Country Report Indonesia
The policy focus in Indonesia is, and will remain, on macroeconomic stabilisation while protectionist policies have been implemented in the past months. As a result, growth is expected to slow to 5.4% this year. No major new structural reforms are expected from the next government.
Strengths (+) and weaknesses (-)
(+) Favorable demographics and growing middle class
Indonesia has a young and growing population (currently 248 million people). While the average income is still relatively low (USD 5,156 in PPP terms in 2013), the middle class is growing fast.
(+) Strong government finances
Indonesia has a rather low public debt (31% of GDP) and posts only limited fiscal deficits. This is due to rather tight control of spending, consistent strong economic growth, but also due the (bureaucratic) inability to fully execute capital spending plans for, among others, infrastructure.
(-) Weak business environment
Indonesia scores poorly on governance indicators such as the Ease of Doing Business, Corruption Perception and Press Freedom. Also, the infrastructure of the country (roads, electricity) is poor.
(-) Large energy and food subsidies
Fuel and (to a lesser extent) food is heavily subsidised in Indonesia, which not only contributed to the current account falling into deficit, but also reduces the efficiency of the economy and results in fiscal inflexibility. About a quarter of the central government budget is spent on subsidies.
1. Focus on macroeconomic stabilisation
With loose monetary conditions and a sizeable current account deficit, Indonesia was one of the countries that were seen as risky by international investors after the US Fed announced it would taper its monetary easing program. A sharp reduction of net portfolio outflows led to a significant weakening of the currency (figure 1). In response, the government has implemented policies aimed at stabilising the macro economy. Fuel price subsidies, partly responsible for large energy imports, were reduced substantially, raising the price of petrol by 44% and the price of diesel by 22%. This measure helped to keep the budget deficit steady – despite the fact that the government provided compensation to poor families to prevent protests – in the face of higher local currency energy import costs. The central bank took measures to reduce credit growth and contain inflation. The policy interest rate was raised by a cumulative 175 basis points to 7.5% between early June and late November 2013 (figure 2). Also, regulations were tightened and the reserve requirement ratio increased from 2.5% to 4%. Domestic credit growth slowed as a result, but is still near 20% y-o-y.
The policies of the government have helped to stabilise the economy. Inflation, although still elevated far beyond the 3.5%-5.5% target range of the central bank due to the impact of the fuel subsidy reduction, has started to decline (to 7.3% y-o-y in April). In addition, the rupiah has regained some of the lost ground despite the continued current account deficit the balance of payments improved. Capital inflows strengthened through renewed portfolio inflows due to increased interest rate differentials as a result of the policy changes in Indonesia and the still very low interest rates in the US and the EU. FDI inflows are also recovering, but are expected to be negatively affected by a new foreign investment law implemented in April 2014. Although more foreign participation has been allowed in some sectors, such as pharmaceuticals and public transport, foreign participation has been strongly reduced in other sectors. Foreign investment in some areas of the energy and retail sectors, such as onshore drilling and upstream production, which was previously 95%-100% open to foreign companies, disallowed altogether. The current account will remain in deficit due to a sharply reduced trade surplus. A new mining export law – implemented in January 2014 - that restricts the exports of minerals ore, and lower Chinese demand for natural resources will restrict commodity export growth. Furthermore, import demand by Indonesia’s growing middle-class is expected to remain relatively strong. Hence, a return to large trade surpluses is unlikely in the coming years (figure 3), despite the weaker currency and fuel subsidies reductions. The policy focus is expected to remain on macroeconomic stabilisation. Monetary policies will thus likely remain tight, which will restrain private consumption growth. In addition, as mentioned, export growth will remain limited. As a result, real GDP growth is expected to slow further this year, to 5.4% before accelerating to 6.4% in 2015 (figure 4).
2. No major new structural reforms expected from the next government
Under the current government policies have become increasingly nationalistic. With the elections favouring the pro-business opposition Indonesian Democratic Party-Struggle (PDI-P) it is hoped that that more market-friendly reforms will be implemented by the next government. However, it remains to be seen if a PDI-P government will actually change course significantly. The party has, for instance, indicated that it supports the current protectionist mineral export ban. On the bright side, Widodo also plans to continue to reduce fuel subsidies (to zero in the next 4 years). As the victory of the PDI-P in the May parliamentary elections was less pronounced than had previously been expected, the party will have to form a broader coalition, which reduces the prospects for reforms. Joko Widodo remains the favourite to win the presidential elections in July. More will become clear after the new government is installed, but it is expected that Indonesia will, in general, continue to muddle through regarding the implementation of structural economic reforms.
In 1945, Indonesia declared independence from the Netherlands. For almost fifty years since, power was in the hands of two men: first Sukarno, a leader in the fight for Indonesia’s independence, and then Suharto, who had removed Sukarno from power in the 1960s. In 1998, when Sukarno was finally toppled, the first free legislative elections took place, followed by the first free presidential elections in 2004. Yudhoyono defeated Megawati, the daughter of Sukarno, in presidential elections. Indonesia benefits from its abundant natural resources, which include coal, gas, oil, timber, gold, silver and palm oil. A decline in oil production made Indonesia a net oil importer in 2005 and triggered its exit from the OPEC in 2008. The oil and gas industry remains its largest industry, though. Coal and gas have become the new strengths – Indonesia is the world’s largest exporter of coal. The export mix is dictated by commodities, followed by manufactured products. During the Asian crisis of 1997/8, Indonesia was among the hardest hit countries. In 1998, GDP plummeted by more than 13%, inflation rose to 58%, the rupiah lost 70% of its value, and the sovereign went into default. This episode left its mark on the country’s economic policies. Consecutive governments have been fiscally prudent (with the country regaining its international investment status), and monetary policy has been able to contain inflation and the value of the rupiah within acceptable boundaries. In socio-economic terms, there is plenty of upside potential, as a large part of the population remains uneducated and poor. Furthermore, religious strife has become more pronounced, as the country rids itself of autocratic leadership to deal with the challenges of being a democracy.