By: Our Correspondent

fourth quarter Gross Domestic Product numbers paint a picture of
sustainable investment-led growth. Discuss.”

“sustainable” part of that picture is true-to-life. The
investment-spending is putting no serious strain on the country’s
finances. What’s more, analysis tells me Indonesia’s
growth currently has the most benign possible outlook: both capital
stock and return on capital stock are rising.

“investment-led” is crucially misleading. No less than
83.3 percent of Indonesia’s gross fixed capital formation last
year went to buildings. Only 10.5 percent was spent on machinery and

Even so,
the price of imported machinery (and virtually all of it is imported)
jumped 14.6 percent last year, which is prima facie evidence of
market failure. It’s also one major reason why Indonesia’s
merchandise terms of trade are falling, even as commodity prices

In short,
this is the curse of commodities at work. Unless there’s a
dramatic change, and soon, in the pattern and pricing of Indonesia’s
investment spending, when the commodity boom retreats wheat will be
left behind will be just . . . the cloud-capped towers, gorgeous
palaces, and subdivisions.

Standard Version

standard reading of national accounts signals that there’s
nothing much amiss in Indonesia. Growth slowed slightly to 6.3
percent annually in the fourth quarter from 6.5 percent in the third,
but this still left 2007 with a growth rate of 6.3 percent, which was
the fastest this century. Growth was driven by investment spending
(up 12.1 percent annually in the fourth quarter vs. 10.4 percent in
the third), and private consumption (up 5.6 percent year-on-year vs.
5.1 percent in the third quarter. A sharp fall of 5.6 percent
year-on-year in the terms of trade for goods during the year
contributed to a 14.2 percent year-on-year fall in net exports for
the quarter, and this stripped out 1.6 percentage points from overall
growth. However, some compromise on the external accounts is to be
expected during a period of investment-led growth.

we do not yet have balance of payments data for the fourth quarter,
we do have trade data, so the models that tell us Indonesia had a
current account surplus of around US$2.2 billion in Q4, or 1.9
percent of GDP, are unlikely to be far off. When we turn to the
financing of this investment spending, there are no visible problems.
While (in nominal terms) the investment ratio rose 75bps to 24.9
percent of GDP last year, the national savings ratio, which rose
44bps on the year, continued to outpace it at 27.3 percent.

country’s private sector savings surplus is stable at around 4
percent of GDP, and possibly is rising once again. We need not,
therefore, expect to see much upward pressure on interest rates, or
strain on the government’s ability to conduct fiscal policy.


Not-So Standard Reading

I have two
problems with this standard version: the first has to do with the
extent to which Indonesia’s current capital spending goes on
buildings rather than machinery. The second, with how much Indonesia
is paying for capital goods when it does buy them.

growth sounds great, particularly when return on investment is also
rising. And that’s what my models, based on depreciating all
capital over 10 years, tell me is happening in Indonesia: in real
terms, capital stock is probably growing around 5.7 percent a year,
and return on that capital stock continues to rise.




Why No

But there
is a major problem: to a quite exceptional degree, Indonesia’s
new capital investment and its accumulated capital stock are
concentrated simply in buildings and construction, rather than
machinery and equipment. This is not immediately obvious: after all,
the national accounts tell us that in nominal terms investment in
building rose 21.5 percent in 2007, compared with 38.7 percent for
machinery and equipment; in real terms, investment in buildings rose
9.9 percent, compared with 22.4 percent year-on-year for investment
in machinery and equipment.

But the
problem is in the starting position: construction accounted for no
less than 83.3 percent of all gross fixed capital formation in
Indonesia during 2007, down only 40bps on the year!

So far as
I know, this concentration simply on building things has no parallel
anywhere else in Asia. In Thailand, for example, construction
accounts for only 32.9 percent of capital formation; in the
Philippines, it counts for 52.9 percent. Even Hong Kong in the
mid-1970s topped out at no more than 66 percent. In China last year,
construction accounted for 44 percent of all new fixed-asset

only 10.5 percent of Indonesia’s gross fixed capital formation
is spent on machinery and equipment. In other words, it is not at all
clear that Indonesia’s current investment spending is really
going to lead to a build-up of useful (i.e., potentially
income-earning) capital stock, rather than just real estate.

