported inflation. On

average, the rupiah stood at Rp9,140 per dollar in 2007

although it did for a time come under pressure due to the

US sub-prime mortgage crisis.

Interaction between Aggregate Demand and Aggregate

Supply (Output Gap)

Inflationary pressures from the interaction of demand

and supply was still minimal, as reflected negative output

gap. The supply side to turned out to be able to meet

the higher level of demand. The response on the supply

side is reflected in the elevated the production index

in the production survey carried out by the Statistics

Indonesia. The production index climbed from 116.9%

on average in 2006 to 123.12%. In addition, SKDU in the

fourth quarter of 2007 demonstrated capacity usage of

73.26%, indicating that most industries still had room to

raise production if demand increased.

Evaluation of Realized Inflation

In 2007, the Government set the CPI inflation target

at 6% with a deviation of ±1%7. The target was set

based on assumptions at the beginning of the year in

regard to fundamental and non-fundamental factors

(shocks) causing inflationary pressures (Table 5.5).

With regard to the fundamental factors, inflation was

expected to originate from external factors in terms of

the weakening of rupiah. As to other external factors, it

was assumed that the price of crude oil in international

markets was US$60/barrel. With pressures from the

output gap anticipated to be minimal and inflationary

expectations expected to remain stable, the core inflation

was estimated to arrive at around 6.3%. As regard the

non-fundamental factors, volatile food inflation was

expected to remain high, although experience a decline.

Meanwhile, administered prices inflation was anticipated

to have a minimal impact on CPI inflation given the

government’s commitment to neither hike fuel prices nor

electricity tariffs.

In reality, the factors which influenced inflation, either

fundamental or non-fundamental, were actually similar

to the original expectations, such that CPI inflation in

2007 was in the range of the predetermined inflation

target. This achievement was the result of improving

coordination between Bank Indonesia and the

Government. Consistency in monetary policy to ensure

7 This was decided in a coordinating meeting on macroeconomics at the Office of the Coordinating Minister for the Economy on 17 March 2006. The inflation target revised the inflation target as set by the government at 5.0% with a deviation of 1%, which is stated in Ministry of Finance decision No. 399/KMK.011/2004 dated 6 September 2004.

Table 5.5

Comparison of Assumption and Realization of Inflation

Target in Year 2007

Variable2007

Inflation Target Realization

Assumption • ExchangeRate(Rp/$)

9,300 9,140

• OilPrice($/barrel) 60 72.3Projection • GDP(%) 6.0 6.3

• CoreInflation(%) 6.30 6.29

• CPIInflation(%) 6.60 6.59Influencing Factors

• ExchangeRate slightly weaken relative stable

• InflationExpectation

stable but remain high

stable but remain high

• OutputGap Low Low

• AdministeredPrices

Low Low

• VolatileFoods high, rice import limitation

high, no rice import limitation

CPI Inflation Target 6.0%±1%

82

the predetermined inflation targets were met and the

ability of the Government to control price shocks through

various sectorial policy packages were key to the 2007

inflation target being fulfilled. With these developments,

core inflation – which portrayed developments in

fundamental factors – hit a level of 6.29%. This shows

that there was still an adequate response from the side of

aggregate supply toward increasing aggregate demand

along with inflationary expectations that were relatively

stable. Nonetheless, in terms of external factors, the

oil price in fact soared sharply to US$72.3 per barrel,

resulting in greater pressures on imported inflation.

Nonetheless, the relatively stable rupiah exchange rate

helped to lessen the pressures of imported inflation

toward domestic inflation.

On the non-fundamental factors, the government’s

commitment to refrain from elevating the prices of

strategic administered goods led to low administered

goods inflation. Meanwhile, volatile food inflation was

still at a high level although sliding slightly. The decline

in volatile food inflation stemmed from lower inflation of

the rice commodity which has a large weight in the CPI

basket of consumer goods.

Policy Initiatives to Control Inflation

The achievement of the 2007 inflation target reflected

the enhanced coordination between Bank Indonesia and

the Government in controlling factors which influence

inflation, as well as in the pursuing macroeconomic and

financial system stability. In regard to Bank Indonesia,

its consistent monetary policy in 2007 was conducted

to ensure that the inflation target could be met. This

was achieved through the management of liquidity

which was in line with the needs of the economy and

the safeguarding of rupiah stability amidst unfavorable

developments on the external front.

