Euroweek Indonesia report: economy

Euroweek, September 2013 

A year ago, Indonesia was the golden child of Asia, perhaps of all emerging markets. Insulated from global shocks by an economy built on domestic consumption, with a bounty of natural resources at a time of high commodity prices and endless Chinese demand, and with a sweet-spot demographic in an orderly new democracy, it attracted many billions of dollars in global fund flows.

One year on, the mood has changed. The trade deficit hit $2.3 billion in July, much worse than expected, while consumer price inflation is rising and stood at 8.8% in August. The country, which once seemed to be at the centre of a perfect storm of a positive kind – resources, labour force, flows – is now instead being hit by a confluence of more negative factors, with an emerging market sell-off, a falling currency, declining commodity prices and weakened demand from its main customers.

“The current account deterioration is driven by two factors,” says Prakriti Sofat, emerging market economist at Barclays Capital. “The first is an unfavourable terms of trade shock, given that commodities make up nearly 70% of total exports. The country has been facing this headwind for the last 12 to 18 months and will continue to do so, given structurally lower growth in China,” particularly since what growth remains in China is increasingly driven by consumption rather than resource-fuelled investment. The second factor, she says, is on the import line: refined petroleum products are a key import for Indonesia, and since the government subsidises the fuel price, “volumes do not adjust to changes in global oil prices or weakness in the rupiah.” That means the government takes the hit on the fiscal side.

Taimur Baig, economist at Deutsche Bank, says Indonesia is “a classic case of overheating. While the underlying strength is undeniable, macro policy has been too accommodating, creating a consumption boom and then an investment boom.” That has increased the import bill far faster than exports have generating earnings to balance them, feeding in to the same trade and current account deficit problems.

And then, on top of that, has come the sell-off in all emerging markets ever since Ben Bernanke began talking about tapering in May. In particular, the rupiah has plunged in value since July, moving from less than 10,000 rupiah to the US dollar then to over 11,500 in early September. “It is now reaching uncomfortable levels,” Baig says. “It is getting to a level where a feedback loop can happen: depreciation leads to a worsening of sentiment and higher inflation, which then causes further depreciation.”

Clearly, Indonesia has lost its allure. But some perspective is useful. “If we go back to the Asian financial crisis, for sure things look much better today than they did in the late 90s,” says Su Sian Lim, Asean economist at HSBC. “If we compare it to the reform momentum of two or three years ago, it does seem as if things have stagnated a little bit. It all depends what timeframe you’re talking about.”

Baig, for all his warnings, agrees. “The situation is serious, but we need to be careful about drawing a line between medium term fundamental strength and short-term weakness,” he says. “Our view is that Indonesia is structurally strong, but cyclically negative, and we have been saying this for a while. It is possible to be long term bullish and short term bearish.”

Lim argues that, perhaps a little belatedly, Indonesia’s government and central bank have realised the problem and started to take action. “Three important things have been delivered,” she says. “One, they did bite the bullet and raise fuel prices at the end of June [causing a 44% increase in petrol prices, 22% in diesel, and protests across the country]: that’s going to take a lot of pressure off the trade account because most of it has been driven by oil demand. Two, the central bank has displayed more inclination to accept that rupiah weakness needs to be part of the toolbox, without which it’s going to be very difficult for external balances to come back in a more sustainable fashion. And three, they have normalised policy rates by 150 basis points of tightening.” All of this, in aggregate, ought to lead to slower domestic demand, and therefore slower import demand, and ultimately less pressure on the deficit.

“All of these policy actions have been delivered over a short span of time and we have not yet had a chance to see the effect on the data. But I think in the months ahead we will start to see a narrower trade deficit, and then a narrower current account deficit.”

Economists vary in what they want to see next. Baig says the situation “is salvageable” but thinks the feedback loop he identified has to be interrupted. He would like to see the repo rate raised further to 7.5%, and the cash rate “substantially more, which will give a good incentive not to keep liquidity in circulation, but to keep it with the central bank: less credit growth and less demand would start improving the situation.” He also calls for another fuel price hike, arguing that the consequent inevitable lower economic growth “would be welcome: Indonesia has grown strongly for four or five years and a cyclical slowdown is exactly what is needed.”

