Indonesia’s economy has been slowing down since 2012, primarily owing to several exogenous shocks. Lower commodity prices and the Chinese slowdown (China is Indonesia’s main trade partner) are the main factors, together with enhanced investor defiance vis-à-vis emerging markets. Hence, being an important commodity exporter, Indonesia has seen its external liquidity deteriorate, which led Credendo Group to downgrade the ST political risk rating last July to 3/7. This year, the most immediate risks will lie in the impact from capital outflows – fuelled by the US Fed’s rate hike(s) – on the balance of payments and from a much depreciated rupiah on external debt repayments as local enterprises have significantly increased borrowing in USD in recent years.
Although Indonesia is showing macroeconomic resilience thanks to robust private demand, the external outlook is more uncertain with the aforementioned negative developments likely to endure. Therefore, restoring Indonesia’s MLT growth in line with past higher levels might partly depend on policy stimuli and the implementation of the bold government infrastructure plan. However, structural delays, difficult land acquisition and government nationalist policies could hinder the necessary FDI and thus government goals. President Widodo’s reformist stance is further complicated by a minority position in Parliament, opposition within his own party and resistance to reforms from the elite. The domestic climate is also affected by chronic religious and ethnic tensions with a rising but moderate terrorist threat related to the influence of the Islamic State (IS) among a few local Islamist groups. All in all, in spite of the political risks mentioned, cyclically and structurally weaker economic performances and external vulnerabilities, Indonesia’s solid macroeconomic fundamentals, including a still sustainable external debt, low public debt and deficit, and a narrowed current account deficit, should help maintain Indonesia’s MLT political risk rating of 3/7.
- Entrenched democracy
- Strong domestic demand, emerging middle class
- Macroeconomic stability
- Low public and external debt
- Recurrent communal tensions
- Infrastructure gap
- Difficult business environment
- High corporate debt in USD
Main export products
- Coal (9.8% of total current account earnings), oil & gas (8.4%), palm oil (8.2%), textiles (6.2%), tourism (4.8%), electrical appliances (4.8%), base metal products (4.4%)
- Lower middle
Per capita income
- USD 3,650
- 252.8 m
Presidential and legislative elections (5-year cycle)
- Next presidential election: July 2019
- Next legislative election: April 2019
Head of State and government
- Mr Joko Widodo
A tough political mandate for President Widodo
The enthusiasm accompanying President Joko Widodo’s arrival in power did not last long. His election in July 2014 was another historic event in Indonesia’s political history. For the first time, a new president had democratically succeeded an elected president after a peaceful presidential vote, albeit one contested by a main opponent, former general Prabowo. After a double 5-year mandate, Susilo Bambang Yudhoyono ceded power to then opposition candidate Widodo, former governor of the capital, Jakarta. At first, the consolidation of democracy and Widodo’s reform-minded stance were welcomed by investors, especially given Yudhoyono’s poor second presidential term and the country’s multiple challenges. Moreover, Widodo was also appreciated as being the first president not to come from the political elite and free of vested interests, as reflected in the government composition with a few entrepreneurs and technocrats.
However, it soon became apparent that those advantages were becoming weaknesses as he was quickly embroiled in a political crisis triggered by the contentious appointment of a new police chief. His anti-graft reputation was tarnished after he initially opted for an allegedly corrupt general, whereas his tricky political position was highlighted by opposition within his own party, the Democratic Party of Struggle (PDI-P), notably from the powerful party leader, former president Megawati Sukarnoputri. Widodo’s weakened position, within his party but also vis-à-vis his supporters, impedes government action. This is particularly true as the absence of a majority in Parliament after the PDI-P’s moderate victory in the legislative elections in April 2014 means that he relies on a large and volatile coalition to pass legislation where the PDI-P is in a vulnerable position and needs some support from the opposition.
Widodo’s room for manoeuvre and authority have been curtailed since the political crisis (see above) with an elite determined to hinder policy-making and his ambitious reform programme during his presidency. Still, those drawbacks are mitigated somewhat by the support for reform from many members of the main opposition party the Golkar party, notably concerning improving the business environment and expanding infrastructure and welfare. Many politicians indeed have close connections with the business world, which explains the existence of various factions within parties and their interests in boosting economic activity and projects. Therefore, Widodo is determined to use his power to move forward symbolic policies such as boosting investments, improving public governance and reducing poverty. This has been illustrated by two cabinet reshuffles, which accommodated a divided opposition and brought Widodo’s close allies into government, with the aim of consolidating his power.
