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With the rupiah hitting long-time lows in mid-2015, it is tempting to assume that Indonesia's economy is going through a bit of a rough patch owed to outside factors; a temporary weakness that time will heal. Such a reading of events, however, would be complacent and oblivious to the fact that much of the current slowdown is of the country's own making. Capital that is leaving the country as developed economies normalize monetary policy will not simply return once the process is completed, because investors’ concern about Indonesia to a significant degree stems from domestic government action – and inaction.
Boosting public infrastructure development could compensate for slowing exports and consumer spending, but the government has been slow out of the blocks to implement higher budgetary spending.
A survey by MasterCard Inc measuring consumer confidence in the Asia Pacific region in the first half of 2015 found an “extreme deterioration” in Indonesia. While Indonesians were shown to remain “optimistic” about their economic prospects, no other country in the survey saw such a strong decline in consumer confidence. This is worrying because household spending has been the main driver of Indonesia's economy over the past years and will continue to play a pivotal role as long as exports suffer from low commodity prices.
The fact that Indonesia largely has itself to blame for the slowdown is a good thing, for it means that the country is not at the mercy of fickle global markets, but that the government can take practical steps to reinvigorate the national economy.
Economic growth has been on a declining path since 2010 and dropped to a year-on-year rate of 4.67% in the second quarter of 2015, the lowest in six years. What would seem like robust GDP growth in the most developed countries is not very impressive in an emerging economy with a growing population.
The slowdown largely reflects lower volumes and prices for key Indonesian export commodities, such as thermal coal, crude palm oil, rubber and metals. Due to ample global stocks, commodity prices are unlikely to recover soon. The slowdown in China's manufacturing industry will have a lasting effect on Indonesian exports, though India and other markets should pick up some of the slack in the long run. Softening business investment and private consumption also impacted growth.
Boosting public infrastructure development could compensate for slowing exports and consumer spending, but the government of President Joko Widodo, in office since October 2014, has been slow out of the blocks to implement higher budgetary spending. Private investors, in many cases, are waiting for the government to take the lead and deliver on public spending plans as well as promised regulatory reforms. The official government target of 5.7% GDP growth in 2015 now looks unattainable. Bank Indonesia (BI), for its part, revised down its growth projection to 5-5.4% in June, and even that seems ambitious from today's vantage point. The central bank based its prediction on an anticipated increase in government spending and private consumption in the second half of the year, accompanied by accelerated infrastructure development.
Indonesia Annual Real GDP Growth (%)
Source: Statistics Indonesia (BPS)
The rupiah's stubborn decline over the past four years is making foreign investors uneasy about pouring money into Indonesia. While Bank Indonesia and the government initially appeared to be happy to let the currency depreciate in order to balance foreign trade, it now looks like they are failing to arrest the ongoing decline. Admittedly, while the rupiah's trend looks alarming against an exceptionally strong US dollar; Indonesia's currency actually gained considerable ground against a weakening Euro after reaching a low at the end of 2013. In any case, monetary tightening in the US, and at some point in Europe and Japan too, is set to pile more pressure on the rupiah, along with other emerging market currencies.
The depreciation of the national currency has curtailed consumer demand for imported goods and therefore aided government efforts to restore the trade surplus. It has also, however, increased the price of imported oil, machinery and input products that the local economy is unable to adequately substitute, thereby placing a burden on manufacturing industries.
USD to IDR Exchange Rate
Source: XE.com
By making imported goods and services more expensive, the lower rupiah has contributed to rising consumer prices in Indonesia. Year-on-year inflation more than doubled from 3.79% in 2011 to 8.36% in 2014 and still exceeded 7% in mid-2015. The raising of subsidized petrol prices, while helping to relieve the state budget, added to inflation.
With weak GDP growth on the one hand and elevated inflation on the other, BI is caught between a rock and a hard place. It cannot reduce interest rates to support credit lending and thereby economic activity without heaping yet more pressure on the rupiah. The central bank has kept the benchmark interest rate, which determines its lending and deposit rates for commercial banks, at 7.5% or higher since late 2013.
Year-on-year Inflation (at end of each quarter)
Source: Bank Indonesia
In a bid to stem the rupiah depreciation, BI issued new rules in June 2015 requiring that all domestic financial transactions, with a few exceptions for infrastructure projects, be priced and executed in the national currency. Non-rupiah transactions, which are particularly common in the real estate sector, amounted to the equivalent of $12 billion USD a day, according to central bank estimates. The new rules have been criticised for burdening companies at a time where they are already struggling to acquire funds at reasonable cost. Meanwhile, their effectiveness in bolstering the rupiah has been questioned.
Foreign Direct Investment (FDI) and Domestic Direct Investment (DDI) continue to rise, albeit not as fast as targeted by the government. FDI, which tends to be about twice as high as DDI, is particularly important with regards to the rupiah. Data from the Investment Coordinating Board (BKPM) show that FDI grew by 16.1% to 174.2 trillion IDR in the first half of 2015 from a year earlier, while DDI increased by 17.4% to 85.5 trillion IDR.
Considering inflation, the increase is not overwhelming; much more will be needed to restore the speed of economic development Indonesia enjoyed three or four years ago. BKPM is optimistic that investment will pick up significantly in the final quarter of the year when some significant infrastructure projects are scheduled to start. The BKPM figures show that while Java continues to attract more investment than the rest of the country, the other regions are slowly picking up. That is an encouraging sign for Indonesia's long-term development.
Direct investment is the most powerful tool in the government's hands to boost GDP growth, strengthen the rupiah and foster long-term development across the archipelago. To attract more investment, Indonesia needs to address the persistent issues afflicting the business climate. Luckily, there is widespread consensus on what these issues are: inadequate transportation and energy infrastructure, a lack of highly-qualified professionals, substandard education and research and – last but not least – bureaucratic hurdles, cumbersome licensing procedures and regulations that are sometimes stacked against foreign investors.
All of these are domestic problems. It would be wrong, therefore, to see Indonesia's current economic troubles primarily as the result of external factors. President Widodo campaigned on tackling most of these problems, but more than nine months after his inauguration, disappointment is growing. “Indonesia's Economy Has Stopped Emerging“, reads the headline of a Bloomberg opinion piece, in which the author contends that the president “must decide what kind of leader he wants to be: a craven populist or the modernizer Indonesia needs.”
The fundamental characteristics of the country remain favourable. A young and growing population, rich deposits of mineral resources and being located in a high-growth region of the world all point to ample potential for long-term economic growth. Investment-friendly regulations, better infrastructure and education will become increasingly important as Indonesian businesses face stronger competition in the upcoming ASEAN Economic Community (AEC). Clearly unhappy with his government's performance, President Widodo in August 2015 replaced several ministers, including the Coordinating Minister for the Economy and the Trade Minister. It remains to be seen whether the cabinet reshuffle was the jolt the government needs to improve Indonesia's investment climate.
Global Business Guide Indonesia - 2015
Capital: Jakarta
Population: 259 million (2016)
Currency: Indonesian Rupiah
Nominal GDP: $936 billion USD (IMF, 2016)
GDP Per Capita: $3,620 USD at Current Prices (IMF, 2016)
GDP Growth: 5.0% (2016)
External Debt: 36.80% of GDP (BI, Q2 2016)
Ease of Doing Business: 91/190 (WB, 2017)
Corruption Index: 90/176 (TI, 2016)
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