IEQJUN2016 FINALforweb

June 2016
Resilience through reforms
Supported by funding from the Australian Government

(Department of Foreign Aﬀairs and Trade, DFAT), under the
Support for Enhanced Macroeconomic and Fiscal Policy Analysis
(SEMEFPA) program.
INDONESIA ECONOMIC QUARTERLY
June 2016
Preface
The Indonesia Economic Quarterly (IEQ) has two main aims. First, it reports on the key
developments over the past three months in Indonesia’s economy, and places these in a
longer-term and global context. Based on these developments, and on policy changes over
the period, the IEQ regularly updates the outlook for Indonesia’s economy and social
welfare. Second, the IEQ provides a more in-depth examination of selected economic and
policy issues, and analysis of Indonesia’s medium-term development challenges. It is
intended for a wide audience, including policymakers, business leaders, financial market
participants, and the community of analysts and professionals engaged in Indonesia’s
evolving economy.
The IEQ is a product of the World Bank’s Jakarta office and receives editorial and strategic
guidance from an editorial board chaired by Rodrigo Chaves, Country Director for
Indonesia. The report is compiled by the Macroeconomics and Fiscal Management Global
Practice team, under the guidance of Shubham Chaudhuri, Practice Manager, Ndiame Diop,
Lead Economist and Hans Anand Beck, Senior Economist. Led by Elitza Mileva, Country
Economist, and with responsibility for Part A, editing and production, the core project team
comprises Magda Adriani, Arsianti, Masyita Crystallin, Indira Maulani Hapsari, Ahya Ihsan,
Taufik Indrakesuma, Yue Man Lee, Dhruv Sharma, Violeta Vulovic, and Kelly Wyett.
Administrative support is provided by Titi Ananto. Dissemination is organized by Jerry
Kurniawan, GB Surya Ningnagara, Kurniasih Suditomo, Nugroho Sunjoyo, and Suryo
Utomo Tomi, under the guidance of Dini Djalal.
This edition of the IEQ also includes contributions from Christopher Juan Costain and
Tatiana Nenova (Part B.1, High lending rate), Babatunde Abidoye, Massimiliano Cali, and
Stephen Marks (Pomona College) (Part B.2, Trade protection and domestic prices), Ndiame
Diop and Fitria Fitrani (Part C.1, Reviving manufacturing competitiveness), Taufik
Indrakesuma and Matthew Wai-Poi (Part C.2, Fiscal policy and inequality). The report also
benefited from discussion with and in-depth comments from Nathaniel Adams, Sarah
Moyer, Shudhir Shetty, Nikola L. Spatafora, Amanda Apsden and Nikhilesh Bhattacharya
(Australia Department of Foreign Affairs and Trade), Ben Bingham (IMF), David Nellor
(Australia Indonesia Partnership for Economic Governance).
This report is a product of the staff of the International Bank for Reconstruction and
Development/the World Bank, supported by funding from the Australian government
under the Support for Enhanced Macroeconomic and Fiscal Policy Analysis (SEMEFPA)
program.
The findings, interpretations, and conclusions expressed in this report do not necessarily
reflect the views of the Executive Directors of the World Bank or the governments they
represent, or the Australian Government. The World Bank does not guarantee the accuracy
of the data included in this work. The boundaries, colors, denominations, and other
information shown on any map in this work do not imply any judgment on the part of the
World Bank concerning the legal status of any territory or the endorsement or acceptance of
such boundaries.
The photographs are copyright of the World Bank, except that of Part B, which is copyright
of Masyitha Mutiara Ramadhan. All rights reserved.
For more World Bank analysis of Indonesia’s economy:
For information about the World Bank and its activities in Indonesia, please visit
www.worldbank.org/id.
To receive the IEQ and related publications by email, please email [email protected].
For questions and comments, please email [email protected].
Table of contents
PREFACE .............................................................................................................................. III
EXECUTIVE SUMMARY: RESILIENCE THROUGH REFORMS .................................... I
A. ECONOMIC AND FISCAL UPDATE ............................................................................... 1
1. The global economy is not yet supportive ..................................................................................... 1

2. Weaker first-quarter activity highlights growth risks ..................................................................... 2
3. Headline inflation moderated but food prices remain volatile ...................................................... 5
4. The private sector experienced net capital outflows in Q1 2016 .................................................... 6
5. Domestic credit growth remains weak despite monetary easing .................................................. 8
6. Budget execution has improved but revenues remain weak.........................................................10
7. Addressing fiscal revenue constraints has become a priority .......................................................15
B. SOME RECENT DEVELOPMENTS IN INDONESIA’S ECONOMY ........................ 16
1. Why are lending rates and net interest margins high in Indonesia?.............................................16
a. What components drive high NIMs in Indonesia? .......................................................................................... 17
b. What are the underlying structural factors behind high NIMs? ...................................................................... 18
c. Inducing banks to lower rates can hurt long-term growth ............................................................................... 19
2. The price of trade protectionism in Indonesia..............................................................................21
a. Why are non-tariff measures potentially harmful? ............................................................................................ 21
b. What is the impact of NTMs on domestic prices? .......................................................................................... 22
c. Are domestic producers being protected? ....................................................................................................... 25
C. INDONESIA 2018 AND BEYOND: A SELECTIVE LOOK ........................................... 27
1. Reviving manufacturing competitiveness .................................................................................... 27

a. Indonesia’s manufacturing journey: knocked off course by the 1997 crisis .................................................... 27
b. Manufacturing exports: drilling down beyond the aggregate numbers .......................................................... 29
c. Regaining competitiveness in manufacturing ................................................................................................. 30
d. How to make manufacturing an engine of growth again................................................................................ 34
2. Fiscal policy could better target inequality reduction.................................................................. 36
a. Public spending in 2012 did not tackle inequality effectively .......................................................................... 37
b. The recent fuel subsidy reform helped reduce poverty and inequality ........................................................... 39
APPENDIX: A SNAPSHOT OF INDONESIAN ECONOMIC INDICATORS ................ 40

LIST OF FIGURES
Figure 1: Global growth and trade momentum weakened… .................................................... 2
Figure 2: … while Indonesia’s net commodity terms of trade are slightly up .......................... 2
Figure 3: Private consumption and investment supported growth in Q1 2016… ..................... 3
Figure 4: Paddy farmers’ real incomes have weakened since September 2015 ......................... 3
Figure 5: Business confidence indicators have improved ......................................................... 4
Figure 6: Inflation eased as energy prices continued to decline… ........................................... 5
Figure 7: … while food prices remained volatile....................................................................... 5
Figure 8: A fall in other investment drove a balance of payments deficit ................................. 7
Figure 9: Imports declined at a slower pace than in previous quarters .................................... 7
Figure 10: Indonesia's private sector has reduced its foreign borrowings ................................ 8
Figure 11: Capital inflow to emerging markets is expected to improve slightly in 2016 ........... 8
Figure 12: Emerging market currency volatility rose in Q2 2016 .............................................. 9
Figure 13: BI’s new policy rate is the 7-day reverse repo .........................................................10
Figure 14: Credit and deposit growth continue to fall ..............................................................10
Figure 15: Year-to-date revenue collection has seen a broad-based decline … ....................... 11
Figure 16: … including corporate income taxes and VAT ....................................................... 11
Figure 17: Indonesian interest rates are higher than those in peer countries ..........................17
Figure 18: NIMs are also higher in Indonesia than in ASEAN and G20 peers .......................17
Figure 19: High overhead costs partly explain higher NIMs… ...............................................18
Figure 20: … as does low fee income .......................................................................................18
Figure 21: An incipient trade liberalizing trend has been observed .........................................21
Figure 22: Trade restrictions kept domestic wheat flour prices high after 2008 ..................... 23
Figure 23: Estimates suggest that recent trade policies increased prices across sectors ....... 23
Figure 24: Consumer goods, in particular food, saw the largest price rises due to trade
measures ............................................................................................................... 24
Figure 25: Rates of protection are even higher when calculated in terms of value added ...... 24
Figure 26: Indonesia’s manufacturing growth is no longer what it used to be… ................... 28
Figure 27: … and the economy de-industrialized prematurely............................................... 28
Figure 28: Indonesia’s global manufacturing market share is low and stagnant ................... 28
Figure 29: Low-tech products dominate Indonesia’s merchandise export basket ................. 29
Figure 30: Several medium-tech exports have grown dramatically…..................................... 30
Figure 31: … while hi-tech exports have shrunk in recent years............................................. 30
Figure 32: The REER appreciated strongly between 2000 and 2011… ....................................31
Figure 33: … with recent depreciation associated with rising manufacturing export growth 31
Figure 34: Average monthly wages in manufacturing are low in Indonesia… ....................... 32
Figure 35: … but unit labor costs are relatively high .............................................................. 32
Figure 36: Fiscal policy in Indonesia has not been very effective in reducing inequality ...... 36
Figure 37: In 2012, Indonesia spent the most on energy subsidies and the least on cash
transfers ................................................................................................................ 38
Figure 38: Direct transfers – most effective at reducing inequality– had the lowest budget 38
Figure 39: Within transfer programs the most effective, PKH, also had the lowest budget ... 38
Figure 40: But spending on education is inequality-reducing ................................................ 38
LIST OF APPENDIX FIGURES

Appendix Figure 1: Quarterly and annual GDP growth.......................................................... 40
Appendix Figure 2: Contributions to GDP expenditures ....................................................... 40
Appendix Figure 3: Contributions to GDP production........................................................... 40
Appendix Figure 4: Motorcycle and motor vehicle sales ........................................................ 40
Appendix Figure 5: Consumer indicators ............................................................................... 40
Appendix Figure 6: Industrial production indicators ............................................................. 40
Appendix Figure 7: Balance of payments ................................................................................41
Appendix Figure 8: Current account components ...................................................................41
Appendix Figure 9: Exports of goods ......................................................................................41
Appendix Figure 10: Imports of goods .....................................................................................41
Appendix Figure 11: Reserves and capital flows ......................................................................41
Appendix Figure 12: Inflation and monetary policy.................................................................41
Appendix Figure 13: Monthly breakdown of CPI ................................................................... 42
Appendix Figure 14: Inflation comparison across countries................................................... 42
Appendix Figure 15: Domestic and international rice prices .................................................. 42
Appendix Figure 16: Poverty and unemployment rate ............................................................ 42
Appendix Figure 17: Regional equity indices ......................................................................... 42
Appendix Figure 18: Selected currencies against USD ........................................................... 42
Appendix Figure 19: 5-year local currency govt. bond yields.................................................. 43
Appendix Figure 20: Sovereign USD bond EMBIG spread ................................................... 43
Appendix Figure 21: Commercial and rural credit and deposit growth .................................. 43
Appendix Figure 22: Banking sector indicators ...................................................................... 43
Appendix Figure 23: Government debt ................................................................................... 43
Appendix Figure 24: External debt ......................................................................................... 43
LIST OF TABLES
Table 1: In the base case, GDP growth is projected at 5.1 percent in 2016 ..............................iii
Table 2: In the base case, GDP growth is projected at 5.1 percent in 2016 and 5.3 percent in
2017 .............................................................................................................................. 6
Table 3: The current account deficit is expected to widen slightly in 2016 .............................. 8
Table 4: The World Bank projects lower revenue and expenditure than in the 2016 Budget ..14
LIST OF APPENDIX TABLES

Appendix Table 1: Budget outcomes and projections ............................................................ 44
Appendix Table 2: Balance of payments ................................................................................. 44
Appendix Table 3: Indonesia’s historical macroeconomic indicators at a glance.................. 45
Appendix Table 4: Indonesia’s development indicators at a glance....................................... 46
Resilience through reforms Indonesia Economic Quarterly
Executive summary: Resilience through reforms
With the global A string of disappointing first-quarter global data have signaled that the world
recovery yet to be recovery projected for 2016 has not yet gotten off the ground. On June 7, the
realized, Indonesia’s World Bank downgraded its global growth forecast by half a percentage point, to
resilience stands out 2.4 percent. Half of this revision is due to the expected significant slowdown in
among commodity growth in commodity-exporting emerging and developing countries to just 0.4
exporters percent this year. The Indonesian economy stands in sharp contrast to the
performance of other commodity exporters, with GDP growth forecasted at 5.1
percent in 2016. However, when compared to regional peers, Indonesia’s expected
growth is higher than in Malaysia (4.4 percent) and Thailand (2.5 percent), but lower
than in the Philippines (6.4 percent) and Vietnam (6.2 percent).
Sound monetary A number of good policies have contributed to Indonesia’s resilience. First, prudent
policy and higher monetary and exchange rate policies, along with international financial conditions
public investment that are more favorable than a year ago, have helped reduce inflation and stabilize
have supported the the Rupiah. These factors, as well as lower energy prices, have supported aggregate
economy, while household consumption. Second, public infrastructure spending has become a
deregulation priority within Indonesia’s limited fiscal space. In addition, the policy reforms
measures may have enacted in the first quarter of 2016 as part of the economic policy packages are likely
boosted business to yield more meaningful medium-term improvements in trade policy and the
confidence… investment climate than the measures announced in the previous quarter. While the
latter comprised a mix of restricting and liberalizing regulations, most recent actions
are expected to be liberalizing. All of these measures, taken together, may mark a
turning point in public policy-making, which in turn may be driving the recent
improvement in business sentiment.
… but the downside However, Indonesia’s outlook is subject to pronounced downside risks. A further
risks to growth have slowdown in major emerging markets, anemic recovery in advanced countries,
recently intensified global financial market volatility, and a longer-than-expected period of low
June 2016 THE WORLD BANK | BANK DUNIA

i
commodity prices are the main international risks. Domestic fiscal risks are also
elevated, as the draft 2016 Revised Budget submitted to Parliament on June 2
assumes considerable revenues from the tax amnesty. If the tax amnesty inflows
disappoint, significant additional expenditure cuts would have to be made, putting at
risk the infrastructure spending momentum. Finally, most recent deregulation
measures focus on procedural improvements. An exception to this is the recent
relaxation of some of the constraints to foreign investments, although many sectors
still remain closed or partly closed to foreign investments. More fundamental
changes in trade policy and the investment climate, as well as effective
implementation at the national and subnational level, may be needed to drive a
sustained rise in private investment.
GDP growth in Q1 In the first quarter of 2016, Indonesia’s real GDP grew at 4.9 percent year-on-year
2016 was 4.9 percent (yoy), a slightly slower pace than expected mainly due to weaker than anticipated
yoy, with public public spending. Private consumption growth remained resilient at 5 percent yoy,
spending lower than though stagnant real incomes continue to weigh on the consumption of households
expected in the lowest deciles of the income distribution, such as paddy farmers. Fixed
investment growth decelerated to 5.6 percent yoy in Q1 2016, compared with 6.9 in
the last quarter of 2015, on account of lower central government capital spending.
Despite the slow start to the year, government investment is expected to accelerate
in the coming quarters, following the historical trend.
The current account Exports and imports continued to decline both in volume and value terms. The
deficit narrowed to broad-based decrease in exports was driven by weak global demand, a real exchange
2.1 percent of GDP, rate appreciation of 3.1 percent in Q1 2016, and weaker prices for all major
as imports fell faster commodities relative to Q1 2015. Both raw material and capital goods imports
than exports declined, while consumer goods (net of fuel) imports increased year on year for the
first time since Q1 2014. The current account deficit narrowed to 2.1 percent of
GDP on account of a sharper quarterly fall in imports than in exports.
The private sector Despite the improvement in the current account balance, the balance of payments
experienced net recorded a small deficit in Q1 2016. Direct investment contracted slightly from the
capital outflows in previous quarter to USD 2.2 billion. Portfolio flows remained robust at USD 4.4
Q1 2016 billion, driven entirely by long-term government borrowing. However, other
investment posted a quarterly deficit on account of private deposit outflows and a
reduction in foreign borrowing by the private sector.
Fiscal risks remain, Turning to fiscal policy, by the end of April revenue collection had declined by 9.8
as the draft 2016 percent compared to the same period in 2015, owing mainly to lower commodity
Revised Budget prices and domestic demand, as well as several revenue policy and administration
relies on significant changes. At the same time, total expenditure increased by 9.2 percent. In response
tax amnesty to the weaker revenue outlook, the Government submitted to Parliament a draft
revenues 2016 Revised Budget. Projected revenues are IDR 88.0 trillion lower than in the
original budget, as the negative impact of weaker-than-expected macroeconomic
conditions is offset by significant anticipated revenues from the tax amnesty. The
ambitious tax amnesty goal has increased the risk of additional, potentially large
expenditure cuts, including to priority spending projects, later in the year.

ii
The baseline outlook Looking ahead, the Table 1: In the base case, GDP growth is projected at 5.1
of 5.1 percent GDP World Bank projects percent in 2016
growth in 2016 GDP to increase by 2015 2016p 2017p
remains unchanged 5.1 percent in 2016 (Annual percent

