World Bank: March 2014 Indonesia Economic Quarterly Investment in Flux
Today (18/03), the World Bank released the March 2014 edition of its Indonesia Economic Quarterly (IEQ), titled Investment in Flux. The report discusses key developments over the past three months in Indonesia’s economy, and places these developments in a longer-term and global context. Secondly, it provides a more in-depth examination of selected economic and policy issues, as well as analysis of Indonesia’s medium-term development challenges. Click here for further information about the World Bank and its activities in Indonesia.
Below we present the executive summary of the March 2014 Indonesia Economic Quarterly:
Indonesia’s economy continues to adjust to weaker terms of trade and tighter external financing conditions, with the composition of growth tilting more towards net exports, and economic growth slowing moderately. While this shift is positive for macroeconomic stability, it has to date been based primarily on tighter monetary policy and the depreciation of the rupiah in 2013, the effects of which are continuing to play out. To further reduce Indonesia’s vulnerability to external shocks, to minimize the risks of a more marked cyclical slowdown in growth, and to convert the near-term macro adjustment into strong, sustained growth over the longer term, further progress on long-standing policy priorities is warranted.
Progress in three key areas can support both near-term macro stability and Indonesia’s longterm economic prospects. First, there is a need to support domestic and foreign investor confidence. Recent policy and regulatory developments, including the partial ban on mineral exports, have increased uncertainty, may weigh on investment across the economy, and compound the usual difficulty of predicting policy ahead of elections. Given rising fiscal pressures from slower revenue growth and higher fuel subsidy costs, the second priority is to broaden the revenue base and improve the quality of spending, notably by reducing energy subsidy expenditure. These measures would also increase available fiscal space for more equitable, pro-growth spending. Third, credible progress is needed on addressing structural impediments to stronger and more inclusive growth, namely infrastructure and worker skills gaps, and factor and product market constraints. The policy environment is naturally constrained ahead of legislative elections in April and the presidential election in July. However, in light of ongoing economic risks and Indonesia’s ambitious development agenda, laying the groundwork for future reforms, minimizing policy uncertainty, and making continued reform progress in some areas, should remain a priority.
The global economy continues to strengthen gradually, led by the ongoing recovery in high income economies, notably the US and the Eurozone. This is broadly positive for emerging market economies (EMEs) including Indonesia, since it means a general strengthening in trade flows. However, the price trajectories of many commodities, which together account for about two-thirds of Indonesia’s goods exports, remain subdued, and downward price pressures may continue due to supply-side factors, and China’s continued rebalancing away from credit-fueled financial investment. In addition, the pricing-in of a gradual withdrawal of extraordinarily accommodative monetary policy in the US is placing upward pressure on global interest rates. Portfolio investment inflows to EMEs have slumped as investors assess adjustment risks and longer-term relative growth prospects, with markets appearing increasingly to differentiate amongst countries on the basis of domestic vulnerabilities.
Indonesia’s economy continued to rebalance in the fourth quarter of 2013, adjusting to weaker terms of trade and external financing constraints through tighter monetary policy and currency depreciation. Net exports provided a significant boost to growth, due to a moderation in import volume growth and pick up in exports. Fixed investment maintained its below-average pace of growth, pulling down growth and dampening import demand. Private consumption indicators have been more mixed, with some signs that this too is moderating, but election-related spending may well provide a short-term fillip.
The speed and extent of Indonesia’s external balance adjustment has remained in focus for policymakers and investors. Indonesia’s current account deficit narrowed sharply in the fourth quarter of 2013, to USD $4.0 billion (2.0 percent of GDP), from USD $8.5 billion in the third quarter, supporting investor sentiment and the rupiah, which has climbed seven percent against the US dollar so far in 2014. The narrowing in the current account deficit was driven by a solid rise in the goods trade balance, partly, but not only, on account of increased mineral exports ahead of the mineral export ban in January. Import compression continued on the back of subdued capital and intermediate goods imports. However, the basic balance, the sum of the current account balance and net FDI, is projected to stay negative in the near term, implying that Indonesia will continue to rely on potentially volatile portfolio and other investment inflows. Gross external financing needs beyond current account financing also remain significant, with short-term external debt standing at USD $56.7 billion as of December, according to Bank Indonesia (BI). Consequently, Indonesia remains susceptible to any renewed tightening in external financing conditions.
