Reversing Indonesia's looming pessimism

Investors are waiting for government action to stop the slide both in GDP numbers as well as confidence. The norm for this kind of policy is that it needs large and bold measures, implemented quickly and visibly.
Investors are waiting for government action to stop the slide both in GDP numbers as well as confidence. The norm for this kind of policy is that it needs large and bold measures, implemented quickly and visibly.PHOTO: REUTERS

A CONSENSUS is forming over Indonesian economic growth this year: The slowdown continues, and growth may not reach 5 per cent.

This is in stark contrast to the optimism when the new government took office last October. The abruptness and severity of the slowdown caught many unawares. What went wrong? What is in store in the short term? And what can the government do to reverse the looming pessimism?

What went wrong? In short it was a combination of bad luck and ill-timed policies.

  • First, the changing pattern of global economic growth. In 2015, the world will grow around 3.5 per cent. This is also where the figure stood for the past five years. It is far below the 2007 record of 6 per cent. The big difference this time is where growth is taking place: in advanced instead of emerging economies.

The big slowdown is taking place especially in China, from 14.2 per cent in 2007 to around 7 per cent this year. And the impact on commodity prices was severe. Oil prices also fell on account of the US becoming a net energy exporter after large-scale shale gas extraction. Hence Indonesia, which relied a lot on commodity exports, felt the pinch in both its trade account and later, on growth itself.

  • Second, the fall of the rupiah. The US Federal Reserve hinted it was reversing course in monetary policy in mid-2013. Since then, the US dollar rose against all other currencies. Although the timing of the US Fed hike is uncertain, each time the US economy shows strength, the probability rises.
  • Third, the fuel price hike in October last year. This was to fulfil President Joko Widodo's campaign promise. And to also show he had the political courage to take bold measures.

The problem, though, was that he raised prices when the prevailing tendency at that time was a downward trend in international oil prices. With patience, the government could have removed the fuel subsidy without raising prices. The reduction in prices in February did little to repair the damage.

  • Fourth, the central bank raised interest rates right after the fuel price hike. In the past, this move reduced inflation fast. But this time, growth was already slowing down and the risk of prolonged inflation was minimal. So the main result was to drag down growth even further.

This resulted in a continued decline of bank loan growth, from 13 per cent in October last year to around 10 per cent in May this year. Growth in bank loans has declined from mid-2012, following the hike of loan down payments to 30 per cent. A sharper downturn started in the fourth quarter of 2013, when the central bank raised its policy rates to 7.5 per cent.

  • Fifth, the slowdown in government spending. One factor was the change in ministerial job descriptions. The impact was a headache in organisation and budgeting, leading to delays in spending. A few ministries, for example, saw their directors-general sworn in only this month. Several key ministries had yet to complete their budget submissions by last month.

Also, capital injections into several construction companies only materialised in June.

Falling oil prices took away most of the windfall of reducing fuel subsidies as non-tax revenues fell. The government responded by raising tax revenue targets. The finance ministry announced measures to expand the tax base and raise rates on several goods. Some of these, including luxury taxes on several goods, are now being scrapped to spur growth. This tinkering at the margin is not going to help much.

Government spending in the first half the year fell short of its target. Even if there is a speed-up in spending in the second half, the impact will most likely carry over to next year. Total government spending of about 17 per cent of GDP is quite significant. But only around 300 trillion rupiah (S$30 billion) or 2.5 per cent of GDP is capital expenditure. This is the amount that has significant impact on GDP growth.

We are now looking at 4.5 to 5 per cent growth this year. That will feel like a recession to some. But that is good enough in comparison with other countries in the region as well as among emerging economies the world over.

Aside from growth, the coming US interest rate hike is another risk facing our economy. Despite two years of warning, this event is still significant for several reasons.

First, US treasuries remain among the largest securities on the market and are held by a host of central banks and investors the world over.

Second, US Fed interest rates are the benchmark that drives most other debt yields, even those in other currencies. A rise in US interest rates means all other interest rates will rise, including yields on Indonesian government bonds, which have risen about 0.8 per cent this year. In the past, a US interest hike triggered a backflow of capital from emerging economies. This process may not always be smooth.

The Indonesian government bond market bears close attention. Further rises in yields and the commensurate fall in prices could take place, especially considering that about 40 per cent of outstanding bonds are foreign-owned.

In the past, the central bank stabilised bond prices by getting into the market. It may need to do so again. Otherwise a sell-off could trigger losses leading to a meltdown.

The finance ministry is also looking at setting aside some funds for a buyback if necessary. These are important means of stabilisation during turbulence and their mere presence helps stave off attacks or excessive speculation.

Investors are waiting for government action to stop the slide both in GDP numbers as well as confidence. The norm for this kind of policy is that it needs large and bold measures, implemented quickly and visibly.

One alternative is to raise more financing from the issuance of government bonds.

It is true that between now and the probable Fed rate hike in September is not the perfect time to increase supply. But increasing the supply, say, by 60 trillion rupiah should not shake up the market too much. After all, raising the issuance by close to 22 trillion rupiah late last year did not stir the market too much. This will raise the deficit by about 0.5 per cent this year. Another 60 trillion rupiah could be pencilled in for next year. This extra funding can jump-start certain sectors and add to infrastructure spending.

The important thing is for the government to come to grips with the reality. Next is for it to unveil a realistic plan to raise growth rates in the medium term. Faster infrastructure spending is one item in that plan to open up several regions and sectors to growth. But we also need a powerful growth engine to take over the role of commodity exports.

Mineral processing is one low-hanging fruit. Others need to get identified and pushed through.

This is the kind of leadership we want to see. Otherwise the deterioration will continue.


The writer is a lecturer at the Economics and Business School, University of Indonesia.

A version of this article appeared in the print edition of The Straits Times on June 26, 2015, with the headline 'Reversing Indonesia's looming pessimism'. Print Edition | Subscribe