Real GDP 4.8 5.1 5.3
change)
and 5.3 percent in
Consumer price (Annual percent
2017, unchanged index change)
6.4 3.9 4.4
from the March 2016 Current account (Percent of
-2.1 -2.3 -2.5
IEQ (Table 1). balance GDP)
Private consumption (Percent of
Budget balance -2.6 -2.8 n.a.
is forecasted to pick GDP)
up slightly on Source: BI; BPS; Ministry of Finance; World Bank staff projections
account of moderate inflation, a relatively stable Rupiah, lower energy prices, an
expected increase in the personal income tax threshold, and a 14th monthly salary for
civil servants. Government expenditure, in particular on capital, is projected to
increase in the next three quarters in line with the historical trend. World Bank
calculations show that 90 percent of the original 2016 Budget investment target
could be achieved with an even lower revenue forecast than in the 2016 Revised
Budget, higher fiscal deficit of 2.8 percent of GDP, and non-priority expenditure
cuts (see Section 6). Towards the end of 2016 and beyond, the outlook depends on
private investment growth picking up as it responds to the Government’s business
climate reform efforts and the gradual recovery in global growth and trade.
High domestic food Over the past several months, CPI inflation moderated to 3.3 percent yoy in May.
prices are one of the Modest headline inflation, however, has masked persistently high food price
costs of trade inflation (7.7 percent yoy in May). One of the reasons for high domestic food price
distortions on inflation, when global food prices have declined in the past several years, is trade
Indonesia’s economy protectionism. According to data collected by the World Bank and Australia
Indonesia Partnership for Economic Governance (AIPEG), the number of
product-level non-tariff measures (NTMs) on Indonesian imports doubled between
2009 and 2015, expanding the number of products covered by NTMs by over 38
percent. The same study shows that, in 2015, the domestic price of milled rice was
68 percent higher than it would have been in the absence of trade measures. After
accounting for the fact that certain products are used both as final goods and as
inputs to production, the analysis suggests that, in 2015, overall trade policies have
increased the cost of living in Indonesia by 7.4 percent compared to a scenario in
which no trade restrictions are imposed.
High interest rates Moderate inflation is also one of the reasons Bank Indonesia (BI) lowered its policy
and net interest rate four times this year. However, the reduction in the BI reference rate has not yet
margins (NIMs) in been fully transmitted to bank lending and deposit rates. This has contributed to the
Indonesia are the perception that interest rates and NIMs charged by Indonesian banks are higher
result of bank than necessary. A study by the World Bank shows that various challenges in the
income and income and expenditure structure of Indonesian banks, notably low fee income,
expenditure high overhead expenses, high capital ratios, and lower provisioning for bad loans,
structure, shallow explain why NIMs are high. Further empirical analysis reveals that underdeveloped
financial markets, equity and debt markets and crowding out by government borrowing are key
and crowding out by structural determinants of NIMs in Indonesia. International experience indicates
government that the long-term sustainable solution to this type of challenge is to augment the
borrowing size of the financial market and improve competition.

iii
Some of the With the sharp decline in commodity windfall export revenues, boosting non-
Government’s commodity exports has emerged as a key priority. Indonesia’s current merchandise
current policy export basket is strongly dominated by “low-tech” products (one-third of goods
priorities will help exports in 2014), followed by medium-tech industries’ exports which were 28
revive manufacturing percent. Hi-tech exports (mainly electronics) collapsed following the 1997 crisis. So
competitiveness, but how can Indonesia make manufacturing an engine of growth again? The
more needs to be Government could consider focusing its efforts on supporting the (export)
done industries that have been growing very fast despite many obstacles and on
leveraging the country’s natural resource abundance. A strategic and transparent
partnership with the private sector is also important. Keeping inflation low through
investments in agricultural productivity and through lower trade barriers would
support export growth by limiting real exchange rate appreciation. Finally, higher
infrastructure spending and regulatory reform, which have already become a policy
priority, would help improve competitiveness.
Fiscal policy in Recent discussion of fiscal policy has focused on short-term fiscal developments
Indonesia has not and their growth impact. However, fiscal policy is also one of the main tools
been very effective in available to governments to reduce inequality. In Indonesia, inequality has risen
reducing inequality, since the early 2000s and many Indonesians believe urgent action is needed.1 Tax
but the fuel subsidy and spending policy choices have been made with a view to reducing inequality in a
reform has helped number of countries. In Brazil, for example, the Gini coefficient (a measure of
inequality) was 14 points lower after accounting for the impact of fiscal policy in
2009. According to a World Bank study, fiscal policy in Indonesia in 2012 reduced
the Gini coefficient by only 2.5 points. Further analysis showed that the
Government spent the least on the most effective programs and vice versa.
However, the 2015 fuel subsidy reform, and related compensation for the poor, has
helped reduce inequality, as savings were redirected into infrastructure, health, and
social assistance.
1 Part B.2 of the March IEQ discusses public concern about rising inequality in Indonesia.

iv
A. Economic and fiscal update
1. The global economy is not yet supportive

Early data show no Global monthly production and trade data point to slow first-quarter economic
signs yet of an activity. Furthermore, the risk appetite of international investors for emerging
emergent global market assets weakened with renewed uncertainty regarding the timing of the next
recovery change in US monetary policy. These factors have prompted downward revisions to
forecasts for 2016 world growth. According to the latest World Bank projections,
global growth is projected at 2.4 percent, unchanged from the pace of 2015. A slight
improvement in Indonesia’s international environment has come only from
somewhat higher commodity prices in recent months. Overall, the downside risks to
Indonesia’s near-term outlook related to external conditions have intensified.
Instead of gaining Monthly global trade and industrial production data point to a weak start to 2016.
momentum, as According to the March 2016 CPB World Trade Monitor, global import volumes
expected, global contracted by 1.8 percent in the first quarter relative to the preceding three months
growth and trade lost (Figure 1).2 Import momentum in advanced countries was marginally positive,
steam in Q1 2016… driven by the Euro Area and Japan, while it contracted further in emerging markets,
in particular in Asia and Latin America. Global industrial production (excluding
construction) grew at only 0.2 percent in the same period, with momentum negative
in the US and Japan and positive and improving in the Euro Area and other
advanced countries in Q1 2016. Among emerging markets, industrial production
growth remains positive, but is decelerating in Asia and has remained negative in
Latin America since December 2014. In addition, global financial market volatility
has gone up somewhat in recent months, as the US Federal Reserve deliberates the
next interest rate increase, while recent US economic data remain mixed.
2 CPB Netherlands Bureau for Economic Policy Analysis: http://www.cpb.nl/en/figure/cpb-world-

trade-monitor-march-2016.

1
Figure 1: Global growth and trade momentum Figure 2: … while Indonesia’s net commodity terms of
weakened… trade are slightly up
(three-month on three-month growth in seasonally adjusted data, (index, 2011=100)
percent)
2.5 120
2.0
Imports 100
Industrial
1.5 production
1.0 80
0.5
0.0 60
-0.5
40
-1.0
-1.5 20
-2.0
0
-2.5
Mar-14 Sep-14 Mar-15 Sep-15 Mar-16
Jan-15 Apr-15 Jul-15 Oct-15 Jan-16
Note: Last observation is March 2016. Note: Net trade-weighted price index of Indonesia’s six main export
Source: CPB Netherlands Bureau for Economic Policy Analysis; commodities (rubber, base metals, coal, oil, gas, and palm oil).
World Bank staff calculations Source: BPS; World Bank; World Bank staff calculations
… but the prices of At the same time, some global commodity prices have risen in recent months,
some of Indonesia’s resulting in a small improvement in Indonesia’s terms of trade (Figure 2). The prices
main export of rubber, base metals, coal, and palm oil have risen since January or February 2016.
commodities have Global oil prices also bottomed out in January, but an increase in the price of crude
increased in recent oil reduces Indonesia’s net terms of trade as it is a net oil importer (though higher
months oil prices do bring in more government revenues). Overall, the World Bank’s net
trade-weighted price index of Indonesia’s six main export commodities increased by
9.0 percent in Q1 2016 relative to the last quarter of 2015, but remained 19.6
percent below its level a year ago.
2. Weaker first-quarter activity highlights growth risks
GDP growth in Q1 In the first quarter of 2016, Indonesia’s real GDP grew at 4.9 percent year-on-year
2016 was 4.9 percent (yoy), a slightly slower pace than expected mainly due to weaker than anticipated
yoy, with public public spending (Figure 3). Private consumption remained resilient, supported by low
spending lower than inflationary pressures in the first quarter and a stable Rupiah. Despite the slow start
expected to the year, government investment is expected to accelerate in the remainder of the
year following the historical trend. The growth outlook for 2016 remains unchanged
at 5.1 percent yoy, supported by gradually improving domestic demand, including an
acceleration in government capital spending. However, the outlook is subject to
significant downside fiscal and external risks.
Private consumption Private consumption expenditure grew at 5.0 percent yoy, the same pace as in H2
remained resilient… 2015. The stable Rupiah and lower inflation supported overall household spending,
while stagnant real incomes continue to weigh on the consumption of households in
the lowest deciles of the income distribution. According to the August 2015 National
Labor Force Survey (Sakernas), the national average wage increased by 0.1 percent
yoy in real (CPI-deflated) terms, after declining by 2.2 percent yoy in 2014. However,
the average real monthly wage in agriculture, forestry, and fisheries, where a third of
the employed work, declined by 2.3 percent yoy in 2015. Among farmers, paddy
farmers have recently been under particular pressure from lower real incomes. The

2
rice farmers’ terms of trade, i.e. the ratio of the prices they receive for their output to
the cost they pay for production and investment, declined in Q4 2015 (Figure 4). The
terms of trade for all farmers did not deteriorate in the same period.
Figure 3: Private consumption and investment Figure 4: Paddy farmers’ real incomes have weakened
supported growth in Q1 2016… since September 2015
(contributions to GDP growth yoy, percentage points) (farmers’ terms of trade index, seasonally adjusted data)
Stat. discrepancy*
Net exports 112
Investment
Government consumption 110
10 Private consumption
GDP All farmers
8 108
6 106
4 104
2 102
0 100 Paddy farmers
-2 98
-4 96
Mar-13 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15
Note: * Statistical discrepancy includes changes in inventories. Note: Farmers’ terms of trade is the ratio of the index of producer
Source: BPS; World Bank staff calculations prices received by farmers to the index of costs paid by farmers for
production and investment.
Source: BPS; World Bank staff calculations
… while public In contrast to the resilience of overall household spending, government consumption
consumption growth fell to 2.9 percent yoy, down from 7.1 and 7.3 percent yoy in the previous two
spending weakened quarters. However, Q1 2016 public spending was broadly in line with the historical
trend of low first-quarter spending and was significantly higher compared with the
average levels observed in the past five years (see Section 6).
Low government Fixed investment grew by 5.6 percent yoy in Q1 2016, compared with 6.9 in the last
spending on capital quarter of 2015. The slowdown was due to low central government capital spending
also contributed to – only IDR 10 trillion in the first three months of the year (5 percent of the annual
slower fixed budget target). The first-quarter share of central government investment was only 1.0
investment growth percent of total nominal fixed investment, compared with 13.3 percent in Q4 2015.
Despite a significant improvement in public capital expenditure disbursement over
the same period last year (see Section 6), the very low share of central government
investment implies that most of the first-quarter investment growth was supported
by the private sector. This may reflect the fact that corporate profits in some sectors,
such as consumer goods and telecommunications, improved considerably in the last
quarter of 2015 and the first quarter of this year.3
The contribution of Export volumes declined by 3.9 percent yoy, while import volumes decreased by 4.2
net exports to growth percent yoy. Thus, net exports contributed 0 percentage points to year-on-year GDP
was zero growth, an improvement from the negative contribution in the previous quarter.
However, there are tentative signs that trade may have bottomed out as the pace of
decline in both real exports and imports decelerated significantly in Q1 2016. By
comparison, in the last quarter of 2015, export and import volumes declined by 6.4
percent yoy and 8.1 percent yoy, respectively.
3 This is based on data for around 100 large companies traded on the Indonesia Stock Exchange.

3
Sentiment indicators Business and consumer Figure 5: Business confidence indicators have
have improved confidence has increased in improved
recently, while other recent months. The BI (indices, points)
high-frequency data business activity indices 60
provide mixed rose sharply in early 2016
signals and the Nikkei/Markit 50
purchasing managers index
(PMI) increased to above PMI
40
50 in March, signaling
improving activity (Figure
30
5). After the somewhat
weaker first three months
of 2016, commercial 20 Business activity:
expectation
cement sales growth picked
up in April. However, 10
capital goods imports Business activity: realization
contracted again in the first 0
quarter, by 18.9 percent Mar-14 Sep-14 Mar-15 Sep-15 Mar-16
Note: A PMI value above 50 indicates an improvement in
yoy. Similarly, consumer economic activity.
confidence was up in the Source: BI; Nikkei/Markit; World Bank staff calculations
first four months of the
year but other high-frequency consumption indicators remain mixed. Motorcycle
sales contracted by 8.3 percent yoy in April, while car sales growth improved to 3.6
percent yoy (following negative growth since August 2014).
In the base case, The World Bank’s projection for GDP growth remains at 5.1 percent for 2016 and
GDP growth, at 5.1 5.3 percent in 2016, despite lower than expected public spending in the first quarter.
percent in 2016, Private consumption is expected to pick up slightly on account of moderate inflation,
remains unchanged a relatively stable Rupiah, and the April cut in energy prices. The announced increase
from the March in the personal income tax threshold from IDR 36 million to IDR 54 million per year
2016 IEQ… in 2016, as well as a 14th monthly salary for civil servants, will provide an additional
boost to household spending. The baseline also takes into account accelerated
government expenditure, in particular capex, in the next three quarters, in line with
the historical trend. However, towards the end of 2016 and beyond the outlook
depends on private investment growth picking up as it responds to the Government’s
business climate reform efforts and the slow recovery in global growth and trade.
Although still expected to decline overall in 2016, exports have been revised up on
account of better-than-expected first-quarter data.
… but the downside The baseline scenario is subject to significant downside risks. On the domestic side,
risks to the outlook a higher than projected revenue shortfall would constrain the Government’s
have increased infrastructure plans (see Section 6), while persistently weak credit growth may limit
the recovery in private investment (see Section 5). The main external risks are
weaker than expected global growth and trade and the possibility of higher global
financial market volatility (see Section 1). There are upside risks related to potential
revenues from the Tax Amnesty program which would boost both public and
private spending. Fixed investment could benefit from the capital injections into
state-owned enterprises, if they are approved by Parliament as part of the 2016
Revised Budget (see Section 6).

4
3. Headline inflation moderated but food prices remain volatile

Inflationary Year to date headline inflation has been modest, partly driven by lower energy
pressures are lower, prices. The Government lowered fuel prices by 11.5 percent in April. As a result,
partly on account of average transport prices declined by 2.4 percent month on month. Headline
lower energy inflation declined further to 3.3 percent yoy in May, from 3.4 percent yoy in April
prices… (Figure 6). At the same time, core inflation, which excludes the more volatile food
and energy prices, has decelerated in the past six months, reaching 3.4 percent yoy
in May.
Figure 6: Inflation eased as energy prices continued to Figure 7: … while food prices remained volatile
decline… (change yoy, percent)
(change yoy, percent)
16 Ramadan Ramadan
120
Rice
Onion
12 80 Chili
Food 40
8 Beef
Headline 0
Sugar Rice
Soybean
4
Core -40
0 -80
May-14 Jan-15 Sep-15 May-16 May-14 Jan-15 Sep-15 May-16
Note: Food prices are a weighted average of the raw and processed Source: BPS; World Bank; World Bank staff calculations
food price components of CPI.
… while food prices However, the stable headline inflation masks persistently high food price inflation.
remain persistently In May, raw food prices increased by 7.7 percent yoy and processed food prices by
high 6.1 percent. The prices of several key foods, such as rice, onion, chilies and beef,
remained high, reflecting insufficient supply and distribution challenges (Figure 7).
Between October 2015 and March 2016, rice price inflation moderated significantly,
likely on account of the Government allowing higher imports during that period.
However, in April and May rice price inflation rose considerably again – to 5.3
percent yoy in May from 1.6 percent yoy in March.
Inflation is expected The World Bank projects an annual average CPI inflation rate of 3.9 percent in
to remain moderate, 2016, rising to 4.4 percent in 2017. Inflation is expected to remain within the BI
but food prices are a target range of 3 – 5 percent per year. Food prices are expected to remain volatile
significant risk especially during Ramadan and the Idul Fitri holiday during June 5 – July 7. Section
ahead of Idul Fitri B.2 of this IEQ provides evidence of the inflationary impact of international trade
restrictions. To limit food price inflation in the short term, the Government could
allow seamless imports of key food commodities.

5
Table 2: In the base case, GDP growth is projected at 5.1 percent in 2016 and 5.3 percent in 2017
(percentage change, unless otherwise indicated)
Annual YoY in Fourth Quarter Revision to Annual
2015 2016 2017 2015 2016 2017 2016 2017
1. Main economic indicators
Total Consumption expenditure 4.9 4.8 5.2 4.8 5.0 4.0 -0.2 0.0
Private consumption expenditure 4.8 5.1 5.2 5.0 5.1 4.0 0.2 0.0
Government consumption 5.4 3.0 4.9 2.9 3.7 4.2 -3.0 -0.3
Gross fixed capital formation 5.1 5.2 5.3 5.6 4.6 4.2 0.1 0.1
Exports of goods and services -2.0 -1.1 3.6 -3.9 3.4 2.7 2.8 0.0
Imports of goods and services -5.8 -1.0 2.8 -4.2 1.5 2.6 -1.2 0.0
Gross Domestic Product 4.8 5.1 5.3 4.9 5.4 4.0 0.0 0.0
2. External indicators
Balance of payments (USD bn) -1.1 1.4 5.8 - - - -0.1 -1.9
Current account balance (USD bn) -17.8 -21.1 -24.9 - - - 0.0 1.1
As share of GDP (percent) -2.0 -2.3 -2.5 - - - 0.0 0.0
Trade balance (USD bn) 4.8 4.2 3.0 - - - 2.1 4.9
Capital & financial acc. bal. (USD bn) 17.1 22.5 30.7 - - - -0.1 -3.0
3. Fiscal indicators
Central gov. revenue (% of GDP) 13.1 12.1 - - - -0.1 -
Central gov. expenditure (% of GDP) 15.7 14.9 - - - -0.2 -
Fiscal balance (% of GDP) -2.6 -2.8 - - - 0.0 -
Primary balance (% of GDP) -1.2 -1.4 - - - 0.0 -
3. Other economic indicators
Consumer price index 6.4 3.9 4.4 4.8 4.0 4.7 -0.1 -0.2
GDP Deflator 4.2 2.9 4.5 4.0 3.6 4.5 -1.7 -0.4
Nominal GDP 9.2 8.1 10.1 9.2 8.8 10.1 -1.8 -0.4
4. Economic assumptions
Exchange rate (IDR/USD) 13389 13300 13300 - - - -500.0 -500.0
Indonesian crude price (USD/bl) 49 40 49 - - - 0.0 2.0
Note: Exports and imports refer to volumes from the national accounts. All figures are based on revised and rebased GDP. Exchange rate
and crude oil price assumptions are based on recent averages. Revisions are relative to projections in the March 2016 IEQ.
Source: BPS; BI; CEIC; World Bank staff projections
4. The private sector experienced net capital outflows in Q1 2016

A decline in other A large decline in other investment resulted in a small balance of payments deficit in
investment resulted the first quarter, following a large surplus in the previous quarter (Figure 8). The
in a small balance of current account deficit narrowed to 2.1 percent of GDP. However, this improvement
payments deficit was due to a sharper quarterly fall in imports than in exports. In Q1 2016, Indonesia’s
financial account balance also declined due to net private sector capital outflows,
although capital inflows into government bonds remained strong. External financing
risks from weak trade and short-term capital flow volatility remain elevated.