In keeping the public’s inflationary expectations at

the level targeted, Bank Indonesia also continued to

strengthen its communication strategy. Other than

through regular press announcements and press

conferences which revealed the decisions made at

the Governors’ Board Meeting and the publication of

Monetary Policy Reports, better communication strategy

was carried out through the program to disseminate

monetary policy to all stakeholders, such as academics,

the business community, journalists, and financial

players, which was conducted either centrally or at

the regional level. The dissemination explained overall

Bank Indonesia’s assessments concerning the latest

developments on the macroeconomic front, inflation

and monetary conditions, along with estimates of

inflation going forward and the monetary policy response

needed to bring inflation down to the targeted level. By

strengthening such communications, the behavior of

inflation expectations in Indonesia is directed toward

the inflation target already set by the government

(forward looking).

On the other hand, the government has tried to

maintain fiscal sustainability while, at the same time,

also safeguarding the supply of goods especially those

of basic needs. These efforts were undertaken through

various sectorial policies such as the abolishment

of Value Added Tax (VAT) and subsidies on food

commodities (such as cooking oil) which are susceptible

toward shocks. In addition, the Government was

committed to safeguarding the supply and distribution

of goods so that their prices did not move sharply (such

goods include rice, kerosene, and sugar). In accordance

with its original commitment, the Government did not

opt to hike the prices of administered goods deemed

strategic (fuel and electricity tariffs).

The government’s commitment was strengthened

through the formation of the Coordinating Team to

Stabilize Basic Foodstuff Prices which comprises

technical departments involved with a number of duties

including: the planning and formulating of policies to

stabilize the prices of basic foodstuffs (rice, sugar, and

cooking oil), and coordinating the realization of these

plans, along with the monitoring and evaluation of such

stabilization policies. Additionally, the Government also

issued Presidential Instruction No. 6/2007 which, among

other things, contains policies to accelerate development

of the real sector as well as to empower SMMEs which

include policies to improve the investor climate and

policies to encourage infrastructure development. To

strengthen policy coordination, Bank Indonesia and the

Government improved further their coordination in the

Inflation Control Team which was assigned to formulate

policies needed to tackle the problem of rising inflationary

pressures. The Team also discussed and formulated

proposals for the inflation targets in the years 2008-2010

(Box: Inflation Targets for the Years 2008-2010). This

policy coordination are very much needed, given that

the permanent component of inflation in Indonesia is still

quite high (Box: Efforts to Comprehend the Behavior

of Inflation in Indonesia: The Permanent Component of

Inflation and the Persistency of Inflation).

83

Efforts to Comprehend the Behavior of Inflation in Indonesia: The Permanent Component of Inflation and the Persistency of Inflation

Efforts to control inflation demand deep understanding

and knowledge regarding the behavior of that inflation.

Two aspects of inflationary behavior which have for

some time been a challenge in efforts to lower or

even control inflation in Indonesia are the difficulty in

lowering the pace of inflation to a lower level1 and the

high persistency of inflation. The difficulty of bringing

the rate of inflation down raises the question of whether

there really is one inherent inflation level for Indonesia.

Comprehension on this matter is very useful - for

example in determining a certain inflation target in a

realistic manner. The establishment of an unrealistic

target will force the central bank to adopt monetary

policy which is too extreme, such that there will be a

large cost for the economy. Meanwhile, the matter of

persistency is related to how quickly inflation will return to

equilibrium after experiencing a shock. Persistent inflation

means that when a shock occurs, the rate of inflation

will tend to take some time to return to its level prior to

the shock. The condition of persistent inflation will also

hamper efforts to bring the rate of inflation to a lower

level. Therefore, the understanding of the persistency of

inflation is also very important as it will determine how

preemptive Bank Indonesia should be in responding to

economic shocks that affect price stability.

Studies show, however, that Indonesia’s inflation has

the characteristic of being rather stubborn in returning

to a lower level (sticky inflation). By calculating average

inflation, the long-term inflation trend for the period

1980-2007 was 9.8%, while for the period 2000-2007

the long-term inflation trend is 8.8%. The high level of

Indonesia’s long-term inflation trend raises the question

whether there is one level of permanent component in

forming inflation in Indonesia. An econometrics approach

proposes the technique of decomposing inflation into

permanent and transitory components2. The permanent

1 The lowest level of inflation was around 5%. This was seen in 1992, 1996, and 2003.

2 Affandi, Yoga (2007): “A Small Monetary System for Indonesia”. Bank Indonesia Working Paper.

inflation component is split into the two elements, that

is the deterministic trend and the stochastic trend. The

deterministic trend is represented by a long-term trend

which is linear. The stochastic trend is the accumulation

of shocks that are permanent in nature which will affect

inflation3. It can be said that the stochastic trend has a

correlation to inflation which tends to have a high level of

persistency.

The results of the calculation of data for the permanent

inflation component show that the lowest level which

can be reached is around 5.3%, occurring in the post

crisis period, during the second quarter of 2003 until the

first quarter of 2004. In the pre crisis period permanent

inflation tended to be above its long-term trend (Chart 1),

while in the post crisis period permanent inflation tended

to be below the long-term trend (Chart 2). This signals

that the stochastic trend is lower in the post crisis period.

