Indonesia tries to balance growth and inflation

With economic growth slowing, inflation rising and the currency weakening, Indonesia faces some tough macroeconomic challenges. However, the government has responded to the situation with variety of monetary and fiscal policy tools, including raising interest rates while at the same time rolling out fiscal stimulus measures.

On August 2 the Central Statistics Agency (BPS) issued GDP figures for the second quarter showing the economy had expanded by its slowest rate since the third quarter of 2010. Year-on-year growth in the second quarter eased to 5.81%, down from the 6.03% of the previous three-month term, with the April-to-June result being the fourth quarter in a row that the rate of economic expansion had slowed.

The situation has been compounded by a fall in the value of the rupiah, which had dropped more than 10% against the dollar this year as of late-August, and a widening of the current account deficit as export growth has failed to keep pace with Indonesia’s appetite for imports. The current account has been in the red for the past six quarters, having previously been in positive territory – with the exception of 2008 – since 2005. While Bank Indonesia, the central bank, predicts that the current account deficit will narrow to $7bn in the third quarter, down from $9bn in the April-to-June period, it may be some time before the deficit is erased in full.

The government has acknowledged that it may not be able to meet its short-term targets. “We had set a 6.3% growth target for this year, but it may be difficult to achieve this,” Chatib Basri, the finance minister, said on August 12. “To achieve an economic growth of 6.3%, we should have 6.6% economic growth next month, which is difficult.”

The central bank had left its key interest rate unchanged at its August 15 meeting, a move seen as intended to foster growth, following a decision to raise rates to 6.5% in July, as inflation hit 8.61%, a steep climb from the 5.9% of the month before and the highest level in more than four years. However, in late August, BI reversed course, raising its benchmark rate to 7%, in an attempt to slow capital outflow, as the rupiah continued to fall. Indonesia, like other emerging markets such as Brazil and India, has seen the value of its currency decline as markets anticipate the US Federal Reserve will end its bond-buying programme.

While high interest rates should help curb inflation and slow the withdrawal of foreign capital, they could also make it more difficult for the government to achieve its target of above-6% growth, particularly with domestic consumption seen as the locomotive of the economy. On August 12 the finance minister said President Susilo Bambang Yudhoyono favoured a “keep buying” policy that would lift household consumption, the largest single contributor to the economy.

“So, if consumption is high, GDP would be high,” Chatib said. “Household consumption and government expenditure will boost the economy because investments are expected to reduce, with no guarantee of export growth.”

In the short run, the government has said that it will introduce a stimulus package, as well as tax holidays, in an attempt to reduce the current account deficit and boost growth. However, the market responded poorly to the plan, with stock and bond values, as well as the rupiah, declining in the days following the announcement.

In the medium term, the 2014 budget could help, with the state saying that it will promote domestic consumption, along with increased spending on infrastructure and human resource development, intended to lift productivity. The effect of this investment will take time to be felt, meaning it is likely that GDP growth will remain at the lower end of Bank Indonesia’s 5.8-6.2% range this year.