6
Figure 8: A fall in other investment drove a balance Figure 9: Imports declined at a slower pace than in
of payments deficit previous quarters
(USD billion) (contributions to year-on-year growth, percentage points)
20 Current account Direct investment 5
Portfolio investment Other investment
Overall balance Basic balance
15 0
10 -5
5 -10
0 -15
-5 -20
Fuel
Capital
-10 -25 Consumer goods net of fuels
Raw materials net of fuel
-15 -30 Imports
Mar-13 Mar-14 Mar-15 Mar-16 Mar-14 Mar-15 Mar-16
Note: Basic balance = direct investment + current account Source: BI; World Bank staff calculations
balance.
Source: BI; World Bank staff calculations
The current account The current account deficit improved slightly to 2.1 percent of GDP, from 2.4
deficit narrowed to percent in the previous quarter. The trade balance remained in surplus at USD 1.6
2.1 percent of GDP billion. Both exports and imports continued to decline, by 12.3 percent yoy and 12.5
in Q1 2016, as percent yoy, respectively. Exports decreased across all categories as a result of weak
imports fell faster global demand, a real exchange rate appreciation of 3.1 percent in Q1 2016, and
than exports weaker prices for all major commodities relative to Q1 2015.4 Both raw material and
capital goods imports declined, while consumer goods (net of fuel) imports
contributed 1.8 percentage points to year-on-year import growth, the first positive
growth (yoy) contribution since Q1 2014 (Figure 9).
Net private sector Turning to the financial account, the private sector experienced net capital outflows,
outflows drove a while net public sector inflows were positive (Figure 10). Direct investment
decline in the contracted slightly from the previous quarter to USD 2.2 billion. Portfolio flows were
financial account also slightly lower, but remained robust at 4.4 USD billion, driven entirely by long-
term government borrowing. However, government borrowing was somewhat lower
than its level in the first quarter of previous years, due to the government’s pre-
financing efforts in Q4 2015. Other investment posted a quarterly deficit, driven by
private deposit outflows, as well as a reduction in foreign borrowing by the private
sector.
4 The prices of crude palm oil and rubber increased in the first quarter of this year relative to Q4 2015.

7
Figure 10: Indonesia's private sector has reduced its Figure 11: Capital inflow to emerging markets is
foreign borrowings expected to improve slightly in 2016
(USD billion) (four-quarter moving average, USD billion)
Financial derivatives forecast
Net public capital flows Indonesia (LHS)
Net private capital flows 25 emerging markets (RHS)
20 30 350
Financial account
25 300
15
250
20
10 200
15
150
5
10
100
0 5 50
0 0
-5 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
Mar-13 Mar-14 Mar-15 Mar-16
Source: BI; World Bank staff calculations Source: The Institute of International Finance; World Bank staff
calculations
The current account The World Bank’s current Table 3: The current account deficit is expected to
deficit is expected to account deficit forecasts for widen slightly in 2016
widen to 2.3 percent 2016 and 2017 remain at 2.3 (USD billion unless otherwise indicated)
2015 2016 2017
of GDP in 2016 and and 2.5 percent of GDP,
Overall balance of
2.5 percent in 2017 respectively (Table 3). Given payments
-1.1 1.4 5.8
mixed commodity price As percent of GDP -0.1 0.2 0.6
developments so far in 2016, Current account -17.7 -21.1 -24.9
and a Q1 2016 fall in export As percent of GDP -2.0 -2.3 -2.5
revenues, exports are likely to Goods trade balance 13.3 12.6 13.8
Services trade balance -8.3 -8.4 -10.8
remain weak in 2016. The
Income -28.2 -30.7 -33.4
trade balance is expected to Transfers 5.5 5.4 5.5
remain positive, however, as Capital and financial
17.1 22.5 30.7
imports are expected to fall by accounts
more than exports. Overall, As percent of GDP 2.0 2.4 2.9
Direct investment 9.9 9.9 11.3
capital flows into Indonesia are
Portfolio investment 16.7 13.7 18.1
expected to improve slightly Financial derivatives 0.0 0.0 -0.1
throughout the remainder of Other investment -9.8 -1.1 1.4
2016, in line with the expected Memo:
increase in capital flows to Basic balance -7.7 -11.2 -13.6
emerging economies in general As percent of GDP -0.9 -1.2 -1.5
(Figure 11). Net government Note: Basic balance = direct investment + current account
balance.
bond flows are likely to be Source: BI; World Bank staff calculations
slightly lower than in 2015,
given the Government’s pre-financing of USD 3.5 billion in December 2015.
5. Domestic credit growth remains weak despite monetary easing
Financing conditions As in most emerging markets, financial asset prices in Indonesia have been affected
have been relatively by an increase in global financial market uncertainty. Domestic credit conditions
tight with weaker remain tight, with credit growth at almost seven-year lows. Furthermore, Bank
credit growth and Indonesia’s (BI) easing of monetary policy (three consecutive rate cuts earlier in the
lower capital inflows year) has not been transmitted effectively to lending and deposit rates. In an effort

8
to address this challenge, BI announced a change in its monetary policy framework:

from August 19, 2016 its main policy tool will be the 7-day reverse repo rate.
Financial asset The recovery seen in the Figure 12: Emerging market currency volatility rose
prices were volatile Rupiah in the first quarter of in Q2 2016
in the second quarter 2016 was halted in the (Index, Jan 4 = 100)
second quarter. In line with 115
other emerging market
currencies, the Rupiah 110
depreciated against the US USD/IDR
dollar in May and then 105
recovered, resulting in a 0.5
percent overall depreciation 100
between the end of March JP Morgan EMCI
and June 13 (Figure 12). In 95
comparison, in the same
period, the JP Morgan 90
Emerging Market Currency
Index (EMCI) depreciated 85
by 1.5 percent. The Jan-16 Mar-16 May-16
downward trend seen since Source: BI; JP Morgan; World Bank staff calculations
the beginning of this year in
government bond yields continued in Q2 2016. The yield on the 10-year bond fell
33 basis points between March 31 and June 13 to 7.6 percent. Bond yields are
significantly lower than they were a year ago when emerging markets experienced a
capital flow reversal.
Indonesian equities After increasing by 5.5 percent in the first quarter of 2016, the Jakarta Composite
have also seen earlier Index has decreased by 0.5 percent since March 31. The performance across sectors
gains partly reversed has been mixed, with agriculture declining by 8.3 percent between March 31 and
June 14. On the other hand, on the back of stabilizing commodity prices, the
mining sector gained 13.6 percent, while infrastructure gained 5.6 percent over the
same period.
The transmission of With the Rupiah remaining relatively stable and inflation well within the target range
monetary easing to of 3 to 5 percent, BI lowered its main policy rate from 7.5 percent in December
lower lending and 2015 to 6.5 percent in June 2016 (Figure 13). While monetary policy easing has been
deposit rates has so transmitted through to the JIBOR, the transmission to bank deposit and lending
far been limited… rates has remained muted.
… and credit and Credit growth, across almost all sectors and loan types, remained weak, reaching
deposit growth have near seven-year lows (Figure 14). Investment loan growth increased slightly to 12.2
remained weak, percent yoy in April 2016, from 11.6 percent yoy in March. Working capital loans,
while non- comprising around 45 percent of total loans, grew at a tepid 4.8 percent yoy in April,
performing loans down from 6.4 percent yoy in March. Deposit growth has also continued to decline,
(NPLs) crept up reaching twelve-year lows. NPLs increased to 2.9 percent of total loans in April,
from 2.7 percent in January. However, the capital adequacy ratio stood at 22 percent
in March (the latest data), well above the BI minimum requirement of 8 percent, in
line with the Basel III global regulatory framework.

9
Figure 13: BI’s new policy rate is the 7-day reverse repo Figure 14: Credit and deposit growth continue to fall
(percent per year) (growth yoy, percent)
9
17
O/N lending facility
8 15 Deposit growth
13
7 O/N JIBOR BI rate
7-day reverse repo 11 Credit growth

6
9
BI policy rate
5 O/N deposit facility
7
4 5
May-15 Sep-15 Jan-16 May-16 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16
Source: BI; World Bank staff calculations Source: BI; World Bank staff calculations
BI changed its main On April 15, BI announced a reformulation of its monetary policy framework. As
policy rate in an of August 19, 2016, the main policy rate will shift from the BI (reference) rate to the
effort to improve the seven-day reverse repo rate. BI plans to establish a symmetrical (and narrower) 75-
effectiveness of basis point interest rate corridor above and below the BI seven-day reverse repo
monetary policy rate. This change in policy instrument – from a reference interest rate to an effective
(reverse repo) interest rate – is intended to improve the transmission mechanism
between the BI policy rate and bank rates. In the short term, the change in policy
instrument is not expected to affect interbank market rates significantly, as the
overnight rate has hovered close to the overnight deposit facility rate in recent years
(owing to surplus bank system liquidity). The revision of the framework is a positive
move but its effectiveness will require surmounting other challenges, such as a lack
of interbank credit lines and uneven distribution of liquidity in the banking sector.
6. Budget execution has improved but revenues remain weak
Four months into the Revenue collection between January and April recorded a broad-based decline of 9.8
fiscal year, the percent compared to the same period in 2015, owing mainly to lower commodity
implementation of prices and domestic demand, as well as several revenue policy and administration
the 2016 Budget changes. On the other hand, total expenditure increased by 9.2 percent, supported by
faces challenges strong growth in material (66 percent yoy) and capital spending (106 percent yoy).
This is a significant improvement in terms of budget execution, although below
expectations in terms of supporting GDP growth. Disbursement increased by 89
percent for material and by 39 percent for capital relative to the average of the past
five years, likely supported by early procurement initiated by the Ministry of Public
Works and Housing.
Year-to-date revenue Turning to revenues, realization in the first four months of 2016 showed a broad-
collection weakened based decrease of 9.8 percent (Figure 15). Oil and gas-related revenues contributed
on account of the 2.4 percentage points to the decline in total revenues, reflecting the 34.6 percent
continued decline in drop in international oil and gas prices in January-April 2016 relative to the
oil and gas prices … corresponding period last year and a Rupiah appreciation of 4.7 percent. Oil and gas
revenues weakened despite an increase in the average daily oil lifting of 2.6 percent
relative to the first four months of 2015.

10
Figure 15: Year-to-date revenue collection has seen a Figure 16: … including corporate income taxes and
broad-based decline … VAT
(contributions to revenue growth yoy, percent) (growth yoy, percent)
O&G related revenues Income taxes N-O&G 40 Jan-Apr 2014 Jan-Apr 2015 Jan-Apr 2016
VAT/LGST Excises
International trade taxes Other 30
15
20
10
10
5 0
-10
0
-20
-5
-10
Jan-Apr 2014 Jan-Apr 2015 Jan-Apr 2016
Note: O&G stands for oil and gas, N-O&G – non-oil and gas; Note: PIT – personal income tax collected under Article 21 and
LGST – luxury goods sales tax. Article 25/Personal of Income Tax Law No. 36 of 2008; CIT –
Source: Ministry of Finance; World Bank staff calculations corporate income tax under Article 25; WT – withholding tax
under Article 22; FWT – final withholding tax under Article 4(2)
of the Income Tax Law; LGST – luxury goods sales tax.
Source: Ministry of Finance; World Bank staff calculations
… also in part due to Furthermore, income taxes from non-oil and gas sectors contributed 1.8 percentage
the moderation in points to the decline in revenues over the same period, despite an increase in Q1
domestic demand… 2016 nominal GDP of 8.0 percent yoy. Similarly, VAT collection contributed 2.5
percentage points to the revenue decrease, driven by both domestic VAT (down 9.1
percent yoy) and import VAT (down 12.3 percent yoy) (Figure 16). While lower
import VAT is in line with weak imports (-5.4 percent yoy in nominal terms in the
first quarter), domestic VAT revenues declined despite 8.3 percent yoy growth in
nominal private consumption. The 39 percent yoy increase in VAT refunds in the
first four months of 2016 is likely to have also contributed to the 1.3-percent yoy
decline in gross VAT receipts.
… as well as tax In addition to global and domestic macro factors, changes in tax policy and
policy and administration possibly contributed to lower revenues. Personal income tax (PIT)
administration collection grew by only 0.2 percent relative to January-April 2015 (compared with a
changes… 2014-2015 average of 13 percent). This was most likely due to an increase in the
non-taxable income threshold (Penghasilan Tidak Kena Pajak, PTKP) from IDR 24.3
million to IDR 36.0 million, a policy introduced in 2015 to support household
spending.5 Non-oil and gas corporate income taxes (CIT) declined by 11.3 percent
yoy, partly driven by lower corporate profits in some sectors, such as non-oil and
gas mining. The Directorate General of Tax also reported a 66.5 percent increase in
non-oil and gas corporate income tax refunds in January-April 2016 relative to the
corresponding period last year. In addition, excise taxes contributed 3.6 percentage
points to the revenue decrease, as the rules on the payment of excise taxes by
5 Minister of Finance Regulation PMK-122/2015.

11
tobacco producers were changed.6 Finally, the ongoing uncertainty around the Tax
Amnesty Law may have negatively impacted both tax-payer morale and tax
administration efforts. For example, the Directorate General of Tax was reported
saying that it was pausing its audit processes while waiting for the Parliament’s
decision on the Tax Amnesty Law.7
The Government has In response to the continued moderation in commodity prices and slowdown in
proposed a 2016 domestic demand, the Government lowered projected revenues by IDR 88.0 trillion
Budget revision, to IDR 1,734.5 trillion in the draft 2016 Revised Budget (which is expected to be
including lower approved in July) (Table 4). In the proposed Budget revision oil and gas-related
revenues… revenues have been revised down by IDR 67.3 trillion, mining non-tax revenues by
IDR 24.3 trillion, and VAT by IDR 97.5 trillion. However, the projected non-oil
and gas income taxes were revised up by IDR 103.4 trillion to reflect more
optimistic expectations regarding revenues from the Tax Amnesty program of
around IDR 165 trillion.8
… a larger fiscal With a weak revenue outlook, the Government has proposed to reduce overall
deficit and several expenditure by approximately IDR 48 trillion (2.3 percent of the total budget), raise
expenditure the fiscal deficit to 2.5 percent of GDP, and use the unspent 2016 balance (Sisa
adjustments… Anggaran Lebih, SAL) of IDR 19 trillion. The spending cuts are expected to come
from a number of measures, including a IDR 50 trillion reduction in line ministry
allocation for non-priority spending, such as travel, honorarium, meeting expenses,
and others;9 further decreasing fuel subsidy costs by IDR 23 trillion by lowering the
maximum fixed subsidy per liter for diesel; and reducing regional transfers by IDR
8.3 trillion through the earmarked grant (Dana Alokasi Khusus, DAK) and by IDR
4.7 trillion through lower revenue sharing. On the other hand, the draft 2016 revised
Budget has also proposed an increase of IDR 39 trillion in other spending areas
such as the electricity subsidy,10 non-energy subsidies, the preparation for the 2018
Asian Games, and the correctional facilities programs. Overall, the expenditure cuts
are relatively modest, far below the IDR 236 trillion projected reduction in spending
estimated by the World Bank (see below).
… as well as an The draft 2016 Revised Budget also proposes an increase in the Government’s off-
increase in off- balance sheet investment fund allocation (Dana Investasi Pemerintah) from IDR 58
balance sheet trillion to IDR 92.5 trillion. This includes increased capital injections of IDR 13.6
funding to support trillion for state-owned electricity company PLN (to support the program to add
infrastructure 35,000 MW electricity generation capacity), IDR 6.8 trillion for the Social Security
investment Agency (Badan Penyelenggara Jaminan Sosial, BPJS), and IDR 16 trillion for the land
bank for infrastructure development.
6 Minister of Finance Regulation PMK-20/2015, issued on February 2, 2015. In the past, producers
were allowed to postpone the payment of excise tariffs for 2 months after they ordered the excise
stamps, regardless of the month of order. Starting 2015, all stamp payments have to be made by
December 31 of the current year. As a result, there were hardly any payments in January and February
2016 and the first full-month payment was received in March.
7 http://www.thejakartapost.com/news/2016/05/17/tax-office-reluctant-mood-tax-amnesty-
stalls.html
8 http://jakartaglobe.beritasatu.com/business/finance-minister-big-hopes-tax-amnesty/
9 Presidential Instruction INPRES No.4/2016.
10 Electricity subsidy costs are higher due to delays (to July) in the implementation of the tariff
adjustment for households with 450 VA and 900 VA power supply, which was initially planned for
January 2016.

