Indonesia - Economic Update

Economic Update

Despite the global slowdown, real GDP growth in Indonesia has accelerated from 3.1% YoY in 2021 to 5.4% YoY in the first three quarters of 2022.  Performance to date compares well with other emerging and developing economies.

Rises in coal and palm oil prices since the Russian invasion of Ukraine have boosted exports and corporate earnings.  In addition, the successful vaccination programme and a drop in COVID cases have resulted in improved mobility, releasing pent-up consumer demand.  Unemployment has fallen below 6% and average wages have risen by 12% YoY.

Higher commodity prices, increased domestic energy tariffs and higher producer prices have fed into higher inflation, which reached 5.7% YoY in October. This is despite the existence of price control mechanisms in energy and agriculture, and imperfect producer price transmission mechanisms in Indonesia, which are being reflected in lower business margins.  Following administered price increases since September, inflation expectations have shown signs of rising, which has led to some dampening in consumer sentiment, as well as in investment intentions.

Commodity exports have supported the current account surplus, which rose from 0.2% GDP in Q3 2021 to 0.9% GDP in Q3 2022.  On the other hand, exports of vehicles, electrical machines, footwear and clothing have constituted nearly half of total exports.  Although external financing has become more difficult with higher US interest rates, near-term refinancing needs are just 2.1% GDP and, although FX reserves have fallen from USD 145bn in December 2021 to USD 130bn in October 2022, they still equate to six months of imports, which is adequate.

Indonesia’s borrowing costs have increased, 3yr bond yields having risen from 4.5% to 6.6% between January and November.  10yr yields are 7.2%.  Borrowing costs are higher than for neighbours but, although the currency has weakened by about 10%, its performance has been better than in the 2013 “Taper Tantrum”, partly as a result of central bank intervention.  The basic balance surplus of 2% GDP and the rupiah’s reduced exposure to non-resident debt investors should have helped.  FDI, led by metals and mining, has risen (1.2% GDP in Q3 2022).

The government has run a modest fiscal deficit in the first ten months of the year, but this is expected to widen somewhat, to 2.7% GDP, for the full year, due to backloaded spending to SOEs.  Nonetheless, higher windfall revenues and expenditure discipline mean the deficit is expected to be significantly less than the 4.9% GDP projected in the 2022 budget law.

The fiscal benefit from September’s adjustment to fuel prices is expected to rise from an estimated 0.1% GDP in 2022 to 0.4% GDP in 2023-2025.  Even then, however, fuel subsidies will still be substantial, being estimated at 1.8% GDP per annum.

Public debt is expected to moderate from 40.7% GDP in 2021 to 38.8% GDP in 2022, which is healthy territory compared to peers.

Banking sector vulnerabilities are deemed to be low, with the NPL ratio standing at 2.8% in September and the average loan at risk ratio at 17.4% in June.  The capital adequacy ratio has been stable at 25.1%, and provisioning levels stood at 204% in August.   Forbearance measures are expected to remain in force until March 2023 – longer than in most country peers – and these create some distortions, however.  Profitability levels are higher than regional peers, as a result of limited competition and the dominance of state-owned banks.  Against this background, credit growth has been on the rise for sixteen consecutive months.

Near Term Outlook

In the context of a high probability of a global recession in 2023, Indonesia is expected to exhibit robust growth, albeit at a slower pace than in 2022.

Growth in 2023-2025 is expected to average 4.9%, slightly above the estimated potential rate of 4.7%.  A continued recovery in private consumption, and in private investment, is the expected cause for this.  (Macroeconomic stability and structural reforms like those contained in the Omnibus Law are expected to attract FDI).  Carry-over effects from higher global prices and administered price increases mean inflation is expected to rise to 4.5% YoY in 2023.  Thereafter, it is expected to drop back towards 3.5%, with lower commodity prices.   The current account is projected to return to a modest deficit, while the fiscal deficit is expected to remain below 3% GDP.

A summary of the World Bank’s projections appears below:

The Omnibus Law and Job Creation

Prior to the introduction of the Omnibus Law on Job Creation, Indonesia had the third highest level of restrictions on FDI in the OECD, and was second most restrictive country in the region behind the Philippines.  The Negative Investment List imposed widespread foreign equity limits, sectoral reservations for MSMEs, special licencing regimes, and minimum content requirements.

The Omnibus Law removed restrictions on “sectors open with conditions” and on sectors “reserved for MSMEs and cooperatives” and reduced discrimination against foreign investment in areas such as horticulture and plantations, postal services, aviation and shipping.  The number of the types of business subject to at least one restriction on foreign investment fell from 813 to 260.

The law also introduced a single online submission system for licences, while the government established a special taskforce to help investors overcome administrative bottlenecks.  At the same time, it reduced constraints on importing key inputs and on the employment of labour.

An initial USD 5bn has been used to establish a new Indonesia Investment Authority (INA), which is to be used create more longer-term investment opportunities for foreign investors.  Framework agreements have been structured with global and domestic investors to invest in manufacturing, services and infrastructure.  INA’s assets under management are now USD 6.8bn; the near-term target is to reach AUM of USD 20bn.

So far, the impact on FDI has been positive.  In the five quarters post-reform it is 29% higher than in the five quarters which preceded it.  FDI in manufacturing has risen faster and, having caught up with non-manufacturing FDI in 2020 and 2021, it has surpassed it in the first nine months of 2022.

