Commentary | 23 August 2018

Indonesia is right to put stability before economic growth

Originally published in Nikkei Asian Review 

Originally published in Nikkei Asian Review 

As Indonesia looks toward presidential elections slated for April next year it faces an increasingly uncertain economic outlook, including a difficult trade-off between pursuing growth and protecting stability.

Along with other emerging markets, the country's currency and financial markets have been under pressure amid rising U.S. interest rates and fears of contagion from an unfolding crisis in Turkey as well as problems in Argentina. Meanwhile, U.S. President Donald Trump's trade wars hang like an ominous cloud over the global economy -- and Asia in particular.

The Indonesian policy response has been proactive. Finance Minister Sri Mulyani Indrawati is committed to fiscal tightening, despite the upcoming election, and on Aug. 15 Bank Indonesia, the central bank, raised its benchmark seven-day repo rate for the fourth time since May -- a combined increase of 125 basis points, to 5.5%. The well-worn mantra among Indonesian policymakers of "stability over growth" remains firmly in place.

Moreover, despite predictable anxieties over the rupiah, Indonesia's fundamentals remain in good shape. Foreign exchange reserves are ample, while external debt and the current-account deficit are broadly comfortable. Banks are well capitalized, the public finances are in good health, and inflation is firmly within target.

The situation is vastly different to the 2013 "taper tantrum," when early signals of an eventual end to quantitative easing from the U.S. Federal Reserve led to a surge in U.S. Treasury yields that seriously undermined many emerging economies -- including Indonesia, which was dubbed one of the so-called "fragile five."

To be sure, Indonesia will continue to be buffeted by global market gyrations, which will likely persist for some time. But with good fundamentals and policymakers continuing to prioritize stability, the country is well-placed to weather most incoming storms. In any case, Bank Indonesia's policy of allowing the rupiah to move in line with market forces, while using reserves and interest rate changes to manage the adjustment, should be considered healthy, not worrisome.

A bigger concern is that this will inevitably crimp economic growth. Indonesia is now looking at its fifth consecutive year of growth at about 5% -- well below the 7% widely thought to be necessary to generate enough good quality jobs for its young and growing workforce.

Even a mild growth uptick to 5.3% in the second quarter of this year will not last, since it reflected the earlier timing of celebrations this year to mark the end of Ramadan, the Muslim month of fasting. Looking further ahead, higher interest rates and fiscal tightening will act as a drag on growth, offsetting any potential gains from election-related spending.

The central difficulty is that Indonesia's economy is hemmed in by the need to protect stability while its growth model has been unable to generate the productivity gains necessary to grow faster. In particular, capital-intensive growth is giving way to diminishing returns while the benefits of an expanding workforce are faltering as more workers end up with low-productivity jobs.

This has happened despite the considerable pro-growth efforts of President Joko Widodo. His signature achievements -- a big increase in infrastructure spending, cuts in hugely wasteful energy subsidies and a major improvement in the business climate -- have been substantial policy accomplishments.

Ultimately though, Widodo's efforts have only steadied Indonesia's trajectory rather than lift it. The level of infrastructure investment, in particular, needs to be much higher. It is keeping pace with growing demand, but remains insufficient to begin plugging the gap left behind by two decades of underinvestment.

Lifting infrastructure investment significantly will be difficult. The government has run out of budget leeway, and has been looking to state-owned companies and the private sector to make up the difference. Yet any increase in investment, wherever it is from, will also widen the current-account deficit, currently 2.3% of gross domestic product.

There is some headroom, but not a lot before the warning level of 3% of GDP would be breached, creating heightened external financing risks. The government is already concerned and looking to compress imports to rein this in. To the extent that they are successful, this will detract from growth.

What can be done? Unlike in 2013, the current-account deficit today is driven entirely by the budget deficit (currently at 2.5% of GDP), reflecting a classic "twin deficits" problem. Substantially raising the tax take, and channeling those funds into higher infrastructure investment, is the essential growth ingredient required.

The government has been chasing tax cheats and trying to reduce noncompliance. Technology may help. But more direct measures such as raising property and value-added taxes and scaling back exemptions should also be in the policy mix, and would deliver faster results.

This should be aided by recalibrating the existing regulatory reform effort to concentrate more on liberalizing markets, rather than just cutting red tape. One strategy would be to begin negotiations to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, also known as TPP 11.

Doing so would put Indonesia on the right reform path, including promoting greater openness to foreign direct investment. Though politically contentious, joining TPP 11 could be billed domestically as a strategic response to rising global protectionism.

Such reforms would help to make the trade-off between growth and stability less binding while generating the productivity gains needed to make faster growth more sustainable. Inevitably though, meaningful reform will have to wait until after the 2019 election. Until then, the Indonesian economy will have to make do with stability over growth.