New and promising chapter in Indonesian economy Taimur Baig  ;   Chief economist of Deutsche Bank for Asia

JAKARTA POST,  03 Desember 2014

                                                                                                                       

Commodity sector headwind and some degree of fiscal/monetary tightness will likely keep growth below trend in 2015, but the ongoing macro adjustments could set the ground for stronger fundamentals and sustained economic performance for years to come. President Joko “Jokowi” Widodo came to office with a platform of (i) fighting corruption, (ii) reorienting fiscal policy from inefficient and wasteful subsidies to targeting spending to reduce poverty and improve health and education standards, and (iii) addressing the economy’s major infrastructure shortcomings. These tasks are formidable and success is by no means assured, especially with the House of Representatives not fully under the control of the President’s coalition. But there is a case to be made that the agenda requires only limited legislative approval, which ought to reduce the risk of implementation. The main downside risks are: second round effect of the latest fuel price hike could turn out to be more than expected, forcing the Bank Indonesia (BI) to tighten aggressively; the bond market could see a sell off next year in the period leading up to interest rate policy normalization in the US; the exchange rate could come under pressure if the current account does not improve in the aftermath of the fuel price hike; the President’s reform agenda could be undermined by a fractious and antagonistic parliament. These tasks are formidable and success is by no means assured, especially with the House of Representatives not fully under the control of the President’s coalition. But there is a case to be made that the agenda requires only limited legislative approval, which ought to reduce the risk of implementation. We think that there is a strong chance that he will be able to capitalize on his popularity to get going with his agenda. Indeed, within weeks after taking over the office, the President’s fuel price decision reflected admirable resolve. While the House could get in his way, slow reforms, and give rise to some uncertainty, Indonesia’s history of political pragmatism suggests as 2015 progresses, more lawmakers will express their solidarity with the ruling coalition. The much anticipated fuel price decision is an unmitigated positive. There were many reasons why the authorities could have blinked. The sharp decline in global oil prices alone could have greatly reduced the incentive to embrace an unpopular move as a first step of the new administration. Fear of a parliamentary backlash could have also had a paralyzing impact. To their credit, the authorities went ahead with the price hike in mid-November. The macro impact of the combination of declining world prices and rising domestic prices would be immense. As per our estimates, the Rp 2,000 (US$0.16) fuel price hike (which pushed up gasoline price to Rp 8,500/liter and diesel to Rp 7,500/liter) would amount to halving the fuel subsidy bill to 1.6 percent of Gross Domestic Product (GDP) next year. The overall subsidy budget, as a result, would fall to 2.5 percent of GDP if not lower. If well planned, the savings could be channeled toward simultaneously cutting the budget deficit sizably, and increasing substantially spending on means-tested, targeted cash transfer, healthcare, education, and infrastructure. Subsidies going down by at least 1.5 percent of GDP will open up space for social and capital spending. The fuel price decision opens up the door to a landmark budget revision in February 2015 that will detail how effectively the government channels the savings to growth critical areas. More clarity about future fuel price decision (automatic or ad hoc) and overall subsidy policy (fixed, nil, or formula based) would be helpful to the market. Short of a major tax and expenditure overhaul, fiscal sustainability would remain under question, especially since budget law prevents the deficit to exceed 3 percent of GDP. Revenue reforms may bring dividends in the medium term, while in the near term the need to cut spending would only make sense if it is done without undermining growth and welfare critical outlays. Fuel subsidy reduction therefore addresses both a cyclical and structural problem. For 2015, inflation would average 7-7.5 percent, as per our projection. In response to the fuel price hike, Bank Indonesia an impressive set of measures, raising the policy rate by 25 basis points (bps) to 7.75 percent, increased the Lending Facility rate by 50 bps to 8 percent, while the Deposit Facility rate was left unchanged at 5.75 percent. Widening of the interest rate corridor was rationalized as providing more room for liquidity management. Additionally, the central bank geared up to assist the central government in effective administration of cash transfers, and provided some mild incentives to boost credit creation (e.g. by expanding the definition of deposit used in loan-to-deposit ratio calculation). We think the central bank likely has one more hike (25bps) of the BI policy rate in store. We are impressed that the central bank has gone ahead with measures to keep inflation expectations anchored at a time when growth has weakened and pricing power seems diminished. This bodes well for the central bank’s resolve, and will be helpful in stabilizing the rupiah and keeping foreign investors favorably predisposed toward the economy. We think that there is a high likelihood of inflation following the same trajectory as it did after the 2013 fuel price hike, which is to undergo sharp disinflation in a year’s time as the base effect wanes. There is little upside risk of second round effects as producer pricing power is low due to weak demand, food price dynamic is favorable, and wage demand has waned lately. Once it is clear that the base effect driven inflation is about to decline sharply in late-2015, a window may open up for the central bank to cuts rates in the fourth quarter, in our view. While we are not very worried about the inflation situation beyond fuel prices, we cannot see growth accelerating anytime soon. President Jokowi’s reform agenda will provide dividend in the medium term, while short term headwinds stemming from tighter fiscal and monetary policy, as well as low commodity prices, will keep demand at best stable, in our view. Money and credit growth rates have been easing for the past two years as economic momentum has flattened; we see no change in that trend next year. In any case, close to double digit credit growth, in real terms, is sufficient for the economy to grow in a robust and sustainable manner. The ongoing modest growth slowdown was overdue, and should not be seen with alarm, in our view. After growing strongly for a number of years on the back of a sharp rise in investment, a consolidation cycle was in order. Growth slowdown and rupiah deprecation (the rupiah has gone from 9, 600 to the dollar in the beginning of 2013 to 12,100 presently) have however taken their toll, with real per capita GDP growth slowing and dollar per capita GDP declining over the last two years. We are sure the administration would be keen to reverse this trend. We do not think expectation of 5 percent growth next year will disappoint investors, as the improvement in fundamentals resulting from the fuel price adjustment would be considerable. The current account, for instance, is ripe for a fairly substantial improvement, which would come at not a moment too soon as the world gears up for Fed policy normalization and associate capital flow volatility. Low oil price and fuel subsidy reduction help external accounts considerably. ●