Sofat wants the government to think further ahead. “On a medium-term basis the government needs to come up with a policy to increase the manufacturing share of exports.” She, too, calls for increases in fuel prices, but believes they should be regular and sustained rather than large and one-off. “High frequency adjustments of smaller amounts are more palatable and would allow the government to reduce the gap between subsidized prices and market prices in a more sustainable way,” she says.

Economists within Indonesian institutions tend to see the situation as less troubling than those at internationals. “We don’t see the current account as a severe problem,” says Aldian Taloputra, in fixed income and economic research at Mandiri Sekuritas. “If you take out the oil part, the current account deficit is not that bad. The problem is, it is happening in an environment where the US is trying to scale down its stimulus.” He does, though, think fuel subsidies need to be cut further “so the government can allocate spending on more productive areas like infrastructure.”

Even if Indonesia isn’t alone in facing external shocks, there is another issue to consider too. “The market is being cautious on countries that have current account deficits such as Brazil, India or Indonesia,” says Sofat at Barclays. “However, Indonesia also has its idiosyncratic issues, such as lack of transparency in the FX market, and concerns around the central bank playing catch-up rather than being pre-emptive.”

The point on FX, little talked about by economists, is becoming a particularly pressing issue and a cause for concern. More and more participants are noticing a difference between official FX rates and what they can get in practice. “There is a fair difference between what you would see as a price level on dollar-IDR on a Bloomberg screen, and what end investors who have sold their bonds and asked their custodian for dollars might get,” one observer says. “It might be 11,200 on screen, but they sell their bonds at 11,700: a huge slippage risk. It is making investors cautious. They don’t really know what the true price is.”

This has come about because of a mismatch between demand and supply. “The central bank is the only game in town as a supplier of dollars,” one says. “Exporters are not selling dollars because they are concerned the dollar is heading higher in an environment of tapering and Indonesian macro vulnerabilities.” And, while Bank Indonesia has been providing dollars, it doesn’t want to do so indefinitely; its foreign exchange reserves have dropped by $20 billion in a matter of months. Commercial banks have plenty of dollars too, but don’t want to lend them out in case they need them back a month later and can’t get them.

Asked about the issue, Lim at HSBC says: “In our communication with the central bank, I do think they are aware of what is going on, in terms of sentiment and confidence. It’s definitely not constructive if you don’t have a properly functioning FX market. But I believe they are putting in every effort to fix the necessary problems.”

The forex issue brings us to a more widely-discussed theme around foreign money flows. Indonesia is renowned as a place where foreign money has sought to take part in domestic debt, and even after recent reverses 30% of local bonds are still owned offshore. Several questions come from this: could more of it take flight? And what if that happens? Could domestic institutions take it up?

There is scope for a positive view here. One, while $2 billion has flowed out of these bonds in recent months, that’s less than might have been expected. “Foreign holdings in bonds are still around 30%, not so much of a decline compared to the beginning of this year,” says Taloputra at Mandiri. “What’s interesting is that conventional foreign investors – funds – are reducing their holdings, but there are new foreign buyers taking their place: foreign central banks. You cannot see a significant sell off in government bonds because of that.”

Sofat adds that “overall the money in the Indonesian local currency bond market is much more sticky money – long-term real money, sovereign wealth funds and central banks. This contrasts with 2008,” she says, “when hedge fund money was more involved, making the market more vulnerable.” In addition, she says, most fixed local currency investors have been cautious on the macro story since September 2011, meaning there wasn’t a lot of froth to dissipate.

Still, one could argue that the lack of a sell-off comes back to issues of liquidity and market efficiency. “It’s a little bit ironic,” says Lim. “Part of the reason the selling has not appeared to be as intense is because the exit door is quite narrow in Indonesia. It hasn’t been all that easy for foreign investors to liquidate their holdings.” Still, even if the money does find its way out, she is not alarmed. “The risk of capital flight is there for sure, but it comes down to whether the central bank has the wherewithal to deal with that situation if and when it arises.” She feels that, with recent policy measures, the risk of capital flight has been reduced. “But if and when we do see a large chunk of capital flowing out, the central bank is very well placed.”