Domestic investment in manufacturing has also risen.  In addition, the World Bank notes that investment in fully-liberalised non-commodity sectors rose in 2019-2021, while investment in restricted sectors fell.

Structural Reform Priorities

Tax Measures

Interest payments in 2023 are expected to be 0.5% GDP higher than the average for 2016-2019; public revenues need to rise by at least this amount to save a spending squeeze.  The World Bank suggests consideration be given to the following:

• Eliminating unnecessary VAT exemptions, using the proceeds to compensate poor households
• Lowering the eligibility threshold for VAT and corporate income tax which, at IDR 4.8bn is high by developed country standards and could be reduced to IDR 600mn.
• Eliminating VAT exceptions and the special final tax treatment for industries such as construction and real estate. Subjecting wide-ranging tax expenditures to closer scrutiny.
• New excises, like the new sugar-sweetened beverages excise, could be introduced (eg. for single-use plastics), and rates raised.
• Simplifying the tobacco tax regime.

Subsidies

The recent energy price hike helped to contain the subsidy bill, but more can be done to narrow the gap between consumer prices and energy costs.

• Assistance to vulnerable households will be needed to help them adjust. Beneficiary databases need to be improved; in the interim, eligibility restrictions should be rigorously enforced.
• With electricity, the process is simpler, as lower voltage connections are closely associated with the most suitable targets of subsidies. With fuels, approaches should include beneficiary registration and vehicle-class restrictions.

Social Security

Indonesia can build on existing programmes just as it did during the COVID crisis.  However targeting needs to be improved.  Blanket subsidies are inefficient, but key groups such as the elderly, the disabled and non-salaried workers (60% of the total) need better protection.

The World Bank suggests consideration be given to unemployment insurance and pensions, which allow households to smooth consumption over the lifecycle.   Extending existing social assistance and social insurance programmes would be an important first step, using well-targeted subsidies to cover premiums and contributions for vulnerable non-salaried workers.  Depending on budget constraints, it may be necessary to begin with coverage expansion for short-term risks such as death and work injury, where the premium is relatively low.

These reforms will require an improvement in delivery systems – an expanded social registry and improvements in coordination between social assistance and social insurance programmes.

Trade Liberalisation to Foster Growth

Between 1980 and 2020, international trade grew seven-fold.  The average volume of exports of Malaysia, Thailand and the Philippines expanded twelve-fold, but Indonesia’s increased by half the world average.  Trade to GDP has fallen from 72% in 2000 to 33% in 2020, the lowest amongst regional peers.

Coinciding with this, manufacturing/GDP has fallen from 31% in 2002 to 19% in 2021.

The structure of exports has remained broadly unchanged for the last two decades.  They are concentrated in resource intensive industries and have the lowest sophistication amongst East Asian peers; they leave Indonesia exposed to Dutch Disease.

The decline in import tariffs, from 15% in 1990 to 2% in 2020, has been offset by an increase in Non-Tariff Measures (NTMs) such as pre-shipment inspections, restrictions on port of entry, import approvals and mandatory certifications.  These now apply to c.90% of all imported consumer goods and to many intermediate inputs and capital goods, even when they are not available domestically.   The associated compliance costs are unusually high.

There are also restrictions that hamper the competitiveness of key services sectors – especially legal, accounting, distribution and telecom.  Whereas the Philippines and Thailand have services exports amounting to 44% and 26% of all exports, they are just 16% of exports in Indonesia.

With respect to trade logistics and trade facilitation, reforms are needed to reduce the time, costs and uncertainty attached to cross-border transactions.  Progress has been made with digitisation – eg. the Indonesia National Single Window and the launch of the National Logistics Ecosystem – and performance has been improving, but there is still scope for further efficiencies.

Improving rather than restricting access to imports could help Indonesia to diversify into higher value-added industries.

Firms that both import and export account for a quarter of total imports and two-thirds of total exports – they are more productive, export more frequently and to more destinations, grow faster and pay higher wages.

The World Bank is concerned that achieving the government objective of 35% import substitution (designed to boost demand for domestic products) will instead burden companies with more costly and lower quality inputs.   It argues that, since the 1970s, Indonesia’s import substitution strategy has not, in fact, reduced its reliance in imported inputs; it has dampened its international competitiveness, through the misallocation of resources and the imposition of significant efficiency losses.

Complementing reforms under the Omnibus Law with further trade reforms could result in large multiplier effects on income and growth, boosting Indonesia’s objective of becoming a high-income country by 2025.

The World Bank also argues that restrictive agricultural and food trade policies are contributing to higher domestic food prices, hurting even farmers, two-thirds of whom are net food buyers.  The effective rate of protection is estimated to be 27% of total consumption (2011-2020), among the highest compared to peers.

The World Bank believes that reforms in import licencing requirements, port of entry restrictions, and import monopolies could reduce food prices by up to 40%.

Countries open to trade have been shown to be better placed to respond to supply shocks in the short term, and recover more quickly in the medium to long term.

Accordingly, the World Bank is recommending that Indonesia should consider:

• Streamlining/eliminating burdensome/unnecessary NTMs
• Deepening existing trade agreements and pursuing additional comprehensive ones
• Accelerating trade facilitation and logistics reforms
• Removing binding constraints to services trade
• Using trade reforms to boost its green competitiveness

 

Overall, they estimate that, if implemented, the NTM reforms alone could increase Indonesia’s total exports by 10% and investment by 27% over the medium – to long run.

 

To read the full report, please use the following link to the World Bank’s website:

https://www.worldbank.org/en/country/indonesia