After a difficult first year in office, President Widodo might enjoy more political stability, but at a cost: scaling down the ambitions of his reformist agenda, pursuing a nationalist policy to please the Golkar party, notably with more protectionist measures in the resources sector, and tightening ties with the army to strengthen his power. Also, his anti-corruption programme, a top pledge during his presidential campaign, is likely to disappoint. Although the independence of the anti-corruption agency KPK has so far been preserved, the latter’s position has been weakened by the retaliatory actions of the police since the KPK voiced suspicions of police corruption. This shows how Widodo is torn between policy commitments and the need to satisfy the interests of various groups, especially the elite, and make concessions to coalition parties to pass laws. His ability to get the balance right between both sides will tell whether he can maintain political stability and make progress in meeting some of the expectations of his electorate during the rest of his mandate.
Terrorism risks resurface from IS spillover
Indonesia sporadically faces instability risks such as those related to West Papua’s longstanding push for independence and the increasing labour protests fuelled by poor working conditions. The most acute security risk is still to be found in sectarian violence in the world’s largest Muslim country. While attacks against minority communities (e.g. Christians) have been on the rise, today’s most serious threat comes from the radicalisation of local militant groups as a result of Islamic State’s call to jihad and for Indonesian fighters (an estimated total of roughly 500) to return from Syria and Iraq. Hence the terrorist risk, which had abated in the past decade thanks to the effective action of the security forces, is back on the agenda, as shown by January’s attacks in the centre of Jakarta. Risks of further terrorist attacks by IS supporters against Western and official targets will be high in the coming year with the support of several Indonesian Islamist groups, albeit not all sharing IS’s ideology in this politically stable and traditionally moderate Muslim country.
Commodities and China soften Indonesia’s landing
The Indonesian economy has slowly lost momentum since 2012, largely as a result of adverse external developments. The euro crisis, a gloomier global economic context, the Chinese slowdown and above all the decline in commodity prices have all hit the country’s economic performance in recent years. GDP growth has been constantly falling since 2011 to reach a 6-year low of 4.7% last year. Indonesia is indeed a top commodity exporter, notably in coal (1st) and rubber (2nd), and a significant LNG and biofuel exporter. With a 50% share of commodities in its total exports, the end of the commodity super cycle, notably in energy and mining industries (where exports have been hit too by nationalist measures), is particularly harmful as it mainly drove Indonesia’s growth. Therefore, until prices rise again – the timing and magnitude are very uncertain, especially given the prospect of low global energy prices for a protracted period – a rebound in GDP growth away from sub-par levels could take some time and depend on structural reforms. More generally, Indonesia also suffers from a less upbeat investor attitude towards emerging markets.
Despite weakened economic data, Indonesia’s large economy is broad-based, well managed and remains resilient thanks to domestic demand and an expansive middle class. Household consumption, the other dominant growth driver, is robust and should be supported by much decreased inflation (from 8.4% in 2014 to 3.4% at the end of 2015) in spite of a 30% fuel price increase (see below, cut in subsidies) and higher import prices resulting from a depreciating rupiah.
The currency has been on a constant downward trajectory since the announced Fed tapering in spring 2013 which made Indonesia one of emerging Asia’s most affected countries. The rupiah then lost 40% against the USD by the end of 2015. The strong USD, the commodity price shock, a persisting large current account deficit, short-term foreign capital outflows and moderating growth also contributed to this negative trend.
A sustainable external position, not free of capital outflow pressure
Moderate trade performances do not affect Indonesia’s external accounts. In fact, weaker exports and more expensive imports are offset by lower domestic demand and especially hydrocarbon prices (although Indonesia rejoined OPEC in 2016, it is a net oil and gas importer1 due to steadily falling production as a result of a lack of investment in recent years and constantly increasing local consumption), thereby allowing the current account deficit to narrow to 2% of GDP in 2015 and stay at around 2.5% in the medium term. Nonetheless, the imported energy bill could deteriorate further due to fast rising energy consumption, which puts pressure on many stalled gas projects moving forward to exploit Indonesia’s still high gas potential.
The balance of payments fell into a small deficit last year but is still considered to be in safe waters in the medium term as a great share of the current account deficit is financed by FDI. Nevertheless, the spring 2013 experience highlights the likelihood of capital outflows and volatility with potentially further Fed rate hikes in the coming months (and years) and enduring low commodity prices, which could exacerbate the sharp slide of the rupiah, now close to its lowest point since the Asian crisis. However, such a shock is perceived to be manageable with a flexible rupiah as absorber and a credible government committed to maintaining macroeconomic stability.
