The Indonesian economy after the Boxing Day tsunami and Treasury's role in the Government Partnership Fund

The Indonesian economy after the
Boxing Day tsunami1 and Treasury’s
role in the Government Partnership
Fund
Milovan Lucich, Nathan Dal Bon and Elisha Houston2
Boxing Day 2005 marked the first anniversary of the tsunami that devastated communities in
Indonesia, Thailand, Sri Lanka, India and as far away as the east coast of Africa, leaving an
estimated 230,000 people dead and 1.7 million displaced. Australia has provided substantial
assistance to the tsunami-affected countries, with the main focus of our effort on one of our
nearest and largest neighbours, Indonesia. The $1 billion3 Australia-Indonesia Partnership for
Reconstruction and Development (AIPRD), announced by Prime Minister Howard on
10 January 2005, is the single-largest aid package in Australia’s history. The Australian Treasury
has worked with the Australian Agency for International Development (AusAID) and other
Australian Government agencies to develop and implement the AIPRD, and the Treasurer is one
of the five Australian and Indonesian Ministers on the AIPRD Joint Commission.
The first part of this paper focuses on how the Indonesian economy has performed in recent
times, particularly since the tsunami, and discusses the reform priorities of the current
Indonesian Government. The second part provides some information on the work Treasury is
doing with Indonesian counterpart agencies under the AIPRD’s Government Partnership Fund
(GPF).

1 This article refers to the 2004 Boxing Day tsunami. Another major tsunami hit Indonesia’s
Java island on 17 July 2006, killing approximately 105 people.
2 The authors are from International Economy Division, the Australian Treasury. This article
has benefited from comments and suggestions provided by David Pearl, Simon Nash, and
Don Graham. The views in this article are those of the authors and not necessarily those of
the Australian Treasury.
3 All dollar amounts in this article refer to Australian dollars unless otherwise stated.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
Introduction
The Republic of Indonesia is located in the Asian Archipelago, the world's largest
archipelago; its 18,108 islands cover five million square kilometres between Indochina
and Australia and the Indian and Pacific Oceans. Indonesia is the most populous
Muslim-majority country in the world and the fourth most populous overall with a
population of over 220 million.
The 2004 Indian Ocean earthquake, which had a magnitude of 9.2 on the Richter scale,
triggered a tsunami on 26 December 2004 that killed approximately 230,000 people
(more than 168,000 in Indonesia alone), making it the deadliest tsunami in recorded
history. The tsunami killed people over an area ranging from the immediate vicinity of
the quake in Indonesia, Thailand and the north-western coast of Malaysia, to
thousands of kilometres away in Bangladesh, India, Sri Lanka, the Maldives, and even
as far as Somalia, Kenya and Tanzania in eastern Africa.
The disaster prompted a huge worldwide effort to help victims of the tragedy, with
billions of dollars being raised for disaster relief. Australia was at the forefront of this
relief effort. In addition to the generosity of private citizens, Prime Minister Howard
announced the $1 billion Australia-Indonesia Partnership for Reconstruction and
Development (AIPRD) on 10 January 2005. The AIPRD is significant not only in terms
of its absolute size but also for the new approach to bilateral aid that it represents.
The AIPRD is a genuine partnership, jointly overseen by Indonesian and Australian
Ministers. It focuses on both immediate reconstruction priorities and Indonesia’s
broader long-term development challenges. It recognises the importance of sound
institutions to successful development and, through the $50 million Government
Partnership Fund (GPF), fosters closer working partnerships between Australian and
Indonesian officials in support of the latter’s reform efforts.
The tsunami followed a period of significant change and upheaval in Indonesia,
including the fall of the Suharto regime, the transition to democracy, and the Asian
financial crisis. After providing a brief overview of the Indonesian economy, the
following section examines economic developments in Indonesia in recent years,
focusing on the period following the tsunami, before detailing Treasury’s engagement
activities with its counterparts in Indonesia.
Economic developments in Indonesia
Indonesia has a market-based economy in which the government plays a significant
role. It owns more than 164 state enterprises and administers prices of several basic
goods, including fuel, rice, and electricity. Manufacturing accounts for 28 per cent of
Indonesia’s gross domestic product (GDP), services 41 per cent and agriculture
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
15 per cent (agriculture employs over 40 per cent of the labour force). Crude oil and
natural gas are Indonesia’s most valuable natural resources and have long been its
major source of export revenue, but growth in domestic oil demand, together with
declines in production since the 1990s, contributed to the nation becoming a net
importer of oil in 2004 and 2005.
During the decades leading up to the 1997-1998 Asian financial crisis, Indonesia shared
in the sustained economic growth that was enjoyed by much of East Asia. Real annual
GDP growth averaged 7.2 per cent from 1977 to 1996, lifting 30 million Indonesians out
of poverty over this period.
The crisis, however, had more severe effects in Indonesia than in any other country in
the region. Indonesia’s real GDP fell by 13.1 per cent in 1998 (18 per cent
through-the-year to December 1998, see Chart 1) as bank failures, capital flight and
disorder took hold in the financial sector. The investment environment deteriorated to
such an extent that Indonesia’s modern, labour-intensive manufacturing sector was
severely undermined.
Chart 1: Real GDP growth (through-the-year)
Per cent
Per cent
15
15
10
10
5
5
0
0
-5
-5
-10
-10
-15
-15
-20
-20
Mar-97
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06

