Singapore (Apr 16): The Indonesian economy is in decent shape and likely to do better. Economic growth is picking up speed, inflation is low, the external position is holding up, infrastructure spending is rising and foreign investors are increasingly warming to its massive consumer market, low costs and political stability under a reformist president. Given the large domestic market, the country is less vulnerable to the spectre of protectionism, which is currently haunting Indonesia’s more trade-dependent neighbours.

Yet, despite all the good things happening, there is a lingering doubt. The question is, can the recovery go beyond a commodity-price-driven cyclical uptick to achieve growth rates similar to that of China, India or the Philippines?

Cyclical trends: Firming growth and good readings on economic stability

Economic growth in 2018 should be somewhat better than the 5.1% in 2017, at around 5.3% to 5.5%, going by The Organisation of Economic Co-operation and Development’s lead indicator for Indonesia as well as other forward-looking indicators. Rising capital goods imports suggest that investment is strengthening and export growth has been robust as well. Many of the headwinds that Indonesia had encountered since 2014 have now abated. President Joko Widodo’s (Jokowi) groundbreaking subsidy rationalisation in early 2015 hurt consumer confidence for some time, but that has now been absorbed. The worst impact of the collapse in commodity prices since late 2015 has also run its course as have the lending restrictions imposed to restrain excessive build-up of debt. In recent weeks, there have been signs that credit demand is finally recovering after a long period of virtual stagnation.

There are some concerns that monetary tightening by the US Federal Reserve and other major central banks will cause ructions in emerging markets such as Indonesia. Indeed, Indonesia’s unusually high foreign ownership of financial assets (40% of Indonesian government bonds are held by foreign entities) makes it vulnerable to any selloff, with sharp asset price corrections and downward pressure on the rupiah likely. However, the central bank is prepared for this and its large hoard of foreign exchange reserves will help it contain the risk to the local currency.

Indeed, we would say that Indonesia’s resilience to such externally induced shocks has grown over time because financial markets have more confidence in Indonesian monetary and fiscal policy now. Effective monetary policy has brought inflation rates down sharply — the headline inflation rate averaged around 3.3% from 2015 to 2017, while core inflation is below 3%. Never before in Indonesian history has inflation remained so low for an extended period of time.

More importantly, the differential in inflation between Indonesia and its trading partners has also fallen to a historic low: Instead of Indonesian costs rising much faster than other countries as in the past, its inflation is converging with others’ inflation. This is game-changing — if Indonesia’s costs are rising in tandem with those of its trading partners, then the rupiah would be at less risk since Indonesia would not be losing cost competitiveness, requiring the rupiah to depreciate every now and then. Even better, if rupiah risk diminishes, then the risk premium built into Indonesian interest rates should come down. That will allow the cost of capital to fall and spur investment, boosting economic growth further.

Similarly, Indonesia’s fiscal managers have also gained more respect from financial markets. Finance Minister Sri Mulyani Indrawati is highly respected, having kept the fiscal deficit at less than 3% of GDP. Indonesia’s public sector debt-toGDP ratio is now just 29%, an outstandingly good level when compared with most developed economies, where the ratio hovers above 90%. Sri Mulyani has also improved fiscal operations so that planned disbursements actually happen, unlike before when much budgeted spending was not implemented.

The problem is with the structure of the economy

So, Indonesia is in a good place. But should it not be doing even better?

In the 10 years to 2017, Indonesia’s economy grew on average by 5.5% — a bit higher during the commodity price boom and a bit lower when commodity prices fell. Unlike India, which broke out of its low-growth trap more than a decade ago, and the Philippines which did so more recently, Indonesia struggles to sustain growth of more than 5.5%. This is not surprising since most economists place Indonesia’s sustainable growth rate at below 5.5%. That may seem decent enough, but our view is that Indonesia has to grow by at least 6% a year if it is to provide good jobs in the formal sector to the roughly 1.6 million new entrants to the workforce each year. And, if Indonesia is to deliver tangible wage increases to the poorer segments of society, it probably needs something closer to 7% a year.

Why Indonesia lags behind countries such as India, the Philippines and Vietnam in growth rates is a bit of a puzzle. After all, these other countries also face challenges similar to Indonesia’s such as poor infrastructure and corruption. There are no firm answers to this puzzle but it looks like the causes of underperformance are deeply rooted in the economic structure.

First, sustaining high growth requires governments to deliver “public goods and services”. These are things that only governments can provide effectively and where the private sector plays a small role. Economic growth needs good infrastructure that governments have to take the lead to provide. Similarly, only governments can take the lead in providing the regulation that markets need to function effectively, kick-starting R&D, extending high-quality public health programmes, and most of all, providing high-quality education ranging from universities, vocational training and adult education to primary and secondary schools. But to provide these public goods, governments need financial resources. Yet, Indonesia’s tax take of 9% of GDP is woefully lower than India’s. Indonesian law requires the government to keep the fiscal deficit at below 3% a year — so the finance ministry struggles to balance spending on social welfare programmes that improve the welfare of poor people right now versus the investment in infrastructure, skills and so on that will take decades to pay back.

Second, higher growth requires more capital and there are two big problems here:

• For reasons that are not clear, Indonesia’s capital productivity is quite low. So if, say, 6% growth is to be achieved, then an investment-to-GDP ratio of close to 37% to 38% of GDP is needed — well above current rates. The business ecosystem in Indonesia somehow does not encourage investment to reach such levels.

• Indonesia also needs to fund this investment. However, the savings rate is well short of 37% to 38% of GDP. What that means is that as soon as Indonesia tries to grow much faster than current rates, its current account deficit (which is the difference between the investment and savings rates) will surge well beyond the 3% of GDP that is considered safe. That would lead to a fall in confidence and a sharp correction of the rupiah.

Third, a short cut to high growth is to attract foreign investors who can provide the capital as well as bring in technology, management, distribution channels and branding power. This is most critical in the area of manufacturing for highly competitive export markets rather than the domestic market. Unfortunately, Indonesia’s labour laws scare away investors while frequent changes in policies raise uncertainty for investors.

Fourth, in some senses, Indonesia’s resource riches have been a curse. When drilling oil and gas or digging coal, copper and nickel from the ground provided high growth, there was a tendency for policymakers to neglect the hard policy choices that were needed to keep Indonesia competitive in export-oriented manufacturing or improve its business environment or productivity. The commodity boom from 2006 to 2014 produced “lazy” growth, which actually held back the real transformation of skills, corporate sector competitiveness and so on that are the hallmarks of true economic development.

Will Jokowi address these hard policy choices in his second term?

Much therefore depends on the political leadership and the policy decisions it will make. This is where Indonesia’s current president, Jokowi, comes in.

Jokowi is a rare phenomenon in politics. More than halfway into his first term, he is still seen as humble and incorruptible and his family has not made forays into politics and business, unlike other political families. Consequently, he is on track to be re-elected in April 2019 so long as there are no unpleasant surprises for him in the coming months. The question is whether he will bring in bolder and more wide-ranging reforms if he is re-elected.

Jokowi has been vigorous in attacking corruption and kick-starting infrastructure. It is fashionable in some circles to pooh-pooh Indonesia’s infrastructure push because there have been delays in some key iconic projects such as the Jakarta-Bandung high speed rail line, or some of the large power projects. But, there is little doubt that infrastructure spending has surged — public sector infrastructure spending has risen by an impressive one percentage point in its share of GDP in the past 1½ years. A plethora of less publicised transportation and power projects is underway and more projects are being implemented. Jokowi has also energetically pushed for deregulation and cutting red tape, one reason why Indonesia’s place on the World Bank’s ease of doing business report has surged dramatically since he became president.

However, Jokowi has not tackled the reform of labour laws, which is politically much more difficult to do. While his tax amnesty was a good initiative, he has not really brought in thoroughgoing tax reforms that could significantly raise tax revenues as a share of GDP. While the improvements in the ease of doing business are impressive, they have not gone far enough to make an impact on foreign investors who these days have a lot of choice in where to go.

Conclusion: Fair chance of bolder reforms after 2019

Privately, the president has indicated to his colleagues that he will address these issues once he has secured re-election in 2019. We believe that he means it. Jokowi is unlike previous presidents who led political parties and wanted to preserve their popularity so that their children could enter politics on their coat tails. He has a genuine passion to put Indonesia on a much better trajectory by the time he leaves. The bet we would make is that he will be re-elected and will then introduce at least some of the tough reform s needed to produce a resurgence in Indonesian economic growth.

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

Indonesia regaining momentum, but can it achieve its true potential?

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