This result is in line with research findings which indicate

that the degree of persistent inflation in Indonesia is

declining further. Studies carried out using the simple

auto-regression model have found that in the period

1990-2006 the level of persistency in Indonesia actually

experienced a change from over time4. The study shows

a decline in the degree of persistent CPI inflation, from

0.27 in the pre crisis period to 0.12 after the crisis. The

change in the degree of persistent inflation was also

confirmed by the results of estimating rolling regression

of the persistency coefficient.

Lower persistent inflation implies that if there are

economic shocks, inflation will return more quickly to its

average level. From the aspect of controlling inflation, the

lower persistent inflation will also make it easier to reduce

inflation, because the people’s tendency to anchor

inflationary expectations to the past will lessen.

The results of the research which confirm that a

3 A shock which is transitory in nature in cumulative terms will disappear.

4 Yanuarti, Tri (2007), “Has Inflation Persistence in Indonesia Changed?,” Bank Indonesia Working Paper.

84

permanent inflation component in Indonesia is still fairly

high remains as an obstacle in efforts to reduce inflation

to a lower level. The continuing high level of permanent

inflation component indicates the presence of more

fundamental problems in regard to the phenomenon

of inflation in Indonesia, especially matters that are

related to productivity, efficiency, and the structure of

the economy. The close connection between inflation

and economic productivity and efficiency implies that

dis-inflationary policy needs to always be adopted

in consideration of the principals of gradualism and

balance. Monetary policy which is excessively tight

when economic productivity and efficiency is low can

contribute toward the recession. In contrast, monetary

policy which is too loose, will only lead to inflator and

not pro-poor economy. The close connection between

inflation and structural aspects also implies that for a

credible process of deflation then good coordination

between the government and Bank Indonesia is deemed

important.

85

Inflation Targets for the Years 2008-2010

Low and stable inflation is a precondition for increased

prosperity and the basis for balanced economic growth.

In line with Act No. 23/1999 concerning Bank Indonesia

which was being superseded by Act No 3/2004, Bank

Indonesia is tasked with achieve and maintain the

stability of rupiah exchange rate. Based on the Acts

(explanation of article 10 clause 1a), the inflation target

is determined by the Government after coordinating with

Bank Indonesia. In turn, the inflation target is used by

Bank Indonesia as the basis in formulating and carrying

out monetary policy by taking into account the stability of

the financial system and the overall economy.

Based on the decision by the Minister of Finance No.

399/ KMK.011/2004 dated 6 September 2004, the

inflation targeting period is fixed for 3 years, while the

type of inflation targeting used is the yearly CPI. In this

decision the inflation target for the years 2005-2007 was

also agreed, which was 6%±1% for 2005, 5.5%±1% for

2006, and 5.0%±1% for 2007. Later, the government

and Bank Indonesia agreed to revise the target on 17

March 2006. The inflation target for 2006-2008 was

agreed at 8.0%, 6.0%, and 5.0%, respectively, with

a deviation of ±1%. Subsequently, at the beginning

of 2008, the government set the new inflation targets

for the period 2008-2010, that is of 5.0%, 4.5%, and

4.0%, respectively, with deviation of ±1% through

the decision of the Finance Minister No.1 year 2008

(Chart 3). In general, the inflation target is set by taking

into consideration the inflation projection and the policies

which need to be taken such that the inflation target is

realistic.

The determination of inflation target is needed as a

reference for each player in the economy in taking

economic decisions, including for the government and

Bank Indonesia in formulating the appropriate policies.

The setting of a lower inflation target demonstrates the

government’s commitment to continue the disinflation

process on a gradual basis such that domestic inflation

will be relatively similar to inflation rates in other countries

in the region. The inflation target is also expected to

become anchor in the formation of inflation expectations

of each economic player (forward looking). This is

seen to be important given the role that inflationary

expectations have in forming inflation.

The Government is well aware that such a goal requires

commitment and hard work from various parties taking

into account Indonesia’s historically high inflation on

average. Based on historical data over the last 30 years,

the lowest inflation on average occurred in the post-

crisis period – edging down at 7.12%, a level of inflation

which was still fairly high (Chart 4). Nonetheless, the

achievement of lower inflation than the historical average

is not impossible given that in the years of 1992, 1996,

and 2003, inflation had reached around 5%. In each of

those three years, the achievement of low inflation was

underpinned by the fact that non-fundamental factors

were under control – that is volatile food inflation (Chart

3) and administered prices. Aware of the various factors

that affect inflation, which not only cover monetary policy

86

yet also cover policies on production and distribution,

the government has decided to form the Coordinating

Forum to Control Inflation aside from strengthening of the

existing teams such as the Inflation Control Team and the

Coordinating Team to Stabilize Basic Foodstuff Prices.

