Indonesia: Struggling to grow faster Asia Pacific Economic Outlook, Q3 2016

The 4.9 percent year-over-year growth during the first quarter falls short of President Widodo’s target of 7.0 percent. Investments are key to pushing GDP growth to targeted levels. But so far the pace of investments has been slow.

In 2014, President Widodo took office, and with it came hopes of a fresh beginning for Indonesia. The president’s target is to revive growth to 7.0 percent annually through infrastructure spending, foreign investments, and easier businesses conditions.1 The journey so far has been mixed. The government has boosted spending, but is facing declining revenues due to the lack of tax reforms. Without adequate infrastructure spending, the government has found it difficult to encourage foreign businesses to set up a manufacturing base and create jobs. Economic activity, as a result, has slowed. Effective reforms, however, are a long-drawn struggle and Indonesia will be better off sticking to that path.

Slowing household spending may seem at odds with labor market trends and rising consumer confidence.

GDP growth slows in Q1

The economy grew 4.9 percent year over year in Q1, down from a 5.0 percent rise in Q4 2015. Domestic demand weighed on GDP growth (figure 1) as government spending and investments slowed. Despite the government’s focus on fiscal stimulus, government consumption grew just 2.9 percent in Q1, down from 7.3 percent in Q4 2015. During that period, growth in gross fixed capital formation fell to 5.6 percent from 6.9 percent. To add to growth woes, private consumption did not pick up pace in Q1, growing at just about the same rate as in the previous quarter.

Indonesia_Figure 1. GDP growth slowed to 4.9 percent in Q1

Exports contracted for the sixth straight quarter in Q1. The weak rupiah has not aided competitiveness, with exports of non-hydrocarbon goods contracting 6.1 percent. Oil and gas exports, however, went up 4.8 percent. Slowing growth in key markets like China has dented Indonesia’s exports in recent times while low commodity prices have impacted export revenues. Imports also contracted in Q1, but less than in Q4 2015. As a result, the contribution of net exports to GDP growth in Q1 was marginally positive.

Households are not ramping up spending yet

Household spending has slowed down since Q3 2011. With inflation under control and Bank Indonesia (BI) cutting interest rates, spending was expected to strengthen in Q1. But, that did not happen. And latest indicators show that households are still being cautious. Real retail sales growth, for example, was lower in April than the average for Q1 (figure 2). Consumption loans by commercial and rural banks also slowed down in April (8.8 percent compared to 9.2 percent in Q1). And imports of consumer goods fell for the first time in four months in April.

Indonesia_Figure 2. Growth in import values (in US$) and real retail sales slowed in April

Slowing household spending may seem at odds with labor market trends and rising consumer confidence.2 Unemployment is low (5.5 percent in Q1) and the participation rate has edged up since 2015.3 Moreover, real income gains for consumers have increased due to lower inflation.4 So, why are consumers not spending more? First, slowing economic activity is likely weighing on consumers. Second, BI’s rate cuts are yet to impact consumption, given that the pass-through to consumers has been far from perfect.5

Investments remain sluggish

To push GDP growth to Widodo’s 7.0 percent target, investments are the key. But the pace of investments so far has been relatively slow. Spending on equipment fell by 6.8 percent year over year in Q1, not a healthy sign for a nation keen to shore up infrastructure and create a manufacturing hub (figure 3). Manufacturing growth, in fact, has been below 5 percent for the past two years. The government has also been trying to woo foreign direct investment (FDI). However, direct investments in Indonesia have fallen in the last three quarters (figure 4). And current data on capital goods imports suggest that there is no upsurge yet in Q2.6 Clearly, foreign companies are not yet flocking to Indonesia, given that the country has some distance to go in closing the gap with strong regional peers when it comes to ease of doing business.7

Indonesia_Figure 3. Investments in machinery and equipment contracted in Q1

Indonesia_Figure 4. Imports of capital goods and FDI have been trending down of late

Falling government revenues a worry

Realized tax revenues in 2015 amounted to just 83 percent of the government’s target (figure 5).8 This year is no better. In the first three months, revenues fell, and by March the impact was felt on the expenditure side. While the government can opt to borrow to fund infrastructure, it may be discouraged by relatively high yields and, hence, pressure on the fiscal deficit target—2.2 percent in the budget and 3.0 percent by law.

Indonesia_Figure 5. Government revenues fell in the first three months of the year

So far, there is not much headway in tax reforms. The tax amnesty bill, which the government hopes will raise revenues, is still stuck in parliament. The bill itself is not without its fair share of criticism.9The other worry will be rising global oil prices. If the government has to mirror global trends—fuel subsidies were cut in 2014–15—it will have to raise petroleum prices, a politically difficult decision.

These fears notwithstanding, the government is sticking to its infrastructure focus. It has budgeted an 8 percent rise in infrastructure spending in 2016. In Q1, electricity production went up by 8.6 percent, the highest in three years. Construction growth—a key indicator of infrastructure spending—has also been going up over the past year.10

Less room for further rate cuts this year

BI cut rates thrice this year by a total of 75 basis points, aided by slowing inflation (within BI’s target rate of 3–5 percent). However, it is not likely to go in for further cuts until the last quarter despite pressures from the government.11 It will likely gauge the lagged impact of rate cuts so far on the economy. Also, BI is likely to check how its new policy rate functions before further cuts. Effective August 19, BI will shift to the 7-day reverse repo rate as its policy rate instead of the current 12-month one. With this move, BI hopes to improve money market liquidity, ensure convergence between the policy rate and the overnight interbank rate, and develop a rate structure for 3-to-12-month securities.12 While the move to a new policy rate is not an easing—the new policy rate is lower than the old rate—it will help create a better policy transmission mechanism in future. That will certainly give a fillip to the economy in the medium term.