Tighten up: The authorities are taking the opportunity to enact structural reforms

Following a decade of averaging 6% growth per year, Indonesia’s economy faced both external and internal challenges in 2013. The world’s 16th-largest economy with GDP of Rp8242trn ($824bn) in 2012, which is a fourfold increase in a decade, and the fourth-most populated with 247m citizens, Indonesia has strong fundamentals for long-term growth. While the sharp reversal of foreign portfolio investment (FPI) flows from May 2013 emphasised economic imbalances, authorities are seizing on the sense of crisis as an opportunity for enacting needed structural reforms. With an election year looming, however, the onus for rapid action is on Bank Indonesia (BI), which adopted a monetary tightening stance that will slow economic growth and redress imbalances. “We know we will eventually return to a pre-quantitative easing world,” Luky Alfirman, head of the Ministry of Finance’s (MoF’s) centre for macroeconomic policy, told OBG. “We can no longer rely on high foreign portfolio inflows and a commodities super-cycle, so we are looking to readjust.” Despite external headwinds, its long-term growth trajectory should put Indonesia among the world’s 10-largest economies by 2030, according to consultancy McKinsey & Company, with a 141m-strong middle class by 2020, double its present size, according to Boston Consulting Group. Yet Indonesia needs to bridge gaps in its social and economic infrastructure, both hard and soft, to leverage a demographic dividend, as half of its population is below the age of 30.

Consistent

Indonesia has sustained a consistent growth record since 2003, the year its economy surpassed the pre-Asian financial crisis peak of 1997. While growth slowed in the wake of the global financial crisis that began in 2008, it remained a healthy 4.6% in 2009, bolstered by high domestic consumption. Although growth cooled from a high of 6.8% year-on-year (y-o-y) in the fourth quarter of 2010 to 6.5% in 2011 and 6.2% in 2012, this above-average expansion was sustained despite the country’s first negative export growth in 2012. Consumption has grown steadily on the back of rising disposable incomes, with GDP per capita of $3596 in 2012. But at only three-fifths China’s income levels and one-third of Brazil’s, per capita income growth is only midway, according to private equity firm KKR, which expects a 40% aggregate rise in the five years to 2017. “While the significance of GDP per capita approaching $4000 is undeniable for the consumer marketplace, in Jakarta the level is probably nearer $12,000,” Rudy Tanoesoedibjo, the president director of MNC Sky Vision, told OBG. Rural-urban migration, which drove the urban population from 41.9% in 2000 to 51% in 2012, according to the UN Development Programme, has driven productivity growth and an expansion in the labour force (see analysis). Despite its sizeable population, low credit penetration and lower-middle-income purchasing power mean Indonesia’s consumer industries are in their nascent stages.

“Due to the rise of purchasing power of the Indonesian public, we are seeing a lot of growth potential for consumer-driven industries including the automotive, retail and entertainment sectors,” Prem Harjani, the president director of Vivaces Prabu Investments, told OBG. As the middle class continues to expand from 18% of the population in 2012 to 35-45% by 2030, according to McKinsey, the tertiary sector is bound to grow. Despite relatively high inequality, with a Gini coefficient of income inequality that rose from 0.36 to 0.38 in 2012, and 115m people living on less than $2 a day, the large domestic consumption engine has insulated Indonesia from volatility in world trade. In the coefficient, zero represents perfect equality, while one represents inequality.

Foreign Direct Investment (FDI)

However, as an open economy Indonesia remains vulnerable to rapid changes in global investor sentiment. The country has arguably been a victim of its own success: attracting record levels of FDI, reaching $24bn in 2012 ($32bn when including hydrocarbons and mining) targeting manufacturing and consumption-related sectors, the current account has remained in a growing deficit since the fourth quarter of 2011. In the absence of a broad industrial base, particularly for the production of intermediate and capital goods, rising FDI has spurred growing imports (see analysis). With FDI covering only two-thirds of the value of the current account deficit, FPI has been crucial in insuring the balance of payments. With FPI accounting for half of Indonesian equities and one-third of its bonds in 2013, sharp sell-offs have a destabilising effect on its currency and economy. While growth projections have been cut to a range of 5.2% (from the IMF) to 5.9% (from the MoF) in 2013 and 5.5-6% in 2014, this remains higher than the emerging markets average of 4.5% for 2013.

