Indonesia: Some promising signs Asia Pacific Economic Outlook, January 2015

The new president’s subsidy cuts signal his intent to address structural flaws in the economy. Other proposed reforms could draw interest from global businesses and help Indonesia become more competitive.

Indonesia

Indonesia’s new president Joko Widodo—or Jokowi, as he is popularly known—has started his term on a positive note. On November 17, he cut subsidies on gasoline and diesel by 31 percent and 36 percent, respectively. The cut in subsidies was a bold step by the new president and signals his intent to remove structural flaws in the economy. The move will also reassure investors. Some have been wary of the government’s ability to enact tough reforms due to the ruling coalition’s lack of a majority in the legislature.

A bold move

Indonesia’s generous fuel subsidy regime has been one of its key drawbacks in recent times. Prior to the recent cuts (and post the cuts in 2013), fuel subsidies amounted to about 13 percent of budgeted spending for 2015, thereby stifling funds for infrastructure, skills, and health care. Without improvements in these areas, Indonesia will find it difficult to generate enough jobs for its large, young, and growing population. Currently, the country ranks 114 out of 189 countries in the World Bank’s ranking of ease of doing business.1 A competitiveness ranking by the World Economic Forum put Indonesia at 56th place in infrastructure and 61st in higher education and training out of 144 countries.2

Popular protests to the subsidy cuts have been muted so far. Markets, on the other hand, have cheered the cuts.

Jokowi appears eager to change this. During his campaign, he was forthright about his intention to spruce up public finances by cutting wasteful subsidies, widening the tax base, and spending more efficiently. According to the coordinating minister for the economy, the fuel subsidy cuts will save the government about 120 trillion Indonesian rupiah (about $9.6 billion).3 The government has already announced its intention to channel these savings into irrigation, roads, and health care. Also, to help poor families cope with the immediate rise in fuel prices, the government has earmarked about 6 trillion rupiah for social assistance this year. Popular protests to the subsidy cuts have been muted so far. Markets, on the other hand, have cheered the cuts; the benchmark stock exchange went up 1 percent the day after the announcement, while the rupiah gained 0.5 percent.

The new administration is also trying to make top civil service appointments more transparent, cut administrative costs, and revamp operations in key ministries such as energy. These are welcome actions, given that an overbearing bureaucracy can stifle investments of the type Jokowi asked for during his address to business leaders in the Asia-Pacific Economic Cooperation summit in China.4 Reforms will help Indonesia improve its competitiveness and benefit from greater economic integration within the Association of South East Asian Nations in the future. They will also help draw interest from global businesses who are concerned about the rising cost of production in China.

The cut in subsidies will also likely bring down Indonesia’s oil imports by reducing demand distortions in the economy. In 2013, the country’s net oil and gas imports amounted to $12.6 billion, a key contributor to the current account deficit of $29.1 billion. As oil imports come down, the resulting easing of the current account deficit will in turn aid the rupiah. It will also please rating agencies, which have been critical of Indonesia’s high deficit at a time when capital flows have been vulnerable due to the winding down of quantitative easing in the United States and the likely rise in interest rates there.

Central bank gets into the act

The hike in fuel subsidies will impact inflation in the short term. Indeed, inflation jumped to 6.2 percent in November from 4.8 percent in October. The spike comes after Bank Indonesia’s (BI’s) success in forcing inflation down to its target range of 3.5–5.5 percent in 2014 post similar fuel price hikes in 2013. In July, inflation had gone down to 4.5 percent and had stayed within the target range until October. Encouragingly, just a day after the cuts, BI raised its key policy rate by 25 basis points to 7.75 percent in an emergency session. Clearly, the bank is keen to keep inflation expectations in check, reflected in the fact that it has kept its 2015 inflation target unchanged at 3.0–5.0 percent. It could cut the rate by another 25–50 basis points in 2015 if the rupiah weakens more than expected due to any monetary tightening in the United States. Weak global commodity prices and a high base from November 2015 will, however, keep downward pressure on prices and help BI. In the medium term, if savings from subsidy cuts are invested in infrastructure, some supply-side bottlenecks will ease, thereby aiding consumer prices.

Growth momentum slows

BI’s rate hike was despite a slowdown in economic momentum, with GDP growing 5.0 percent year over year in Q3 2014, its slowest pace in five years. Investments in particular lost steam and grew a mere 4.0 percent in Q3, down from 5.2 percent in Q2 and the lowest rate since Q3 2009. Businesses are likely to hold on for some more time as they seek policy clarity from a new government. The recent fuel price hikes will also weigh on investment in the near term as the cost of production rises. In fact, this was the primary reason behind a decline in the manufacturing purchasing managers’ index in November.

Indonesian businesses will also face pressure from slowing growth in key export destinations, especially China, and the mineral ore export ban since January 2014. Exports fell 0.7 percent in Q3, the third straight quarter of contraction. Household spending, however, is expected to remain strong despite rising inflation in the near term. Evidence from 2013–14 suggests that Indonesian consumers have bounced back from previous fuel price hikes. Private consumption expanded 5.4 percent in Q3, marginally down from 5.6 percent in Q2, and is likely to grow at an annual rate of 5.0–5.5 percent next year.

A small step on a long road

Jokowi will find it tougher to implement other structural reforms as he encounters entrenched interests and opposition in the legislature. In fact, the recent fuel subsidy cut is only the first step in overhauling public finances. Even now, fuel prices in the country are 10–15 percent lower than international prices. Moreover, low global prices of oil have reduced the margin between domestic and global fuel prices. This dynamic will change when oil prices rise again. Consequently, the government’s best medium- to long-term bet would be to deregulate fuel prices completely. Politically this will be a difficult pill to swallow, but investors will hope that the government holds its nerve. After all, the country is at the crossroads of choosing its next growth path—and the road to higher rewards is not easy.