The adjustment of Indonesia’s external balances has been the explicit focus of BI since mid-2013. The tighter monetary policy stance in the second half of last year, as well as the more subdued investment outlook, has contributed to a marked slowdown in credit growth. Weaker deposit growth and limited loan-to-deposit ratio headroom, especially for some smaller banks, indicate that this is likely to persist for some time. In terms of the near-term outlook for inflation, the recent appreciation of the Rupiah, and the lags in the pass-through effect to the economy of earlier interest rate increases, should combine to keep inflationary pressures in check.
Indonesia’s fiscal sector faces pressures from weaker nominal revenue growth and higher energy subsidy costs. The provisional 2013 Budget outturn showed a fiscal deficit of 2.2 percent of GDP, a better-than-expected result, which was due to expenditure shortfalls rather than higher than projected revenues. Nominal revenue growth, having declined markedly to 6.8 percent in 2013 from 10.5 percent in 2012 and 21.6 percent in 2011, is expected to remain soft in 2014, reflecting the moderation in economic, and import, growth, and the absence of significant new measures to boost revenue collections. On the expenditure side, fuel subsidy spending continues to be poorly targeted, distortionary and to impose high opportunity costs and fiscal risks. For example, higher rupiah-denominated fuel costs are projected by the World Bank to push up fuel subsidy spending to IDR 267 trillion in 2014 (2.6 percent of GDP) from IDR 210 trillion in 2013 (2.2 percent of GDP), and above the original 2014 Budget allocation of IDR 211 trillion. Reform, such as a move from a discretionary to rule-based fuel price adjustment, is clearly important and should aim to reduce budget uncertainty and subsidy spending and to ensure that the poor and vulnerable are protected from higher prices.
The baseline World Bank projection for Indonesia’s GDP growth in 2014 remains unchanged from the December 2013 IEQ, at 5.3 percent year-on-year (yoy) (Table 1). Private consumption is expected to receive a temporary boost ahead of the April and July elections, but tighter credit conditions for households may be an offsetting factor for 2014 as a whole. Similarly, investment growth is expected to remain subdued on account of higher borrowing costs, lower commodity prices, and higher Rupiah-denominated prices of imported capital goods compared with recent years. Export growth is projected to rise gradually along with external demand, contributing to a modest rise in GDP growth, to 5.6 percent in 2015. By the end of the year, monthly CPI inflation is expected to fall just below the ceiling of BI’s target band of 3.5-5.5 percent yoy and to remain there until end-2015. The current account deficit is projected at 2.9 percent of GDP for 2014. Moving into 2015, the current account balance is expected to improve further but to remain in deficit, with the impact of the mineral export ban likely to delay the return of the trade balance to surplus, and persistent structural deficits in the income and services accounts.
Table 1: Under the baseline scenario, Indonesia’s growth is projected at 5.3 percent in 2014:
The baseline projection of only a relatively modest further reduction in growth is predicated on the continued availability of external financing to meet significant gross financing needs. Investor sentiment has recently improved and, year-to-date, the Rupiah has gained approximately 7 percent against the US Dollar, domestic equities are up 9 percent, and domestic currency government bond yields have declined by about 30 basis points. Nevertheless, a resumption of heightened volatility in external financing conditions remains a risk, particularly as the US Federal Reserve (Fed) continues to “taper”. In addition, should the US recovery surprise to the upside, this would be positive for Indonesia’s trade prospects, but would also likely cause markets to re-evaluate the timing of Fed policy rate increases, potentially pressuring investment flows to major EMEs such as Indonesia. There also remains a risk of weaker-than-projected external demand, in particular from the trade impact of China’s rate and composition of growth, which may also affect commodity prices.