Structural Drivers

Key to this sustainable growth has been the economy’s diversified base. Although agriculture employs 35% of the workforce it accounts for just 15% of GDP. Since 2010 the services sector has become the major employer, and accounted for 39% of GDP as of the second quarter of 2013. A sign of the diversified production base, manufacturing accounts for 23.8% of GDP, construction for 10.3% and mining for 10.4%. The global commodities downturn caused contraction in the mining and quarrying sector of 1.2% y-o-y in the second quarter of 2013, and in oil and gas, which fell 4.7%. The secondary and tertiary sectors remained key drivers of growth, with manufacturing growing 5.8% y-o-y and construction 6.9%. In services, transport and communications expanded 11.5% y-o-y in the second quarter of 2013, while hotels and restoration grew at 6.5%, according to the World Bank.

Indonesia’s economy remains relatively insulated from the effects of slow world trade growth. Exports fell from 40.8% of GDP in 2000 to 29.9% in 2008 and 24.1% in 2012, the region’s lowest, according to World Bank figures, while that of household spending remained constant at 57%. Despite strong credit growth in recent years, with above-20% growth in bank lending since 2010, the Indonesian consumer remains under-leveraged compared to regional peers, with household debt-to-GDP of a mere 10% in 2012, compared to Singapore’s 76%, Thailand’s 77% and Malaysia’s 81%, according to the Asian Development Bank (ADB). Yet the combination of a fuel subsidy cut, a consequent spike in inflation, higher domestic interest rates and slowing growth temporarily affected consumer confidence in mid-2013. “Consumer confidence has been quite high in the past three years,” Ndiame Diop, lead economist and economic advisor at the World Bank, told OBG. “We should watch the extent to which the rupiah’s depreciation and the weaker outlook may affect confidence, and thus the propensity to spend versus save.”

Rebalancing

The Yudhoyono administration has pursued a fiscal rebalancing strategy over the past decade, aiming to reduce the share of unproductive recurrent expenditure covering wages and social transfers, such as power and fuel subsidies, and expanding investment in infrastructure development. Capital expenditure rose from 8.3% of central government budgeted spending in 2006, at the start of the administration’s two terms, to 17% by 2012. While the central government budget expanded by 11.2% in 2010, 24.3% in 2011 and 11.2% in 2012, capital expenditure rose by 5.8%, 46.8% and 74%, respectively. Despite an infrastructure master plan published in 2011, however, government spending on infrastructure stagnated at 2.03% of GDP in 2012, lower than India’s 8%, China’s 9% and Vietnam’s 10%, according to the World Bank (see analysis).

Subsidies

While the central government has remained prudent in spending plans, a key variable stems from subsidies that have eaten a large share of the budget. Energy subsidies accounted for 22% of the budget in 2011 and 19% in 2012, with 55% of these allocated to fuel sales. Despite fuel price adjustments in 2005 and 2008, the domestic sales price remained well below world prices at Rp4500 ($0.45) per litre and prompted spending on fuel subsidies to reach roughly $20bn in 2012, or 3.7% of GDP, while total spending on subsidies reached Rp348.1trn ($34.8bn) in the revised 2013 budget, more than spending on health and education combined.

From 2013 the presidency regained authority for price adjustments, whereas it depended on parliamentary approval in the previous two budgets. “The authority for setting fuel subsidies rests with the government entirely in the 2013 and 2014 budgets, whereas in 2012, the government needed to meet a threshold set by the parliament before it was allowed to adjust the subsidised fuel price,” Luky told OBG. “It is very significant as it gives us more flexibility.”

This allowed the government to raise premium petrol prices by 44% and diesel by 22% in June 2013, to Rp6500 ($0.65) per litre and Rp5500 ($0.55) per litre, respectively. This cut allowed authorities to trim the subsidy budget by 3.4% between 2013 and the proposed 2014 budget, to Rp336.2trn ($33.6bn).

