Covid-19 shock hits vulnerable Indonesian economy

In South East Asia, Indonesia was one of the economies most affected by the covid-19 shock. This is particularly due to its high dependence on foreign capital inflows and the importance of its commodity sector. As often during a stress period characterised by high capital volatility, Indonesia’s twin deficit (fiscal and current account deficit) made the country a top Asian victim. Following the covid-19 outbreak in China, Indonesia suffered large capital outflows and the largest currency depreciation in South East Asia (more than 17% decline between January and early April). The drop in commodity prices – particularly significant for hydrocarbons – has hit Indonesia hard as commodities account for roughly half of its exports of goods (palm oil, oil & gas, coal, etc.). Also imports from China, its first export market, tumbled for a few months. On top of that, the rising tourism sector has experienced a record crisis. Therefore, the multiple external shocks (combining a volume and price impact) have been severe for Indonesia’s export sector.

The main consequence is the sharp decrease in current account receipts, which will more than offset the decline in imports and could deepen the current account deficit from 2.7% to 3.2% of GDP in 2020. Plummeted foreign capital inflows (FDI and portfolio) have further widened the balance of payments deficit and thus increased external financing needs. Hence, Indonesia tapped financial markets and successfully issued sovereign ‘pandemic bonds’ of very long maturities (including Asia’s longest-ever, 50-year USD bond). As part of its emergency quantitative easing policy to stem capital outflows and support the economic relief measures, the Bank of Indonesia has been allowed to buy government bonds in the primary market as a last resort. Besides, the central bank’s market interventions contributed to reducing depreciation pressures on the rupiah, but in March (see graph) they also brought the foreign exchange reserves down to their lowest level in 18 months. Decreased external liquidity, including a higher short-term debt, led Credendo to downgrade its short-term political risk rating to 2/7 (from 3/7) in May. Looking ahead, the central bank’s agreement of a substantial currency swap with the US Fed (worth USD 60 billion, i.e. nearly 50% of its foreign exchange reserves) could help easing liquidity pressures.

Commercial risk rating downgraded in April

As everywhere in the world, domestic activity has slowed down as a result of restrictive measures to contain the covid-19 spread. Even though the government chose not to impose a nationwide lockdown, several provinces (and the capital Jakarta) enforced wide social restrictions including the closure of non-essential businesses, factories and shops, and temporary travel bans. By mid-June, more than 38,000 people infected and 2,100 deaths had been officially reported, and the number of infection cases was still rising while containment measures were being eased. In addition to a loosened monetary policy (including two interest rate cuts), the government’s fiscal response to the health and socioeconomic crisis has translated into a stimulus package worth 4.2% of GDP. Indonesia could near a recession this year before strongly rebounding in 2021. Nevertheless, the forecast will depend on the severity and duration (extra waves of contaminations) of the pandemic, and on how the situation evolves domestically and in Asia in general. Meanwhile, in this crisis context, Credendo downgraded Indonesia’s commercial risk from B to C in April when the rupiah was fluctuating at a historical low against the US dollar.

Public finances and external debt deteriorated

Besides the negative impact on the balance of payments, Indonesia’s macroeconomic fundamentals see deterioration at the level of public finances and external debt. After years of slight increases, public debt (around 30% of GDP in 2019) will increase significantly this year as a result of the wide fiscal deficit of 6.2% of GDP the government is expecting in 2020, i.e. well above the legal 3% cap that has been suspended until 2023. Weaker economic activity and lower commodity revenues will curtail already low government revenues (below 15% of GDP) and therefore affect future repayment of public debt and government spending. Given the current crisis situation, President Widodo decided to postpone the construction of the new capital city, his flagship project, from this year to 2022 at the earliest, pragmatically giving priority to increased social and health spending, tax relief and capital injections into the financially weakest SOEs.

The covid-19 crisis has pushed up external debt stock and service ratios, in absolute and relative terms. The main issue lies in volatile and decreased current account revenues, which deteriorate Indonesia’s financial profile, as the country will need to borrow more in foreign currency to repay its external debt. Indonesia’s market access has become more costly as it goes together with rising borrowing costs. 

Positive MLT economic prospect beyond the covid-19 shock

Although Indonesia is one of the South East Asian countries that are most vulnerable to the covid-19 economic shock, the dominant yet cautious scenario is to see Indonesia overcome it and strongly rebound thereafter. It seems that financial markets could somewhat share this optimism when one looks at oversubscribed sovereign bond purchases and gradually eased currency pressures since early April, thereby allowing the rupiah to almost fully reverse its annual decline. Indeed, the MLT economic perspectives remain positive for Indonesia’s resilient and rather diversified economy. In the future and when the covid-19 impact wanes, it is likely for the economy to benefit from the rising middle-class’ domestic demand – even if it’ll probably rise slowly in the short term –, the gradual Chinese recovery (in demand of goods and partially in tourism flows) and increasing FDI notably related to BRI projects and resulting from trade diversion. In the medium term, reviving infrastructure investment projects are likely to boost economic growth again. Effective policymaking and political stability are also valuable benefits in times of crisis. Therefore, despite the 2020 pandemic shock and deteriorated financial risks, Credendo is keeping Indonesia’s MLT political risk in category 3/7.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com