12
The World Bank has The changes in the World Bank’s macroeconomic projections -- in particular weaker
revised down slightly nominal GDP, import, and private consumption growth, as well as a stronger
its 2016 revenue Rupiah -- relative to the March IEQ, have prompted a revision of the 2016 revenue
projection, reflecting projection from IDR 1,547 trillion in March to IDR 1,506 trillion (Table 4). The
the revised macro- projection does not include potential revenues from the tax amnesty, as it is still
economic outlook unclear when the Tax Amnesty bill will be passed and implemented.11 With these
assumptions, the revenue shortfall in 2016 could reach IDR 316 trillion (2.5 percent
of GDP) relative to the Budget target. A large part of the difference between the
draft 2016 Revised Budget and the World Bank’s revenue forecast is likely explained
by the assumed tax amnesty proceeds.
The projected 2016 To partly compensate for lower revenues the Government can expand the fiscal
fiscal deficit remains deficit within the fiscal rule of 3 percent of GDP and reduce non-priority
at 2.8 percent of expenditure to prioritize public investment to support growth. Assuming the
GDP Government will use these options, the World Bank projects a fiscal deficit of 2.8
percent of GDP for 2016, unchanged relative to the forecast published in the March
2016 IEQ. The projections reflect an expenditure disbursement rate of 89 percent of
the total budget and a higher fiscal deficit relative to the target of 2.5 percent of
GDP in the draft revised 2016 Budget. Despite a higher expected 2016 fiscal deficit
relative to the Budget, financing risks remain contained. By June 7, 2016, the
Government had already raised around IDR 440 trillion in securities and multilateral
loans, compared with 2016 gross financing needs of IDR 708 trillion estimated by
the Word Bank.
11International experience suggests that the tax amnesty revenue impact varies greatly and depends on
the design of the program. Key factors include credibility that the reform is a one-off opportunity and
that taxpayer information will not be used for other purposes; increased tax enforcement; higher post-
amnesty penalties; as well as the applicable tax rate and penalty structure. Amnesties tend to generate
more revenue when the standard tax rate is applied. For example, Ireland collected 1.9 percent of
GDP in 1988 by waiving interest and penalties but not reducing the tax rate. In contrast, Italy
collected just 0.1 percent of GDP in 2001, as a large tax rate reduction (in addition to other factors)
contributed to a low revenue impact. Source: Baer. K. and E. Le Borgne, 2008, “Tax amnesties:
theory, trends, and some alternatives,” IMF.

13
Table 4: The World Bank projects lower revenue and expenditure than in the 2016 Budget
(IDR trillion, unless otherwise indicated)
2015 2016 2016 2016 2016 2016
Difference
Draft
Audited between draft World Bank
Budget Revised Jan – Apr
actual revised and (June)
Budget
original Budget
A. Revenues 1,508 1,822 1,734 -88 1,506 387
1. Tax revenues 1,240 1,547 1,527 -20 1,304 321
Income taxes 602 757 844 87 652 186
Oil & Gas 50 41 24 -17 n.a. 12
Non-Oil & Gas 553 716 819 103 n.a. 174
VAT/LGST 424 572 474 -98 448 101
Property taxes 29 19 18 -1 31 1
Excises 145 146 148 2 134 19
International trade taxes 35 40 36 -4 34 11
Import duties 31 37 33 -4 31 11
Export duties 4 3 3 0 4 1
Other taxes 6 12 7 -5 6 2
2. Non-tax revenues 256 274 205 -69 200 66
Natural resources revenues 101 125 50 -75 51 17
Oil & Gas 78 79 28 -51 n.a. 11
Non-Oil & Gas 23 46 22 -24 n.a. 6
Other non-tax revenues 155 149 155 6 149 49
3. Grants 12 2 2 0 2 0
B. Expenditures 1,806 2,096 2,048 -48 1,860 545
1. Central government 1,173 1,326 1,289 -37 1,150 276
Personnel 281 348 n.a. 306 97
Material 233 325 n.a. 255 42
Capital 215 202 n.a. 183 18
Interest payments 156 185 192 7 183 64
Subsidies 186 183 189 6 162 40
Energy 119 102 98 -4 97 30
Fuel 61 64 41 -23 42 18
Electricity 58 38 57 19 55 13
Non-energy 67 81 91 10 65 10
Grants 4 4 8.5 5 2 0
Social 97 55 n.a. 54 12
Other 10 25 n.a. 6 2
2. Transfers to regions 623 770 758 -12 710 269
Overall Balance -298 -273 -313 -353 -158
(% of GDP) -2.6 -2.2 -2.5 -2.8
Assumptions
Real GDP growth rate (%) 4.8 5.3 5.2 5.1
CPI (%) 6.4 4.7 4.0 3.9
Exchange rate (IDR/USD) 13,458 13,900 13,500 13,300
Crude-oil price (USD/barrel) 51 50 40 40
Memo
Nominal GDP 11,541 12,716 12,635 12,480
Note: The World Bank projection does not include potential revenues from the tax amnesty.
Source: Ministry of Finance; World Bank staff projections

14
7. Addressing fiscal revenue constraints has become a priority

The expected global Although the World Bank’s outlook for Indonesia remains unchanged from the
recovery remains March 2016 IEQ, the downside risks have increased. External downside risks relate
uncertain… to the recent rise in uncertainty. For example, the timing and potential impact of
further rate increases by the US Federal Reserve, as well as the result of the UK
referendum on EU membership, have increased financial market volatility in recent
weeks. In China, the pace and manner in which rebalancing and deleveraging efforts
are implemented also present potential global risks. These factors have contributed
to the current wait-and-see attitude of investors towards emerging markets.
… and there is a risk Second, there is uncertainty regarding the outlook for commodity prices. As
that the recent discussed in Section 1, they have rebounded in recent weeks. However, the upswing
increase in may prove temporary because, under the baseline scenario, global growth is forecast
commodity prices to pick up only moderately over the medium term. This again means higher
may not be sustained uncertainty both for Indonesian investors and for fiscal revenues.
… while at home, Uncertainty is also high with respect to domestic conditions. Economic activity, in
fiscal risks have particular public spending, lost some steam at the beginning of the year and high-
increased since the frequency indicators provide mixed signals. This suggests intensifying downside
March 2016 IEQ risks to the World Bank outlook for Indonesia, especially related to the limited fiscal
went to press… space. The Government submitted its draft revision of the 2016 Budget to
Parliament on June 2. This is a very important policy step to help protect public
investment spending, when the economy relies on it.
… as the draft 2016 However, as discussed in the previous section, the budget revisions proposed by the
Revised Budget Government do not sufficiently reflect the deterioration in macroeconomic
needs further conditions since the original 2016 Budget was discussed in Parliament last year. In
adjustment to better particular, the latest draft includes an increase in non-oil and gas related tax revenues
manage fiscal risk of 48.1 percent relative to the 2015 preliminary revenue outturns. Even if the tax
amnesty is approved by Parliament and implemented before the end of 2016, it may
be difficult to achieve the high target set for tax collection.

15
B. Some recent developments in Indonesia’s economy
1. Why are lending rates and net interest margins high in Indonesia?
Interest rates in In recent months, there has been a great deal of discussion and policy debate around
Indonesia are the perception that the interest rates and net interest margins (NIMs) charged by
perceived as being Indonesian banks are higher than necessary. Moreover, the transmission of the policy
excessively high rate cuts, introduced by Bank Indonesia in the first three months of 2016, to bank
lending and deposit rates has so far been limited (see Part A.5). In an attempt to drive
deposit rates lower, in October 2014 the Financial Services Authority (Otoritas Jasa
Keuangan, OJK) capped deposit rates charged by large banks at 200 or 225 basis points
above the BI rate, depending on the level of core capital. OJK tightened the deposit
rate caps to 75 and 100 basis points above the BI rate in March 2016. This article
attempts to shed light on the determinants of interest rates and margins in Indonesia
and the contributing role of both structural and policy factors.12
Indonesia does have Both nominal and real interest rates, as well as government bond yields, have been
the highest interest higher in Indonesia relative to peers in the G20 and ASEAN (Figure 17). In addition,
rates in the region, the spread between bank rates and the government bond yield in Indonesia has been
with both sovereign significantly higher than that of neighboring countries. This implies that, while
and private sector sovereign risk factors may play an important role in interest rate determination for
risk being important Indonesian banks, Indonesia remains the outlier among ASEAN countries in terms
of private sector risk premia.
12An article on this topic, prompted by the slowdown in credit growth in 2009, was published in the
June 2010 IEQ (pp. 23-27).

16
Figure 17: Indonesian interest rates are higher than Figure 18: NIMs are also higher in Indonesia than in
those in peer countries ASEAN and G20 peers
(2010-2015 average, percent per year) (net interest revenue as a share of average interest-bearing assets, percent)
Thailand Malaysia Philippines Indonesia IDN Regional average G20 peers
Lending-5yr gov bond 8

yield 7
Deposit-5yr gov bond 6

yield 5
4
Lending-deposit
3
2
Lending-inflation
1
-5 0 5 10 0
2005 2007 2009 2011 2013
Source: CEIC; World Bank staff calculations Source: Bankscope; World Bank staff calculations
a. What components drive high NIMs in Indonesia?
NIM is a measure of One way to understand what factors explain high interest rates in Indonesia is to
bank profitability examine the determinants of NIMs. NIM is the value of a bank's net interest revenue
as a share of its average interest-bearing (total earning) assets. It reflects realized
lending experience in contrast to the interest spread, which is an indication of the
rates at which banks offer to transact.
NIMs have been The Indonesian NIM has been markedly higher and also more stable than NIMs in
high and persistent peers in the region and within the G20 (Figure 18).13 The coefficient of variation of
in Indonesia the NIM in Indonesia over the period 1999 to 2015 is the second lowest (13.4
percent) of the ASEAN countries analyzed after Vietnam (12.2 percent). It is also
much lower than in the more developed financial markets of Singapore (51.1
percent), South Korea (48.1 percent), and Hong Kong (37.1 percent). High NIMs,
as well as the low variation, may point to structural challenges within the Indonesian
financial sector.
Indonesian banks One component of NIM is overhead costs, which are higher in Indonesia than in
have high overhead peer countries (Figure 19). This may reflect the particular geographic challenges of
costs Indonesia and perhaps the low levels of financial inclusion. If banks are to achieve
their required return on equity, higher overhead costs will demand a higher source of
income either through fee income or NIM.
Low fee income also Fee income in Indonesia is lower than in other countries, leading to greater reliance
pushes NIMs up… on interest income (Figure 20). This implies a need for a higher NIM to generate the
same return on equity. It is notable that the return on equity for Indonesian banks is
not higher than in comparator countries. This does not necessarily mean that the
banks are highly competitive. It would be equally possible to arrive at this outcome
through inefficiencies in some areas which are compensated by high interest margins.
… as do high capital It is also the case that capital ratios are slightly higher in Indonesia, which in turn
ratios… increases pressure for greater income and also higher interest margins. According to
13ASEAN peers include Malaysia, the Philippines, Singapore, Thailand, and Vietnam; G20 peers –
China, India, Mexico, South Africa, and Turkey.

17
Bankscope data, capital-to-asset ratios in Indonesia were some 2 percent higher than
in regional peers and 4 percent higher than in G20 peers in 2014. Higher capital also
contributes directly to NIM, as it increases the amount of earning assets without a
commensurate interest expense.
Figure 19: High overhead costs partly explain higher Figure 20: … as does low fee income
NIMs… (non-interest income as a share of total income, percent)
(overhead costs as a share of total assets, percent)
IDN Regional average G20 peers IDN Regional average G20 peers
4.5 45
4.0 40
3.5 35
3.0 30
2.5 25
2.0 20
1.5 15
1.0 10
0.5 5
0.0 0
2005 2007 2009 2011 2013 2005 2007 2009 2011 2013
Source: Bankscope; World Bank staff calculations Source: Bankscope; World Bank staff calculations
… and lower loan The most interesting component of NIM is that which relates to provisioning (i.e. an
loss provision expense set aside as an allowance for bad loans). Non-performing loans (NPLs) have
been historically high in Indonesia but have improved, this will have increased the
NIM. According to Bankscope data, NPLs in Indonesia in 2010-2014, at 2.0 percent
of gross loans, have been lower than in countries, such as Germany (2.8 percent) and
the Netherlands (3.0 percent). It might be argued that the effect of global market
conditions, the reduced prices of commodities, and the slower pace of growth in
China could contribute to an economic environment in Indonesia which requires an
increase in provisioning. The banks’ 2016 first quarter results would suggest that this
trend may be forming.
b. What are the underlying structural factors behind high NIMs?
Regression analysis While the breakdown of the components of NIM explains the likely entry point for
helps identify the high interest margins in Indonesia, it does not explain what are the underlying
structural factors factors in the economy which bring this about. For this purpose a regression
behind high NIMs analysis is conducted, following the academic literature.
One such factor is The results show that the limited number of non-bank financial institutions and
shallow financial underdeveloped equity and debt markets lead to few options for borrowers other
markets than bank loans. In 2015, banks held 79 percent of the financial system’s total
assets. The value and number of stock issuances have declined since 2013.
Corporate debt as a share of GDP in Indonesia is the lowest among ASEAN peers,
falling behind the Philippines. Global studies point to the important role that a
functional debt market can have, providing borrowers an alternative to commercial
bank financing. Moreover, as international guidelines for bank capital have become
stricter in recent years, in many countries the debt markets now act as an important

18
conduit for longer-term financing and risks that are incompatible with the short-
term, highly leveraged structure of commercial banks.
Although the However, the banking sector in Indonesia is not excessively oligopolistic. The
banking sector is not Herfindahl index, a measure of market concentration, based on the total assets of
highly concentrated, the top 15 banks was 0.049 in 2015, down from 0.058 in 2011.14 Indonesia
there are signs of compares favorably against other countries. For example, the Herfindahl index is
weak competition 0.068 for all of the banks in the European Union, 0.210 in the Netherlands, and
0.308 in Finland. This is reflected also in the lower concentration amongst the
largest institutions: the biggest 13 banks in Indonesia hold around 83 percent of the
assets, a figure matched or exceeded by the top 5 banks in Belgium, Estonia,
Netherlands or Finland.15 However, low market concentration does not preclude
uncompetitive behavior by banks (and vice versa). The lack of variance in interest
margins discussed above may point to low interbank competition and a high degree
of discretion in setting lending rates.16
Government The fiscal balance emerges as an important determinant of NIM. Although the
borrowing reduces analysis presented here does not identify the transmission mechanism, it is likely
NIMs that this reflects pressure on deposit rates as banks and the Government compete
for funds. Government bonds are a substitute for time deposits. The high loan-to-
deposit ratio, at 93. 3 percent in 2014, has been a potentially exacerbating factor in
this regard, as bank liquidity has tightened since 2009.
c. Inducing banks to lower rates can hurt long-term growth
Interest rate caps Turning to the issue of constraining bank interest rates, there is a long history of
have hurt long-term governments across the globe seeking to cap rates on lending and a comprehensive
economic growth… literature has been developed to addresses the related arguments.17 The evidence
indicates that placing caps on interest rates is detrimental to long-term economic
growth for several reasons.
… by limiting First, the very high interest rates associated with microfinance (above 40 percent per
financial inclusion… year in some countries) can be justified by the small loan size and high operating
costs.18 Even for larger loans, attempts to impose artificially low interest rates may
exclude low-income households that want to borrow and would be creditworthy at
the high rates needed to cover the costs of processing the loans. Although many
countries still have interest rate ceilings, these have been relaxed or qualified by
exemptions.19 Where constraints on interest rates exist, banks become more and
more selective as to who they have as clients, and increasingly exclude poorer clients
with high transaction costs relative to income.
14 The U.S. Department of Justice describes a market with a Herfindahl index between 0.15 and 0.25 as
“moderately concentrated.”
15 Source: European Central Bank, 2014, Structural financial indicators.
16 An analysis of coordinated behavior by banks, which is beyond the scope of this article, would be
needed to provide evidence of low market competition.

17 Notably in Demirguc-Kunt, A., T. Beck, and P. Honohan, 2008, “Finance for all? Policies and
pitfalls in expanding access,” Washington, DC: World Bank.

18 See various publications prepared by the Consultative Group to Assist the Poor
(http://www.cgap.org/publications)
19 See Policis, 2004, “The effect of interest rate controls in other countries;” Helms, B. and X. Reille,
2004, “Interest rate ceilings and microfinance: the story so far,” CGAP Occasional Paper No 9.