The government is seeking to cap fuel subsidies at roughly Rp212trn ($21bn) in 2014, although given an oil price assumption of $106 per barrel, volatile global markets could force spending to exceed this target. Over the medium term the MoF is looking at ways to cap total subsidy payments – one option would be to set a subsidy ceiling per litre rather than an absolute domestic price. Yet in the run-up to the 2014 elections, economists do not expect significant further reform on this front.

Savings from the fuel price hike were shifted towards infrastructure investment, health and education, to which 20% of the central government budget is allocated, and targeted cash transfers of $900m to 15m low-income households. Provision of social services will attract a growing share of government spending in the next six years given the extension of social security benefits, including universal health insurance for all Indonesians by 2019, which will cost up to $16bn a year, according to the World Bank.

Disbursement

Boosting capital spending has faced the constraint of low budget disbursement. While central government budget execution rose from 84% in 2011 to 89% in 2012, disbursement of investment funds remained at 85%, according to the MoF. With half of the budget decentralised to sub-national administrations (provincial, district and municipal) since 2001, the execution rate for investment stands at below 50%. Coordination between the major tiers of government has proved problematic, while inefficiencies between central government departments and in project-level execution, including land acquisition, have hindered full budget absorption.

The government has taken steps to improve spending by introducing performance benchmarks for ministries, accelerating the budget approval process to frontload projects towards the start of the year and introducing an e-procurement system that will be fully implemented by 2014. “The new electronic procurement system rolled in for most agencies and local governments is improving both the efficiency and transparency of our procurement process,” Bobby Hamzar Rafinus, deputy minister for fiscal and monetary coordination at the Coordinating Ministry for Economic Affairs, told OBG.

Funding

In aggregate the government retains ample fiscal space. While the central government’s fiscal deficit reached 2.1% of GDP in 2013, it remains below the legal limit of 3%. Gross debt has trended down from 95% of GDP in 2000 to 24% in 2012, of which 44.4% is in foreign currency, according to the ADB. Despite high reliance on domestic bond financing, however, the government remains highly dependent on portfolio inflows given foreign investors’ holdings of roughly one-third of domestic bonds outstanding. The sharp rise in bond yields from May 2013 pushed up the government’s cost of funding by 300 basis points, while investors have proven increasingly discerning on funding investment projects over unproductive subsidies.

Tax Base

With the informal economy accounting for 54% of employment and an estimated 24% of GDP according to the World Bank, Indonesia’s tax base is low, at 17% of the population, while tax take remains only 12% of GDP. The tax office has achieved some notable successes in boosting collections, with tax revenues growing 16.7% in 2010, 20.8% in 2011 and 6.5% in 2012. Yet while tax compliance has improved, lower revenues linked to commodity exports, which account for 63% of foreign sales, have trended downwards in line with key commodity prices since the second quarter of 2012. “Although authorities intend to raise the tax ratio by 1 percentage point to 13%, this looks unlikely given the commodities downturn,” Anton Gunawan, Danamon Bank’s chief economist and executive vice-president, told OBG.

Bonds

While its cost of funding has risen since May 2013, Indonesia still has ample access to global and domestic bond markets to finance its deficit – particularly since its sovereign credit rating upgrades to investment grade in 2010 by Japan’s rating agencies and at the start of 2012 by Fitch and Moody’s. The government has been a regular issuer of foreign currency bonds, issuing two dollar-denominated bonds worth a combined $3.8bn and a Yen bond worth $692m in 2012. Coupons on bonds issued in 2013 have risen, however, while 10-year and 20-year bonds worth $1.5bn each fetched coupons of 3.375% and 4.625%, respectively in April. A $1bn 10-year bond issue in July was priced at 5.375% and a $1.5bn 5.5-year issue in September had a rate of 6.125%. That these issues were over three times oversubscribed reflects the continued global appetite for Indonesian sovereign debt, albeit at higher prices (see analysis). The government also has standby contingency facilities worth $5bn (at 2.5%) from the World Bank ($2bn), Japan ($1.5bn), Australia ($1bn) and the ADB ($0.5bn) that it can draw on any time.

