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Indonesia Economic Outlook, Q4 2009
By Arpitha Bykere, HyunGyu Kim
- Despite fragile exports and investment, growth will be sustained by fiscal stimulus, private consumption, and improved investor confidence boosted by political stability;
- Inflation risks will invite monetary tightening but attractive yields will finance the loose fiscal policy;
- Any slowdown in risk appetite among foreign investors poses risk to the asset market rally, short-term external debt payments and low foreign exchange reserves.
Low dependence on exports and relatively strong consumption have helped Indonesia maintain modest economic growth despite the global recession and volatile asset markets. The economy rebounded in Q2 2009, helped by public and private spending. Declining exports and weak investment will nevertheless keep GDP growth subdued at 4.2% in 2009. Given RGE’s baseline scenario of a U-shaped U.S. recovery, Indonesia will grow 4.8% in 2010 due to sluggish recovery of exports and foreign direct investment (FDI). In case of a “double-dip” recession in the U.S. or a correction in global asset markets, Indonesia's exports and asset markets will take a hit, leading to a much slower growth.
RGE’s baseline scenario for Indonesia is a shallow U-shaped recovery. Strong consumer spending, portfolio inflows and faster implementation of the fiscal stimulus will help Indonesia recover faster than other Southeast Asian economies. But given RGE's outlook for a weak recovery in the U.S. economy, global commodity prices and FDI flows, Indonesia isn’t likely to see 5%-6% growth again until 2011. Growth prospects will also depend on the success of structural reforms to improve the business climate and develop the commodity sector.
Domestic Demand Will Determine Economic Recovery
Low inflation, fiscal and monetary stimuli, and wealth effects in rural areas from the pick-up in commodity prices have boosted consumer sentiment and retail sales on durable goods. However, the end of election-related fiscal spending, a possible reduction in fuel and electricity subsidies in 2010, and job losses in the export manufacturing sector might slow the momentum in consumer spending going forward.
Strong private consumption and low inventory adjustment have sustained industrial production. Export contraction has eased but the recovery in exports will be sluggish. Commodity prices have picked up recently but remain below their 2007-08 levels. These factors will keep industrial production weak until 2010.
Despite the pick-up in portfolio inflows and equity and corporate debt market activity, investment will remain weak in 2009 due to declining FDI, tight bank credit and sluggish export recovery. Indonesia’s narrowing output gap and an improvement in global credit conditions will determine the pace of investment recovery in 2010. Government measures to improve the investment climate, including tax and regulatory reforms, might boost FDI going forward.
External Balance Cushioned Despite the Export Downturn
Exports have declined sharply since November 2008, owing to the correction in commodity prices such as palm oil, gas, coal, tin and rubber, and declining exports to the U.S. and Asian countries. The pick-up in commodity prices since early 2009 and Chinese commodity stockpiling have moderated the pace of export contraction in recent months. But a sluggish recovery in global commodity prices and export demand in the U.S. imply that exports will continue to contract through 2009 and will then pick up slowly in 2010.
Since a large share of Indonesia’s imports are supplies that go into the production of goods that are then re-exported, the decline in exports has led to an even faster decline in imports. Declining exports and investment activity will continue to limit the import bill. These factors will cushion the country’s trade and current account surpluses in 2009. In 2010, as imports pick up on improving oil prices and domestic activity, the trade and current account surpluses will narrow.
Declining FDI is putting pressure on the capital account. Any slowdown in risk appetite will be a negative for portfolio inflows and low foreign exchange reserves. However, the US$2.7 billion that Indonesia received under the IMF's Special Drawing Rights (SDRs), Indonesia’s bilateral currency swap agreements, and access to the Chiang Mai foreign exchange reserve pool will reduce the risks associated with the country’s balance of payments.