PeriodDevaluation(1979-1984)

Before Crisis(1985-1997)

Crisis(1998-1999)

After Crisis(2000-2007)

Mean(%,yoy) 14.49 7.94 41.02 8.81 7.12*

* Increasing Fuel Price Impact

It is expected that these forums will be able to monitor

the undertaking of activities involved with controlling

inflation. This forum is directly chaired by the Minister for

the Economy, with the permanent members being the

Finance Minister, the Governor of Bank Indonesia, and

the Minister of Trade.

Chapter 6

Monetary Developments

88

Monetary policy in 2007 faced challenges from the considerable impact of the global economic turmoil and excess liquidity on the domestic money market. Bank Indonesia announced a series of cuts in the BI Rate before a pause in rate cuts that lasted until close to end of year. In operational side, monetary policy was conducted by adjusting money market liquidity through open market operations. The BI Rate cuts were effectively transmitted to the financial market and raised real sector economic agents confidence. This circumstances was supported by adequate liquidity in the economy, despite the continued buildup of excess liquidity on the money market. Overall, monetary policy with the support of fiscal policy was able to balance the dual goals of achieving the inflation target and promoting economic growth.

Chapter 6: Monetary Developments

In early 2007, considering the confidence in

macroeconomic stability, progress towards the

inflation target and financial system resilience, Bank

Indonesia embarked on a series of measured cuts

in the reference rate before pausing rate movement

until close to end of year. As Indonesia entered 2007,

domestic economic conditions increasingly pointed to

recovery in the wake of the fuel price hikes of 2005.

This improvement was reinforced by macroeconomic

stability reflected in the stable exchange rate and

downward trend in inflation. After assessing these

conditions, Bank Indonesia resumed the loose bias

monetary policy stance first launched in May 2006.

However, early in the second half of 2007, the domestic

economy came under pressure triggered by the impact

of the subprime mortgage crisis in the United States.

The resulting turmoil stirred negative sentiment across

global financial markets, with subsequent implications

for weakening in the exchange rate. Exacerbating the

shocks were surging world oil prices that carried the

risk of heightened inflation. In response to these risks,

Bank Indonesia kept the BI Rate on hold from August

until November 2007. At year end, BI announced a

new rate cut to 8% following the signal of declining

future inflationary pressure and to support for renewed

economic expansion.

In monetary policy, consistency and commitment in

curbing inflation was reinforced by policy transparency

and improved coordination with the Government.

Transparency was implemented through a revamped

strategy and intense communication and dissemination

of monetary policy through a range of media and to

stakeholders at the central government and regional

levels. Through these communications, stakeholder

perceptions would be brought into line with Bank

Indonesia’s intentions for implementing monetary policy.

In addition, policy transparency would encourage a

shift from the prevailing backward-looking formation of

public inflation expectations towards greater alignment

with the future inflation target. In related moves, the

closer monetary-fiscal coordination has created a level

of macroeconomic stability conducive for sustainable

economic expansion. This policy coordination operates,

among others, through regular meetings between Bank

Indonesia, the Government and relevant agencies in

a coordination forum and within the Inflation Control

Team.

This monetary policy met with positive response from

the financial market and strengthened the optimism

of economic agents in the real sector. Response

from financial market players was manifested in the

continued rise in stock market activity accompanied

by accelerated gains in the Indonesian Composite

Index. Activity was also brisk on the government

securities market, bolstered by attractive yields. Banks

continued to lower their deposit and lending rates, in

89

turn providing added momentum to economic activity

in the real sector and encouraging alternative forms of

financing through stock and bond issues. In the real

sector, positive response was reflected in relatively

stable inflation expectations among economic agents

and rising consumer and business confidence in the

domestic economy. This represents an important signal

bolstering the performance of the economy.

Domestic economic expansion was matched by

accelerated growth in economic liquidity particularly

in lending to the private sector. However, the banking

system still carried high levels of excess liquidity, a

condition that must be carefully monitored in regard to

implications for macroeconomic and financial market

stability.

Monetary Policy Implementation

The monetary policy strategy involving the setting of the

BI Rate is directed towards achieving the Government-

set inflation target. The strategy is pursued through

measured, prudent actions with careful consideration

the state of the economy including future inflation

pressure, latest dynamics in the economy and

financial system stability. Under these conditions, the

safeguarding of macroeconomic stability continued

alongside lowering of the BI Rate from 9.5% to 8.25%

in a series of rate cuts from January to July 2007. In

March 2007, about midway during this period, issues

over subprime mortgages began to surface, but

without significantly impacting economic stability.