19
… imposing Second, it is sometimes argued that interest caps are necessary, as lenders have an
additional fees and oligopolistic position which allows them to extract rent through excessive rates.
unnecessary While the need to respond to monopolistic practices is real, this should be done
services… through increasing competition in the sector. Otherwise, banks will use their market
power to introduce opaque cost structures, such as fees and penalties, which result
in costs of credit greatly exceeding stated interest rates. Another way this is
manifested is through bundling of products whereby borrowers have to buy other
services to gain access to loans.
… reducing Third, appropriate incentives are key to encouraging banks to extend services to
innovation… excluded segments of the population. Particularly, banks will not invest in new
technology if they cannot recover their costs and will seek to reduce the quality of
services provided to accommodate lower interest rates.
… limiting banking Fourth, if banks are not allowed to set interest rates which compensate them for the
services to higher greater risk associated with lending to smaller and younger enterprises, they are
quality clients and likely to concentrate on larger, established companies, with whom they already have
existing borrowers… a lending relationship. This way they can avoid the higher transaction costs of a new
lending relationship.
… leading to In addition, research in Europe indicates that, in countries which cap interest rates,
undercapitalization companies are more likely to over-borrow, leading to greater defaults. In other
of firms’ words, cheaper credit encourages companies to overemphasize debt in their capital
operations… structure.20 This tendency is also seen among retail borrowers in the US, where
defaults on credit cards are significantly higher in states which cap interest rates.21
… and creating Finally, in any market where access to a product is artificially constrained, incentives
incentives for poorly are created for the allocation of the scarce product, providing opportunities for
governed credit corruption. It is also important that the focus on interest rates should not ignore
allocation depositors, who are entitled to a fair rate of return. Recent history provides many
examples whereby financial repression has reduced rates of return available to savers.
Financial repression was practiced in OECD countries, such as the UK and US, until
market liberalization in the 1980s. More recent examples, including in East Asia, have
been linked to the development of shadow banking activities and over-investment in
capital equipment.
The sustainable Overall, the evidence suggests that while there can be instances of banks setting
solution is to interest rates which are too high and occasions when credit quality is adversely
increase market size affected (as entrepreneurs will only borrow for high risk, high return investments),
and improve the solution is to seek to increase the size of the market and to pursue initiatives which
competition increase competition amongst banks. Interest rate caps only reduce competition.
20 Policis, 2006, “Economic and social risks of consumer credit market regulations.”
21 See footnote 17.

20
2. The price of trade protectionism in Indonesia

The economic policy Indonesia has recently started to reverse the trade protectionist trends of previous
packages have years. Since September 2015 the government has announced and partly
dismantled some implemented a series of 12 reform packages with a strong focus on reducing non-
non-tariff barriers… tariff barriers. For example, the Ministry of Trade abolished several import and
export requirements: e.g., product-specific import and export licenses for a wide
range of products and applying Indonesian language labels to imported goods in
producer countries before shipment. In addition, the National Agency of Drug and
Food Control (Badan Pengawas Obat dan Makanan, BPOM) established priority
service for pharmaceutical and food inputs and processed drugs and foodstuffs,
which covers more than 2,000 product lines.
… resulting in more These reforms follow a Figure 21: An incipient trade liberalizing trend has
trade-liberalizing period during which been observed
measures than Indonesia was among the (number of trade liberalizing and restricting measures)
restricting ones world’s top users of trade Restricting Liberalizing
40 37
being implemented barriers according to
so far in 2016 Global Trade Alert data 35
(Figure 21). Over the last 30 28
four quarters, Indonesia’s
25
ratio of liberalizing relative 21
19
to restrictive measures has 20 18
16 16
increased, a trend that has 15
12
strengthened in the last two 12 10 11
10 9
quarters, culminating in Q1 6 6 6 5
2016 with three times more 5 4 4 4 3
00 0 01 0 1 00 1 0 1 01
trade liberalizing than 0
restricting measures. The
12Q1
12Q2
12Q3
12Q4
13Q1
13Q2
13Q3
13Q4
14Q1
14Q2
14Q3
14Q4
15Q1
15Q2
15Q3
15Q4
16Q1
country’s world ranking in
terms of restrictive Source: Global Trade Alert accessed on May 10, 2016; World Bank
measures has dropped for staff calculations
three consecutive quarters – from number 3 in Q2 2015 to number 8 in Q1 2016.
Its ranking in terms of liberalizing measures improved from number 12 to number
6. These trade reforms are an important change in direction, given the previous rise
in trade protectionism which was implemented mainly through a more intense use
of non-tariff measures (NTMs).
a. Why are non-tariff measures potentially harmful?
While Indonesia has Like most countries in the world, Indonesia has progressively slashed its import
been slashing import tariffs over time to the point where they no longer represent a major barrier to trade
tariffs, it has for the vast majority of products.22 The average applied tariff rate in Indonesia
increased the use of declined from 7.7 percent in 1996 to 2.3 percent in 2013.23 On the other hand, the
NTMs use of NTMs has proliferated. According to data collected by the World Bank and
Australia Indonesia Partnership for Economic Governance (AIPEG), the number
22 An important exception is the increase in Indonesian import tariffs on a wide range of consumer
goods introduced in August last year.
23 Averages are computed by weighting each tariff by the corresponding product import shares for
each partner country (source: World Bank’s World Development Indicators). To the extent possible,
specific rates have been converted to their ad valorem equivalent rates and have been included in the
calculation of weighted mean tariffs.

21
of product-level NTMs on Indonesian imports doubled between 2009 and 2015,

expanding the number of products covered by NTMs by over 38 percent.24,25 On
the export side, where NTMs are less frequent, the number of product-level NTMs
grew fourfold and the number of products covered increased threefold.
NTMs are aimed at NTMs often respond to societal demands for product traceability and consumer
protecting protection against various hazards, such as unhealthy foods, environmentally
consumers but can damaging products, fraudulent pharmaceuticals, dangerous toys, and so on.26 But
also significantly they can also act as significant barriers to trade and, in certain instances, are used by
distort domestic governments to pursue purely protectionist objectives as global trading rules have
markets made the use of import tariffs more difficult. NTMs can protect domestic producers
or intermediaries, thus increasing their rents at the expense of higher prices and/or
lower availability of the product for consumers.
NTMs in Indonesia In Indonesia, many NTMs impose quantitative restrictions on exports and imports,
are a mix of highly such as quotas (e.g., on wheat flour imports), bans (such as on exports of
restrictive—product unprocessed or semi-processed mineral ore, logs, and rattan), and mandatory import
specific measures licensing (e.g., for sugar, rice, alcoholic beverages, fruits and vegetables, livestock
and less restrictive— and livestock products, basic steel products, cellular telephones, and tablet
widely applied computers). These measures can potentially greatly distort domestic markets, as they
measures significantly restrict the ability to import these products. Other NTMs are less trade
restrictive but cover many products. For example, pre-shipment inspections are
required on imports of most processed foods and beverages, personal care
products, traditional medicines, virtually all apparel and other finished textile
products, footwear, many household electrical appliances, consumer electronics
products, and children’s toys. Quarantine inspections are applied to almost all
primary and manufactured products containing animal or plant materials. These
inspections increase both the time and the costs of trading, which can increase the
domestic price and reduce the availability of the products.
b. What is the impact of NTMs on domestic prices?
This section presents Irrespective of their intended objective, one of the major effects of non-tariff
estimates of the cost measures is to raise the domestic price of traded goods by increasing the costs of
of trade distortions trading and/or reducing the domestic supply of goods. The nominal rate of
on Indonesia’s protection (NRP) provides an estimate of the impact of all trade distorting measures
economy (tariff and non-tariff) on domestic prices. These estimates are important as they
illustrate the significant cost of trade distortions on the Indonesian economy.
For example The ideal NRP estimation approach – which can be applied only to a few products
between 2011 and owing to lack of data – measures the difference between the change in the
2014, NTMs resulted Indonesian price of a good before and after the introduction of a trade measure and
in a domestic price the same change for that good in a reference market where the trade measure was
of wheat flour 22- not applied. For example, the retail price of wheat flour in Indonesia remained high
percent higher than after 2008, while the wholesale price of wheat flour in the US declined sharply
(Figure 22). This increase in the spread between the two prices resulted from a
24 This article presents some of the findings of Marks, S.V., September 2015, “Non‐tariff trade
regulations in Indonesia: Measurement of their economic impact”:
http://research.pomona.edu/stephen-marks/files/2016/05/Analysis-of-NTMs-in-Indonesia.pdf
25 A recent more comprehensive data collection by the Economic Research Institute for ASEAN and
East Asia suggests that the share of products subject to at least 1 NTM is 62 percent in Indonesia.
26 See Cadot and Malouche (2012) “Non-tariff measures – a fresh look at trade policy’s new frontier,”
Washington DC: The World Bank.

22
without the series of policy actions taken by the Government between 2008 and 2014, including
measures anti-dumping measures and import quotas.27 As a result, in 2014 wheat flour
imports were 73.6 percent lower than in 2011 and the price of wheat flour was 22
percent higher than would have been the case in the absence of these measures.28
In another case, the Another example of the cost of trade distortions is the ban on the use of the Jakarta
2012 ban on port, Tanjung Priok, to import horticultural products into Java. Since June 2012,
horticultural imports products which used to be imported largely via Tanjung Priok have had to go
at the Jakarta port through the Surabaya port, Tanjuk Perak.29 A comparison of the change in prices for
caused an 8-percent fruits and vegetables in Jakarta vis-à-vis the change in Surabaya, while controlling
increase in their for the changes in overall prices in the two cities, reveals that this restriction has
prices in the capital raised horticulture prices in Jakarta by 8.2 percent compared to Surabaya.
Figure 22: Trade restrictions kept domestic wheat Figure 23: Estimates suggest that recent trade
flour prices high after 2008 policies increased prices across sectors
(US and Indonesian wheat flour prices, USD/kg) (price difference compared to a free trade scenario, percent)
1.00 2008 NRP 2015 NRP
30
0.90 Average retail flour
price, Indonesia 20
0.80
0.70 10
0.60 0
0.50
-10
0.40
0.30 -20
0.20
Wholesale price, bakery
0.10 flour, Minneapolis
0.00
Note: The US reference price is that of the city of Minneapolis. Source: Marks and Rahardja (2012);30 World Bank staff
Source: Ministry of Trade of Indonesia; Wheat Yearbook of the calculations
U.S. Department of Agriculture; World Bank staff calculations
The results show The estimates suggest that the overall Indonesian NRP has almost tripled between
that recent trade 2008 and 2015 in line with the increase in NTMs (Figure 23). The most heavily
measures have protected sector is food crops: domestic food prices in 2015 were, on average, 33
contributed to higher percent higher than would have been the case in the absence of trade restrictions.
27 Specifically, the Government initiated anti-dumping investigations in October 2008 and eventually
imposed antidumping duties on wheat flour imports from Turkey in 2009, a temporary 20 percent
safeguard duty on all imports of wheat flour, and temporary anti-dumping duties on India, Sri Lanka,
and Turkey in 2013, followed by temporary across-the-board import quotas in 2014.
28 This approach is complemented by other, less data-intensive methods that allow the calculation of
the NRP for a wide range of goods in Indonesia. One approach is to compare retail prices of identical
products in Jakarta and Singapore while accounting for the cost of living difference between the two
cities. As Singapore has zero import tariffs on almost all items, and is relatively free of trade
restrictions, such a comparison should isolate the price effect of trade restrictions in Indonesia. The
second method is to compare the domestic wholesale price of a good, net of the wholesale margin
and handling charges, with its border price inclusive of cost, insurance and freight. The two prices
should be identical unless there are costs associated with crossing the border.
29 Horticultural products may be imported through Jakarta international airport Soekarno-Hatta but
that is only viable for high-end products.

30 Marks, S. V. and S. Rahardja, April 2012, “Effective rates of protection revisited for Indonesia,”
Bulletin of Indonesian Economic Studies 47, 53–80.

23
domestic prices, Moreover, the NRP for food crops was more than double that in 2008. Similar
especially for food increases in NRP were observed in other major sectors, such as processed food,
beverages and tobacco (from 4.5 in 2008 to 13.7 percent in 2015) and machinery
and transport equipment (from 3.4 to 7.8 percent). The increase in NRP was even
larger for livestock and their products, with a jump from 0.7 percent in 2008 to 8.8
percent in 2015. These figures indicate that trade policies keep prices of food and
capital equipment products high, imposing a rising cost on households and on
domestic producers.
Indonesian prices of At the product level, consumer goods, and food products in particular, comprise
milled rice, sugar, eight of the ten products with the highest NRP in 2015 (Figure 24). In 2015, the
meat, and fruit are domestic price of milled rice was 68 percent higher than it would have been in the
more than 20 percent absence of trade measures. Alcoholic beverages, sugar, meat, and fruit all had NRP
higher as a result of above 20 percent in 2015, up from levels close to zero in 2008 (except for sugar).
trade restrictions While trade measures did not affect the price of cement in 2008, they had raised it
by 11.6 percent relative to the free trade price by 2015.
Figure 24: Consumer goods, in particular food, saw Figure 25: Rates of protection are even higher when
the largest price rises due to trade measures calculated in terms of value added
(price difference compared to a free trade scenario, percent) (difference in value added per unit of output compared to a free trade
scenario, percent)
2008 NRP 2015 NRP 90 2008 ERP 2015 ERP
60
40 70
20 50
0 30
-20
10
-40
-60 -10
-80 -30
Source: Marks and Rahardja (2012); World Bank staff calculations Source: Marks and Rahardja (2012); World Bank staff calculations
In a few cases – non- At the other end of the spectrum, non-oil and gas mining, as well as the forestry
oil and gas mining sector, have negative NRPs. This indicates that the domestic price of these products
and forestry products is subsidized, for example via export taxes and/or export bans. This subsidy
– domestic prices are increased between 2008 and 2015. For example, the prices of silver ore (NRP in
lower due to 2015 of -90.5 percent, from +2.9 percent in 2008) and tin ore (-56.8 percent, from 0
subsidies percent in 2008) have become highly subsidized. These large negative NRPs reflect
the impact of the export ban on unprocessed minerals, the aim of which was to
stimulate domestic value addition.
Trade-protection Higher prices in one sector due to trade measures also impact the rate of protection
driven price in other sectors of the economy which use those goods as inputs to production. By
increases are even accounting for these effects, the estimation of the effective rates of protection
higher after (ERP) provides a more complete picture of the economy-wide price impact of
accounting for the trade-distorting measures, amplifying the value of the distortion captured in the
NRP. The ERP is defined as the proportion by which value added per unit of

24
effect on input output with distortive policies exceeds the level under a free trade scenario.31 In the
prices… ERP case, the prices of food crops are over 83 percent higher in 2015 compared
with a free trade scenario (Figure 25). Similarly, the domestic prices of metals and
chemicals are 65 percent and 58 percent higher, respectively, due to trade
restrictions. Overall protection granted to producers in these sectors hinges not only
on trade barriers on imports of the same products, but also on trade subsidies for
the inputs they use (e.g., fertilizers for food crops, minerals, etc.). As in the case of
NRPs, the estimates show a marked increase compared to 2008 across sectors.
… leading to an The aggregation of the ERP estimates suggests that, in 2015, overall trade policies
overall increase in have increased the cost of living in Indonesia by 7.4 percent compared to a scenario
the cost of living in in which no trade restrictions are imposed. Much of this effect is driven by the rice
Indonesia of 7.4 import restrictions: if the non-tariff restrictions on rice imports were allowed to
percent lapse and only rice import tariffs were maintained, the trade policy impact on the
cost of living would drop to 4.7 percent. Finally, if only import tariffs and export
taxes remain in effect at their present levels, the increase in the cost of living falls to
only 2.9 percent, confirming that most of the effect on the cost of living in
Indonesia comes from NTMs.
c. Are domestic producers being protected?
Data suggest that One of the most prominent public policy objectives of trade-restrictive measures is
international rice the protection of domestic producers from import competition. That is evident, for
price movements are instance, in the case of paddy. The import of (medium-quality) milled rice is subject
transmitted to to a strict monopoly by the state-owned enterprise Bulog. However, data suggest
domestic wholesale that, while trade protectionism has substantially increased the domestic price of
but not producer polished rice, it does not appear to have impacted significantly the prices rice
prices… farmers charge. During 1998-2003, when the rice import monopoly was eliminated,
changes in international rice prices were to a large extent transmitted to domestic
wholesale prices but not to rice producer prices.32 On the other hand, during the
period with trade restrictions (post-2003) international price changes were passed
through neither to wholesale, nor to producer prices.
…consistently with These findings suggest that trade restrictions largely insulate Indonesian consumer
high market power rice markets from international price movements. The lack of transmission to
of wholesalers and farmer prices during the trade liberalization period is consistent with the high degree
of market power by wholesalers and millers vis-à-vis rice farmers.33 This asymmetric
31 The ERP is estimated by using sectoral NRPs matched with input-output tables that inform what
amount of inputs a specific sector uses from the other sectors of the economy. The estimation uses
the Humphrey method, which assumes that trade policies affect prices of services directly and
indirectly: policies boost the prices of services to the extent that prices of tradable inputs used to
produce these services increase and also because workers are assumed to demand higher nominal
wages to compensate for higher prices of all goods and services so that their real wages remain
constant.
32 The analysis is based on monthly prices and uses a Vector Error Correction Model. This is a suitable
model as the series are co-integrated, as confirmed through the Engle-Granger test. Each of the
domestic prices (in first difference) is regressed on the international price (also in first difference) and
on its own lag. The results suggest that a 10-percent price reduction in the international price led to a
reduction in wholesale prices by 2 percent. On the other hand, there was no statistically significant
response of producer prices.
33 According to the 2015 OECD Services Trade Restrictiveness Index, Indonesia is the country with
the highest restrictions to competition in distribution services and the second highest in warehousing
services among the 42 countries surveyed. Restrictions include limits to foreign ownership, excessive
minimum capital requirements, restrictions on the location of operations, and cumbersome licensing
requirements.

25
millers vis-à-vis rice market power implies that lower international rice prices are not passed through to
farmers producers, as their margins are already squeezed by wholesalers and millers and do
not leave room for further downward adjustments in the short run. It also implies
that when international prices rise, the increase is retained by wholesalers and not
passed through to rice farmers. Hence, trade restrictions may not be an effective
tool to protect farmer income, at least in the rice sector.

