Indonesia on track

Feature | 18 May 2017
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With a robust rate of economic growth, low current account deficit, a conservative fiscal deficit and inflation at a record low, the fundamentals of the Indonesian economy continue to be strong. Despite global policy uncertainty, economic growth strengthened in 2016 on the back of higher private consumption growth.

The economic outlook remains positive, supported by a projected pick-up in the global economy and recovering commodity prices, carrying both investment and exports. Major shifts in trade policies among advanced economies, unexpected changes in US monetary policy, political uncertainty in Europe, a protracted period of elevated domestic inflation, and weak fiscal revenues pose significant downside risks.

Growth remains strong

Real GDP growth in Q4 2016 eased to 4.9% year-on-year (yoy) from 5% in Q3, as government expenditure continued contracting and import growth rebounded. The 4% decline in government expenditure was the largest since Q1 2010, due in part to base effects of strong expenditure growth in Q4 2015. Meanwhile investment growth rose and export growth turned positive after eight quarters of contraction, in line with stronger commodity prices.

After five years of adjusting to lower commodity prices, economic growth edged up to 5% in 2016 as a whole, from a revised 4.9% in 2015, despite heightened global policy uncertainty. A stable rupiah, record low inflation, declining unemployment and soaring real wages lifted consumer confidence and private consumption. In contrast, falling government expenditure and weaker investment growth weighed on overall economic growth for the year.

While revenues from the tax amnesty programme increased overall revenue collections, non-tax amnesty revenue collection weakened in 2016. Fiscal policy credibility was enhanced by cuts in government expenditure, along with the more achievable revenue targets in the 2017 budget, which bolstered investor confidence. The budget also features growth-enhancing improvements in the composition of spending, including sustained higher allocations for infrastructure, health and social assistance, and improved targeting for energy subsidies and social programs. The fiscal deficit was 2.5% of GDP in 2016, lower than expected and down from 2.6% in 2015.

The external sector also strengthened with the current account deficit narrowing to a five-year low of 0.8% of GDP in Q4 2016, from 1.9% in Q3 2016, largely due to an improvement in manufacturing exports. For 2016 as a whole, the current account balance as a share of GDP narrowed to 1.8% from 2% in 2015, also a five-year low.

The official poverty rate fell by 0.4% between September 2015 and September 2016 to 10.7%. This suggests that the slight uptick in the pace of poverty reduction seen between March 2015 and March 2016 has continued, on the back of stronger GDP growth, contained inflation, and the lowest core unemployment rate since 2012. However, this decline is still lower than the rates of poverty reduction achieved between 2007 and 2011, which averaged 1.1% annually.

Exports and investments rebound

With all expenditure components expected to firm up, real GDP growth is projected to rise to 5.2% in 2017, and reach 5.3% in 2018. Household consumption growth is projected to gain as a stable rupiah buoys consumer confidence, while higher real wages and continued low unemployment support consumer purchasing power. Private investment growth is also poised to increase as commodity prices recover, and the effects of monetary easing in 2016 and recent economic reforms gain traction.

At the same time, higher commodity prices will also ease fiscal constraints and lift government spending, while stronger global growth carries exports. Both government spending and exports are therefore likely to rebound from their contractions in 2016. While GDP growth rates in the medium-term are projected to surpass those of recent years, they are significantly lower than those seen immediately following the 2008 financial crisis, as the economy rebounded from the global downturn. Staying the course on continued structural reforms is therefore necessary to further enhance the economy’s potential growth.

Consumer price inflation is expected to jump from 3.5% in 2016 to 4.3% in 2017, due to hikes in electricity tariffs and vehicle registration fees. However, inflation is projected to slow in 2018 as the effects of the price hikes dissipate.

The projected central government fiscal balance of 2.6% of GDP in 2017, is wider than the 2.4% deficit in the government’s approved 2017 budget. Higher public expenditures, partly due to renewed efforts to boost public infrastructure investment, are expected to be partially offset by revenue growth, in turn carried by stronger GDP growth and dividends from administrative and tax policy reforms.

Risks and opportunities

Risks to the outlook are tilted to the downside. There is heightened policy uncertainty in major advanced economies amid a climate of increasing protectionist sentiments. In addition, the US Federal Reserve is expected to proceed with monetary normalisation and gradually raise the federal funds rate in the coming years.

Should the Fed hike interest rates more rapidly than expected, taper tantrum-like capital outflows from emerging markets could occur as investors rapidly re-evaluate and rebalance portfolios to maximise expected gain. Volatility in financial and capital markets could weigh on growth of the Indonesian economy in the medium term.

A protracted period of elevated inflation, due to recent hikes in administrative prices, poses a key downside risk to consumption growth. Apart from volatility of the exchange rate, consumers are generally sensitive to price increases, especially those of food, and household consumption, which constitute the dominant portion of the Indonesian economy.

Should inflation remain higher and longer than expected, consumer spending may be dampened, resulting in lower output growth. In addition, Bank Indonesia (the central bank) may be compelled to act by tightening monetary policy, which would also cool investment growth. At the same time, fiscal revenues continue to pose a downside risk, as lower revenue collection constrains fiscal spending and much needed infrastructure investment.

The services sector appears to be one of the most promising engines of growth. It represents increasingly higher shares of the Indonesian economy and trade, although the proportions are still below those of many other middle-income economies. The importance of the services sector for economic growth is underscored by its strong forward linkages to the rest of the economy (any policies applied to the services sector would have implications to the other sectors in the economy). Indonesia is a net services importer as demand exceeds supply in most service sectors.

Despite this, Indonesia has some of the most restrictive barriers to services trade. This restrictiveness is likely to have contributed to the relatively low productivity of the Indonesian services sector vis-à-vis comparator countries. It also penalises manufacturing productivity, as services are key inputs for manufacturing production. Hence, it is important to re-evaluate restrictions to services trade, in light of their importance to the overall economy.

Financing small businesses

Originally established by the government of Indonesia in 2007, the Kredit Usaha Rakyat (KUR) programme is one of the largest subsidised loan programmes for micro, small and medium sized enterprises (MSMEs) in emerging markets. During a major redesign in 2015, the focus of KUR changed from facilitating access to loans for first-time MSME borrowers through the provision of partial credit guarantees, to the provision of loans at subsidised interest rates to MSMEs regardless of their previous access to finance.

This redesign has led to a ten-fold increase in the cost of the programme to the government, in terms of both direct and indirect subsidies. Unless significant benefits from the KUR program can be properly documented, there is a strong need to reconsider the use of subsidised loans to support MSMEs, in view of the costs.

In particular, the government should consider whether the additional benefits of the new KUR programme justify the large increase in cost, or whether a focus on other tested and less expensive instruments – such as partial credit guarantees together with a strengthening of the financial infrastructure – could support the MSME sector at a much lower cost. Government spending on interest rate subsidies comes at the expense of spending on other priority interventions, given scarce fiscal resources.

This is an extract from the World Bank’s Indonesia Economic Quarterly, March 2017. It has been reproduced here with permission

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