In the second half of 2007, the subprime mortgage

problem took a more serious turn with spreading

impact that also affected Bank Indonesia in determining

the BI Rate. In August, investors began reassessing

their investment risks and adjusting portfolio holdings

in a flight to quality. This in turn impacted the rupiah

exchange rate, as well as exchange rates in other

emerging market countries. Conditions took a further

turn for the worse with soaring oil prices that put

added pressure on both the exchange rate and future

inflation. Responding to this, Bank Indonesia halted

the downward movement in interest rates from July

to November 2007. The BI Rate was held at 8.25%

to fend off accelerated inflation expectations and

ease pressure on the financial market. At the end of

2007, in view of the safe level inflation expectations,

adequate production capacity and renewed equilibrium

in financial markets, BI lowered the rate to 8%. This

policy sent a positive signal for the ongoing economic

expansion while nevertheless prioritizing achievement

of the inflation target.

This policy strategy was implemented through liquidity

management in Open Market Operations (OMO) and

other instruments. Following the reductions in the BI

Rate, all instruments directly linked to the BI Rate were

automatically lowered by the same margin. At the end

of 2007, the overnight Bank Indonesia Short-Term

Deposit Facility (FASBI O/N), customarily used as the

floor for overnight rate movements on the interbank

market, stood at 3% (down from 4.75% at end-2006).

Likewise, the SBI repo rate, which marks the ceiling

on overnight interbank rate movements, eased to 11%

(from 12.75% at end-2006). OMOs were held primarily

to absorb excess liquidity and ensure availability of

interbank liquidity. The regular OMOs relied mainly

on the weekly auction of 1-month SBIs in a fixed rate

tender at the level of the BI Rate. However, the non-

regular Fine Tune Operations (FTOs) were implemented

on a limited scale and with varying pricing, adjusted to

the conditions on the money market. Complementing

these monetary instruments on the rupiah market was

forex intervention used to curb excessive exchange rate

volatility.

Response to BI Rate by Financial Market and

Economic Agents

Financial Market Response

Changes in the BI Rate were followed by

commensurate movement in money market rates.

During 2007, the overnight rupiah interbank rate

showed greater average decline than the BI Rate, as

could be expected with the over liquid condition of

the money market. Volatility, however, was relatively

unchanged from 2006 (Table 6.1). These interest

rate movements were strongly influenced by the

microstructural condition of the money market and

the effect of movement in autonomous factors, most

importantly government financial operations. On

a day-to-day basis, this condition was reflected in

the fluctuating movement in the overnight interbank

rate, which varied considerably against the BI Rate

(Chart 6.1).

Movement in the BI Rate met with strong response in

bank deposit rates. The magnitude of this response

also reflected the excess liquidity and was consistent

90

with movement in the rupiah deposit guarantee rate

(Chart 6.2). Bank deposit rates averaged over all tenors

fell by 2.3%, more than the cumulative reduction in the

BI Rate over the same period (1.75%). The steepest rate

cuts took place in the 12 and 6 month tenors (Chart

6.3). Leading in rate cuts on deposit funds were state-

owned banks, while foreign and joint venture banks

registered the slowest decline compared to the banking

system as a whole. In September 2007, the downward

movement in deposit rates began levelling off in all

tenors, with the 1-month deposit rate even edging up

slightly from October 2007. This appears to be related

to bank efforts to retain customers by ensuring that

depositors would continue to receive positive and

competitive real interest rate.

On the other hand, lending rates were slower to

respond. The sluggishness of the response was

indicated by the variation in variables affecting the

pricing of lending rate, including overhead costs, profit

margins and risks, not all of which can be influenced

Table 6.1

Rupiah Interbank Money Market O/N Interest Rate and

its Volatility

Period

Weighted Average Interbank Money Market O/N (%)

Volatility O/N (%)

Morning Afternoon Morning Afternoon

2006 9.2 8.7 2.2 2.1

January 5.0 4.9 0.1 0.1

February 5.2 5.1 1.2 0.9

March 7.5 7.3 5.1 3.7

May 8.5 7.9 3.8 3.5

June 6.9 6.3 3.1 2.9

July 5.6 5.3 2.3 1.9

September 5.2 4.8 1.8 1.2

October 4.9 4.8 2.0 2.0

November 6.8 6.7 3.3 3.0

January 5.1 4.7 3.7 3.4

February 6.5 6.4 3.0 3.0

March 4.3 4.2 1.4 1.4

2007 6.0 5.8 2.6 2.2

91

by monetary policy. In December 2007, the steepest

drop in lending rates was recorded in working capital

and investment credit, in contrast to the thin decline in

rates for consumption credit and especially unsecured

loans and credit cards (Chart 6.4). However, when

overall average lending rates are compared by category

of bank, regional development banks were the most

reluctant to lower their lending rates, while private

national banks in fact cut their loan rates by more

than the banking industry average. Since September

2007, lending rates for various uses have been

marked by slowing decline understood to be linked

to the achievement of bank business plans, renewed

increases in deposit rates and bank caution regarding

the future of the economy.