26
C. Indonesia 2018 and beyond: A selective look
1. Reviving manufacturing competitiveness

a. Indonesia’s manufacturing journey: knocked off course by the 1997 crisis
Indonesia’s previous Indonesia’s manufacturing growth experienced a structural break following the
manufacturing 1997/98 Asian financial crisis. Real manufacturing growth plummeted from 11
prowess plunged percent annually between 1990 and 1996 to 4.8 percent in the period from 2001 to
after the Asian 2014. This subdued performance of manufacturing post-2000 ostensibly reduced
financial crisis… overall economic growth (Figure 26). The strong correlation between manufacturing
growth and overall economic growth is not surprising as manufacturing still
represents close to one-fifth of total output and 13 percent of total employment in
Indonesia.
… and the country Following a rapid rise in the 1990s, the share of manufacturing in total output has
experienced a fallen sharply since 2005, giving way to a rapid expansion of low-end services
“premature de- absorbing labor released from rural activities.34 That services activities take over
industrialization” manufacturing when an economy reaches a high level of income per capita is
expected. This is because demand for services increases much more than demand
for manufacturing as household income rises.35 However, in the case of Indonesia,
this structural change occurred at a low level of per capita income and before
industrialization reached maturity, reflecting a premature “de-industrialization”
(Figure 27).36
34 See World Bank, 2014, “Indonesia development policy review: Avoiding the trap.”
35 See Chenery, H., S. Robinson, and M. Syrquin, eds., 1986, “Industrialization and growth: A
comparative study,” Oxford, U.S.: Oxford University Press for the World Bank.
36 Rodrik D. (2015) attributes this phenomenon, also observed in a large number of developing
countries, to globalization and labor-saving technological progress in manufacturing. See Rodrik, D.,
2015, “Premature Deindustrialization,” NBER Working Paper No. 20935.

27
Figure 26: Indonesia’s manufacturing growth is no Figure 27: … and the economy de-industrialized
longer what it used to be… prematurely
(growth in GDP and real manufacturing output, percent) (manufacturing as a share of GDP, percent)
GDP 40
16
Before 1997/98 Manufacturing growth Thailand
crisis China 2005 Thailand
14 35 1990 China
2005 2014
12 Malaysia
30 China 2005
10 Post 1997/98 crisis Thai 1990
Malaysia
Indonesia 2014
2014
8 25 2005
Malaysia
6 1990
20 Indonesia Indonesia
4 2014
1990
2 15
GDP per capita, PPP
0
1990
1991
1992
1993
1994
1995
1996
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
10
0 5,000 10,000 15,000 20,000 25,000
Source: World Bank staff calculations Source: UN-COMTRADE; World Bank staff calculations
Indonesia’s global The weak performance of Figure 28: Indonesia’s global manufacturing market
share of manufacturing can also be share is low and stagnant
manufacturing has seen from export data. (share in global manufacturing market, percent)
stagnated at a low Once a global Indonesia Malaysia
level manufacturing Vietnam China (RHS)
powerhouse, Indonesia’s 2.5 20
manufacturing share in 18
global markets stagnated at 2.0 16
about 0.6 percent over the 14
past 15 years (Figure 28). 1.5 12
Exports stagnated in 10
Malaysia as well, but at 1.0 8
double the share of 6
Indonesia. Trends in these 0.5 4
two countries are in sharp 2
contrast to China whose 0.0 0
share of global demand 1990 1995 2000 2005 2010 2015
rose from 2.5 percent to Source: UN-COMTRADE; World Bank staff calculations
17 percent. Perhaps more
strikingly, Indonesia is now overshadowed by Vietnam, a country that was hardly
present in global manufacturing markets in the early 1990s.
Beginning in 2006, The subdued performance of manufacturing exports is the flip side of the
commodities commodities export boom from 2003 to 2012. Between 2000 and 2010, benchmark
overtook international prices for coal, crude palm oil, rubber and crude oil each rose threefold
manufacturing as in real US dollar terms. As a result, commodities overtook manufacturing as
Indonesia’s largest Indonesia’s largest export by 2006. Today, seven out of the top ten export products
exports of Indonesia are commodities and about 60 percent of the country’s exports are
commodities or commodity-related. Most of the commodities are exported
unprocessed, suggesting a weak link between manufacturing and the commodities
sectors.

28
b. Manufacturing exports: drilling down beyond the aggregate numbers
How has Indonesian With the sharp decline in commodity windfall export revenues since 2012, boosting
manufacturing non-commodity exports has emerged as a key priority for Indonesia. To inform
changed since the industrial policies, it is important to go beyond the aggregate numbers and examine
1997/98 crisis? export dynamics at the industrial branch level. Which specific industries drove
manufacturing exports over the past 25 years? How did the manufacturing export
basket change? What is the contribution of low-, medium- and hi-tech sectors to
export performance?
Unfortunately, high- Using the methodology of Figure 29: Low-tech products dominate Indonesia’s
tech manufacturing Diop and Ghali (2012), 37 merchandise export basket
exports have Indonesia’s export products (share in total merchandise exports, percent)
declined sharply are classified by level of High technology Medium-high technology
technology.38 The analysis Medium-low technology Low-technology
shows that the merchandise 45
export basket is strongly
dominated by “low-tech” 36
products (one-third of
goods exports in 2014) 27
despite a decline since its
peak of 43 percent in 1993 18
(Figure 29). This decline has
given way to a steady 9
increase in medium tech
industries’ exports which, in 0
2014, accounted for 28 1990 1993 1996 1999 2002 2005 2008 2011 2014
percent of total Source: UN-COMTRADE, HS4 digits and OECD industrial code;
merchandise exports, from World Bank staff calculations
10 percent in 2000. However the sharpest trend is that of high-tech industries
which, after an initial rise in the 1990s (from 1 percent in 1990 to 12 percent in
2000), declined sharply in subsequent years to 4 percent in 2014.
Within low- and The steady growth in medium-tech exports reflects the strong performance of palm
medium-tech oil, rubber tires (medium-low-tech), completely built cars, automotive spare parts
industries, palm oil, and insulated cable fibers (medium-high) (Figure 30). Rubber tire exports grew by
rubber tires and cars an average of 24.8 percent per year between 2002 and 2011.39 Car exports grew
stand out as from 1,258 units in 2002 to 207,691 units in 2015. This expansion is impressive, but
Indonesia’s best it lags Thailand’s, which exports six times more cars than Indonesia and is the
export performers regional car export hub.
37 N. Diop and S. Ghali, 2012, “Are Jordan and Tunisia's exports becoming more technologically
sophisticated? Analysis using highly disaggregated export databases,” MNA Working Paper No. 56,
the World Bank.
38 Products are captured at the HS-6 digit level with their sector of origin, using ISIC REV2 industrial
codes. Further classification by level of technology (OECD’s low, low-medium, medium-high and
high tech) allows us to examine the specific products that drove growth and the extent to which
Indonesia climbed the technological ladder between 1990 and 2014.
39 Recent foreign direct investment could help this sector grow further. In 2013, Hankook Tire from
the Rep. of Korea and Pirelli Tyre S.p.A of Italy opened their global production plants in Indonesia
(in cooperation with PT. Astra International).

29
Figure 30: Several medium-tech exports have grown Figure 31: … while hi-tech exports have shrunk in
dramatically… recent years
(share in total merchandise exports, percent) (share in total merchandise exports, percent)
Rubber tyres 6
1.6 12 Office & computer equipment
Cars
Radio, TV & commmunication equipment
1.4 Automotive spareparts
10 5
Palm oil prod (RHS)
1.2
Insulated cable fiber
8 4
1.0
0.8 6 3
0.6
4 2
0.4
2 1
0.2
0.0 0 0
1990 1993 1996 1999 2002 2005 2008 2011 2014 1990 1993 1996 1999 2002 2005 2008 2011 2014
Source: UN-COMTRADE, HS-4 digits and OECD industrial code; Source: UN-COMTRADE, HS-4 digits and OECD industrial code;
World Bank staff calculations World Bank staff calculations
Hi-tech exports were Exports of office and computer equipment, radio, and TV and communications
knocked off course equipment plummeted following the 1997 crisis (Figure 31). The only bright spot in
after the 1997 crisis the hi-tech sector is the rise of drug and medicine exports from a very low basis.
c. Regaining competitiveness in manufacturing
i. Keeping inflation low and avoiding excessive real exchange appreciations
Real effective A key factor behind the relative decline in Indonesia’s manufacturing sector is the
exchange rate appreciation of the real effective exchange rate (REER). The REER is the nominal
appreciations played effective exchange rate (the value of a currency against a weighted average of several
a key role in the foreign currencies) divided by a relative price deflator or index of costs. The
weak performance of commodity boom from 2003 to 2012 created revenue windfalls, supported capital
manufacturing in inflows and led to increased demand for non-tradable services (e.g., transport,
2003-2014 logistics and real estate) and higher prices for these services. This led to an
appreciation of the REER (Figure 32).
When prices rise the Firms in non-tradable sectors (e.g., hotels, restaurants and the retail trade) can
manufacturing sector accommodate increasing prices by passing them on to consumers. In the tradable
suffers most sectors such as manufacturing, however, firms are price-takers and cannot pass on
the increases in non-tradable prices. Thus, an increase in the price of non-tradable
goods relative to tradable goods is an obstacle for manufacturing industries because
it renders these sectors less profitable than the services sector or the booming
resources sectors.40
40For related theoretical developments, see Corden, W. M., 1984, “Booming sector and Dutch disease
economics: Consolidation and survey,” Oxford Economic Papers 36, 359–80; and Corden, W. M. and
J. P. Neary, December 1982, “Booming sector and de-industrialisation in a small open economy,”
Economic Journal, 92(368), 825–48. For empirical tests of these concepts, see Rodrik, D., 2008, “The
real exchange rate and economic growth,” Brookings Papers on Economic Activity 2008(2); and
Havrylyshyn, O., 2010, “Does the global crisis mean the end of export-led open-economy
strategies?”, Paper prepared for the World Bank.

30
Going forward, the On account of mainly global factors (e.g., US dollar strength and low commodity
REER could support prices), the Rupiah is no longer pressured toward sustained appreciation (Figure 33).
exports, provided For instance, the Rupiah has depreciated by 16 percent in nominally trade-weighted
that inflation is kept terms since December 2012. Furthermore, with low commodity prices, the relative
low attractiveness of manufacturing activities for investors seeking high returns is
restored. Going forward, the REER could support exports, provided that inflation
is kept low. Although inflation is forecast to be lower than in the past three years
(3.9 percent in 2016 against 6.5 percent on average from 2013 to 2015), there is
evidence that trade restrictions (tariff and non-tariff barriers) lead to higher
domestic prices both for consumers and for producers (see Part B.2). It is thus
important to reduce those barriers to support competitiveness.
Figure 32: The REER appreciated strongly between Figure 33: … with recent depreciation associated with
2000 and 2011… rising manufacturing export growth
(index, 2000=100) (non-commodity export growth yoy, LHS; REER change yoy, RHS;
percent)
120 Non-commodity exports
Real effective exchange rate (rhs)
110 6 -15
5
100 -10
4
3
-5
90 2
1 0
80
0
5
70 -1
-2
10
60 -3
-4 15
Feb-12 Aug-12 Mar-13 Sep-13 Apr-14 Oct-14
Note: A decline in the REER indicates appreciation. Note: A decline in the REER indicates appreciation.
Source: BIS; World Bank staff calculations Source: BIS; World Bank staff calculations
ii. Raising labor productivity
Although Indonesia Indonesia’s labor cost patterns are striking. While Indonesia has the lowest wage
has the lowest wage cost in US dollar terms in Asia, this advantage is lost when adjusted for labor
cost in Asia, the productivity (Figure 34 and Figure 35). In 2014, unit-labor costs—the ratio of how
advantage is lost due much workers are paid to how much they produce—were higher than in the
to low productivity Philippines, Vietnam and Malaysia, not because of how much workers were paid but
because of how little they produced (the recent dramatic rise in unit labor cost in
Thailand reflects the same issue). Malaysia illustrates how high labor productivity is
crucial for cost competitiveness. Despite high manufacturing wages, Malaysian
workers remain competitive because of their high productivity. Their unit labor cost
is slightly higher than Indonesia’s, despite wages that are 7 to 8 times higher. Wages
in China have increased threefold since 2005, but lack of data prevents us from
calculating unit labor costs. It is not clear, therefore, that China is losing cost-
competitiveness, since rising wages may be offset by productivity increases.
The commodities Labor productivity depends on the types of production (for example, low versus
boom reversed higher value-added production), levels of technology used, skill levels of workers,
Indonesia’s rise up and work disruptions. Indonesia gradually ascended the manufacturing value chain
in the 1990s, but this trend was reversed by the commodities boom and as high-

31
the manufacturing technology exports as a share of total manufacturing exports declined. What is now
value chain needed is to attract FDI again into manufacturing, but within a context of a well-
designed industrial strategy focused on increasing value-addition in order to increase
the overall productivity of the manufacturing sector.
Figure 34: Average monthly wages in Figure 35: … but unit labor costs are relatively high
manufacturing are low in Indonesia… (2012 = 100)
(in real 2012 US$)
China Indonesia Malaysia Indonesia Malaysia Thailand
Philippines Thailand Vietnam Vietnam Philippines
900 150
800
140
700
130
600
500 120
400 110
300
100
200
100 90
- 80
2005 2007 2009 2011 2013 2011 2012 2013 2014
Source: CEIC; World Bank staff calculations Source: CEIC; World Bank staff calculations
iii. Reducing logistics and doing business costs

Indonesia has higher In addition, surveys show that Indonesian firms incur large indirect costs due to
indirect costs than poor logistics, gaps in infrastructure and restrictive licensing and permitting
its peers procedures. This places firms located in Indonesia at a disadvantage to their peers
operating in countries where these costs are lower. Measures to reduce these costs,
as well as improved trade facilitation and a reduction of non-tariff measures, are
especially important in a context of growing global value chain integration where
efficient importing is critical to export success.
Poor logistics is one Good logistics is a vital prerequisite for supplying domestic markets efficiently and
of the main reasons competing internationally. At about 24 percent of GDP, the cost of logistics—
for high costs moving goods around the country, as well as in and out—is high in Indonesia, while
Thailand spends about 16 percent of GDP.41 For Indonesia, this difference amounts
to an additional US$70 billion in costs per year.
Transport and A recent World Bank survey of manufacturers across Indonesia’s major
container-handling agglomerations shows a breakdown of logistics costs. Average total logistics costs
costs are the main reflect transport and container-handling costs (45 percent of the total), inventory
contributors to high costs (26 percent), warehousing (17 percent) and logistics administration (17
logistics costs percent). Inventory costs are clearly much higher than in some of Indonesia’s
competitors: these are only 13 percent of total costs in Malaysia and 16 percent in
Thailand.
41 See Part C.1 in the March 2016 IEQ for a more detailed discussion of the challenges Indonesia’s
freight logistics system faces.

32
Firms hold high High inventory costs reflect uncertainties in the supply chain. A key source of
inventories to protect uncertainty lies in hinterland connections. The costs of bringing containers to
them from uncertain Jakarta’s main port, Tanjung Priok, are double those in Malaysia, although distances
hinterland are similar. A survey of 83 trucking firms operating in Greater Jakarta highlights
connections why: prolonged idle and waiting times due to congestion; long queuing at the port;
and low efficiency in synchronizing cargo deliveries and pick-ups.
Obtaining permits, Regulatory procedures, licensing and permitting at the central level are also
paying taxes and complex, imposing additional delays and costs. Along with construction permits,
enforcing contracts paying taxes and enforcing contracts are among the most cumbersome procedures
are difficult globally (World Bank Group, 2016 Doing Business survey).42
iv. Devising a sound industrial strategy

Indonesia’s Finally, the fact that hi-tech exports (mainly electronics) quasi-vanished, following
experience suggests the 1997 crisis, suggests the absence of a solid, home-based industrial strategy in
a lack of a sound Indonesia. Indonesia received significant FDI from Japan, Hong Kong, Taiwan,
industrial strategy South Korea and Singapore in the early 1990s. However, technology transfer or
capacity development in terms of product design, product engineering and product
development, which require some government involvement, was limited. The
manufacturing operations focused mainly on blending and assembly, making
Indonesia vulnerable to changes in multinationals’ location strategies because no
country can be competitive in assembly and light manufacturing forever. A key
lesson from Indonesia’s own experience is that to upgrade industries and climb the
technological ladder, government’s involvement and partnership with the private
sector is required.
Experience in East East Asian countries, such as Japan, Korea, Singapore and Taiwan, provide good
Asia and around the examples of industrial policies implemented successfully. But many developing
world can inform countries have attempted to mimic this experience and failed because government
Indonesia’s new support is captured by vested interests. Indonesia can thus draw on the cases of
industrial strategy successes and failures around the world in devising a sound industrial policy today.
What is needed is policy focus and pragmatic, accountable and transparent support
to promising industries, such as those that have done well in the past 25 years in
spite of many obstacles. Global experience suggests that key principles that underlie
such a strategy could be: tying support to clearly defined performance criteria, an
emphasis on competitiveness in world markets, and the need to preserve
competition.
SEZs can be The government has announced the establishment of many special economic zones
strategic tools to (SEZs), which could help to reduce immediately the regulatory burden for
support promising sectors and provide a hospitable environment to develop a supply base
industrialization for large investors. China is an example where SEZs have been used to support
under certain industrial development in the coastal areas. However, SEZs can be ineffective if
conditions planned and designed poorly. Given what is constraining competitiveness in
Indonesia (see below), SEZs should be designed as favorable micro-climates for
firm productivity growth with a focus on the few sectors that have demonstrated
42 Indonesia’s three worst performance are: starting a business (173rd), enforcing contracts (170th) and
paying taxes (148th). On dealing with construction permits, Indonesia is ranked 107th, below the East
Asia and Pacific average (the Philippines ranked 95th, China 90th, Thailand 26th and Malaysia 18th).