Source: CEIC Asia Database.

As a consequence, Indonesia sought assistance from the International Monetary Fund
(IMF), as well as receiving bi-lateral support from a number of countries. Australia and
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
Japan were the only countries in the region to contribute to all three IMF packages to
the crisis-affected economies of Korea, Thailand and Indonesia.4
Indonesia’s subsequent recovery has been slower than those of other crisis-affected
countries in the region, with poverty and unemployment remaining stubbornly high.
The country only regained pre-crisis levels of real GDP in 2003, and real per capita
GDP did not recover to pre-crisis levels until early 2005. Indonesia’s GDP per capita
(measured on a purchasing-power-parity basis) was US$4,458 in 2005, compared with
US$30,897 for Australia.
Despite slower growth than its neighbours since the crisis, Indonesia’s economy
remains the largest in South East Asia, accounting for almost half of the ASEAN-4’s
aggregate GDP (see Chart 2).
Chart 2: ASEAN-4 GDP comparison at PPP (2005)
Thailand
Indonesia
24%
44%
Philippines
19%
Malaysia
13%

Source: IMF World Economic Outlook Database, April 2006.


4 In October 1997, Indonesia and the IMF reached agreement on a programme aimed at
macroeconomic stabilisation and economic reform. President Suharto resigned in May 1998,
and in August 1998 Indonesia and the IMF agreed on an Extended Fund Facility (EFF) under
President BJ Habibie that included significant structural reform targets. President
Abdurrahman Wahid took office in October 1999, and Indonesia and the IMF signed another
EFF in January 2000. The new programme also contained a range of economic, structural
reform, and governance targets. Indonesia graduated from the EFF at the end of 2003 but
engagement with the IMF continues via the Post-Program Monitoring (PPM) process.
Indonesia has successfully completed its IMF programme, and on 30 June 2006 Indonesia
repaid half of its IMF debt (US$3.9 billion), with the intention of repaying the balance within
two years.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
The relatively slow recovery in Indonesia reflected the scale and complexity of its
economic challenges as well as the lack of political consensus on how best to deal with
them. After the resignation of President Suharto in 1998, it was not until the Megawati
Government (2001-2004) that the authorities were able to restore macroeconomic and
financial stability. However, the much-needed recovery in investment has taken longer
to materialise, due partly to weaknesses in Indonesia’s regulatory framework and legal
system, as well as gaps in its physical infrastructure. The current Government, led by
President Susilo Bambang Yudhoyono, which took office in October 2004, has taken
steps to strengthen the reform agenda and has made addressing institutional
weaknesses one of its key priorities (see reform agenda section below for further
details).
Recent economic performance
Economic growth
Economic growth has slowly gained momentum over the years following the Asian
financial crisis, increasing from 3.8 per cent in 2001 to 5.1 per cent in 2004 and
5.6 per cent in 2005 — the fastest annual rate of growth since the crisis. The
composition of growth has also changed, with a welcome rebalancing from
consumption to investment. Investment grew by around 15 per cent in 2004 compared
with 0.6 per cent in the previous year, assisted by a recovery in foreign direct
investment (see Charts 2 and 3).
More recently, economic growth and investment have begun to slow, with investment
weakening again in the second half of 2005. Overall, investment growth for 2005
declined to 9.9 per cent, partly due to a financial ‘mini crisis’, which is discussed
further below. As a result, the ratio of investment to GDP, which had been moving
back towards pre-crisis levels of 25-30 per cent, has now declined to around
22 per cent.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
Chart 3: Contributions to GDP growth
Per cent
Per cent
14
14
10
10
6
6
2
2
-2
-2
-6
-6
-10
-10
Mar-99
Mar-00
Mar-01
Mar-02
Mar-03
Mar-04
Mar-05
Mar-06
Consumption
Investment (including inventories)
Net exports and residuals
GDP

Source: CEIC Asia Database.

