Healthy Q3 GDP growth was a welcome relief for Indonesia. However, to tackle long-term challenges, it needs to open up key sectors, encourage investment, upgrade infrastructure, and tackle corruption.
Indonesia’s economy is going through some anxious moments. On one hand, it is dealing with a high current account deficit with resultant currency weakness; on the other, it is facing slowing investments and subdued exports. Given such a scenario, healthy third-quarter GDP growth was a welcome relief. The economy held up well, with consumer spending and government expenditure driving growth. Encouragingly, the current account deficit also fell during the quarter. Challenges remain for the economy, however, especially over the medium to long term. To tackle them, Indonesia needs to open up key sectors, encourage investments, upgrade infrastructure, and tackle corruption. Thus all eyes will be on the mid-2014 elections, with economy watchers hoping for a stable government with a strong reform agenda.
Growth not bad in the third quarter
GDP growth dipped in Q3 2013, but not by much. The economy grew 5.6 percent year over year, down from 5.8 percent in Q2 (figure 1). Investments were subdued, with fixed capital formation growth sliding to 4.5 percent from 4.7 percent in Q2. This is not likely to change much, at least until the second half of 2014, given expectations of high interest rates, currency vulnerability, and policy uncertainty due to the coming elections. Offsetting subdued investments in Q3 was an 8.8 percent rise in government expenditure. This was the fastest expenditure growth in four years and was primarily due to the speeding up of infrastructure projects.
Surprisingly, private consumption continued to support the economy in Q3 despite high interest rates and real wages dented by high inflation. Indonesian households take recourse to credit primarily to purchase cars and houses, so there were fears that high interest rates would force down consumer expenditure as well as residential investment. This clearly did not happen in Q3. Private consumption grew 5.5 percent, up from 5.1 percent in Q2, with consumers optimistic about jobs and the economy. Low-income families also benefitted from government handouts to counter oil subsidy cuts.
A glimmer of hope for exports and external balances
Indonesia’s external sector has been struggling for some time now, with exports contributing only marginally to growth, which has been forcing up the current account deficit. However, there was positive news on this front as well. First, exports grew 5.3 percent year over year in Q3, the fastest rise in six quarters. Export volumes are expected to continue edging up, especially during 2014–15, as global economic growth recovers. While demand from China will not spike soon, a modest economic recovery in the United States, India, and Europe will aid Indonesia’s exports.
Second, a recovery of export volume is likely to be followed by a recovery of revenues. Prices of palm oil and coal (figure 2), which together make up a fourth of Indonesia’s exports, have revived marginally since the end of Q3 (13 percent and 7 percent respectively). If this trend continues, it will benefit both growth and external balances. Finally, in a welcome respite for policy makers, the current account deficit fell to 3.8 percent of GDP in Q3 from 4.4 percent in Q2. However, external balances continue to face pressure from the capital account due to sharp withdrawal of funds by global investors fearing US Federal Reserve (Fed) tapering.
Bank Indonesia to continue countering rupiah depreciation
Bank Indonesia (BI) has continued its monetary tightening spree to support the Indonesian rupiah, which has declined around 18 percent against the US dollar this year. BI has raised its key policy rate by a cumulative 175 basis points (bps) since June (figure 3). Its latest move was in November, when it hiked the rate by 25 bps to 7.5 percent, the highest in four years. Although the rupiah has stabilized at a level BI thinks is more in line with fundamentals, any policy loosening is not expected until 2015. In fact, BI is expected to raise rates by a further 50–75 bps in 2014 to counter the impact of any Fed tapering. Currently markets have already factored in a large share of the impact of such a move, so an actual event is not likely to force the rupiah down by more than 5–6 percent, especially given expectations of a tough BI response.
Both BI and the government will continue to shape policy to support the rupiah and spruce up external balances. They have already introduced currency hedging tools and carried out dollar-denominated bond auctions. One such auction took place in November, but it was open only to domestic investors. The response, however, was tepid, with only $190 million raised, much less than the intended $450 million. The government would do well to wait for any Fed announcements before further auctions.
Both BI and the government will continue to shape policy to support the rupiah and spruce up external balances.
Inflation to ease more quickly from second half of 2014
Price pressures continue to remain high, primarily due to the impact of fuel subsidy cuts earlier this year. Inflation rose marginally in November to 8.4 percent year over year from 8.3 percent in October (figure 4). The impact of fuel subsidy cuts is evident from the relatively lower core inflation figure of 4.8 percent in November. Going forward, inflation is likely to go down, starting in the second half of 2014, to about 5.0–5.5 percent by 2015. There are three reasons for this expected downward trend. First, the lagged impact of monetary policy will start weighing on prices by that time. Second, the rupiah is likely to stabilize by the end of 2014 and start appreciating the year after, thereby easing import prices. Third, by the second half of 2014, a high base effect will come into play, and the one-off impact of the rise in fuel prices will ease.
Indonesia still a lucrative destination for foreign investors
If a reformist and stable government emerges post elections in mid-2014, it will benefit external balances and investments. For example, profits and investment in the mining sector have suffered due to nationalistic policies and the dip in the commodities cycle equally. The fluctuating currency and policy uncertainty due to impending elections have not helped foreign direct investments (FDI) either. Nevertheless, Indonesia remains a lucrative investment destination with its expanding economy and large population. This is evident from the Q3 FDI figures. Net FDI inflows grew 16 percent in Q3 relative to Q2 despite currency depreciation and other economic risks (figure 5). To make Indonesia a more attractive investment destination, policy makers should invest more in infrastructure and education. This will enable the country to wean away global firms from manufacturing and services hubs in China and India, where costs are rising.
Need to focus on infrastructure, education, and corruption
Despite political uncertainty ahead of crucial 2014 elections, GDP growth is likely to remain healthy at 5.5–6.0 percent in 2013 and 2014. Private consumption will stay strong, and commodity exports will benefit from an expected uptick in global growth. This in turn will encourage higher investments in the sector and elsewhere from 2015 onward. However, much also depends on which government takes over in 2014. The new government will have its task cut out in closing the country’s infrastructure gap, expanding education, and tackling corruption. Indonesia will require bold reforms in both political and economic governance. Only then can it attain the above–8 percent growth that will propel it into the league of its more illustrious Southeast Asian neighbors.