Clearly, the strong levels of foreign exchange reserves, though somewhat reduced, are important here. Reserves stood at $93 billion at the end of August, down almost $20 billion in fourth months but considerably up on the $50 billion level from 2008. Lim points out, though, that portfolio flows aren’t the only way money leaves. “One point that gets missed is the substantial outflow of corporate income,” she says, highlighting foreign multinationals in Indonesia. “This is important to the current account: it’s not just about oil imports, but corporate repatriation.”

Baig at Deutsche argues there is another reason outflows have been modest: Indonesia’s upgrade last year to investment grade. “The flows have not been that bad at all,” he says. “It’s interesting: Indonesia has seen rather alarming macro numbers, but the magnitude of the sell-off has been small. When you’re in the investment grade index, your stability is maintained, because nobody will reduce their exposure to you to zero. When there’s a sell-off, countries that have done the right thing and joined investment grade do better than those that have not.”

In any event, he thinks Indonesia has better things to be occupying itself with than flows.  “Instead of worrying about external triggers, which the country can do very little about, the focus should be on domestic policy-making leading to better fundamentals.”

Also in the mix, and more so every month, is Indonesia’s election, which must take place next year [the planned date is July 9 2014]. There is no question of the incumbent, Susilo Bambang Yudhoyono, running again, because he has served two terms, and the plunge into the unknown is worrying some economists. Or perhaps ‘unknown’ is the wrong word, because all the likely candidates look somewhat familiar: Megawati Sukarnoputri, former President; Jusuf Kalla, former Vice President; Prabowo Subianto, former vice presidential candidate. There is some excitement about Joko Widodo, Governor of Jakarta, but beyond that, economists have not been particularly excited.

And in any event, it’s no secret that a pending election tends to lead to policy paralysis; it’s something of a surprise that the government put through a fuel hike at all with an election only a year away. “There is definitely a sense that the reform momentum has stalled,” says Lim. “But the economic team that we have right now – the finance minister, the central bank governor, the trade minister – is very much reform-minded, and it would be good if we continue to have this calibre of economic managers even if the election brings changes next year.”

Sofat says that “political risk premium needs to rise for Indonesia’s assets given elections next year and a likely increase in nationalistic policy bias ahead of the polls,” and she is surely right. In addition, she points to a likely coalition outcome, with a fragmented parliament. “Coalition politics is here to stay, posing a risk to structural reforms.”

Taloputra again takes a more positive view, pointing out that “in 2004 and 2009, when there was an election, political factors did not have a significant impact. It can be done without disturbance on the economic front,” he says. “On one side, the election will boost consumption; on the other, investment will not be as high, so the impact will be positive to neutral.” This is a more positive view than many of his peers.

Despite all the clear headwinds, nothing has changed the long-term positives for Indonesia.

“Indonesia has a lot of things going for it,” says Lim. “It is still one of the richest countries in the region in terms of natural resources; demographically, it is still a very young population with a large and ready labour pool; and it has a growing middle class.” GDP per capita broke $3000 for the first time two years ago. “Beyond that level, that’s when people start to look at more discretionary goods to purchase, rather than just living on the basics.”

Taloputra says around 60% of Indonesia’s population is in the productive age group, and more and more of it is in the middle income bracket; he expects that to anchor growth. Mandiri expects 6.6% growth in 2016, 6.8% in 2017. “We are still quite optimistic on the long term story of the economy.” And Baig adds: “Nothing that has happened in the last year or so in terms of policy takes away from Indonesia’s favourable demographic dynamic, the fact that it has a thriving democracy and political economy, and other positive signs of a maturing society. One would still be optimistic about that.”

But in order to stop the hurdles Indonesia faces today from becoming insurmountable and permanent, the emphasis must be on the right long-term measures rather than the populist.

“The last 10 years have brought about quite significant change in Indonesia: they have become more open to the foreign investment community, more aware of what investors desire to see, whether it’s investment policy or the amount of red tape,” says Lim. “What will be necessary in the next couple of years is that they continue with economic reform.”