Notwithstanding the terrible cost in human lives and damage to infrastructure and
homes in the province of Nanggroe Aceh Darussalam (Aceh), the tsunami had only a
small impact on Indonesia’s economic growth in 2005. This reflected the fact that Aceh
accounts for only 2 per cent of Indonesia’s GDP, and that the reduced agricultural
production in the region has been largely offset by reconstruction spending.5
According to a World Bank study, the direct impact of the tsunami lowered the
national GDP growth rate by 0.1-0.4 percentage points in 2005. The Bank concluded
that, when the offsetting effects of reconstruction activities were taken into account, the
net economic impact of the tsunami on nationwide growth in Indonesia was likely to
be close to zero.6

5 Since the tsunami, Indonesia has been subject to a number of further natural disasters. A
major earthquake took place off the west cost of Sumatra on 28 March 2005. The quake
measured 8.7 on the Richter scale and killed around 1,300 people mainly on the island of
Nias. Australia provided $1 million in emergency aid, and dispatched Australian Defence
Force medical teams and equipment to Nias. Another major earthquake struck the
Yogyakarta region in central Java on 27 May 2006. The quake measured 6.3 on the Richter
scale, causing massive devastation across the province and killing 5,760 people. In response,
Australia has committed $7.5 million to provide emergency relief and $30 million to help
rebuild the region.
6 World Bank 2006, East Asia Update, p 1.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
Chart 4: Foreign direct investment7
Per cent of GDP
Per cent of GDP
2
2
1
1
0
0
-1
-1
12 month rolling average
-2
-2
-3
-3
-4
-4
-5
-5
-6
-6
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
FDI as per cent of GDP

Source: CEIC Asia Database.

August 2005 ‘mini crisis’
Despite strong growth in the first half of 2005, last year proved to be a testing year for
the Indonesian authorities. In August, the Indonesian rupiah and stock market both
fell sharply, reflecting concerns in financial markets about the impact of higher oil
prices on Indonesia’s public finances and external financial position8 (see Charts 4
and 5). The Government responded to the ‘mini crisis’ with a policy package on
1 October 2005, including a large increase in domestic fuel prices. The reduction in fuel
subsidies led to domestic fuel prices increasing by an average of 114 per cent.
Budgetary savings from the fuel price rise in 2005 are estimated at approximately

7 Chart based on data for inward direct investment only. Net private capital flows remain
negative over the last two years.
8 The relationship between oil prices and Indonesia’s economic and budgetary position is not
straightforward. Indonesia has traditionally been a net oil exporter, but a lack of investment
in oil-related infrastructure has limited Indonesia’s oil production capacity so that it is now a
net oil importer. The Indonesian Government, however, continues to derive increased
revenues as a result of higher oil prices, which to a certain extent offsets the fiscal impact of
increased subsidies. Nevertheless, there was a strong perception that oil prices were having a
major negative effect on Indonesia’s budgetary position, as well as genuine concerns about
the skewing of fiscal priorities. The fuel subsidy cuts, after subtracting the compensation
programs, will free up $3-3.5 billion for other kinds of spending.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
0.5 per cent of GDP and could amount to up to 2.5 per cent of GDP in 2006, depending
on international oil prices.9
The reduction in fuel subsidies, together with Bank Indonesia’s lifting of official
interest rates from 8.75 per cent in August 2005 to a peak of 12.75 per cent in
December 2005, led to the stabilisation of financial markets. Since the peak of the crisis
in August 2005, the exchange rate has appreciated by 10.5 per cent and the stock
market has risen by 34.7 per cent.
Chart 5: Jakarta composite index
Chart 6: Rupiah per $US
1,600
1,600
11,000
11,000
'Mini Crisis'
1,400
1,400
Depreciation
10,000
10,000
1,200
1,200
1,000
1,000
9,000
9,000
800
800
600
600
8,000
8,000
400
400
7,000
7,000
200
200
0
0
6,000
6,000
l
-
0
2
l
-
0
3
l
-
0
4
l
-
0
5
l
-
0
6
l
-
0
2
l
-
0
3
l
-
0
4
l
-
0
5
l
-
0
6
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju
Ju


Source: CEIC Asia Database, Datastream.