Risk Appetite Buoys the Asset Markets
The Jakarta Stock Exchange was one of the best performers in Asia in 2009 due to better-than-expected earnings and net equity purchases by foreign investors. Improvement in the commodity and mining sectors and GDP growth outlook will likely continue to support equities. Political stability, investor optimism about continued economic and structural reforms, rising investment in the infrastructure sector, and possible public offerings by state enterprises in 2010 are pluses. However, rising valuations and weak business investment pose the risk of a slight market correction. In 2010, risks of a “double-dip” U.S. recession or global asset market correction might trigger capital outflows.
Attractive yields, an appreciating currency, a debt ratings upgrade and the revival of global carry trade have boosted sovereign, Islamic and samurai bond issues at home and abroad, helping finance Indonesia’s fiscal deficit. Policy rate cuts and front-loaded bond issues have flattened the yield curve but an increase in government borrowing needs and inflation might steepen the yield curve again in 2010.
The Indonesian rupiah has strengthened in 2009, led by robust capital inflows into the equity and bond markets. The current account surplus and global carry trade will support the currency in 2009. But the currency is vulnerable to asset market correction and capital outflows depending on the outlook for the U.S. economy and global asset markets. The central bank will continue to intervene in the foreign exchange market to reduce currency volatility and allow the currency to appreciate in 2010 to control import inflation.
Despite policy rate cuts, credit growth in the banking sector remained weak in H1 2009 due to weak loan demand, high credit risk and double-digit lending rates. However, credit growth might pick up in the coming months as banks recently agreed to cut lending rates. Non-performing loans, especially in the corporate sector, will continue to rise in H2 2009, posing risks to banks' earnings. But strong capital positions should help banks withstand asset deterioration.
Fiscal Spending Will Support Growth
Due to implementation delays, Indonesia’s fiscal stimulus might affect the economy during H2 2009 and into 2010. The government's 2010 budget is also expansionary, raising spending on infrastructure and energy sectors. Amid tax cuts and declining commodity revenues, the budget deficit will exceed 2.5% of GDP in 2009. As economic growth improves and inflation rises, the fiscal stimulus and fuel and electricity subsidies might be scaled back starting H2 2010. If ongoing tax reforms boost revenues, the budget deficit might narrow in 2010. Debt financing and access to external bilateral and multilateral loans will contain risks to the budget deficit.
Reviving Inflation Will Drive the Monetary Cycle
Monetary easing likely ended in September 2009, given central bank concerns that capital inflows, increasing commodity prices and fading base effects of 2008 are all increasing the risk of inflation. The Consumer Price Index (CPI) is picking up on a month-on-month basis. The recovery in commodity prices, domestic demand and capacity utilization, and the reduction in subsides will lead the central bank to start tightening interest rates by Q1 2010. However, risks of a slower-than-expected U.S. recovery or global asset market correction might delay interest rate hikes to Q2 2010. Monetary tightening will be aggressive and the central bank will allow currency appreciation to contain commodity inflation.
Promise of Reforms Will Attract Investors
The confirmation of Susilo Yudhoyono as president has boosted investor confidence about continued reforms and macroeconomic stability in Indonesia. The government will keep up its poverty alleviation, anti-corruption and anti-extremism measures. It is also expected to increase infrastructure spending, privatize state-owned companies, reduce subsidy spending and reform the tax system. Investors increasingly view Indonesia as a potential BRIC member. But reforms related to the business environment—regulatory hurdles, investor protection, bureaucracy and labor laws—will be slow, constraining foreign investment.
Resource Sector Woes to Persist Beyond the Recession
Indonesia's natural resource sector is taking a hit from the correction in oil and commodity prices and decline in commodity production, investment and exports. Slow recovery in global commodity prices will affect the profits of domestic and foreign companies and discourage investment, especially by neighboring Asian countries. President Yudhoyono’s stance to promote foreign investment in the resource sector in order to raise production and refinery capacity is a positive. But further reforms are required to improve the regulatory, tax and legal environments, and to reduce corruption. The government is increasingly confronted by the debate on whether commodity output should be exported or used to cater rising domestic needs.