Goods Prices

one of the reasons why Indonesia is buying so little machinery is
that it is so expensive. Indonesia has virtually no domestic
machinery industry, and consequently last year it imported 83 percent
of all the machinery it bought.

more, Indonesia appears to be a very lucrative market for foreign
machinery. Breaking down the deflators in Indonesia’s national
accounts, it seems that the price of foreign machinery and equipment
jumped 14.6 percent year-on-year in 2007 (and 17.2 percent
year-on-year in the fourth quarter), while the price of domestic
machinery rose only 8.3 percent. As the chart below shows, the
extraordinary divergence between price trends in imported and
domestic machines is a new, but very marked, phenomenon.

Since the
rupiah was, on average, up 0.5 percent against the dollar last year,
it is extremely difficult to understand such inflation in machinery
prices. Looking at Japan’s export prices for machinery and
general equipment, for example, one finds they rose only 2.2 percent
in yen terms, or 0.9 percent in dollar terms.




Pricing and Terms of Trade

This seems
like either mispricing (i.e., the market for capital goods
misfiring) or disguised capital flight. However, it has a
further consequence. Spending on machinery and equipment is but a
small proportion of Indonesia’s gross fixed capital formation,
but nonetheless, the amount spent on foreign equipment is equivalent
to no less than 17.7 percent of the total imports of merchandise
goods reported monthly. And with their prices rising so remarkably,
this contributes strongly to the inability of Indonesia to get its
terms of trade to rise even in an era of strong and rising commodity
prices. In fact, remarkable as it may seem, Indonesia’s terms
of trade ended 2007 lower than in any other year this century.




all this matter? In one sense, it does not: Indonesia’s
investment spending may be unproductive in the long-term, but
provided that the projects are financed domestically – as they
are – then this is no immediate bar to their being continued
for some time. For now there is nothing “unsustainable”
about the pattern of Indonesia’s economic growth.

But the
unwillingness or inability to invest Indonesia’s savings in
productive capacity, rather than bricks and mortar, does suggest that
the “curse of commodities” is in play once again. While
rising commodity prices underpin Indonesia’s cash flow and
investment spending, all will be well. The danger is that current
investment patterns suggest that if the commodities bonanza ever
retreats, there’ll be no alternative economic engine to power
the country.

banks: Where’s the Money?

the national accounts tell me that Indonesia’ is running a
private sector savings surplus of around 4 percent of GDP. This
should guarantee the continued liquidity of domestic financial
markets, put a ceiling on bond yields (and inflation) and allow the
government a degree of maneuver for fiscal policy.

But if
Indonesia’s private sector is indeed running at savings
surplus, then we would expect the balance sheet of the local banking
system to a) show a private sector loan/deposit ratio that was steady
or falling, and b) show a build-up of net foreign assets.

And, in
fact, although the private sector loan/deposit ratio was rising, in
absolute terms the private sector continued to put in more cash then
the banks lent back out to it. But what then happened to the cash?
For, as the chart below shows, the last few months has seen a
collapse in the net foreign assets of the banking system from a
surplus of US$4.6 billion as of end-September, to a net foreign
liability of US$664 million at year-end. This happened because
between September and December, Indonesia’s banks sold off
US$3.925 billion of their foreign assets, and took on US$1.292
billion of new foreign liabilities. This is the first time
Indonesia’s banking system has (been allowed to) run a net
foreign liability position since 1998.




The answer
is reasonably simple. The cash raised by selling foreign assets has
been retained as increased reserves in order to satisfy Bank
Indonesia’s demand that all banks reach tier 1 capital of 80
billion rupiah as of December 31as part of the long-run
implementation of Basel II, the voluntary regulatory framework being
put in place to seek to ensure capital adequacy for the world’s
banks.. In fact, all that has happened is that just under 80 percent
of the net foreign assets sold have re-appeared as new bank reserves
held with Bank Indonesia.

Taylor is an independent economist at Coldwater Economics. He can be
found at