Contrary to expectations, Indonesia’s growth story has been rather bleak. Will the government’s recent efforts to boost infrastructure and foreign investments finally pay off?
It’s hard not to look at Indonesia’s economy and expect more. With its favorable demographics, democratic institutions, and rich resources, it would be wrong to write off the country’s potential. No wonder then, that, when President Joko “Jokowi” Widodo came to power, he put the country’s growth target at 7.0 percent.1 That target, however, has remained elusive. Growth has been steadily declining since 2008, when it was 7.4 percent, with the figure coming down to 5.0 percent in 2016.2 So, will 2017 be any different? Will growth shoot up this year? We believe that is unlikely, despite the government’s efforts to boost infrastructure and foreign investments, and a revival in exports.
With its favorable demographics, democratic institutions, and rich resources, it would be wrong to write off the country’s potential.
The economy grew by 5.0 percent year over year in Q1 2017, slightly above the 4.9 percent expansion in the previous quarter (figure 1). While growth in Q1 was healthy, the figure was below the government’s 5.6 percent target for 2017.3 Household consumption continues to be the key growth driver, expanding by 4.9 percent in Q1, although this was marginally below the previous quarter’s 5.0 percent increase. With inflation rising, households may face slower real income gains, thereby impacting spending. Retail sales volumes, for example, grew 4.8 percent in Q1, much lower than the previous quarter. Growth in fixed capital investments was modest at best during the quarter, despite a 5.9 percent rise in investment in buildings; growth in spending on machinery and equipment was weak at 1.4 percent. The economy did not find much support from government expenditure either. There was, however, good news from exports, which expanded 8.0 percent in Q1, the fastest pace of increase since Q4 2013.
The recovery in real exports in Q1 was primarily driven by non-oil and gas exports (9.9 percent) and services (7.3 percent). In fact, merchandise exports volumes, after contracting for 10 quarters, have been growing since Q3 2016; in Q1 2017, volumes rose by 7.0 percent, followed by a 10.8 percent rise in April. The story has been similar for merchandise export values, which rose 21.0 percent in Q1 (figure 2). Within this recovery, the interesting thing to note is that the export value of oil and gas products rose 15.0 percent in Q1, despite a 2.0 percent drop in volumes. This points to the impact of higher hydrocarbon prices on exports. Other commodity exports have also benefitted from a similar trend—in Q1, the value of mining and related exports grew 31.3 percent, the fastest pace of growth since Q3 2011. What is more impressive, however, is that the current exports recovery is not driven by commodities alone—manufacturing export values, for example, grew 22.3 percent in Q1.
Reviving exports augur well for external balances. The merchandise trade balance, after fluctuating above and below zero during 2012–15, has been improving steadily since Q1 2016 (figure 3). That, in turn, has benefitted the current account, where the deficit improved to 1.8 percent in 2016 from 3.2 percent in 2013; in Q1 2017, the non-seasonally adjusted deficit fell to 1.0 percent. Improvement in external balances has aided the rupiah, which has stabilized this year. As of May 17, the rupiah had gained 0.8 percent (year to date) against the US dollar, reversing some of its losses of 2016.
With the US Federal Reserve (Fed) poised to raise interest rates again—at least twice more this year—and Bank Indonesia (BI) likely to keep rates on hold in the near term, rising interest rate differentials may put pressure on the rupiah.4 Adding to that is the risk from elevated foreign exposure in government debt—foreign holders account for 39.1 percent (as of April 2017) of total government securities. Given this scenario, a recovery in exports and consequently, external balances, is a big relief. If this recovery continues, it will help offset downward pressure on the rupiah in the near term.
In its latest policy meeting in May, BI kept the policy rate on hold, continuing its wait-and-watch policy since October 2016. Last year, BI had gone on an easing spree, cutting the policy rate six times. As it plans its next move, BI will be looking closely at three factors. First, BI will be analyzing the lagged impact of lower interest rates on credit growth, which has been trending down over the past few years. BI will also be wary about a rise in commercial banks’ nonperforming loans (NPLs). NPLs as a share of total commercial bank credit started edging up in 2014 and were at 3.2 percent in February. Second, BI will be looking closely at the impact of Fed rate moves on currency markets. Finally, BI will be wary of rising inflation, driven primarily by higher energy prices (figure 4). Inflation rose to 4.2 percent in April, the highest in a year. The figure, however, is within BI’s 3.0–5.0 percent target range. In such a scenario, the central bank is unlikely to cut rates further and any change in its current monetary stance is not expected until Q4 2017.
With households likely to come under pressure from rising inflation and the central bank unlikely to ease monetary policy, the onus for any strong push for growth falls on the government. The government’s hands, however, are tied by Indonesia’s low tax base, a 3.0 percent upper bound (by law) for the fiscal deficit, and the absence of any one-time revenue inflow akin to the tax amnesty program in 2016.5 Foreign investors—a key focus area for the president—are also not expected to ramp up spending sharply this year. In fact, in 2016, FDI realization at $29.0 billion was not much higher than what it was in 2014 ($28.5 billion) when President Jokowi came to power. While FDI in manufacturing rose sharply in 2016, restrictions on mining continue to weigh on foreign inflows into the sector. In such a scenario, it seems unlikely that the economy will expand at the targeted 5.6 percent in 2017. Growth is expected to end up in the 5.0–5.3 percent range. Although healthy, the figure is hardly reflective of Indonesia’s true potential.
With households likely to come under pressure from rising inflation and the central bank unlikely to ease monetary policy, the onus for any strong push for growth falls on the government.