At the same time the Indonesian Government commenced the unwinding of fuel
subsidies, it also announced a compensation package for the poor. Under the
Indonesian Government’s oil price compensation arrangements, around 15.5 million
poor households are being allocated an ongoing cash transfer of 100,000 rupiah
(around US$9 at July 2006 exchange rates) per month distributed quarterly.
Reflecting the unwinding of fuel subsidies and higher interest rates, economic growth
slowed in the latter part of 2005. This trend has continued into the first half of 2006,
with GDP growth slowing to 4.6 per cent in the March quarter. Looking forward,
economic growth is expected to strengthen, due in part to stronger Government
expenditure. Overall, Consensus Forecasts expects growth of 5.2 per cent in 2006,
down from 5.6 per cent growth in 2005.

9 World Bank 2005, East Asia Update, pp 2-3.
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
Inflation and interest rates
While inflation has fallen substantially in the years following the 1997-98 crisis, the
unwinding of fuel subsidies in October 2005 saw inflation rise sharply, with inflation
peaking in November at over 18 per cent through-the-year (see Chart 6). In the first
half of 2006, inflation has moderated to some extent, with the CPI rising by
15.5 per cent through the year to June 2006. It is expected to decline further through the
second half of the year as the subsidies reductions pass through. Consensus Forecasts
expects average inflation of 13.3 per cent for the year.
The decline in inflation has enabled Bank Indonesia to relax monetary policy settings,
with official interest rates reduced in May and June this year to the current rate of
12.25 per cent. The reduction in interest rates should assist the banking sector, which
came under pressure during the August ‘mini-crisis’. In the second half of 2005, loan
growth decelerated and the net non-performing loan ratio rose from 1.9 per cent to
5.0 per cent. In particular, State-owned commercial banks reported non-performing
loan ratios of around 15 per cent, up from 5.5 per cent in 2004.
Chart 7: CPI and real interest rate
20
6
18
4
16
14
2
12
0
10
-2
8
6
-4
4
-6
2
0
-8
Jun-03
Dec-03
Jun-04
Dec-04
Jun-05
Dec-05
Jun-06
CPI (LHS)
Real interest rate (RHS)

Source: CEIC Asia Database.

External sector
In 2005, Indonesia’s current account surplus fell to US$3 billion or 1.1 per cent of GDP,
compared with a surplus of 4.8 per cent of GDP in 2000. In value terms, total
merchandise exports rose by around 20 per cent in 2005. However, in volume terms,
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The Indonesian economy after the Boxing Day tsunami and Treasury’s role in the GPF
export growth was flat. At the same time, merchandise imports rose by about
26 per cent in value terms in 2005.
In recent years, Indonesia has experienced a significant slowdown in the growth of
exports in sectors where it traditionally has had a comparative advantage, including
furniture, palm oil, rubber, textiles, and footwear. This has led to concerns that
Indonesia has been losing trade competitiveness, particularly to China and Vietnam,
through persistent inflation, rising labour costs and a relatively strong currency. The
IMF estimated in 2004 that Indonesian unit labour costs were about 35 per cent higher
in dollar terms than before 1997. Generally weak investment in recent years has also
hampered Indonesia’s competitiveness. This applies not only to a lack of investment in
manufacturing, but also in transportation, ports, and other infrastructure that affects
exporters’ costs.
Government sector
Indonesia has significantly improved its fiscal situation in recent years, with the central
government budget deficit narrowing from 2.4 per cent of GDP in 2001 to 0.5 per cent
in 2005. The outcome last year was helped by the cuts in fuel subsidies and delays in
spending caused by changes to budgetary procedures.10 The deficit is expected to
widen to 1.2 per cent in 2006, primarily reflecting spending carryovers from 2005.
On the revenue side, the Indonesian Government is making a concerted effort to
improve tax compliance and more generally to reform the tax system. The system has a
limited capacity to raise revenue due to a very large informal sector (in a country of
around 220 million people there are only 10 million registered income tax payers).11
In 2005, total tax revenue amounted to only 12.8 per cent of Indonesia’s GDP — a low
figure compared with other developing countries.
Fiscal consolidation and solid GDP growth have reduced the central government debt
to GDP ratio from around 100 per cent in 2000 to close to 50 per cent in 2005. The ratio
of external public debt to GDP has also steadily declined in recent years, from about
45 per cent in 2000 to 27 per cent in 2005. As part of the international response to the
tsunami, Australia joined with other Paris Club members to delay debt repayments

10 These delays were caused by changes to budgetary procedures in the transition to
decentralisation. The process of decentralisation involves the devolution of some fiscal
responsibilities from the central to local governments.
11 The informal sector expanded following the 1997-98 crisis as Indonesians who lost their job
in the formal sector attempted to find work in the informal sector. While the informal sector
accounts for only 20 per cent of GDP, it is estimated to employ almost two-thirds of the
Indonesian workforce (Heriawan, p 1).
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