Summary: KEY ISSUES Context: A slowdown in growth in major emerging market economies (EMEs) and decline in commodity prices, and more recently, a reversal in push factors tied to a prospective exit from extraordinarily easy global monetary conditions, has put pressure on Indonesia’s balance of payments and heightened its vulnerability to shocks. Domestic policy accommodation and rising energy subsidies have also given rise to increased external and fiscal imbalances. Recent policy tightening, fuel price hikes, and exchange rate flexibility have been firmly aimed at reducing these pressures. Against this backdrop, discussions centered on actions needed to further buttress policy buffers in the face of heightened market volatility and to reduce structural impediments in support of broad-based growth. Outlook and risks: Growth is projected to slow to 5-5½ percent in 2013 and 2014. Inflation will likely peak at just below 10 percent at end2013, due mainly to the one-off effect of June fuel price increases and recent rupiah depreciation. The current account deficit is expected to exceed 3 percent of GDP in 2013 and 2014 on weak commodity exports. Reserves have also come under pressure, partly due to Bank Indonesia’s heavy intervention in the foreign exchange market in mid-2013 in order to stem the rupiah’s depreciation. In the near term, downside risks relate externally to a further adverse shift in funding conditions in EMEs and/or weaker-than-anticipated growth in these economies, notably spillovers from China and India, and domestically to a further weakening in investor sentiment, prompted by adverse external conditions and/or policy uncertainty. Key policy recommendations: Recent market volatility and reserve losses highlight the need to deal decisively with macroeconomic imbalances and contain financial stability risks. The current delay in tapering of unconventional monetary policies provides an opportunity to strengthen policy and financial buffers and improve market perceptions. Monetary policy should remain focused on anchoring inflation expectations and reducing balance of payments pressures; fiscal policy should support monetary policy in this effort, led by tax and subsidy reforms; and the exchange rate and bond yields should continue to reflect market conditions in order to facilitate an orderly adjustment to a shifting global environment. Careful monitoring of banks as financial conditions tighten and a firm closing of the gaps in the crisis management framework are needed to keep financial stability risks in check. Structural reforms should focus on a more predictable business climate and greater labor market flexibility.

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