Inflation

A combination of higher energy prices from June and increased food prices linked to horticultural and meat import controls spurred resurgence in inflationary pressure in mid-2013. Inflation has trended downward from an average of 7.49% between 2002 and 2007 to 5.49% from 2007-12, reaching a low of 4.3% in 2012 according to BI figures, within the central bank’s 3.5-5.5% target.

The impact of the falling rupiah, which dropped from an average of Rp8800:$1 in 2011 to Rp9400:$1 in 2012, pushed inflation up to 5.5% y-o-y in May 2013 and 5.9% in June. Annualised inflation jumped to 8.6% in July and 8.8% in August, however, due to the combination of fuel price increases and higher food demand coinciding with Ramadan in July. “In each of the economic crises in 2005, 2008 and 2013 one of main drivers of inflation pressure has been the lifting of fuel subsidies,” Iwan Wisaksana, senior vicepresident at Kresna Graha Sekurindo, told OBG. Although full-year inflation projections range from Bank Danamon’s 8.7-9.2% to BI’s 9.2-9.8%, the subsidy cut’s impact on inflation will only be short-term, given previous experiences in 2005 and 2008. “We only expect the direct and indirect impact of the fuel price hike on inflation to last three months, although due to the base effect we will only return to the trend 4. 5-5% inflation rate by June 2014,” Anton told OBG. Indeed, by September 2013 month-on-month (m-o-m) inflation turned negative, falling by 0.35%, while the annualised rate cooled to 8.4%. Food inflation remained high at 11.4% y-o-y in September, although it started to fall with a m-o-m drop of 3.4%, while non-food inflation cooled to 6.9% y-o-y.

Domestic Demand

While inflation has exceeded BI’s target band from July 2013, the central bank’s interest rate hikes appeared more directed to cooling domestic demand to reduce the current account deficit rather than taming the on-off spike in inflation. “BI is able to accept some discrepancies in its inflation-targeting framework when we see one-off inflationary shocks like that caused by the fuel subsidy cut in June 2013,” Bimo Epyanto, BI’s assistant director of investor relations, said. “Inflationary pressure in 2013 has stemmed from the government’s administered price policies.” Nonetheless, the bank embarked on a sharp monetary tightening cycle from June, hiking rates for its overnight lending facility ( FASBI) and benchmark interest rates by 150 basis points in three months to mid-September, and enacting a series of macro-prudential measures aimed at cooling credit growth and curbing imports (see analysis).

Managing Imbalances

Although Indonesia’s fundamental growth story remains convincing to foreign direct investors, the balance of payments came under strain in 2013, given significant portfolio outflows. By June major investment banks like Morgan Stanley had categorised Indonesia as one of the “fragile five” emerging markets with twin current account and fiscal deficits, highly dependent on capital inflows to finance these shortfalls.

Although portfolio inflows were sufficient to cover the deficit with some downward pressure on the currency from mid-2012 on – although the rupiah was emerging Asia’s worst-performing currency in 2012, with a 5.1% drop against the dollar – the stark reversal in portfolio investor sentiment initiated by the US Federal Reserve’s indication in May 2013 of a slowdown in quantitative easing brought matters to a head. As Indonesian credit default swap spreads rose 60 basis points in three months to the end of July and foreign investors pulled Rp42.3trn ($4.2bn) out of Indonesian markets in three months to September, pressure on the currency rose markedly. This stemmed from a combination of capital outflows by both foreign and domestic investors. “The capital outflow offshore in 2013 was partly caused by a speculative attack on our financial system by our own banks,” Purbaya Yudhi Sadewa, Danareksa’s chief economist, told OBG. Despite short-lived upticks in demand for equities and bonds, the correction in Indonesia’s capital markets continued into the fourth quarter of 2013 (see Capital Markets chapter).

Stocking Up

Meanwhile, exporters preserved as many foreign earnings as possible in dollars in anticipation of a continued slide in the currency. “Dollar liquidity is very tight as exports slump while imports keep growing to support local market demand, and exporters keep earnings in dollars, only converting into rupiah as and when necessary,” Nirmala Salli, HSBC’s head of trade in Indonesia, told OBG.