1 Indonesia is a net energy exporter thanks to coal exports exceeding net oil and gas imports.
Business hindrances harm growth potential
Looking forward, while there is still uncertainty about future external developments and main trade partner China’s slowdown is set to continue, Indonesia’s MLT outlook is still bullish as economic growth is forecast to progressively rise again towards 6% in the long term thanks to an improving economic cycle and particularly to support from Widodo’s huge infrastructure development plan. The President aims to adjust the Indonesian economic structure by granting a higher share to investments and manufacturing production to benefit from regionally competitive labour costs and the demographic dividend. Although it requires tackling the enduring infrastructure deficit (in transport, communication and power generation) which explains why Indonesia lags behind its regional peers in attracting foreign manufacturing projects and investments, Widodo’s goal and its timely implementation face three main hurdles: heavy bureaucracy, complex land acquisition and a continued nationalist trend in the framework of the general 'local content' policy.
The first hurdle is reflected by sharp under-spending due to inefficient budget implementation in 2015 and the second should see new rules progressively being put into practice, whereas nationalist policies are characterised by restrictions on foreign ownership (e.g. in the mining industry), growing protectionism in natural resources (as witnessed by the 2014 ban on exports of unprocessed mineral ores) and future review of bilateral investment treaties. Nevertheless, the recent opening of many non-key sectors to FDI indicates that the protectionist trend could soften in a context of much lower commodity prices and force the government to adopt a more conciliatory policy towards investors, including to some extent in the extractive industry.
All those protectionist developments could harm productivity and highlight Jakarta’s intention to favour investments from local companies while prioritising FDI – particularly from China under concessional terms as the recent deal on high-speed railway underlines – in infrastructure sectors. Though FDI inflows have been experiencing annual double-digit growth since 2010, foreign investors remain wary of a difficult business environment despite the authorities’ pledge to improve it, thereby representing a risk to sustainable stronger growth.
Fiscal stimulus constrained by lower energy revenues
Indonesia has a relatively good track record in terms of public finances, leaving the fiscal policy in theory available to stimulate the economy while the Bank of Indonesia maintains high interest rates (7.25%) to shore up the rupiah. Once in office, Widodo seized the opportunity presented by tumbled oil prices to drastically reduce energy subsidies – from 3.2% to 1% of GDP in 2015 – to direct the money saved towards infrastructure expenditure and possibly social transfers to a huge poor population. However, the near halving of oil and gas revenues between 2014 and 2015 will bring the weak government revenue ratio further down (to 14.6% of GDP last year). Hence, it will constrain public spending and prevent a decrease in the budget deficit, which is to stabilise at 2.8% of GDP in the future, whereas public debt should slowly rise towards a still modest 30% of GDP by 2018.
Impact of a tumbled rupiah, the biggest short-term risk
In a context of moderating economic activity and given its negative net foreign asset position, the banking sector is vulnerable to capital outflows and a further depreciation of the rupiah hitting Indonesian corporate foreign currency-denominated debts, particularly in the resource sector. However, despite increasing vulnerabilities for small and medium-sized banks, risks from external shocks should be manageable as they are mitigated by a sound banking sector with adequate capital buffers and a low level of bad loans.
External debt ratios have strongly increased since 2012, from 100% of export receipts in 2011 to 168% in 2015, and from 26.6% to 36.6% of GDP during the same period. This is a direct consequence of slowing growth, contracting exports and a weakening rupiah. The increase essentially comes from the private sector as corporate foreign debt has been boosted by borrowing cost differentials. Therefore, with more than 50% of corporate debt denominated in USD (exacerbated by the small size of the local bond market), a continued drop in the rupiah and probably further Fed interest rate hikes are likely to make debt servicing more difficult for corporates, especially in the resource sector, which is also hit by deteriorating profitability.
Although the level of total corporate debt is still acceptable compared with that of Indonesia’s peers, i.e. below 35% of GDP, its fast evolution needs to be closely monitored and has led the central bank to significantly raise liquidity and hedge ratios (introduced in 2015) on borrowing companies with USD-denominated debts. At a country level, external debt remains sustainable and MLT debt dynamics are forecast to improve with a downward trend in private borrowing that should result from gradual global monetary tightening.
As for external liquidity, risks are limited with foreign exchange reserves allowing cover above 5.5 months of imports (i.e. in line with its post-2008 crisis average), over twice the debt service and 1.5 times the short-term debt. Nevertheless, in a slowing economic context, some deterioration is underway with the short-term debt-toexport receipt ratio on an upward turn (owing to corporates) from 23.5 to 35% between 2011 and mid-2015, an external debt service now around 25% of export receipts and volumes of foreign exchange reserves dropping in 2015 notably due to the central bank’s interventions to limit the rupiah’s decline.