Indonesia’s central bank has raised its BI rate several times over the past one and a half years in an effort to combat high inflation (caused by fuel price hikes), curb capital outflows ahead of US monetary tightening, limit the current account deficit and support the rupiah.
In the Revised 2015 State Budget, the Indonesian government targets gross domestic product (GDP) growth of 5.7 percent (y/y), up from the 5.02 percentage point growth that was recorded in 2014. Indonesian President Joko Widodo, who took office in October 2014, is optimistic that this ambitious target can be achieved although international institutions such as the World Bank and the International Monetary Fund (IMF) project the country’s GDP growth at 5.2 percent and 5.0 percent, respectively, in 2015.
Both institutions downgraded Indonesia’s 2015 economic growth because of the negative impact of the weak global economy which will result in tighter external financing and may translate into higher domestic interest rates, hence increasing pressures on local banks, businesses, and households in servicing their debt, while blocking ability to invest or spend. Meanwhile, Indonesia’s central bank (Bank Indonesia) estimates that Indonesia’s economic growth will be in the range of 5.4 - 5.8 percent this year.
Therefore the question is how Indonesia can manage to achieve its economic growth target of 5.7 percent in 2015. The following points are believed to be necessary:
• Public investments in infrastructure; the lack of quality and quantity of infrastructure in Indonesia is not a new problem to Southeast Asia’s largest economy. Starting from the period of Reformation (after the authoritarian New Order regime of President Suharto) there has been under-investment in the country’s infrastructure resulting in significant logistics costs (making Indonesian businesses less competitive) and making investors think twice before investing in the country.
The infrastructure issue involves both hard infrastructure (such as roads, harbours, and electricity) and soft infrastructure (healthcare, law enforcement, and so on). However, after Widodo became Indonesia’s seventh president there has been a positive development. The new president reformed the country’s fuel subsidy scheme (as promised during his presidential campaign) thus saving a total of IDR 230 trillion (USD $18.4 billion) in the 2015 State Budget.
More than half of these funds will be spent on infrastructure development. However, it is estimated that Indonesia requires a total of IDR 5,519.4 trillion (USD $442 billion) worth of investment over the next five years to support the country’s infrastructure development. Most of the needed funds will have to originate from the private sector and therefore it is vital to contain a conducive investment climate to attract foreign and domestic direct investment. Successful infrastructure projects are believed to have a multiplier effect on the Indonesian economy. However, it will take some time before most of these effects will be felt.
• Improve the investment climate; Indonesia has been characterized by a costly and lengthy bureaucracy, weak government coordination (between the various government institutions on the central and regional level), corruption and weak legal certainty. Although foreign direct investment (FDI) has reached a record high in 2014 there is ample room for further growth as the relatively weak investment climate is something that blocks investors to come to Indonesia.
President Widodo is eager to combat bureaucratic obstacles but this may take a long time as it seems that the country’s bureaucracy has become a 'power centre' in its own right. In an effort to simplify the country’s licensing system for investment projects, Indonesia launched its integrated one-stop service center (Pelayanan Terpadu Satu Pintu, abbreviated PTSP) at the Indonesia Investment Coordinating Board (BKPM) in late January 2015.
Investors will not need to visit various ministries or government agencies to obtain the necessary permits but can now turn to the BKPM’s one-stop service center. However, as this constitutes a new service we cannot yet determine whether the new service center is a success or not. Regarding corruption and weak legal certainty in Indonesia, it is the country’s natural resources that is most problematic (particularly the oil and gas sector).
• Become a manufacturing exporter; in terms of export Indonesia is still dependent on (raw) commodity exports. This implies that Indonesia is highly susceptible to the effects of commodities’ price volatility on the international market. In recent years, as commodity prices have been falling, Indonesia’s export performance declined drastically.
To make matters worse, in the foreseeable future there are few to no signs of a rebound in commodity prices happening. To overcome this vulnerable position Indonesia needs to diversify its export products, particularly boosting downstream industries for the manufacturing of value-added products. Improving the domestic supply side is also important as the Indonesian population (which is characterized by a rapidly expanding middle class which numbers about 75 million now) is demanding more and more products. Due to a lack of domestic manufacturing this situation leads to inflation and an increase in imports thus placing more pressures on the trade and current account deficits.
Regarding exports, it is also important for Indonesia to search for non-traditional export markets. With China (one of the largest export markets for Indonesian products) experiencing sharply slowing economic growth demand from the world’s second largest economy is weakening accordingly. Lastly, it should also be pointed out that the large infrastructure projects that are targeted by the government will spur imports as these projects require a large amount of imported materials.
• Lower the benchmark interest rate; Indonesia’s economic slowdown (which started in 2011) is partly self-inflicted as Bank Indonesia raised its key interest rate (BI rate) aggressively between June 2013 and November 2014 (from 5.75 percent to 7.75 percent) in a move to combat high inflation (that emerged as a consequence of Indonesian subsidized fuel price hikes in June 2013 and November 2014), curb the country’s wide current account deficit (about 3 percent of GDP in 2014), support the rupiah exchange rate (which had started depreciating severely from June 2013 as the US Federal Reserve started to hint at the winding down of its quantitative easing program in late May 2013), and to avert future capital outflows ahead of an expected US interest rate hike later this year.
Although this monetary policy of Bank Indonesia is considered correct to safeguard the country’s financial and fiscal fundamentals, higher borrowing costs have come at the expense of higher economic growth in Indonesia. However, it is unlikely that Bank Indonesia will lower its BI rate in the foreseeable future.
Although inflation eased to 6.96 percent (y/y) in January 2015 (from 8.36 percent in December 2014), and the current account deficit is also improving, a US interest rate hike is expected to lead to severe capital outflows from emerging economies, particularly if these economies are showing a current account deficit (such as Indonesia) as this signals that the country is dependent on foreign funding. Therefore, many analysts agree that the central bank of Indonesia is more likely to hike its BI rate than to lower it ahead of higher interest rates in the USA.
• Foster political stability; slowing economic growth in 2014 was partly the result of the ‘political year’ (Indonesia organized legislative and presidential elections in 2014). As Indonesia constitutes a young democracy such elections bring along concerns about the country’s political stability. Therefore, investors preferred to wait & see for the election results before engaging in investment projects.
As there are many opposing forces in the country’s political arena and it lacks a long democratic tradition Indonesia tends to be more unstable than other countries (currently political tensions have increased as the Corruption Eradication Commission/KPK - the country’s corruption watchdog - and the National Police are involved in a battle). It is important for President Widodo to walk the fine line between pushing through his reform program in order to foster economic and social development and keeping harmonious ties with other political forces (particularly as his support in parliament is fragile).
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