EoAE Forecasts – 1Q19

  • Rising fiscal revenues provide fiscal flexibility for spending ahead of the April 2019 election; expected to proceed smoothly with polls predicting a Jokowi re-election.
  • Policy ambivalence on foreign investment is not conducive to building a competitive manufacturing sector or for optimal development of Indonesia’s extensive resources.
  • Interest rates have risen by 175bp since April 2017. Risk of renewed US-China trade tensions in March 2019 for another 50bp rise to 6.5%.

Anthony Nafte |

Political stability, gradual growth

Indonesia will hold combined presidential and parliamentary elections on 17 April 2019. Polls suggest Mr Jokowi will be re-elected for a second (and final) five year term to 2024. The expectation is for the election to proceed smoothly without major political disturbance in the run-up over the next four months. Specifically, religious tensions which marred the Jakarta governor election in 2017 have been defused by Jokowi’s selection of a senior cleric as his running mate for the election. This choice however, along with Jokowi’s shift to consensus politics (political appointees rather than competent economic managers) raises doubts on prospects for bold restructuring in the second term of a Jokowi presidency.

Mr Jokowi was viewed as a reformer with his decisive move to zero fuel subsidies at the outset of his presidency in 2014. However, when tested by rising global oil prices, Jokowi backtracked and re-initiated, economically indefensible, energy subsidies. Global oil price rises have not been passed on to domestic fuel prices since April 2018 leaving the fiscal account exposed. Jokowi has also failed the test of opening the Indonesian economy more widely to foreign investment; policy remains ambivalent and initiatives have been unconvincing. Policy failures have been offset by some policy successes, notably faster infrastructure implementation (albeit still gradual) and increased social spending.

Political stability has been maintained moreover, an achievement that should not be understated in this extensive archipelago with its large and diverse population. Indonesia’s widening current account deficit left it vulnerable to tightening global liquidity and resulting emerging market risk aversion. Bank Indonesia reacted forcefully in order to maintain balance of payments and exchange rate stability, BI followed up on its commitment to support the exchange rate by raising its policy rate by 175bp from April 2018, to 6% in November 2018.

Will higher interest rates choke off the investment recovery? No, not on our prediction that 6.5% will mark the end of the tightening cycle. Exchange rate stability will be more crucial for business confidence and a sustained investment upswing. The sustained rise in bank credit growth in late 2018 was reassuring. Fiscal constraints have been eased by revenue growth in excess of expectations, at an estimated 16.2% YoY in 2018. With expenditure growth lower, at an estimated 10.6% YoY, the fiscal deficit will be contained at 1.9% of GDP in 2018. This will provide fiscal flexibility for stepped up pre-election spending.

Prospects for a sustained gradual investment upswing (from 7% growth in 2018 to 7.4% in 2019) and strengthening private consumption growth (from 5.1% in 2018 to 5.5% in 2019) make us optimistic relative to consensus. We forecast rising real GDP growth to 5.5% in 2019 from our 5.2% estimate for 2018. Weakening global demand and declining commodity prices will keep GDP growth capped at 5.5% in 2020 even while Indonesia, as a domestically driven economy, will be more resilient than Asia’s export driven economies.

Sub-optimal FDI inflow

The execution and implementation of pro-investment policies have not been optimal’. This was the criticism levelled by Mr Lembong, chairman of the Investment Coordinating Board (BKPM). Bureaucracy and legal recourse have not been adequately tackled in order to facilitate foreign investment. This is not a consensus view within government though, with ministers blaming low foreign investment on external factors or on uncertainty ahead of the April 2019 election.

These excuses are disingenuous given that average annual FDI inflow has been stuck at a low 1.5% of GDP over the last five years. Indonesia’s resources and manufacturing sectors should have been magnets for foreign investment but the necessary structural challenges have not been confronted. Specifically, labour market reform is needed for a thriving manufacturing sector; Indonesia has the highest severance pay in the region which deters hiring in the formal sector. Development of Indonesia’s extensive resources requires regulatory consistency and less nationalistic policy. Reform of the state owned oil sector is needed to halt the relentless decline in oil output.

Investment initiatives were announced in late 2018. First, the tax holiday scheme has been expanded to more sectors including the digital economy and agricultural industry. Second, 54 business sectors were removed from the negative investment list. This was subsequently reduced to 49 sectors as the government yielded to pressure from the Employers’ Association; 5 sectors were kept on the negative list in order to shield domestic SMEs from foreign competition. These measures fall way short of the bold restructuring that would indicate an unequivocal policy stance on welcoming foreign investment into Indonesia. Will we see this in Jokowi’s second (and final) presidential term, assuming that he is re-elected in April 2019? The answer, regrettably, is no until proven otherwise.

Current account deficit above 3% of GDP

Governments undertake restructuring only with their back against the wall. There will be sustained pressure post-election from the persistent current account deficit and renewed fiscal constraints. The low 2018 fiscal deficit obscured rising SOE debt. Fiscal exposure has been heightened by energy subsidies which rose from 0.7% of GDP in 2017 to 1.1% of GDP estimate in 2018. Government compensation is due to the national oil company, Pertamina, for fuel sale costs, estimated at 3% of GDP (combined 2017-18). Subsidy pressure will be sustained through 1H19 with a firming oil price to USD70/bbl; but with subsequent relief as the oil price eases to USD60/bbl by end-2019 and to USD50/bbl by end-2020.

The current account deficit has been widening with imports boosted by the pickup in infrastructure and other investment growth. Rising oil prices have widened the oil trade deficit, exacerbated by Indonesia’s declining oil production and consequent rising oil imports. To the extent that oil prices rise, there will be added exposure as the divergence between the global oil price (USD) and the domestic fuel price (IDR) encourages fuel smuggling.

The IDR depreciation in 2018 will eventually curb the current account deficit. The lagged effect though, may only come through in late 2019, retarding the current account deficit increase in 2020. While there is also potential offset from rising tourism revenues, trends have not been encouraging. Tourism revenue inflows at 1.3% of GDP in 2018 were barely higher than in 2016-17. With rising GDP growth and an expanding fiscal deficit (which will exacerbate the domestic savings-investment gap), the current account deficit will widen from an estimated 3.1% of GDP in 2018 to 3.3% of GDP in 2019 and 3.4% of GDP in 2020.

Risk of another 50bp rate rise

Policy strategy for containing the current account deficit should focus on raising competitiveness for higher export growth while attracting higher FDI for balance of payments support. Instead, policy response has been short term fixes (import restrictions, postponing import intensive projects) which are counterproductive.

As for monetary policy, Bank Indonesia demonstrated its commitment to current account deficit control through aggressive tightening. Exchange rate stabilization in late 2018 and subdued inflation within BI’s 2.5-4.5% target have provided relief. The key to containing inflation was to keep food prices down by preventing food shortages. This will be reinforced by a new rice procurement scheme from the start of 2019. The 8% minimal wage increase for 2019 follows the official guideline (real GDP growth plus average inflation); there would be concern by a matching rise in general wages which would require a productivity offset.

There is the risk of China and the US failing to reach agreement on trade and consequently the Trump tariff rate on Chinese exports to rise to 25% in March, for renewed emerging market currency pressure. We forecast another 50bp rate rise by Bank Indonesia to 6.5% by mid-2019.

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