Indonesia Jokowi finds the going tough

President Joko Widodo, who came to power last year, is finding the going tough. Economic growth has slowed, investors appear wary, and political constraints are casting a shadow on reforms.

Indonesia_spotA political honeymoon rarely lasts long. No wonder then that President Joko Widodo (Jokowi), who came to power last year amid high hopes, is finding the going tough. Economic growth has slowed, investors appear wary, and the compulsions of politics are casting a shadow over reforms. To be fair to Jokowi, he made a good start by cutting fuel subsidies. He is correctly focusing on infrastructure while expanding measures to promote education and health. But, to address problems ranging from investments to skills, the government needs private capital, especially from abroad. And for this, Jokowi needs to, among other things, ease regulations, free the labor market, and rejuvenate institutions. It is a tall order for the president. But, he would do well to try. Today’s electorate is impatient. A young population might not be shy to voice its displeasure soon.

Growth slips in Q1 2015

Economic growth fell to 4.7 percent year-over-year in Q1 2015 from 5.0 percent in Q4 2014. This was the weakest pace of expansion since Q3 2009. Exports fell 0.5 percent in Q1 2015, although this was an improvement from the previous quarter’s 4.5 percent decline. Slowing growth in China has dented demand for Indonesia’s commodity exports, which have also been affected by a ban on the export of some non-processed minerals. Although the ban’s intent is to drive growth in domestic mineral processing—a higher value-added activity—the benefits will likely not filter in soon.

GDP growth in Q1 was also hit by slowing government spending; spending grew 2.2 percent, down from 2.8 percent in Q4 2014. Worryingly, the government has fallen short of its infrastructure spending targets so far this year. As of April 27, only IDR 7 trillion of the budgeted infrastructure spending of IDR 290 trillion for 2015 had been used.1 In fact, capital expenditure may fall short of budget provisions this year due to disbursement inefficiencies and a shortfall in revenues due to slower-than-expected GDP growth.

This is expected to add to pressures on investments. Although fixed investment growth edged up to 4.4 percent in Q1 2015 from 4.3 percent in Q4 2014, the figure is much below 2011–12 levels as well as what is required to prop up GDP growth to President Widodo’s ambitious target of 7 percent by 2017. Arguably, private consumption was the only bright spot in Q1, growing at 4.7 percent. However, the pace has been slowing as households adjust to high inflation and tight monetary policy.

Indonesia_Figure 1. GDP growth (percent, year-over-year) slowed down in Q1 2015

Bank Indonesia on the right track

In May, Bank Indonesia (BI) kept its key policy rate unchanged despite slowing growth in Q1. Rightly, BI has kept its focus on inflation, which remains elevated after the removal of fuel subsidies. In April, headline inflation went up to 6.8 percent from 6.4 percent in March (figure 2) and is not likely to go down to BI’s target range of 3–5 percent this year. While a slowdown in global oil prices since 2014 has softened some of the impact of subsidy cuts, a significant base effect will still be in place this year. Moreover, in the coming months, the pressure on prices (food in particular) is likely to rise due to the holy month of Ramadan. This will weigh on BI’s near-term policy action.

Interestingly, inflation is not BI’s only concern; the bank is also wary about the rupiah’s weakness. The currency has slipped by about 6 percent against the US dollar this year.

Indonesia_Figure 2. Trends in headline inflation (percent) and key components

BI’s cautious approach has come in for pressure from the government. Days before the latest rate decision, the country’s vice president and the BI governor gave diverse opinions on the current monetary stance.2 BI, however, acknowledges that credit growth is slow. In March, loan growth fell to 11.3 percent year-over-year from 12.2 percent in February, much below BI’s outlook of 15–17 percent growth for 2015.3 Consequently, while announcing its decision to keep the policy rate unchanged, BI promised to ease lending rules, including those related to loan-to-deposit ratios, reserve requirements, and loan-to-value ratio.4

Interestingly, inflation is not BI’s only concern; the bank is also wary about the rupiah’s weakness. The currency has slipped by about 6 percent against the US dollar this year. Although an improving current account will help the rupiah, it will face pressures due to slowing economic growth and a possible rate hike by the US Federal Reserve. In this scenario, BI is expected to keep monetary policy tight in the near term.

A tough task ahead for the president

Jokowi came to power in 2014 on the back of promises to tackle corruption, spruce up growth, and initiate tough economic reforms. After assuming office, Jokowi has cut subsidies, increased budgeted capital expenditure, and courted foreign investors. However, there’s still much more to do. He could benefit from tackling structural challenges, including infrastructure, education, the labor market, and institutions.

Indonesia lags far behind key Association of South East Asian Nations (ASEAN) peers in terms of economic prosperity (figure 3). If it wants to be at the average per-capita income levels of Singapore, Malaysia, and Thailand by 2040, Indonesia’s GDP will have to grow by 6.0–7.0 percent every year until then. Estimates by Oxford Economics, however, put Indonesia’s potential GDP growth for 2014–23 at 5.3 percent.5 Clearly, this is not enough to catch up with leading Asian economies in the next 25 years if the current trends continue.

Indonesia_Figure 3. Per-capita income comparisons between Indonesia and key ASEAN peers

To spruce up potential GDP growth, among other things, Indonesia should increase investments and productivity. Jokowi appears to realize this considering that he has picked infrastructure as a focus area. Poor transport- and trade-related infrastructure (figure 4) is a big impediment to high-value manufacturing and services in Indonesia. To upgrade infrastructure, the country will likely need large inflows of private capital; the government estimates that it can fulfill only 30 percent of the country’s infrastructure needs. To bridge this gap and also boost key sectors, Jokowi is eager to attract foreign direct investments (FDI). But, that won’t be easy. Indonesia ranks low on the World Bank’s ease of doing business index.6 And even though the country fares better in the World Economic Forum’s competitiveness rankings, it is not as competitive as its ASEAN neighbors like Singapore, Malaysia, and Thailand (figure 5).7

Indonesia_Figure 4. Infrastructure rankings for Indonesia and key peers

Indonesia_Figure 5. Ease of doing business and global competitiveness rankings for Indonesia and key peers

It may be possible to improve global rankings, attract investments, and improve productivity by focusing on regulations, innovation, and labor market flexibility (figure 6). The last in particular is a major worry for investors. However, any labor market improvements are meaningless without strong institutions. And strengthening institutions is not easy, as Jokowi is finding out. A good example of this is the outcry over the nomination of a tainted official as a police chief.8

Indonesia_Figure 6. Rankings on notable metrics for Indonesia and key peers*

As investors look beyond the initial euphoria of the new government, Jokowi may be well-advised to focus on Indonesia’s long-term fundamentals.9 He should consider actions such as easing regulations, opening up education to the private sector and to foreign investors, and reforming debt and equity markets. Savings and higher revenue, as a result, could be invested in social welfare similar to how the government transferred some of the savings from the removal of fuel subsidies to poor households.10Investors would also want the government to hold its ground on current reforms in the face of political opposition or a change in the economic environment. For example, the rise in global oil prices will be a challenge for the government’s fuel subsidy reforms. No doubt, Jokowi faces tough times over the next few years. But, he would do well to keep on the right side of economic and structural reforms. It is likely the only way to lift Indonesia to the level of economic progress of more prosperous neighbors in the region.