The 1997/98 budget announced in early January holds no great surprises. However, that in itself is good news since some quarters were expecting an expansionary budget in an election year, which in turn could derail macroeconomic stability. The record of the last two years shows the government's serious intention to bring down inflation and achieve stable growth through a combination of conservative fiscal policy, relatively tight monetary policy, and a more flexible exchange rate policy. This mixture of policies appears to have succeeded in bringing down inflation to 6.6 percent compared to the average of 9 percent in the previous three years. At the same time growth only declined slightly from 8.27 percent in 1995 to 7.8 percent in 1996. The business as usual budget in an election year signals the government's continued concern with macro economic stability. This will allay fears, at least temporarily, that the budget will be expansionary given elections and that possible interference with the conservative budget policy may derail macro economic management. The nominal increase of the 1997/98 budget represents a modest increase of 11.6 percent or a real increase of around 5-6 percent. The total budget is now Rp. 101.1 trillion. This can be compared with the nominal increase in the 1996/97 budget compared with the previous years budget of 16.1 per cent or a similar real increase of around 7 percent given the higher inflation rate. The budget is also considered to be contractionary in the sense that the amount of rupiah injected through domestic spending is less than the amount of rupiah taken out due to tax and non tax revenues. The rough estimate of the contraction is Rp. 5.4 trillion compared with Rp. 6.6. trillion in the 1996/97 budget, or slightly less contractionary. The budget is also said to be slightly in surplus rather than deficit as was the case last year, based on the IMF calculation. Development expenditures have been increased at 12.8 percent compared with 15.7 percent last year. The allocation of revenues from the 1996/97 budget will in most likelihood be higher than budgeted due to the higher oil prices. Oil prices were budgeted at $16.50, whereas Indonesia's oil export prices had reached an average of $20.57 for calendar year 1996 and can be expected to average at around $20 for the fiscal year ending March 1997. Thus, oil prices are $3.50 higher than budgeted, and according to government sources for every $1 increase in oil prices, the net increase in government revenues (i.e. after netting out subsidies and the lower or negative profits from fuel sales) is estimated to be $300 million. It is not clear what will happen to the extra revenues which will be around $1 billion. In the last budget speech, the President stated that extra revenues will be spent to prepay debt. There are expectations that this will be the case for the extra revenues from the 1996/97 budget. However, there are also concerns that the revenues will be spent on certain projects or off budget expenditures, given again election year and interventions that may make it hard to maintain a conservative budgetary policy. The issue of transparency of the use of surplus revenues as well as non tax revenues, which includes forest concession fees, has been raised again. For instance the utilization of the extra revenues which were included under the development reserves (cadangan anggaran pembangunan) item introduced in 1991, as a result of the increase in oil prices due to the Gulf War, has never been made clear. The 1997/98 budget was announced in early January and contained no surprises. The nominal increase of 11.6 percent compared with the previous budget means that the total budget is now Rp. 101.1 trillion. The budget remains contractionary using a rough estimate of the domestic impact of the budget, at Rp. 5.4 trillion compared with Rp. 6.6 trillion in the previous year, although it is slightly less contractionary compared with the 1996/97 budget. Routine expenditures are expected to increase at only 10.8 percent, with expenditure on salaries only targeted to increase at 15.9 percent. The issue of whether civil servants salaries will go up has been referred to the parliament to decide and the implicit message is not clear as to whether there will be an increase. On the one hand civil servants salary increase maybe undertaken given that it is an election year and that past increases are considered to have not compensated sufficiently for inflation. However, on the other hand, since increasing salaries could contribute to inflation, it may be postponed or that the increase will be smaller than desired. Oil revenues are expected to be around the same given that oil prices have been assumed at $16.50 for both 1996/97 and 1997/98. Meanwhile, non oil revenues are expected to increase by 14.2 percent with income taxes increasing at 22.8 percent and sales tax however, only increasing at a lower rate of 12.9 percent. The structure of this budget and the rates of increase are very similar to the previous budget. One important difference is that, in contrast to the trend of a continued increase in past years, there has been a decline in debt service payments of 3.5 percent. The decline is in part due to the weaker yen, but it has also been due to the strategy of the government since a few years ago to prepay government debt earlier than maturity. In the last three fiscal years, the government has successfully paid off high interest debt with interest rates above 10 percent amounting to US$2.6 billion or Rp. 6 trillion. The funding for prepayment has been sourced from the realized surplus revenues over expenditure in the budget, and the proceeds from the sale of government owned shares in state owned enterprises such as P.T. Indosat and P.T. Telkom. The reduction in interest payments resulting from this strategy is around US$1.45 billion or Rp. 3.4 trillion. The government is also in the process of preparing to prepay another $750 million such high interest debt. Development expenditures increased by 12.8 percent or slightly lower than last year at 15.7 percent. The breakdown of development expenditures shows that certain subsectors have experienced high growth in the 1997/98 budget year compared with the previous ones, namely manpower; trading; tourism; population, family planning and welfare; social welfare and health; and political affairs. However, each of these subsectors account for shares below 1 percent of the development expenditures. Transportation, regional development, education and mining and energy continue to account for the largest shares of development expenditure allocation. It is of interest to note that allocation for transportation, except for road works, and telecommunications, have declined. This is in line with World Bank's recommendation that government expenditures in these sectors should decline given the privatization that is taking place. The main spending on roads will be on upgrading roads outside Java, especially in Eastern Indonesia. Other important features of the budget itself are the increased decentralization trend that was evident beginning a few years ago. The decentralization mostly comprises of a greater portion of revenues that can now be retained by the regional governments, such as land taxes for instance, as well as greater autonomy to determine their expenditures. Beyond the government budget itself, the accompanying speech as well as announcement of the government's latest figures shed light on a number of other important trends that one should bear in mind in evaluating 1997 and 1998. The most important being, the balance of payments outlook. The budget document contains also the government's projections regarding the balance of payments for 1997/98. The estimated current account deficit for 1996/97 increased significantly by 26 percent compared with the previous year, so that the current account deficit is now US$ 8.8 billion. The main reasons for the continued high deficit is that the balance of trade has not improved. Despite a much lower estimated import growth of 12 percent compared with 22 percent last fiscal year, the continued low growth of non oil exports and that oil exports did not perform as well as anticipated given the higher oil prices, meant that the balance of trade in fact deteriorated further from US$ 6.3 billion to US$ 5.2 billion over the 1995/96-96/97 period. The lackluster non oil export performance was in fact a region wide phenomenon which saw other economies in the region experience slowdown in manufactured export growth which was lower than Indonesia. The reasons given for the overall regional phenomenon are the overall decline in external demand as well as the slump in the electronics industry. Secondly, the deficit on the services account continues to increase from US$ 13.2 billion to US$14 billion on account of increased interest payments due to the rise in external debt by the private sector. The continued increase in the debt can be expected given the booming economic situation, as well as the increased limits posed on credit growth domestically. Given an open capital account, banks and non banks will resort to offshore borrowings as soon as restrictions are imposed and even to fund reserve requirement needs. The current account deficit is projected to worsen in 1997/98 to $ 9.8 billion due to similar reasons. Despite an estimated pick up in non oil export growth due to expected better world economic conditions in 1997/98 and realization of foreign investment, this is estimated to be offset by a decline in oil exports which means that the balance of trade is only going to improve slightly to US$5.4 billion. Import growth is projected to be maintained at a 9 percent growth. Meanwhile, the deficit in the services account is expected to continue to increase another $1 billion to reach $15.2 billion. The projected deficit in 1997/98 is in fact three times more than the level in 1994/95. However, the alarm bells are not ringing as yet for Indonesia due to several reasons. The size of the deficit still translates to around 4 percent of GDP or half of the close to 8 percent growth rate of the economy. Second the level of foreign exchange remains high at $20 billion or close to 5 months of imports. Third the debt service ratio is still relatively high, but shows signs of falling, mainly due to the decline in government debt service which is in part related to the prepayment strategy. Fourth the dramatic rise in the deficit has been accompanied by fundamental changes in the level and composition of capital inflows. The amount of capital inflows in 1995/96 doubled that of the previous year from $4.8 billion to $11.5 billion and is estimated to be $10.8 billion in 1996/97. This level is projected to continue in 1997/98. The composition has also changed so that direct foreign investment accounts for slightly more than half of this amount, meaning that realized foreign investments have also doubled from an average of slightly below $2 billion a year to $5-6 billion currently. The remaining of around $5 billion are approximately equally divided between net foreign borrowing (non central government) and other capital or portfolio flows. Net government capital inflows are negligible as the amount of new borrowing is almost the same as the amortization on debt. Despite the uncertainties and less than hopeful picture on the balance of payments, growth is still expected to be 8 percent or close to that in 1997 and only slightly lower in 1998. The main reason being that the world economic situation will be much more robust this year and the next compared with previous years. Furthermore the realization of the high levels of approved investments will begin to be felt, hopefully on the non oil export growth, within 1997 and 1998. The picture painted is of a rosy macroeconomic outlook. The situation could of course change very quickly if investor confidence were to be eroded leading to a capital outflow. Thus, it is crucial to maintain investor confidence. The risk outlook for 1997 and 1998 are more political in nature than economic. Expectations of a build up of unrest leading up to the May 1997 general elections may lead to some capital outflow, but only temporarily assuming that the elections go relatively smoothly. It is expected that the government party, GOLKAR, will win, although it is still debatable whether the win will be with a higher majority than before as the government hopes. However to date investor confidence appears to still be positive, and despite disturbances at the end of the year, the swap premium continues to fall from the jump it experienced after the 27 July riots of 8.9 percent to 6.5 percent by beginning of January. Maintaining investor confidence will imply that it is of utmost importance to send appropriate signals and undertake actions that will vindicate that the path continues to be toward maintaining macroeconomic stability. Given an open capital account, the moment that there are perceptions of macro economic mismanagement, there will be capital outflows. Other than macroeconomic stabilization, it is also equally important to reduce present inconsistencies in policy and the lack of transparency as certainty and predictability of policy are crucial to the private sector. This is the reason for investors and investor confidence to be more affected by the decision on who will be Vice President and Cabinet Ministers in March 1998. The selection will lead to certain judgments being made about policy direction. Finally, it is clear that the outlook on growth and the macro economic front will be optimistic in the short run. However, in the longer run, the issues of labor productivity and competition with other countries, ability and access to the right kind of technology, and marketing capability, the need for greater transparency, will and can affect the sustainability of growth. This is the message that the government must remember at all times, but especially now.