Notwithstanding the political noise ahead of the April and July elections, it will be especially important, to the extent possible, to make continued progress on improving Indonesia’s economic resilience and sustainable growth rate. However, some recent policy and regulatory developments, including the partial ban on unprocessed mineral exports, new trade and foreign ownership laws, and the delay in implementing the revised negative investment list, are in fact increasing policy uncertainties. The January ban on unprocessed mineral exports has been a particularly prominent recent policy change, with potentially farreaching implications for the mining sector and wider economy. The policy process leading to the introduction of the revised regulations in January 2014, and the subsequent legal challenges, has further weakened perceptions of Indonesia’s mining investment climate, which is already rated one of the poorest in the world.
Through the imposition of the partial ban and new export tax on unprocessed mineral exports, Indonesia is seeking to boost domestic value-addition in the mineral sector. It is hoped that this will lead to higher growth, employment and fiscal revenues. Whether these outcomes will be achieved depends on the extent to which the policy can stimulate development of new smelting and refining capacity, on the degree to which increased processing increases value-addition, and on achieving sufficient gains in export and fiscal revenues from processed minerals to offset losses from reduced unprocessed exports and higher import requirements from building and operating smelters. International experience highlights that such policies often fail to achieve their aims. Focusing on the short to medium-term impacts, the World Bank estimates that there will be a negative impact on net trade of USD 12.5 billion and a total loss in fiscal revenues (royalties, export taxes and corporate income tax) of USD 6.5 billion from the current (as written, de jure) policy in 2014-17, including a USD 5.5 to 6.5 billion drag on the trade balance in 2014 alone. While the quantum remains uncertain, negative impacts of this order from the ban, along with the broader economic issues the policy raises, suggest it is worthwhile to evaluate a wider set of policy options to ensure that Indonesia benefits to the maximum extent possible from its considerable mineral wealth in a socially and environmentally sustainable manner.
While near-term macroeconomic adjustments, and the debate over value-addition in the minerals sector, have understandably captured much of the attention in recent policy debates, an election year is also an opportune time to re-examine Indonesia’s wider, longer-term economic development aspirations. Within the next two decades Indonesia aspires to generate prosperity, avoid a middle-income trap and leave no one behind as it tries to catch up with high-income economies. These are ambitious goals. Realizing them requires sustained high growth and job creation, as well as reduced inequality. Can Indonesia achieve them? This edition of the IEQ provides a summary of the World Bank’s forthcoming report, Indonesia: Avoiding the Trap. This argues that Indonesia has the potential to rise and become more prosperous and equitable. But the risk of “floating in the middle” is also real. Which pathway the economy will take depends on: (i) the adoption of a growth strategy that unleashes the productivity potential of the economy; and (ii) the consistent implementation of a few, long-standing, high-priority structural reforms to boost growth and share prosperity more widely. Indonesia is fortunate to have options in financing these reforms without threatening its long-term fiscal outlook. The difficulties lie in getting the reforms implemented in a complex, and decentralized, institutional framework. But Indonesia, given the high stakes, cannot afford to not try hard.
In light of the repeated flooding in urban areas seen again in this year’s wet season, this IEQ also focuses in on the disaster and climate risks that Indonesia faces as it continues to urbanize, and how these risks are likely to grow as a consequence of this urbanization trend. Indonesia is leading the world as the most rapidly urbanizing country, surpassing even China, India and Thailand. However, many urban centers are located in hazardous zones. Recent research emphasizes the importance of aligning infrastructure development with disaster and climate change impacts to build resilience, particularly in mid-sized cities. In Indonesia, these are the very cities that will be driving economic development in the coming decades. Without strategically planned investments, policy interventions, and stronger institutional capacity, poorly managed urbanization could act as a constraint on sustainable and inclusive growth. Even more worrying, this could also expose Indonesians to undue disaster and climate change-risks, highlighting the need to mitigate such risks through controlled and well-managed spatial planning.