Banks responded to the movement in the BI Rate

by switching to shorter-term funding structures. At

end-2007, growth in depositor funds reached 17.4%,

ahead of 14.1% at the end of 2006 (Chart 6.5),

providing banks with ample liquidity. This increase was

dominated by savings deposits, which now command

92

a larger share than demand deposits (Chart 6.6). Time

deposits, on the other hand, saw growth taper off,

particularly in the case of 24 and 12 month deposits

in response to the steep interest rate decline for these

tenors. As a result, deposit funds became increasingly

concentrated in the 1-month tenor (Chart 6.7). At

the same time, the upward trend in foreign currency

deposits led by time deposits, which appears to be

generally linked to falling returns on rupiah deposits,

heightened perceptions of depreciation and inflation

expectations over a certain period.

The strong response to the BI rate was also evident in

accelerated credit expansion. Credit expansion at end-

2007 was recorded at 25.5%, having climbed sharply

from only 14.1% at the end of 2006 (Chart 6.5). More

robust credit expansion was particularly noticeable

during the second half of 2007, when the economy

gained momentum. As a result, credit expansion for

the banking industry as a whole surpassed the initial

forecast early in the year (22%). Accelerated credit

expansion was reported for all categories of use, with

working capital credit in the lead (Chart 6.8). This credit

was channelled into a wide range of economic sectors,

with credit growth advancing most rapidly in mining,

business services, transportation and construction.

The year 2007 also recorded brisk growth in foreign

currency lending, which surpassed the overall rate of

credit expansion. This strong growth in foreign currency

lending was channelled mainly for working capital

and investment in traded sectors, including mining,

and non-traded sectors such as trade, construction

and business services. The surge in foreign currency

loans appears to be related to attractive interest rates

for these loans in the 6.9%-10.4% range and the

confidence demonstrated by some business actors

in Bank Indonesia’s commitment to exchange rate

stability.

On the stock market, response to the BI Rate was

evident in the bullish market trend. Stock index

movement varied considerably during 2007, while

maintaining an upward trend. At end of year, the IDX

93

Composite Index closed at 2,745 points or 52.1%

up from the end of 2006 (Chart 6.9). With this index

growth, the Indonesian Stock Exchange (IDX) ranked

the second best-performing market in 2007 after

China. This achievement was underpinned by a range

of domestic and global factors. Domestic factors

included macroeconomic stability, represented by

movement in the BI Rate, rising purchasing power

and the sound condition of the micro fundamentals

of some listed companies. At the same time, global

factors included positive perceptions among foreign

investors and sustained high world commodity prices.

The irrepressible rise in the IDX index also stimulated

market liquidity, with average turnover reaching Rp4.3

trillion per day compared to the previous year’s average

of only Rp1.8 trillion per day.

The government bonds market responded to the BI

Rate with a renewed surge in trading activity despite

relatively stable yields. Trading in government securities

maintained an overall upward trend, reflected in rising

volume and frequency of transactions. Government

bonds trading in 2007 averaged Rp5.8 trillion per

day, up significantly from the preceding year (Rp3.3

trillion per day). Average frequency of trading mounted

to 253.4 transactions per day, also representing a

significant climb in comparison to 146.7 per day in

2006 (Chart 6.11). At the end of 2007, average yield on

government bonds in various tenors eased by a thin 17

bps from one year earlier. The modest decline in yield is

explained most importantly by strong global sentiment

over the subprime mortgage crisis and soaring world

crude oil prices in the second half of 2007 (Chart 6.10).

Before this, yield had been in steady decline in keeping

with stable macroeconomic conditions.

The BI Rate was one factor that encouraged steady

growth in mutual fund Net Asset Value (NAV). At

end-2007, NAV in mutual funds reached Rp92.2

trillion, representing growth of 78.6% over the end

of 2006 (Chart 6.12). The steep rise in NAV resulted

largely from price appreciation, particularly in equity

funds. Total net subscriptions/new cash flow mounted

Rp20.2 trillion, also dominated by equity funds. While

conducive macroeconomic conditions played a role,

these gains were also bolstered by growing investor

knowledge following the aggressive public education

and promotion campaign launched by mutual fund

sales agents, as well as support from a more robust

legal framework. As a result, mutual funds have not

only expanded in NAV, but also in diversity of offerings.

At end-2007, mutual funds represented a total of 473

products, up from 403 products one year earlier.