33
strong performance and not simply places where firms enjoy tax incentives.43 In
addition, also focusing on the few promising sectors, the government could
consider promoting public-private partnerships to close skills gaps through training
centers and specific schools. Focused investments in research and development that
target promising sectors are also key to move toward the global technological
frontier.
A competitive Finally, the industrial strategy should recognize the growing service-intensity of
modern service manufacturing and support the availability of efficient, low-cost modern services for
sector is also manufacturers. This again places a premium on fostering competition and
important facilitating domestic and foreign investments in these sectors.
d. How to make manufacturing an engine of growth again
Four specific The end of the commodities boom provides an opportunity for Indonesia to revive
measures would help its manufacturing competitiveness. Lessons from the country’s own experience, the
Indonesia to address few cases of global successes and the many cases of failures can inform a new
these challenges industrial strategy in Indonesia. The following are a few concrete measures that
could help it succeed.
First, a strategic and SEZs could be a strategic tool for the Government’s involvement, provided that
transparent they are designed as favorable micro-climates for firm productivity growth, with a
partnership with the focus on the few sectors that have demonstrated strong performance and not
private sector is simply places where firms enjoy tax incentives. Focusing on these sectors, public-
important private partnerships can be devised to help reduce skills gaps (e.g., through focused
provision of training) and to undertake focused investments in research and
development targeting promising sectors to support local product development.
Second, maintaining Keeping inflation low through investments in agricultural productivity and through
low inflation would lowering trade barriers would support export growth via lower REER appreciation
help limit REER pressures. Indeed, the prolonged bouts of appreciations of the REER between 2003
appreciation and 2012 undermined the competitiveness of manufacturing. The appreciation was
largely driven by higher inflation in Indonesia than in trading partners.
Third, higher Finally, the Indonesian government has an ambitious plan to close the infrastructure
infrastructure gap in the years to come. It has also started, since September 2015, to address
spending and regulatory restrictions through a series of “policy packages”. To reduce logistics
regulatory reform costs, strengthening inter-agency coordination for better logistics policy reform
would improve implementation, reducing regulatory bottlenecks in the supply chain, and closing
competitiveness gaps in logistics infrastructure will be key. If well implemented, these policies could
crucially reduce logistics costs and the costs of doing business in Indonesia,
supporting the country’s overall competitiveness.
Fourth, policy could Not all sectors can underpin a successful industrial strategy and focusing on the
focus on promising country’s strengths is crucial. The Government could consider focusing its efforts
sectors on supporting the industries that have been growing very fast despite many
obstacles and that have demonstrated a strong capacity for export over the past 25
years. Leveraging the country’s natural resource abundance, where relevant, should
be an integral part of the strategy. The example of rubber tire industries, which use
43Economic zones are normally established to act as catalysts for trade, investment, and wider
economic growth. In different countries, however, the specific objectives vary, from attracting FDI to
creating employment to experimenting with reforms.

34
the country’s own rubber as raw material, process it to match international quality
standards and sell the finished products to the growing domestic car industry and in
global markets is an illustration of what is possible.
However, Indonesia is fortunate to have clear reform options and leadership geared toward
implementation addressing the country’s competitiveness challenges. As is the case for other reform
challenges should be areas however, the difficulty lies in getting the reforms implemented in a complex
addressed. A few institutional and decentralized framework. In this context, exploiting any entry point
factors provide entry for pushing reforms forward is crucial. The recent “policy packages” provide a
points framework for implementing many needed reforms. Furthermore, the momentum
created by a possible renewal of Indonesia’s global engagement through the Trans-
Pacific Partnership (TPP) and the free-trade agreement with the EU is another
possible anchor for reforms. If Indonesia is to reach its goals, now is the time to
pull out all the stops to return to its former status as a manufacturing powerhouse.

35
2. Fiscal policy could better target inequality reduction

Inequality in Inequality in Indonesia has risen since the early 2000s and many Indonesians believe
Indonesia has risen urgent action is needed. During the 1997-98 Asian financial crisis, poverty rose
in the past 15 years sharply, while the Gini measure of inequality fell as the richest were the hardest hit.
Since then, the Gini has increased from 30 points in 2000 to 41 points in 2014, its
highest recorded level. The consequences of doing nothing to address high levels of
inequality can be serious. High inequality can cause economic growth to stall and
poverty reduction to slow. There is also evidence that Indonesian districts with
higher inequality have a higher incidence of conflict. The public shares this view: 88
percent of Indonesians who were surveyed in 2014 believed that it was urgent for
the Government to address inequality.
Fiscal policy is a key Fiscal policy is one of the Figure 36: Fiscal policy in Indonesia has not been
option to reduce main tools available to very effective in reducing inequality
inequality… governments to reduce (reduction in the Gini coefficient from market income to final income,
inequality, both in the long points)
term and the short term. 0
Fiscal policy – how and -2
where the Government -4
spends, and how it raises -6
money to fund this -8
spending – is one of the -10
four main policy responses -12
to address inequality, as -14
identified by a recent -16
World Bank study. In the
45 -18
long term, increased -20
budget allocation on health
and more effective
spending of the nationally
mandated 20-percent Source: Armenia (Younger et al. 2014); Bolivia (Paz et al. 2014);
budget allocation on Brazil (Higgins and Pereira 2014); Ethiopia (Woldehanna et al.
2014); Mexico (Scott 2014); Peru (Jaramillo 2014); Uruguay (Bucheli
education could help poor et al. 2014); Lustig (2014) based on Costa Rica (Sauma et al. 2014),
children and children in El Salvador (Beneke de Sanfeliu et al. 2014), and Guatemala
remote regions to receive a (Cabrera et al. 2014); South Africa (Inchauste et al. 2014); World
Bank staff estimates for Indonesia based on Susenas 201244
better start in life and
develop the skills needed in the modern workplace. At the same time, greater
investments in infrastructure would not only reduce prices for food and other goods
consumed by the poor and vulnerable, but also make firms and workers more
productive, leading to the creation of more skilled jobs for the higher-skilled
workers who are coming out of the improved health and education systems.
Additionally, fiscal policy can reduce inequality in the short term by raising revenues
through higher taxes paid by richer households and spending in ways that benefit
the poor and vulnerable the most.
44 Full references in Inchauste, G. and N. Lustig, forthcoming in 2016, “The distributional impact of
fiscal policy: Evidence from developing countries”, Washington, DC: World Bank.
45 The 2015 World Bank report “Indonesia’s Rising Divide: Why inequality is rising, Why it matters
and what can be done” explores the causes, consequences, and recommended policy responses to
inequality in greater detail. Available:
http://www.worldbank.org/en/news/feature/2015/12/08/indonesia-rising-divide

36
… and several In a number of countries, often in Latin America where inequality is the highest of
developing countries any region, tax and spending policy choices have been made with a view to reducing
have successfully inequality. One can see how inequality in a country changes as a result of fiscal
done just that measures, when the distribution of market incomes from wages, interest, rents, and
private transfers and remittances are compared to final incomes after all taxes are paid,
services used along with any fees, public transfers received (i.e. after accounting for
the full effects of fiscal policy). In Brazil, for example, the Gini coefficient calculated
for market income was 14 points higher than the one for final income, indicating a
very large reduction in inequality due to fiscal policy in 2009 (Figure 36). In South
Africa, the reduction in the Gini coefficient in 2010 was even larger at 17.5 points.
Declines of 6 points or more have also been observed in Costa Rica, Uruguay,
Mexico and Bolivia in recent years. However, in Indonesia in 2012 the Gini
coefficient was reduced by only 2.5 points, the second-lowest, after Ethiopia, in the
12-country sample.
a. Public spending in 2012 did not tackle inequality effectively
A World Bank study A “Commitment to Equity”46 study was initiated by the World Bank to examine the
examined the impact impact of fiscal policy on inequality in Indonesia using data from 2012. The study
of fiscal policy on looked at 57 percent of total public spending, covering social assistance, energy
inequality in subsidies, and contributory pensions. The two largest components — energy
Indonesia… subsidies (mostly for fuel)47 and education—together made up 69 percent of total
social, subsidy and pension spending (Figure 37). By law education must make up
20 percent of the total budget. Only 5 percent of the budget was spent on health
and less than 3 percent on social assistance through cash transfers targeting poor
and vulnerable households. For methodological reasons, the study excluded housing
and urban spending and other subsidies (mostly for fertilizer and seeds), but these
are relatively small.
… and found that The study found that in 2012 Indonesia spent the least on programs that are most
the Government cost-effective at reducing inequality. The Government also spent the most on the
spent the least on the least cost-effective programs. This can be shown using an effectiveness index, which
most effective is calculated as the change in the Gini coefficient from market income to final
programs and vice income due to a given program divided by the program spending in percent of
versa GDP. Energy subsidies, which are the least cost-effective at reducing inequality,
received by far the highest spending in 2012 (3.7 percent of GDP) (Figure 38). In
contrast, direct transfers, which scored highest on the effectiveness index, had the
lowest spending (0.3 percent of GDP). Education is half as effective as direct
transfers, but because larger sums are spent on it (2.6 percent of GDP), it has the
largest overall effect. Health is only one-third as effective in reducing inequality as
direct transfers and since relatively little was spent on health (0.9 percent of GDP),
it had a small overall impact on inequality.
46 The “Commitment to Equity” is a joint project of the Center for Inter-American Policy and
Research (CIPR), Tulane University, and the Inter-American Dialogue, designed to analyze the impact
of taxation and social spending on inequality and poverty in individual countries.
47 Sweeping reforms by the new administration in 2015 mean that fuel subsidy spending is now much
lower.

37
Figure 37: In 2012, Indonesia spent the most on Figure 38: Direct transfers – most effective at
energy subsidies and the least on cash transfers reducing inequality– had the lowest budget
(Public spending by type, in percent of total social, pension and (Effectiveness index, LHS; spending in percent of GDP, RHS)
subsidy spending)
Budget (RHS)
5% 4% 4% Effectiveness Index (LHS)
Cash Transfers
1.2 4.0
Non-contributory pensions
9% 3.5
Health 1.0
3.0
36% Education 0.8
2.5
Housing/Urban 0.6 2.0
33%
Contributory Pensions 1.5
0.4
8% Energy Subsidies 1.0
0.2
Non-Energy Subsidies 0.5
2%
0.0 0.0
Direct Education Health Subsidies
Transfers
Note: For methodological reasons, housing and urban spending Note: Effectiveness is the change in Gini coefficient from market
and non-energy subsidies are excluded from the analysis. income to final income due to a given program divided by the
Source: Audited 2012 State Budget; World Bank staff calculations program spending in percent of GDP.
Source: 2012 National Socio-economic Survey (Susenas), 2012 State
Budget, World Bank staff calculations
Figure 39: Within transfer programs the most Figure 40: But spending on education is inequality-
effective, PKH, also had the lowest budget reducing
(Effectiveness index, LHS; spending in percent of GDP, RHS) (Effectiveness index, LHS; spending in percent of GDP, RHS)
Spending as % GDP Spending as % GDP
350 Effectiveness Index 0.3 120 Effectiveness Index 1.2
300 100
1.0
0.2 80
250 0.8
60
200 0.2
40 0.6
150 0.1 20
0.4
100 0
0.1 0.2
-20
50
-40 0.0
0 0.0 Primary Junior Senior Tertiary
PKH Raskin BSM Secondary Secondary
Note: See note to Figure 4. Note: See note to Figure 4.
Source: 2012 National Socio-economic Survey (Susenas), 2012 State Source: 2012 National Socio-economic Survey (Susenas), 2012 State
Budget, World Bank staff calculations Budget, World Bank staff calculations
The most effective Within direct transfers, the least budget was spent on the most effective Family
direct transfer Hope Program (Program Keluarga Harapan, PKH), Indonesia’s conditional cash
program also transfer program. Every Rupiah spent on PKH reduces inequality by 2.5 times more
received the lowest than every Rupiah spent on Raskin, the Government’s rice distribution program for
budget allocation the poor, yet Raskin’s budget is more than 10 times higher (Figure 39). Four times
more is spent on Assistance for Poor Students (Bantuan Siswa Miskin, BSM) than
PKH, and because of bad targeting, BSM was even less effective than Raskin. In
contrast, most education spending goes to primary and junior secondary schools,
which have the greatest inequality-reducing effect, as poorer households tend to

38
have more children than richer households (Figure 40). By comparison, tertiary
spending increases inequality, as very few poorer children make it to university.
International While the greatest impact on inequality is likely to come through spending choices,
experience shows how Indonesia raises revenue matters too. If too much is spent on redistribution
that improving tax and other social spending relative to revenues, the fiscal framework can become
collection can also unsustainable. For example, cash transfers in Brazil now represent 4 percent of
help address GDP. Thus, tax revenues must also be raised. In Indonesia, according to the World
inequality Bank study, indirect taxes, such as value-added tax and tobacco excise, are relatively
neutral and do not have much impact on inequality. Personal income tax collection
is low, making up only 10 percent of total tax revenues, or around 1.9 percent of
GDP. An increase in compliance and a broader tax base would both increase
revenues and lower inequality. In other countries personal income taxes raise
significantly more revenue and are borne to a much greater degree by the rich,
helping to reduce inequality directly, as well as funding pro-poor spending.
b. The recent fuel subsidy reform helped reduce poverty and inequality
Several rounds of In June 2013 and November 2014, in response to high international oil prices and a
subsidized fuel price weak Rupiah, Indonesia raised subsidized fuel prices by 30 percent or more. As in
rises, accompanied the previous years (e.g., 2005 and 2008), in 2013 a temporary unconditional cash
by compensation for transfer (Bantuan Langsung Sementara Masyarakat, BLSM) was implemented to
the poor, culminated compensate the poor and vulnerable. The payment covered the poorest 25 percent
in a fuel subsidy of households and provided each household with IDR 150,000 (USD 12) per
reform… month for seven months. In 2014, President Joko Widodo increased fuel prices
immediately after taking office. This was also accompanied by six monthly BLSM
payments as compensation for the poor. However, by the end of December 2014,
large decreases in oil prices meant that regulated prices were above market prices.
The Government responded by largely removing fuel subsidies altogether and
redirecting spending into infrastructure, health, and social assistance.
… which had a The BLSM payments had a significant (though temporary) effect on poverty and
positive impact on inequality. In 2013, the World Bank estimated that poverty would have been 2.5
both poverty and percentage points higher due to the direct and indirect effects of higher fuel prices,
inequality reduction had there been no BLSM.48 In addition, because the BLSM payments were only
made to poor and vulnerable households, the transfers would have also contributed
to reducing inequality. With a combination of BLSM and the redirection of
spending into more effective policies, the overall impact of fiscal policy in reducing
inequality for 2013, 2014, and 2015 is likely to be higher than 2012. Ongoing work
by the World Bank seeks to quantify these effects and will update the “Commitment
to Equity” results presented above.
48 See Part B.2 of the December 2013 IEQ for a more detailed discussion.

39
APPENDIX: A SNAPSHOT OF INDONESIAN ECONOMIC INDICATORS

Appendix Figure 1: Real GDP growth Appendix Figure 2: Contributions to GDP expenditures
(percent) (contribution to real GDP growth yoy, percent)
4 8 Private cons. Gov cons.
Investment Net exports
8 Stat.discrepancy* GDP
Year on year (RHS)
3 6 6
Quarter on quarter seas. 4

2 adjusted (qoq sa) 4
2
Average qoq sa
0
1 2
-2
0 0 -4
Mar-10 Mar-12 Mar-14 Mar-16 Mar-13 Mar-14 Mar-15 Mar-16
Source: BPS; World Bank staff calculations Note: * includes changes in stocks.
Appendix Figure 3: Contributions to GDP production Appendix Figure 4: Motorcycle and motor vehicle sales
(contribution to real GDP growth yoy, percent) (seasonally-adjusted sales growth yoy, percent)
Agriculture Mining and constr. 40
Manufacturing Comm & transport
Trade, hotel & rest Other services
8 GDP
20 Cement sales
6 Motor vehicle sales
0
4
-20
2
Motorcycle sales
0 -40
Mar-13 Mar-14 Mar-15 Mar-16 Apr-13 Apr-14 Apr-15 Apr-16
Source: BPS; World Bank staff calculations Source: CEIC; World Bank staff calculations
Appendix Figure 5: Consumer indicators Appendix Figure 6: Industrial production indicators

(retail sales index 2010=100) (PMI diffusion index; industrial production growth yoy, percent)
200 BI Retail sales index 60 20
BI Consumer
180 Survey Index Industrial production, RHS
160 55 10
140
120 50 0
100
Manufacturing PMI
80 45 -10
May-13 May-14 May-15 May-16 May-13 May-14 May-15 May-16
Source: BI; World Bank staff calculations Source: BPS; Nikkei/Markit: ; World Bank staff calculations

40
Appendix Figure 7: Balance of payments Appendix Figure 8: Current account components

(USD billion) (USD billion)
Current account Capital and financial
16 Errors and omissions Overall BoP inflows 8 Goods trade
Secondary income
4
8
0
0
-4
Current account
-8
-8
Services trade
-16 -12 Primary income
Mar-13 Mar-14 Mar-15 Mar-16 Mar-13 Mar-14 Mar-15 Mar-16
Appendix Figure 9: Exports of goods Appendix Figure 10: Imports of goods

(USD billion) (USD billion)
18 18
15 15
Total Exports (fob) Total Import (cif)
12 12
Manufacturing
9 9
Raw materials
6 6
Oil and gas
3 Oil and gas 3 Capital goods
Mining
Consumer goods
Agriculture
0 0
May-14 Nov-14 May-15 Nov-15 May-16 May-14 Nov-14 May-15 Nov-15 May-16
Source: BPS; World Bank staff calculations Source: BPS; World Bank staff calculations
Appendix Figure 11: Reserves and capital flows Appendix Figure 12: Inflation and monetary policy
(USD billion) (percent)
150 8 12.0
Headline inflation, yoy 3.8
International BI policy rate