By late September the rupiah had become Asia’s worst-performing currency, falling 17% year-to-date and breaking the Rp11,500:$1 mark, down from averages of Rp8779:$1 in 2011 and Rp9384:$1 in 2012. The MoF readjusted its 2013 budget assumptions from Rp9600:$1 to Rp10,200:$1 mid-year and from Rp9750:$1 to Rp10,500:$1 for the 2014 budget. This deterioration in the current account deficit and the exchange rate prompted a swift response by BI and a government package of policy measures in August 2013 aimed at narrowing the deficit over the medium term (see analysis). Despite concerns over a possible repeat of the 1997-98 Asian financial crisis, where corporates’ significant currency mismatches prompted widespread bankruptcies as the currency devalued sharply, Indonesian corporates remain much better-placed to weather the storm in 2013.

Corporates most exposed to such mismatches, caused by rupiah-denominated earnings and foreign exchange-denominated debt, are in the property sector, including larger developers like Lippo Karawaci, Alam Sutera and Kawasan Industri Jababeka, although Fitch reported in August that over 80% of their forex exposure was hedged. Meanwhile, export-oriented companies in mining, energy and plantations are able to sustain foreign debt burdens, although lower commodity prices in 2013 have placed their earnings under pressure. The banking sector is in a good position to weather any uptick in non-performing loans given high capital adequacy and liquidity ratios, while the banks maintained open currency mismatches (net-open-positions) of just 2% in the third quarter of 2013, according to Fitch.

Consumption

With little comfort expected from export growth, the onus for driving growth in the coming year will fall on household consumption and government investment.

While progress in disbursing funds under the government’s infrastructure plan has been slow, it expects to expedite key projects under its 2014 budget (see analysis). BI’s consumer confidence index dipped in July and August 2013 to its lowest level in 14 months due to the impact of fuel prices on disposable incomes, before rebounding by 0.9% in September.

This was matched by a rebound in the manufacturing purchasing managers’ index compiled by HSBC, which rose from 48.5 in August to 50.2 in September, just above the 50 level indicating expansion in manufacturing output.

While consumption will remain constrained by higher domestic lending rates and slower growth into 2014, the run-up to presidential elections in July 2014 will provide some offsetting effects. “We estimate the election will add 0.2%-0.3% to GDP growth in 2014, in the form of private consumption,” Destry Damayanti, Bank Mandiri’s chief economist, told OBG. “This spending typically goes to small and mediumsized enterprises and the informal sector.” These estimates are similar to BI’s, based on previous elections in 2004 and 2009. While cash transfers to voters may provide additional impetus to private consumption, official party spending will stimulate the services sector in particular. “Excluding money politics that could generate more retail spending we expect the preelection campaign to generate growth in sectors like transport, hospitality and media,” Anton told OBG.

Outlook

While forecasting agencies – governmental, multilateral and private sector – have downgraded Indonesian growth forecasts significantly in 2013, they disagree on the timing of the slowdown. The IMF forecasts the slowest growth of 5.25% in 2013, down from 6.2% originally forecast, followed by a rebound to 5.5% in 2014, while the World Bank downgraded its 2013 growth forecast from 5.9% to 5.6%, and 5.3% in 2014, signalling a slower downturn. More optimistic, the MoF expects 5.9% and 6% growth for 2013 and 2014, respectively, while BI is targeting 5.5-5.9% and 5.8-6.2% growth for the two years. Despite disagreements on the pace of the slowdown, growth remains higher than emerging markets’ average of 4.5% in 2013, and points to the resilience of long-term drivers of economic growth. While policy continuity amid the political transition in 2014 will be an important factor in determining the pace of growth, the authorities will continue to balance the need to support domestic consumption growth with ensuring broader macroeconomic stability and the confidence of global investors.

This confidence game will be a tightrope walk, yet authorities see in the short-term crisis an opportunity for enacting key structural reforms aimed at sustaining FDI flows and diversifying trade patterns.