The adjustments in the BI Rate met with positive

response in more vigorous financing of economic

activity from outside the banking sector. The ongoing

economic expansion amid macroeconomic stability and

a bullish stockmarket trend prompted greater demand

for corporate financing. In 2007, corporate financing

from the capital market reached Rp78.3 trillion, a

remarkable increase of 236.1% over the end of 2006

94

(Rp23.3 trillion). Of this total, Rp47.0 trillion originated

from initial public offering (IPOs) and right issues and

the remainder was raised through bond issues. IPOs

were held by 21 companies for a total value of Rp17.2

trillion, with rights issues mobilizing a further Rp29.8

trillion used primarily for business expansion. Forty-

three companies issued bonds, with proceeds used

mostly for refinancing.

Real Sector Response

The lowering of the BI Rate was regarded as adequate

to boost optimism for doing business in Indonesia.

Confirming this were the findings in the business

tendencies survey by the Central Statistics Agency

(BPS). This survey pointed to an improving trend in

business tendencies in keeping with the prudently

managed macroeconomic conditions and outlook

for continued economic expansion (Chart 6.13).

Consumers also developed positive perceptions of

monetary policy, reflected in the upswing in aggregate

consumer expectations for economic outlook, incomes

and availability of employment (Chart 6.14).

95

chart credibility gains, which has paid off in addressing

the challenges for achievement of the inflation target in

the coming years.

Liquidity

Base Money and Excess Banking Liquidity

Base money underwent expansion in line with the pace

of economic activity. At end-2007, base money reached

Rp379.6 trillion with growth at 27.8% (Table 6.2). This is

The monetary policy stance also eased inflation

expectations among economic agents. In 2007, the

commitment and consistency upheld in monetary

policy for inflation control proved adequately effective

in influencing the inflation expectations of real sector

agents (Chart 6.15) and financial market analysts

(Chart 6.16). This points to steady improvement in

policy transparency, reflected in the growing ability

among stakeholders to understand the Bank Indonesia

monetary policy. This has enabled Bank Indonesia to

Table 6.2

Developments in Base Money

billions Rp

2005 2006 2007

Base Money 239,781 297,080 379,582

I Currency in Circulation 144,869 178,572 220,785

1. Currency Outside Banks 124,316 151,009 183,419

2. Cash in Banks Vaults 20,553 27,563 37,366

II Commercial Bank Transferable Deposits at BI 94,531 118,417 158,452

III Private Sector Transferable Deposits 381 91 345

Net Foreign Assets 173,806 274,694 356,883

Net Domestic Assets 65,976 22,386 22,700

I Net Claims on Central Government 39,357 49,865 49,458

II Claims on Banks 233,398 243,220 227,555

III Other Claims 19,984 19,919 8,407

IV Open Market Operation (121,325) (242,001) (281,163)

1. SBI (74,632) (208,762) (247,687)

2. BI Deposits Facility (57,212) (41,568) (48,933)

3. Government Bonds 10,519 8,330 15,457

V Net Other Items -105,438 -48,618 18,444

96

explained mainly a steep rise in currency in circulation

consistent with the ongoing economic expansion in

the real sector. However, statutory reserves held by

banks grew at a more moderate rate. The Loan to

Deposit Ratio (LDR) incentive resulted in a reduction

of Rp1.0 trillion in the statutory reserve requirement.

Besides statutory reserves, bank excess reserves were

up significantly over the previous year. This occurred

during the closing days of 2007, a result of realized

government expenditures at the end of the year.

Average 2006 2007C/PDB 3,9 3,9M1/PDB 10,0 10,4M2/PDB 40,2 39,4

Base money expansion was driven primarily by activity

on the part of the Government and Bank Indonesia.

The Rp82.5 trillion surge in demand for base money

over the previous year was adequately offset by

expansionary Government rupiah transactions and

activity by Bank Indonesia (Chart 6.17). Net liquidity

expansion from Government account at Bank Indonesia

reached Rp66.9 trillion, down significantly from 2006

(Rp115.1 trillion). With the fiscal deficit widening from

0.9% of GDP in 2006 to about 1.3% of GDP in 2007,

this decline was reportedly related to the switch in the

97

Rp39.2 trillion to Rp281.2 trillion. The rise in the OMO

position reflects the steady increase in excess liquidity

on the money market that could not be optimally

absorbed into economic activities in the real sector

(Chart 6.18). This will be addressed through a range

of actions, including financial deepening, and further

strengthening of commitment and consistency on the

part of Bank Indonesia in its monetary operations on

the money market. Added to this, various policies in the

real sector will be reinforced to accelerate economic

growth and create greater capacity to absorb excess

liquidity on a permanent basis.

Government financing strategy to renewed emphasis

on domestic issuance of government bonds rather than

making use of the account at Bank Indonesia. At the

same time, Bank Indonesia activity boosted liquidity

from the costs of monetary management. This was

consistent with the Bank Indonesia commitment for

maintaining rupiah stability in support of sustainable

macroeconomic stability.

