THE economic news flow for Indonesia has generally been downbeat — industrial production and tourist arrivals are growing tepidly while purchasing manager indices exports and foreign investment are falling. The economy grew 4.73% y-o-y in 3Q2015, barely edging up from growth rates in the first half, which marked the slowest expansion since the global financial crisis.
Worse still, the composite lead indicator that predicts future growth is still signalling desultory growth, well below what Indonesia is capable of achieving.
The challenges are real, but our view is that it would be a mistake to be too pessimistic. There are signs of a turnaround and President Joko “Jokowi” Widodo’s administration is beginning to get its act together. Of course, much can still go wrong, particularly with the rupiah, but these can be managed and Indonesia should see a decent acceleration in 2016. The real question is whether this cyclical recovery can morph into a more exciting and sustained acceleration: On this score, the outlook is not rosy.
Cyclical upturn in the offing
There are some straws in the wind suggesting a possible upturn. Consumer confidence rose in November after several months of decline and cement sales have also ticked up smartly in November. The more upbeat state of consumers is important: Having borne the brunt of the multiple shocks that hit Indonesia in the past year — such as falling commodity prices, high inflation owing to the sharp depreciation of the rupiah and the removal of fuel subsidies — their renewed vigour would contribute decisively to a recovery.
The good news is that enough is happening under the surface of the economy to sustain this fledgling recovery:
• The most important driver is simply the fading away of the multiple shocks mentioned above. As commodity prices, the rupiah and household incomes stabilise, the drag on consumer spending should diminish. It does seem like the worst is over for consumers, important since consumer spending accounts for close to 60% of the economy.
• Second, central bank policy is becoming more supportive of growth. Bank Indonesia has started to gingerly ease policy. It has cut rates charged to banks to encourage them to lend, while also reducing some of the lending restrictions it had put in place in 2013 to restrain credit growth. As credit growth recovers, both consumers and businesses will find it easier to fund spending.
• Third, the Jokowi administration has introduced seven stimulus packages since August. While the measures are sector-specific and small-scale, cumulatively they will help businesses to grow. The government has also streamlined its procedures for budgetary spending so that the notorious under-spending of budgets can be improved. For example, the government has opened the process for bidding for 2016 construction projects early, well before the fiscal year so that the projects can start without delay in the new year. As government spending boosts local economies, private businesses will feel encouraged to invest as well, boosting overall demand.
In addition, Indonesia’s external position has improved. The rupiah has regained some of its lost ground in the past month and the current account deficit had fallen to 1.8% of GDP in the third quarter, much better than the 3% level it was at in 2013 and 2014. Also encouraging is the improvement in inflation, which fell to 4.9% in November after reaching a high of 8.4% in December 2014. This improvement in economic stability is important because it allays fears about the economy and contributes to better investor confidence.
What can go wrong?
Thus, a rebound in economic growth to around 5.5% in 2016 is achievable. But there are two issues with this recovery. The first is that it is vulnerable to exogenous shocks and the second is that growth rates of around 5.5% still leave Indonesia grossly under-performing what it can achieve for its people if the right things were done.
What are the exogenous shocks that could hurt Indonesia?
First, the rupiah remains vulnerable to another sharp depreciation, particularly considering that the US Federal Reserve Bank is about to embark on monetary tightening, which is likely to prompt more capital outflows from emerging economies such as Indonesia. Indonesia’s trade position continues to act as a drag on growth. Exports contracted 20.98% y-o-y in October 2015, continuing a contraction that started a year earlier. While declines in oil and gas exports account for part of this export weakness, manufactured exports are not doing well either, falling in value terms while volume growth has decelerated sharply. Indonesia’s share of world manufactured goods exports has yet to pick up. This is not surprising, since the real effective exchange rate is still 6% stronger than at end-2013. The rupiah, in our view, has not depreciated enough to significantly boost manufactured exports.
Second, while Indonesia’s external position has improved, as described above, it is not out of the woods. The narrowing of the current account deficit, for example, was largely owing to a stronger contraction in imports relative to exports because the economy was in the doldrums. As investment grows more strongly in 2016, we are likely to see the current account deficit widen again. Moreover, Indonesia’s short-term external debt exposures represented around 38% of its foreign exchange reserves, higher than the 30% level beyond which countries are regarded as vulnerable to sharp changes in capital market conditions.
These vulnerabilities do not condemn Indonesia to a certain external crisis, but they raise risks and constrain policymakers from aggressively easing monetary policy to boost growth. If the Jokowi administration continues with the improvements in policy posture evident since the cabinet reshuffle in August, we are confident that Indonesia can avoid external shocks and keep the growth recovery on an even keel.
The real issue is that Indonesia is under-performing its potential
Indonesians deserve better than the 5.5% growth rates that are likely in the near future. Given its youthful demographics, urbanisation, abundant resources and bountiful opportunities to attract export-oriented manufacturing activities relocating from China as the republic moves up the value chain, Indonesia should really be growing closer to 7% or 8%.
This underperformance is all the more disappointing because it could have been avoided if policy actions had been taken. Just take a few areas where there is considerable untapped potential and it becomes clear that policy inaction has to take a large share of the blame for underperformance:
• Export-oriented manufacturing — the path to high growth that has served most successful emerging economies — has been held back by labour laws that scare away investors, poor infrastructure that adds hugely to logistics costs and a business environment that makes things difficult for investors. The Jokowi administration is making some progress in tackling the business environment and is beginning to get infrastructure projects off the ground, but the going is hard. For example, a US$4 billion power project which Jokowi himself launched with great fanfare is mired in a legal imbroglio created by poorly drafted laws and regulations on land acquisition. For now, it seems politically impossible to reform the labour laws, which means that most of the factory activity being relocated out of China will not come to Indonesia.
• Indonesia, with its 17,000 islands, extraordinary cultural and archaeological heritage and unique endowment of flora and fauna, should be attracting tens of millions of tourists each year. Instead, it received 9.3 million visitors last year — compared with 27.4 million for Malaysia and 24.8 million for Thailand. Even tiny Singapore gets 15 million tourists. Policies on international aviation, visas and infrastructure are not helping. Also, unlike Malaysia and Thailand, which invest heavily in diversifying their range of tourist attractions and on improving the tourism product, little has been done in this regard in Indonesia.
• Housing construction: The World Bank estimated a shortfall in affordable housing of between 220,000 and 370,000 units a year and found that the under-building could be explained partly by poor policies and cumbersome regulations which drove up the cost of land acquisition, made securing building permits difficult and swelled construction costs. With proper policy action, not only would hundreds of thousands of Indonesians be living decently, housing construction would have tremendous multiplier effects on the economy as well.
The bottom line
The Indonesian economy is set to enjoy a cyclical recovery. While the tightening of US monetary policy will spark off capital outflows and potential risks for the rupiah, these challenges can probably be managed, allowing for growth in 2016 to be stronger than in 2015.
The key issue is that Indonesia is underperforming its potential. While the Jokowi administration’s efforts to address this underperformance will yield some results, the political constraints on pushing through all the policy reforms needed appear to be too strong. So, Indonesia will enjoy decent enough growth but fall short of the exciting pace of growth seen in the early 1990s.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy