Indonesia's Poverty Trap

The tragic loss of 21 Indonesians who were trampled to death as they jostled outside a house in East Java to receive a cash handout of just 30,000 rupiah (US$3.20) has shocked the nation and exposed the plight of its poorest citizens.

Politicians were quick to dismiss any link between the country’s chronic poverty problem and last week’s tragedy, citing a drop in the official poverty rate last year to 16.6 per cent from 17.8 per cent the previous year.

But that is a fairly meaningless statistical improvement to the more than 19 million Indonesians who still live on less than US$1 a day. Moreover, almost half of the country’s 225 million people live on less than US$2 a day.

Rising food and fuel prices this year have hit hard for the bottom third of households, which spend 65 per cent of their income on food and drink.

If Indonesia wants to significantly reduce its poverty rate, the Organisation for Economic Cooperation and Development says that its economy needs to grow at least 8 per cent a year.

But that is looking virtually impossible for the next few years. Rising inflation, a sliding rupiah and the breakdown in world financial markets are already threatening this year’s expected growth rate of 6 per cent.

And some economists are predicting a significant slowing next year, with HSBC forecasting growth of just 4.9 per cent.

While that’s below most analysts' expectations it is a real possibility given that Indonesia’s economy is driven by domestic spending and interest rates have risen by 1.25 percentage points since May to 9.25 per cent, with more rate rises to come.

"That [forecast] is really reflecting our feeling that the rate increases will feed into the economy at that time," says HSBC senior economist Robert Prior-Wandesforde.

"It’s a double-whammy of weaker exports and higher interest rates."

The man with his hands on the lever, new central bank governor Boediono, is confident Indonesia can overcome current challenges.

"It’s as if we are on a boat amidst stormy seas," he told reporters last week. "We have to stay calm, controlling the boat as best we can until the swings subside and we can see a better direction. The point is our boat is in good shape."

He does have a point. Indonesia’s economy grew at a surprisingly robust 6.4 per cent in the first half of the year as companies raked in profits from selling coal, gas and crude palm oil to China, India and Japan, amid record spending by local consumers on everything from mobile phones to cars. Foreign investment also surged as high commodity prices tipped the risk-reward ratio in investors’ favour and followed positive government reforms including an easing in rules for expats and a new regulation that will cut the corporate tax rate from 30 per cent to 25 per cent by 2010.

But in the last few months commodity prices have been dropping from their highs, hurting investor sentiment and leaving Indonesia even more vulnerable to a fall in domestic spending.

"In the last two months, commodity prices have fallen and the hot money has left the country," presidential candidate and former finance minister Rizal Ramli told foreign journalists in a panel discussion this month.

"There will be a correction. And the only adjustments that can be done are on domestic interest rates. If you want to stabilise the macro-economy you need to raise rates. But that will have a significant impact on investment and job creation."

The problem for Indonesia is that when financial markets are in turmoil, investors look to lower their risk profile and emerging markets bear the brunt of that swing in sentiment.

"If you look at global money flow, it’s not only Indonesia which is doing badly, other emerging markets in Asia and South America are also being hit," says Adrian Rusmana, an analyst at HD Capital.

Ramli believes that any slowing in the economy will hit small to medium sized businesses the hardest.

"Ten years ago, big business overheated because of the financial crisis," he said.

"The small to mid-size companies were not great, but doing ok. Now, big business has recovered but the small to medium-sized businesses are the hardest hit in 40 years.

"Over the last five years, the Indonesian economy has been going very well thanks to commodity prices. The improvement in the macro-economy has been export driven. But there’s a missing link in what happens at the macro and micro level."

Standard Chartered economist Fauzi Ichsan agrees.

"When you look at the big corporates that the banks are lending to, they are Crude Palm Oil companies, coal companies and service companies like shipping so that when commodity prices rise they benefit and can absorb rate rises because their revenue is up," he says.

"The smaller companies, like manufacturers, don’t have the same revenue boost and so the rate rises have a bigger impact for them."

Even if Boediono does steer the economy through the current market turmoil, a lack of adequate infrastructure is still holding the economy back from growth rates anywhere near 8 per cent.

"Infrastructure bottlenecks are the biggest challenge for the country," says Ichsan.

"If Indonesia can tackle this issue, GDP could be more than 7 per cent."

Before the last election four years ago, the government promised to build a 1,100 kilometre trans-java toll-road by 2009. But up until now, just 109km is close to being built.

There is also concern that that the government’s plan to build new power plants that will add 10,000 megawatts to the system is falling well behind schedule.

The power shortage has become so bad that the government recently introduced a hasty regulation, forcing factories to shift two working days each month to a Saturday or Sunday. The move is designed to take the pressure off during peak electricity periods.

Apart from a lack of infrastructure, investors complain that Indonesia’s labour laws are too rigid and its judicial system was recently voted the worst in Asia, according to a survey by research group Political and Economic Risk Consultancy (PERC).

There is some concern that none of these problems will be properly addressed until after the elections next year, with the parliamentary vote in April and the presidential poll three months later.

"Up to October 2009, we are in a holding pattern," says Umar Juoro, an economist at the Habibie Center.

"We will have to wait until after the election but the pressure to move on issues like labour laws and a lack of infrastructure will be stronger then."

Political parties are likely to spend money during the campaign and that could provide some relief to poor families. But general government spending on health, education and social programs has been falling.

It’s a vicious circle. As oil and commodity prices rose boosting the price of food and fuel, government subsidies also jumped putting pressure on the budget and cutting spending in other areas. The cost of government subsidies for food, fuel, fertiliser and electricity is expected to be equal to 7 per cent of gross domestic product this year up from 3.8 per cent in 2007, according to a recent report by the Asian Development Bank. As a result, planned spending on education was cut by 9.5 per cent from the original budget and the health budget dropped by 7.4 per cent.

Meanwhile, economic growth of around 6 per cent has been generating jobs, but not nearly enough to fix the chronic problem of underemployment. Slightly less than 28 per cent of the labour force is underemployed, or works less than 35 hours a week, and 70 per cent of total employment is in the informal sector, where there is no minimum wage and very little supervision.

The ADB is forecasting growth of 6.2 per cent next year, depending on the central bank’s handling of the current inflation threat and the cost of subsidies.

Ichsan also predicts the economy will be resilient.

"There is little reason to be pessimistic," he says. "The economy is more or less driven by domestic issues, the government expects a budget deficit of 1.8 to 1.9 per cent of GDP and we are expecting less than that, growth has been robust in the first half, business indicators – like motor sales and credit growth – are robust and oil is likely to come down. And among its neighbours, Indonesia is looking like the most politically stable."

All of this may be true but the people who are deciding whether or not they can afford to go home this year to celebrate the main religious holiday of Idul Fitri are pessimistic.

And the photos of last week’s tragic stampede outside the home of a wealthy Indonesian, who distributes cash handouts every year as part of Ramadan, has shone the light on the country’s uneven distribution of wealth.

The poorest fifth account for just 8 per cent of consumption, while the top 20 per cent of income earners account for 45 per cent.

It is a telling statistic.