Current account in check: Growth spurred spending, and a manageable trade deficit

Amidst Indonesia’s open capital markets the deterioration of the current account deficit (CAD) in 2012 was at the centre of investors’ concerns, weighing on the currency throughout the year. One of the main transmission mechanisms of the global economic slowdown on the Indonesian economy, the drop in exports was not matched by a slowdown in imports until the second half of 2012. While debates were held during the summer about whether this reflected an overheating of the economy, authorities at both the Ministry of Finance and Bank Indonesia (BI) enacted reforms meant to rebalance growth and reduce pressure on the country’s balance of payments. Over the longer term the key uncertainty surrounds the prospects for Chinese and global growth, as well as Indonesia’s ability to rebalance the direction of its exports and develop its industrial capacity. “While domestic consumption has kept growth resilient, the key question in the medium term will be the situation in China, which is the major destination for Indonesia’s coal and palm oil,” Bimo Epyanto, senior economic analyst at BI, told OBG.

SLOWING EXPORTS: Demand for Indonesian exports has slowed markedly in 2012 with exports dropping continuously year-on-year (y-o-y) from March onwards. With 65% of exports linked to commodities either directly or indirectly, this decline was due to the drops in commodities prices and sales volumes as intra-Asian trade flows weakened. “We have seen mineral exports fall quite sharply since China is a key market for them and softening in demand has had a big impact,” said Su Sian Lim, ASEAN economist at HSBC.

A new 20% tariff imposed on 65 unprocessed mineral commodity exports including nickel, copper, tin and gold (but not coal) also affected export volumes. “The decrease in exports is due to weakening demand and weakening prices for commodities, which are related,” Zaafril Amir, president director of Indonesia’s Export Credit Guaranty Agency, told OBG.

Total exports of goods and services fell consistently since their peak of $57.76bn in the third quarter of 2011, to $51.06bn a year later, according to data from BI. Exports contracted y-o-y for six months in a row to September, falling 7.3% y-o-y in July, 24.7% in August and 4% in September according to the Asian Development Bank (ADB). The trade surplus thus narrowed significantly in the year to the first half of 2012, falling from $16.3bn in the first half of 2011 to $335m y-o-y, the trade balance switched to deficit in the four months to August 2012, with a $176.5m trade deficit in July 2012 alone. This drop was driven by the non-oil trade balance switching to a deficit of $400m in the first half of 2012, while the oil and gas sector recorded a surplus of $200m, according to the Ministry of Trade.

This led the State Ministry of National Development Planning to lower export forecasts for 2013 from 11.7% to 8.3% in October 2012. However, as the Chinese economy showed signs of gradual recovery in the fourth quarter of 2012, HSBC forecast in November a rebalancing of trade with other emerging economies in Asia, the Middle East and Africa with roughly 10% annual growth in Indonesian exports to Asia (excluding Japan) and 8% growth in exports to the Middle East and Africa each over the next decade. In the shorter run the drop in exports slowed from 9% y-o-y in September 2012 to 7.6% in October. Imports, on the other hand, have not slowed as quickly as exports.

IMPORT STRUCTURE: With a strong domestic consumption engine, accounting for over 55% of GDP, and buoyant investment in domestic production, Indonesia’s imports sustained growth from a trough of $22.74bn in the first quarter of 2009 to $55.38bn in the second quarter of 2012. While some foreign investment banks like Credit Suisse and Morgan Stanley rang the alarm in August over what they viewed as possible overheating of the economy, with strong imports linked to robust domestic demand fast outstripping exports and a current account swinging from a surplus of $766m in the third quarter of 2011 to a record deficit of $7.69bn by the second quarter of 2012, or 3.1% of GDP, others downplayed such fears based on the structure of imports. Local authorities, the IMF and some investment banks, like Barclays, argued that the structure of imports reflected the productive use of imports.

“We do not see the CAD in 2012 as a sign of overheating, particularly since the structure of imports is not dominated by consumption but rather by productive domestic investments,” Bimo Epyanto told OBG.

NATURAL CONSEQUENCE: Only 7.5% of total imports were destined for domestic consumption in the second quarter of 2012, while the main driver of import growth – capital goods – accounted for 19% of imports. This increase was led by heavy equipment and aircraft imports, according to Bank Danamon, whose share of imports grew from 11.8% and 8.3% respectively in 2011 as a whole to 16% and 12.8%, respectively, in the first half of 2012. “The CAD is a structural issue: growing FDI entails higher imports since Indonesia simply has not developed the necessary downstream industries that exist in countries like Malaysia and Thailand,” Destry Damayanti, chief economist at Bank Mandiri, told OBG. In a note on Indonesia in the third quarter of 2012 the IMF said that CAD being caused by imports of machinery and capital goods was a “a natural and desirable consequence” of economic development.

In an open economy like Indonesia’s the CAD has weighed particularly on the exchange rate, which dropped over 6% in the year to December 2012, from close to Rp9000 to $1 at the start of the year to over Rp9630 by December. Despite debate over the structural significance of the deficit, Morgan Stanley argued in a November 2012 note that the tolerance for a CAD in Indonesia is lower than in regional peers given the more open nature of the capital account. Following shortfalls in dollar liquidity to the market in the second quarter of 2012, BI intervened more forcefully in open-market operations to stabilise the rate at around Rp9600 over the summer of 2012, just as upward pressure on the deficit eased from July onwards.

NARROWING GAP: While the impact of new loans-to-value caps on consumer loans for vehicle and home purchases started to bring down y-o-y domestic credit growth towards the 22-24% range from July, weighing down on consumer-linked imports, imports of machinery and equipment linked to the commodities sectors also started to cool from July, returning to single-digit y-o-y growth, given the lag in domestic industries adapting to lower export earnings. The central bank also raised its deposit facility rate from 3.75% to 4% in August, raising the cost of short-term funding to reduce upward pressure on imports. The Ministry of Finance meanwhile announced its intention to unveil new tax incentives for 122 industries to encourage local production of capital goods to reduce pressure on imports over the medium term, although the specific level of tax breaks was still being discussed in late 2012.

By late 2012 BI forecast 24% annual credit growth for the year as a whole, with a higher share of credit going towards productive purposes (working capital and investment loans) rather than consumer loans. Import growth thus slowed from 0.9% y-o-y in July 2012 to a slump of 9.2% in August according to data from Bank Mandiri, causing the trade balance to revert from four months of deficit reaching $263m in July to a surplus of $233m by August and $533m in September.

“As imports have started to slow gradually since July, we are expecting a narrowing of the deficit to around 2.2% for 2012 as a whole,” Bimo Epyanto told OBG. With oil and gas accounting for 55% of imports, the trade balance had a deficit of $561m year-to-date in November 2012, down from a surplus of $23.6bn in the same period in 2011. While it is encouraging that investment in manufacturing is driving growth in productive imports, the rise in oil and gas imports is a worrying sign and reflects the need to list subsidised domestic fuel prices in the near term. The deficit may not reflect an overheating of the economy as feared by some in 2012, but it does reveal structural weaknesses of an economy with little downstream capacity. These developments add pressure to enact policies to establish industrial production locally and lift fuel subsidies that exacerbate consumption-related import growth.