125 6
Reserves (LHS)
8.0
2.6
100 4
75 2 4.0 Core inflation, 1.4

yoy
50 0
0.0 0.2
25 -2
Non-resident portfolio inflows, (RHS):
Equities SUN SBI Global bonds
0 -4 Headline inflation mom (RHS)
Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 -4.0 -1.0
May-13 May-14 May-15 May-16
Source: BI; Ministry of Finance (MoF); World Bank staff calculations Source: BPS; BI; World Bank staff calculations

41
Appendix Figure 13: Monthly breakdown of CPI Appendix Figure 14: Inflation comparison across countries
(percentage point contributions to monthly growth) (change yoy)
4 Core Administered
India
Volatile Headline
Indonesia *
3 China
Malaysia
2 Philippines
USA
1
Korea
Thailand *
0
Japan
Singapore
-1
May-13 May-14 May-15 May-16 -2 -1 0 1 2 3 4 5 6 7
Source: BPS; World Bank staff calculations *Note: May 2016; others April.
Source: BPS; CEIC; World Bank staff calculations
Appendix Figure 15: Domestic and international rice Appendix Figure 16: Poverty and unemployment rate
prices ( percent)
(percent LHS, wholesale price, in IDR per kg RHS)
120 12,000 24
Domestic rice, IR64-II (RHS) 20

100 10,000
80 8,000 16 Poverty rate
Vietnamese rice 5% broken (RHS) 12

60 6,000
40 4,000 8
Unemployment rate
20 Percentage spread (LHS) 2,000 4
0 0 0
May-13 May-14 May-15 May-16 2003 2005 2007 2009 2011 2013 2015
Source: Cipinang wholesale rice market; FAO; World Bank staff Source: BPS; World Bank staff calculations
calculations
Appendix Figure 17: Regional equity indices Appendix Figure 18: Selected currencies against USD
(daily index in local currency, June 14 2013=100) (monthly index May 2013=100)
250
100
South Africa
200 Shanghai-China India
80
Indonesia
150 BSE-India
JSI-Indonesia 60 Turkey
100
SET-Thailand
SGX-Singapore Brazil
50 40
Jun-13 Jun-14 Jun-15 Jun-16 May-13 May-14 May-15 May-16
Source: CEIC; World Bank staff calculations Source: CEIC; World Bank staff calculations

42
Appendix Figure 19: 5-year local currency gov. bond Appendix Figure 20: Sovereign USD bond EMBIG
yields spread
(percent) (basis points)
10 420 60
Indonesia spread less overall EMBIG
Indonesia index spread (RHS)
8 360 0
6 300 -60
Malaysia
4 240 -120
Thailand
2 United States 180 -180
Indonesia EMBIG bond spread
Singapore
0 120 -240
Jun-12 Jun-13 Jun-14 Jun-15 Jun-16 Jun-13 Jun-14 Jun-15 Jun-16
Source: CEIC; World Bank staff calculations Source: JP Morgan; World Bank staff calculations
Appendix Figure 21: Commercial and rural credit and Appendix Figure 22: Banking sector indicators
deposit growth (monthly, percent)
(growth yoy, percent)
30
100 Loan to deposit ratio 5
Commercial and rural bank loans

25
80 4
Return on assets (RHS)

20 60 3
Non performing loans (RHS)
15 40 2
Capital adeqacy ratio (RHS)

10 20 1
Private deposit
Liquidity asset ratio
5 0 0
Apr-12 Apr-13 Apr-14 Apr-15 Apr-16 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16
Appendix Figure 23: Government debt Appendix Figure 24: External debt
(percent of GDP; USD billion) (percent of GDP; USD billion)
Private external debt, RHS
60 Domestic debt, RHS 320 60 Public external debt, RHS 320
External debt, RHS Total external debt to GDP, LHS
Total debt to GDP, LHS
45 240 45 240
30 160 30 160
15 80 15 80
0 0 0 0
2008 2010 2012 2014 2016 2008 2010 2012 2014 2016
March March
Source: BI; MoF; World Bank staff calculations Source: BI; World Bank staff calculations

43
Appendix Table 1: Budget outcomes and projections

(IDR trillion)
2011 2012 2013 2014 2015 2016
Actual Actual Actual Actual Actual Budget
A. State revenue and grants 1,211 1,338 1,439 1,550 1,508 1,822
1. Tax revenue 874 981 1,077 1,147 1,240 1,547
2. Non-tax revenue 331 352 355 399 256 274
B. Expenditure 1,295 1,491 1,651 1,777 1,807 2,096
1. Central government 884 1,011 1,137 1,204 1,183 1,326
2. Transfers to the regions 411 481 513 574 623 770
C. Primary balance 9 -53 -99 -93 -142 -89
D. SURPLUS / DEFICIT -84 -153 -212 -227 -298 -273
(percent of GDP) -1.1 -1.8 -2.2 -2.1 -2.6 -2.2
Note: Budget balance as percentage of GDP uses the revised and rebased GDP.
Source: MoF; World Bank staff calculations
Appendix Table 2: Balance of payments

(USD billion)
2014 2015 2016
2013 2014 2015
Q4 Q1 Q2 Q3 Q4 Q1
Balance of payments -7.3 15.2 -1.1 2.4 1.3 -2.9 -4.6 5.1 -0.3
Percent of GDP -0.8 1.7 -0.1 1.1 0.6 -1.3 -1.9 2.2 -0.1
Current account -29.1 -27.5 -17.7 -6.0 -4.1 -4.3 -4.2 -5.1 -4.7
Percent of GDP -3.2 -3.1 -2.0 -2.7 -1.8 -1.9 -1.7 -2.2 -2.0
Trade balance -6.2 -3.0 5.0 -0.1 1.2 1.5 2.0 0.2 1.6
Net income & current transfers -22.9 -24.5 -22.6 -5.8 -5.4 -5.8 -6.2 -5.3 -6.3
Capital & Financial Account 22.0 45.4 16.9 9.6 5.0 1.8 0.2 9.8 4.2
Percent of GDP 2.4 5.1 2.0 4.4 2.2 0.8 0.1 4.3 1.8
Direct investment 12.3 14.7 9.9 5.0 1.7 3.7 1.8 2.8 2.2
Portfolio investment 10.9 26.1 16.7 1.9 8.5 5.6 -2.2 4.9 4.4
Other investment -1.2 4.1 -9.8 5.0 -5.2 -7.4 0.6 2.2 -2.4
Errors & omissions -0.2 -2.6 -0.5 -1.3 0.4 -0.9 -0.7 0.7 0.0
Foreign reserves* 99.4 111.6 101.7 111.9 111.6 108.0 101.7 105.9 107.5
Note: * Reserves at end-period.
Source: BI; BPS; World Bank staff calculations

44
Appendix Table 3: Indonesia’s historical macroeconomic indicators at a glance

2000 2005 2010 2011 2012 2013 2014 2015
1
National Accounts (% change)
Real GDP 4.9 5.7 6.2 6.2 6.0 5.6 5.0 4.8
Real investment 11.4 10.9 8.5 8.9 9.1 5.0 4.6 5.1
Real consumption 4.6 64.0 4.1 5.1 5.4 5.7 4.7 4.9
Private 3.7 0.9 4.8 5.1 5.5 5.5 5.3 4.8
Government 14.2 6.6 0.3 5.5 4.5 6.7 1.2 5.4
Real exports, GNFS 30.6 16.6 15.3 14.8 1.6 4.2 1.0 -2.0
Real imports, GNFS 26.6 17.8 17.3 15.0 8.0 1.9 2.2 -5.8
Investment (% GDP) 20 24 31 31 33 32 33 33
Nominal GDP (USD billion) 165 286 755 893 918 913 890 862
GDP per capita (USD) 857 1,396 3,167 3,688 3,741 3,668 3,530 3,374
Central Government Budget (% GDP)2
Revenue and grants 20.8 16.8 14.5 15.5 15.5 15.1 14.7 13.1
Non-tax revenue 9.0 5.0 3.9 4.2 4.1 3.7 3.8 2.2
Tax revenue 11.7 11.7 10.5 11.2 11.4 11.3 10.9 10.7
Expenditure 22.4 17.3 15.2 16.5 17.3 17.3 16.8 15.7
Consumption 4.0 2.8 3.6 3.8 3.9 4.1 4.0 4.5
Capital 2.6 1.1 1.2 1.5 1.7 1.9 1.4 1.9
Interest 5.1 2.2 1.3 1.2 1.2 1.2 1.3 1.4
Subsidies 6.3 4.1 2.8 3.8 4.0 3.7 3.7 1.6
Budget balance -1.6 -0.6 -0.7 -1.1 -1.8 -2.2 -2.1 -2.6
Government debt 97.9 44.3 24.3 22.8 22.6 24.1 23.8 25.6
o/w external government debt 51.4 23.4 11.1 10.2 9.9 11.2 10.2 10.8
Total external debt (including private sector) 87.1 47.1 26.8 25.2 27.5 29.2 33.0 36.0
3
Balance of Payments (% GDP)
Overall balance of payments .. 0.2 4.0 1.3 0.0 -0.8 1.7 -0.1
Current account balance 4.8 0.1 0.7 0.2 -2.7 -3.2 -3.1 -2.0
Exports GNFS 42.8 35.0 22.0 23.8 23.0 22.5 22.3 19.8
Imports GNFS 33.9 32.0 19.2 21.2 23.2 23.2 22.7 19.2
Trade balance 8.9 2.9 2.8 2.7 -0.2 -0.7 -0.3 0.6
Financial account balance .. 0.0 3.5 1.5 2.7 2.4 5.1 2.0
Direct investment -2.8 1.8 1.5 1.3 1.5 1.3 1.7 1.2
Gross official reserves (USD billion) 29.4 34.7 96.2 110.1 112.8 99.4 111.6 101.7
Monetary (% change)3
GDP deflator1 20.4 14.3 8.3 7.5 3.8 5.0 5.4 4.2
Bank Indonesia interest key rate (%) .. 9.1 6.5 6.0 5.8 7.5 7.8 7.5
Domestic credit (eop) .. 24.3 22.8 24.6 23.1 21.6 11.6 10.4
Nominal exchange rate (average, IDR/USD)4 8,392 9,705 9,087 8,776 9,384 10,460 11,869 13,389
Prices (% change)1
Consumer price Index (eop) 9.4 17.1 7.0 3.8 3.7 8.1 8.4 3.4
Consumer price Index (average) 3.7 10.5 5.1 5.3 4.0 6.4 6.4 6.4
Indonesia crude oil price (USD per barrel, eop)5 28 53 79 112 113 107 60 36
Source: 1 BPS and World Bank staff calculations, using revised and 2010 rebased figures. 2 MoF and World Bank staff calculations (for 1995 is
FY 1995/1996, for 2000 covers 9 months, for 2015 based on revised State Budget), 3 BI, 4 IMF, 5 CEIC

45
Appendix Table 4: Indonesia’s development indicators at a glance

2000 2005 2010 2011 2012 2013 2014 2015
1
Demographics
Population (million) 213 227 242 245 248 251 254 258
Population growth rate (%) 1.3 1.2 1.3 1.3 1.3 1.3 1.3 1.3
Urban population (% of total) 42 46 50 51 51 52 53 ..
Dependency ratio (% of working-age population) 55 54 51 51 50 50 49 ..
Labor Force2
Labor force, total (million) 98 106 117 117 120 120 122 122
Male 60 68 72 73 75 75 76 77
Female 38 38 45 44 46 45 46 46
Agriculture share of employment (%) 45 44 38 36 35 35 34 33
Industry share of employment (%) 17 19 19 21 22 20 21 22
Services share of employment (%) 37 37 42 43 43 45 45 45
Unemployment, total (% of labor force) 8.1 11.2 7.1 7.4 6.1 6.2 5.9 6.2
Poverty and Income Distribution3
Median household consumption (IDR 000 per month) 104 211 374 421 446 487 548 623
National poverty line (IDR 000 per month) 73 129 212 234 249 272 303 331
Population below national poverty line (million) 38 35 31 30 29 28 28 29
Poverty (% of population below national poverty line) 19.1 16.0 13.3 12.5 12.0 11.4 11.3 11.2
Urban (% of population below urban poverty line) 14.6 11.7 9.9 9.2 8.8 8.4 8.3 8.3
Rural (% of population below rural poverty line) 22.4 20.0 16.6 15.7 15.1 14.3 14.2 14.2
Male-headed households 15.5 13.3 11.0 10.2 9.5 9.2 9.0 9.3
Female-headed households 12.6 12.8 9.5 9.7 8.8 8.6 8.6 11.1
Gini index 0.30 0.35 0.38 0.41 0.41 0.41 0.41 0.41
Percentage share of consumption: lowest 20% 9.6 8.7 7.9 7.4 7.5 7.4 7.5 7.2
Percentage share of consumption: highest 20% 38.6 41.4 40.6 46.5 46.7 47.3 46.8 47.3
Public expenditure on social security & welfare (% of GDP)4 .. 0.4 0.4 0.4 0.4 0.6 0.5 0.6
Health and Nutrition1
Physicians (per 1,000 people) 0.16 0.13 0.29 .. 0.20 .. ..
Under five mortality rate (per 1000 children under 5 years) 52 42 33 32 30 29 28 27
Neonatal mortality rate (per 1000 live births) 22 19 16 16 15 15 14 14
Infant mortality (per 1000 live births) 41 34 27 26 25 24 24 23
Maternal mortality ratio (modeled est., per 100,000 live births) 265 212 165 156 148 140 133 126
Measles vaccination (% of children under 2 years) 74 77 78 80 85 84 77 ..
Total health expenditure (% of GDP) 2.0 2.8 2.9 2.9 3.0 3.1 .. ..
Public health expenditure (% of GDP) 0.7 0.8 1.1 1.1 1.2 1.2 .. ..
Education3
Primary net enrollment rate (%) .. 92 92 92 93 92 93 97
Female (% of total net enrollment) .. 48 48 49 49 50 48 49
Secondary net enrollment rate (%) .. 52 61 60 60 61 65 66
Tertiary net enrollment rate (%) .. 9 16 14 15 16 18 20
Adult literacy rate (%) .. 91 91 91 92 93 93 95
Public spending on education (% of GDP)5 .. 2.7 3.5 3.6 3.8 3.8 3.6 ..
Public spending on education (% of spending)5 .. 14.5 20.0 20.2 20.1 20.0 19.9 20.6
Water and Sanitation1
Access to an improved water source (% of population) 78 81 85 85 86 86 87 87
Urban (% of urban population) 91 92 93 93 94 94 94 94
Rural (% of rural population) 68 71 76 77 77 78 79 80
Access to improved sanitation facilities (% of population) 44 53 57 58 59 60 61 61
Urban (% of urban population) 64 70 70 71 71 72 72 72
Rural (% of rural population) 30 38 44 45 46 47 48 48
Others1
Disaster risk reduction progress score (1-5 scale; 5=best) .. .. .. 3.3 .. .. .. ..
Proportion of seats held by women in national parliament (%)6 8 11 18 18 19 19 17 17
Source: 1 World Development Indicators; 2 BPS (Sakernas); 3 BPS (Susenas) and World Bank; 4 MoF, Bappenas, and World Bank staff
calculations, only includes spending on rice distribution for the poor (Raskin), health insurance for the poor, scholarships for the poor, and
Family Hope Program (PKH) and actuals; 5 MoF; 6 Inter-Parliamentary Union

46
June 2016
Supported by funding from the Australian Government

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June 2016

Resilience through reforms

Supported by funding from the Australian Government

PREFACE .............................................................................................................................. III

EXECUTIVE SUMMARY: RESILIENCE THROUGH REFORMS .................................... I

A. ECONOMIC AND FISCAL UPDATE ............................................................................... 1

1. The global economy is not yet supportive ..................................................................................... 1

B. SOME RECENT DEVELOPMENTS IN INDONESIA’S ECONOMY ........................ 16

C. INDONESIA 2018 AND BEYOND: A SELECTIVE LOOK ........................................... 27

1. Reviving manufacturing competitiveness .................................................................................... 27

APPENDIX: A SNAPSHOT OF INDONESIAN ECONOMIC INDICATORS ................ 40

LIST OF APPENDIX FIGURES

LIST OF APPENDIX TABLES

Executive summary: Resilience through reforms

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

remains unchanged 5.1 percent in 2016 (Annual percent

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

A. Economic and fiscal update

1. The global economy is not yet supportive

2 CPB Netherlands Bureau for Economic Policy Analysis: http://www.cpb.nl/en/figure/cpb-world-

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

0 100 Paddy farmers

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

3. Headline inflation moderated but food prices remain volatile

June 2016 THE WORLD BANK | BANK DUNIA

4. The private sector experienced net capital outflows in Q1 2016

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

to address this challenge, BI announced a change in its monetary policy framework:

June 2016 THE WORLD BANK | BANK DUNIA

7-day reverse repo 11 Credit growth

June 2016 THE WORLD BANK | BANK DUNIA

5 Minister of Finance Regulation PMK-122/2015.

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

7. Addressing fiscal revenue constraints has become a priority

June 2016 THE WORLD BANK | BANK DUNIA

B. Some recent developments in Indonesia’s economy

June 2016 THE WORLD BANK | BANK DUNIA

Lending-5yr gov bond 8

Deposit-5yr gov bond 6

a. What components drive high NIMs in Indonesia?

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

needed to provide evidence of low market competition.

pitfalls in expanding access,” Washington, DC: World Bank.

June 2016 THE WORLD BANK | BANK DUNIA

June 2016 THE WORLD BANK | BANK DUNIA

2. The price of trade protectionism in Indonesia

June 2016 THE WORLD BANK | BANK DUNIA

of product-level NTMs on Indonesian imports doubled between 2009 and 2015,

Washington DC: The World Bank.