INDONESIA HASN’T HAD it this good for a long time. Investors can’t seem to get enough of the country, with portfolio capital as well as foreign direct investment rising rapidly, drawn in by the promise of rapidly developing domestic demand in the world’s fourth most populous country. The economy has been more resilient than many expected in the face of the global financial crisis, Indonesian equities are performing strongly and the rupiah has been appreciating. The key question for investors used to the ups and downs of Indonesia’s past is: How sustainable are the good times?
Growth set to accelerate, no overheating yet
As we argued in this column in May, there are good grounds for expecting Indonesia’s economic growth to accelerate in the coming years. In fact, if the right policy measures are taken, we believe that Indonesia can easily match China or India later this decade. Recent economic data shows economic activity to be in sound shape:
- GDP growth accelerated to 6.2% in 2Q2010, compared with 5.7% in 1Q2010. Much of this was driven by strong domestic demand — consumer spending was robust and investment is recovering.
- Forward-looking indicators suggest that investment is set to pick up strongly. Investment approvals have soared and many of these are being realised now. Actual investment by foreign and local investors rose 40% y-o-y during 1H2010 to US$10.3 billion ($13.91 billion). Foreign investments alone grew 46% y-o-y.
- Poverty is falling: Government statistics report a 1.5 million drop for those living in poverty for March y-o-y, bringing the number of poor to a still-high 31 million.
- Japan Credit Rating Agency has upgraded Indonesia’s credit rating to investment grade, citing the nation’s economic prospects and prudent fiscal management.
Structural weaknesses not being addressed aggressively enough
In the past, the weak underbelly of Indonesia’s economy has been in the financial dimension — inflation and the external accounts. Here, the current indicators look good but there are some, albeit early, signs of deterioration:
- Inflation has surged recently, rising to 6.2% last month from 5.1% in June. But much of this was driven by food prices or a result of adjustments to administered prices. Nevertheless, with global food prices set to rise further on weather damage to crops and the economy running at high levels of capacity, the risks to underlying inflation appear to be on the upside.
- The balance of payments remains positive. The trade surplus narrowed in June to US$580 million from May’s US$2.68 billion and April’s US$799 million. Import growth however, has outpaced that of export growth for an extended period now. With global demand poised to slow while domestic demand remains high, the likelihood is that the World Bank is right in projecting that the current account surplus will disappear in 2011.
- The country continues to be exposed to the vagaries of undisciplined flows of capital. Foreign purchases of Indonesian bonds and equities soared to US$9 billion in January-April (US$4 billion in
- April alone) but when the European debt crisis caused a scare among global investors, Indonesia saw a sharp US$5.7 billion outflow in May. These swings in capital flows produce volatility in the exchange rate, increasing uncertainty over the rupiah and making monetary management much more difficult.
In addition, a quick look at the structural aspects of the economy reveals some areas of concern as highlighted in recent reports by the World Bank and Asian Development Bank.
First, while economic growth has been rising, the economy’s capacity to generate jobs in the formal sector continues to disappoint. The latest labour market report (August 2009) shows that the number of formal sector jobs declined in the 12 months to August 2009. Transport and communications — one the fastest growing sectors in Indonesia — actually saw a loss of jobs. If GDP growth does not translate into jobs, the welfare gains of high growth will be muted.
Second, there remain glaring inefficiencies in the economy that hold the economy back. The costs of financial intermediation are extremely high in Indonesia, much of this due to the oligopolistic nature of the banking system, where the top four banks control 44% of deposits. This raises the cost of borrowing and constrains investment needed to raise the economy’s potential. The International Monetary Fund estimated last December that Indonesia’s real domestic lending rate stood at 10.9% compared with 3.8% in Malaysia, 3.8% in Philippines, 6.1% in Singapore, and 2.3% in Thailand.
Third, inadequate infrastructure will become a more serious obstacle to growth in the near term. The 2010 World Economic Forum Report ranked Indonesia 96th among 133 countries in infrastructure. By contrast, Malaysia and Thailand ranked 27th and 36th respectively — a major reason why they were relatively high in overall global competitiveness — Malaysia was placed 24th and Thailand ranked 36th compared with Indonesia’s 54th placing.
Fourth, human capital development is lagging. More than two-thirds of workers have not completed high school education while surveys show Indonesian students performing relatively poorly in science, mathematics and reading compared with their peers around the world.
Fifth, the fiscal position needs to be strengthened. The tax effort — revenues as a percentage of GDP — is only 15.8% compared with 17.9% in 2005. This suggests that tax collection remains weaker than it should be. On the expenditure side, the budget remains burdened by excessive subsidies, which means that inadequate resources are available for education, healthcare and infrastructure.
Policy needs to step up, otherwise risks will rise
All these weaknesses underline how critical it is for Indonesia to get key policies right — particularly as they relate to monetary policy, budget strategy and the need for structural reforms. On the whole, Indonesian policymakers have performed rather well and this is certainly one reason for the expanding confidence in Indonesia. Nevertheless, investors need to look at the following policy issues carefully:
- Monetary policy: Unlike its counterparts across the region, Bank Indonesia has not raised interest rates yet — despite the surging recovery in the economy and rising inflation. The central bank does have a point in saying that monetary conditions remain appropriate given the high interest rates in Indonesia compared with elsewhere. However, Indonesia has a history of high inflation and sudden depreciations of the rupiah. This means that exchange rate and inflationary expectations for domestic savers as well as foreign investors are very volatile — a trend of rising inflation and weakening current account balances can produce a sharp turn in confidence and precipitate a destabilising outflow of funds from the country. Far better for monetary policy to be more conservative than it is.
- Fiscal policy: President Susilo Bambang Yudhoyuno has just outlined the proposed 2011 budget, which is clearly on the right track. The budget achieves a surplus on the operating budget after the previous year’s deficit. Development spending is raised 38%, much faster than routine spending, which only rises 4%. The net impact of the budget on the economy will be mildly contractionary — which is appropriate, given the strong rebound and overly loose monetary conditions. There is also a promise of reducing subsidies on electricity, which is healthy, allowing the government to spend its limited resources in a more effective way.
- Structural reforms: Progress remains disappointingly slow here. Employment generation needs to be raised through reforms of labour laws that deter formal sector employment. The tax effort has to be stepped up together with a bolder approach to cutting inefficient subsidies so that fiscal resources can be directed in a more targeted manner to improve welfare and raise the quality of infrastructure.
In short, Indonesia is on a roll and has the best chance in recent years to break into the big league. Windows of opportunity such as these may not last — it is critical that the pace of reforms be accelerated.