SINGAPORE (May 8): The Indonesian economy has been performing well relative to most large emerging economies such as Brazil, Mexico or Russia. But its growth, at 5% in 2016 and 4.9% in 2015, is well below what it is capable of and pales beside China and India, raising questions over what is holding this potential global dynamo back. In recent weeks, these niggling concerns have been compounded by worries about rising political risk, following the defeat of the progressive but controversial incumbent governor of Jakarta in his re-election attempt.

Our view is modestly positive. We see political risks being contained and a cyclical pickup in economic growth as likely. The longer-term underperformance of the economy will take longer to reverse, but policy changes are beginning to address some of the constraints on economic growth.

Should we worry about political risks?
At one level, the victory of Anies Baswedan should not by itself be seen as a setback. Anies is a former education minister and a highly respected academic known for his moderate views; his running mate, Sandiago Uno, is a young, impressive and dynamic business leader. The nature of their victory, however, is what is worrying many long-time observers of Indonesia. The incumbent governor, Basuki Purnama, or Ahok as he is commonly known, had built a good reputation for getting things done and delivering progress to the long-suffering citizens of Jakarta. It was this performance that gave him an initially comfortable lead in opinion polls even though he was a double minority in being a Chinese and a Christian in a Muslim-majority city and despite his occasionally abrasive style.

However, when extremist groups hurled allegations of blaspheming the Quran against him, the ground shifted. Anti-Ahok groups were able to mobilise the largest demonstration in recent Indonesian history against him even as he argued that his statements had been distorted. Ahok was prosecuted for blasphemy but that did not prevent a continued upsurge in religious tensions. In the final round of the election, Ahok lost decisively to Anies.

This has raised two concerns. First is the religious threat: Many now fear that there is a strong incentive for political contenders to exploit religious sentiment against their opponents. Second, Anies’ victory is also seen as undermining President Joko Widodo’s position because Ahok was Jokowi’s protégé and Jokowi had dismissed Anies as education minister. And all the more so because Anies had been backed by Prabowo Subianto, whom Jokowi defeated in the 2014 presidential election and who is Jokowi’s most likely challenger in 2019, when the president is expected to run for re-election.

While both concerns are valid, we believe they are exaggerated. On the question of extremism, there is little doubt that the religious connotations in the election campaign have raised tensions. But we should also remember that the moderate nature of Indonesian Islam has deep roots and the forces of moderation in Indonesia are more forceful and effective than, say, in the Middle East. For example, home-grown Nahdlatul Ulema, one of the largest Muslim organisations in the world, has been a strong voice for moderation and is boldly calling for a modern interpretation of Islamic law, not something that moderate forces elsewhere have so explicitly done. Extremist parties have struggled to make headway in Indonesian elections. In short, extremists will try to take advantage of recent developments, but the response from moderates will almost certainly be effective in keeping Indonesia on a moderate path.

The second question, of the threat to Jokowi’s position, should not be lightly dismissed. Jokowi has lost political momentum, and his inability to protect his protégé has shown up his vulnerability and given his political rivals an opening to attack him. Jokowi did not come from virtually nowhere to become president for nothing, though. He is an extremely skilful political strategist who has learnt to employ the levers of political power to make him the strongest president of Indonesia since the fall of the authoritarian President Suharto. He is quite likely to respond to this setback in the coming weeks with a series of initiatives to claw back momentum and reassert his authority.

The other key to Jokowi’s position is the economy. He needs to show concrete results that tangibly improve the lives of ordinary citizens. There is an improving chance that he can succeed in this.

Economic growth set to improve in the near term
More evidence is emerging of a cyclical improvement in the economy:

  • Global demand is perking up, helping exports to rev up: Export growth accelerated sharply to 23.6% y-o-y in March from 11.5% in February. While oil and gas exports rose 19.5% on the back of higher prices, non-oil exports surged 24.0% in March;
  • Domestic demand is firming: Imports rose 18.2% y-o-y in March, up from 11.6% in February;
  • The manufacturing sector is picking up: The Purchasing Managers’ Index rose to 51.2 in April, up from 50.5 in March. Better still, order books are expanding, giving us confidence that the rebound can be sustained;
  • Direct investments are rising, up 17% in the first quarter of this year, led mostly by domestic investors, but foreign investment is also growing; and
  • Fiscal revenues are rising, up 19% in the first quarter, a vast improvement from a year ago when revenues fell.
In addition, the hit to consumer confidence from reduced fuel and other subsidies is now easing while improving commodity prices are boosting rural incomes. Also, with fiscal revenues improving, spending cuts will not be needed, as they were last year, to keep the fiscal deficit under control.