With mounting excess liquidity on the money market,

Bank Indonesia took action in OMOs to absorb liquidity.

During 2007, the aggregate OMO position widened by

Table 6.3

Monetary Aggregates

2006 2007 2006 2007

Billions Rp Growth (percent)

Broad Money (M2) 1,382,074 1,643,203 14.87 18.89

M2 Rupiah 1,198,141 1,427,296 18.13 19.13

Narrow Money (M1) 361,073 460,842 28.08 27.63

– Currency Outside Banks 151,009 183,419 21.47 21.46

– Demand Deposits 210,064 277,423 33.30 32.07

Quasi Money 1,021,001 1,182,361 10.82 15.80

– Deposits in Rupiah 837,068 966,454 14.30 15.46

= Time Deposits 506,565 533,376 11.94 5.29

= Saving Deposits 330,503 433,078 18.10 31.04

– Deposits in Foreign Currencies 183,933 215,907 (2.65) 17.38

(billions $) 20,392 22,922 6.09 12.41

Net Foreign Assets 413,265 524,703 32.00 26.97

Bank Indonesia: 377,936 530,913 51.09 40.48

– Foreign Assets 385,820 538,775 12.19 39.64

– Foreign Liabilities 7,884 7,862 (91.59) (0.28)

Commercial Banks: 35,329 -6,210 (43.87) (117.58)

– Foreign Assets 93,924 70,907 (20.89) (24.51)

– Foreign Liabilities 58,595 77,117 5.03 31.61

Net Domestic Assets 968,809 1,118,500 8.84 15.45

1. Net Claims on Central Government 506,488 497,478 1.52 (1.78)

– Bank Indonesia 265,919 249,069 11.19 (6.34)

– Commercial Banks 240,569 248,409 (7.39) 3.26

2. Net Claims to IBRA 0 0

3. Claims to Enterprises 837,072 1,040,996 13.29 24.36

– Loans to Private Sector 787,136 995,111 14.13 26.42

Loans to Private Sector (billions $) 87,27 105,65 24.38 21.07

= Loans in Rupiah 639,152 793,186 12.84 24.10

= Loans in Foreign Currency 147,984 201,925 20.09 36.45

Loans in Foreign Currency (billions $) 16,41 21,44 30.88 30.67

– Other Claims 49,936 45,885 1.55 (8.11)

4. Net Other Items -374,751 -419,974 7.81 12.07

98

The BI Rate has a strong bearing on movement in the

components of economic liquidity. The downward

movement in the BI Rate influenced economic liquidity

components by producing a shift in public liquidity

preferences, as evident in the accelerated growth in

savings deposits relative to time deposits. This was

followed by mounting activity in privately-held demand

deposits in line with bullish activity on the stock

market. Activity in privately-held demand deposits was

dominated by insurance companies, pension funds and

other private business (including securities companies

and investment managers). As shown in Chart 6.23, the

stock index has demonstrated a markedly increased

correlation with this category of demand deposits since

2005. This augurs for the possibility of an expanded

institutional investor role on the domestic stock market.

The expansion in economic liquidity was dominated

by domestic factors. Claims on business sector had

a leading influence over levels of economic liquidity.

Growth in claims on business sector reached 26.4% in

December 2007, representing an increase of Rp208.0

trillion over the end of 2006. Of this total, Rp154.0

trillion comprised credit extended in rupiahs, while

the remaining Rp54 trillion, equivalent to US$5 billion,

was loans extended in foreign currencies. External

factors bearing on economic liquidity were reflected

in the overall 27.0% expansion in net foreign assets

(NFA), representing an increase of Rp111.4 trillion. This

increase took place in NFA held by Bank Indonesia in

line with the hefty rise international reserves from the

windfall in oil and gas revenues generated by soaring

oil world oil prices. Despite this, the banking system

reported a decline in NFA, particularly in foreign assets

held in call money and demand deposits at overseas

banks.

Economic Liquidity

Economic liquidity, reflected in M1 and M2, expanded

considerably during 2007. At the end of December, the

narrow money (M1) widened 27.6%, to Rp460.8 trillion.

The broad money (M2) grew 18.9% to reach Rp1,643.2

trillion. This growth in economic liquidity is markedly

high compared to the historical condition over the past

five years, despite relative stability in terms of ratio to

GDP compare to the previous year (Chart 6.20). The

rapid expansion in economic liquidity is an indication of

potential for future inflationary pressure1 (Chart 6.21).

As a result of this nominal expansion, real M1 and M22

growth reached 21.0% and 12.3% (Chart 6.22).

1 In the chart, M1 growth is a leading indicator for inflation 18 months forward.

2 Calculated by CPI inflation.