Indonesia: Domestic demand drives growth

While many markets struggled with debt and fall-out from the world economic crisis in 2011, Indonesia bucked global trends by recording its fastest rate of growth in 15 years. Buoyed by strong domestic demand and huge resource wealth, Indonesia’s economy grew 6.46% last year, making it a magnet for investors who have also been attracted by its macroeconomic stability.

Foreign direct investment (FDI) reached $20bn in 2011, up 20% from the previous year, making the country one of the largest and fastest-growing economies in the world.

With a population of about 240m, domestic demand is playing a key role in driving Indonesia’s growing market. Consumption accounted for 55.5% of GDP in 2011, which is helping to provide Indonesia with some protection against international fluctuations in prices and demand.

The global economic recovery has seen particularly strong growth in commodity-hungry emerging markets, helping to bolster Indonesia’s exports while also boosting investment in industries such as mining. Exports hit a record $203.6bn in 2011, contributing 26.3% to GDP.

Much of Indonesia’s success in building growth can be traced back to sound fiscal and monetary policy and a reinforced financial system introduced in the wake of the 1997/98 Asian economic crisis. Indonesia instituted an overhaul of its macroeconomic structures and moved to build sound, economic foundations following the crisis.

Bank Indonesia, the country’s central bank, took steps to cool inflationary pressures and cut rates to encourage demand, and fiscal policy has also been tighter over the past decade. Banks remain generally well-capitalised, having avoided overexposure to the bad assets that triggered the more recent economic crisis of the last three years in some other financial institutions.

The country’s strong economic performance at the end of 2011 was boosted by two interest rate cuts in the year, which were aimed at offsetting the effects of a cooling global economy and should help maintain performance in early 2012. A third cut brought the interest rate to 5.75% earlier this year.

Growth forecasts for this year hover around 6-6.5%, with the IMF forecasting 6.3%. As the IMF Executive Board noted in October 2011, “cautious policymaking [...] has underpinned a strong macroeconomic performance during the global crisis and a favourable growth outlook”. Analysts are likely to view anything above 5% as an excellent performance, given current uncertainty caused by concerns about how the Eurozone and China’s economy will perform in 2012.

Indonesia will also be hoping that the recent decision of international ratings agencies Fitch and Moody’s to raise the country’s rating to investment grade will strengthen its bid to attract further investment. However, observers have also highlighted a number of areas causing concern among investors, particularly shortfalls in the country’s infrastructure.

The Doing Business 2012 report published by the World Bank and International Finance Corporation gave Indonesia a disappointing world ranking of 129, pointing out problems that need addressing such as infrastructure connectivity and contract enforcement.

Critics have referred to a shortage of professionally-trained human resources, particularly in the knowledge-intensive sectors which Indonesia hopes to nurture, and the need for the country to cultivate a more business-friendly climate by cutting red tape. Further regulatory liberalisation would also be welcomed by the business community, particularly in labour legislation, company law and sectors in which foreign investment has been limited.

The threat of a serious escalation of the eurozone crisis and a second global recession may pose further risks for Indonesia’s outlook, although the country will likely look to domestic demand to compensate for any slowdown in exports.

While slow growth elsewhere will continue to make Indonesia’s solid investment returns attractive by comparison, a serious international crisis could lower growth across the board. Indonesia could also become more susceptible to international fluctuations as it looks to strengthen its connections in the global market which will inevitably reduce insulation from external financial problems.

The government plans further issues this year which could help fund much-needed investments in infrastructure and public services. It also recently passed legislation aimed at making it easier for businesses to acquire land for infrastructure development.

The authorities will be hoping that these measures, together with others which include a drive to strengthen Indonesia’s transportation network and power supply, send a signal to investors that the country is tackling its challenges and looking to reinforce its position as one of the 20 largest economies in the world.