Moreover, the stability indicators are mostly in good shape, which reduces the risk that the recovery will be interrupted by externally induced stresses. The current account deficit had fallen to multi-year lows of around 0.8% of GDP in the last quarter of 2016. More encouragingly, three developments have boosted long-term fiscal stability. One is the tax amnesty, which turned out to be more successful than anyone had anticipated. Another is the government’s commitment to cut spending whenever realised revenues underwhelmed . As a result of budget cuts, the fiscal deficit was 2.5% of GDP in 2016, down from 2.6% in 2015. Finally, Indonesia is now reaping the benefits of Jokowi’s courageous decision to scrap most energy subsidies.

So, the economy should perform well in the next one to two years. The remaining question is over the longer term, which we discuss below.

Can Indonesia accelerate beyond this cyclical recovery?
Indonesia’s abundant natural resources as well as its favourable demographic dividend should have produced higher growth than it has actually enjoyed. We believe that, without too much effort, the Indonesian economy is capable of growing 6% to 7% — and if reforms can be fast-tracked to resolve issues of logistics and infrastructure, Indonesia could be on track to achieve even 8% growth. Yet, the government’s 5.1% growth forecast for 2017 suggests that there are inherent weaknesses in the local economy that are weighing down on growth.

If one looks closely at the patterns in Indonesia’s economic performance over the last 50 years, it is clear that three main factors account for this performance.

  • First, the economic growth has been too often sidetracked by external or financial shocks;
  • Second, the manufacturing sector has failed to provide the dynamic stimulus enjoyed by the more successful economies; and
  • Third, there have been too many lost opportunities to create highgrowth poles in the economy in areas such as tourism and oil and gas.
What is encouraging is that there are signs of improvement in some of these areas.

Increasing resilience — better prospects for sustained growth
Where the first issue, of frequent interruptions to growth due to shocks, is concerned, there are signs that Indonesia is becoming more resilient to external developments as seen in recent episodes of global stresses such as the taper tantrums of mid-2013 and the financial market turbulence from August 2015 through March 2016. In all these, the currency held up remarkably well compared with its peers while capital outflows and the knock-on effects on the local banking sector were contained. The improving strength of the domestic financial sector and the rising credibility of the central bank have helped. While Indonesia is not out of the woods, its economic growth is not going to be thrown offtrack as before.

More needs to be done to boost manufacturing
Manufacturing’s share of the economy grew from 8.4% of GDP in 1961 to a peak of 28.1% in 2006 but, since then, its share has declined to just 22.2% in a process that some have dubbed “premature de-industrialisation”. In particular, export-oriented manufacturing — which is what transformed China’s economy so dramatically and is now doing the same for Vietnam — has struggled to make headway in the past 20 years since the financial crisis of 1997. Partly as a result, low-value manufacturing remains dominant in Indonesia, account ing for 63% of total manufacturing output in 2015. Indonesia has also failed to functionally integrate into the nascent Chinese manufacturing value chains to the same degree as economies such as Thailand and Vietnam. Indonesia, therefore, has not been able to capture the significant value (in terms of technology transfers, income and so on).

Is enough being done to address this? The Jokowi administration is rigorously implementing a series of economic policy packages to make the investment environment more appealing, which could then bring in foreign investors to expand export-oriented manufacturing. As we argued in an earlier piece, these reforms are cumulatively powerful and are likely to help improve Indonesia’s competitiveness over time.

Lost opportunities are being tackled
Tourism can play an important role in economic development, as it faci li tates infrastructure development, growth of domestic industries, foreign direct investment, and the transfer of technology and information while creating employment opportunities. Our findings indicate that tourism has been a driver of growth in Indonesia, but nothing on the scale enjoyed by Malaysia or Singapore. In 1995, the shares of world tourism receipts going to Indonesia, Malaysia and Singa pore were relatively similar. Malaysia has since consistently improved its share of world tourism receipts; Singapore's performance has also climbed since reaching a trough in 2003. However, Indonesia has experienced a gradual but consistent decline in its share of world tourism receipts from 2002 onwards. Fortunately, the Jokowi administration is energetically addressing constraints on the sector — it has aggressively expanded visa-free travel and is allowing more airlines access to more locations within Indonesia. These efforts should help boost the sector.

Another area of lost opportunity has been the oil and gas sector. Despite its significant recoverable oil and gas assets, oil production has been falling since around 1997 while consumption has steadily risen through time, converting Indonesia into a net importer. The lack of a clear and supportive regulatory system and legal framework has worked against Indonesia. Here, too, the Jokowi government is making notable changes to ease regulations — scrapping contradictory laws and reducing foreign ownership limits.

The bottom line
There is no doubt that Indonesia faces challenges in both politics and the economy. Still, we are encouraged by policy changes in recent years and believe that, with time, it should be able to enjoy an acceleration to around 7% growth.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

This article first appeared in Issue 778 (May 8) of The Edge Singapore