Indonesia is entering 2012 confidently, with strong growth momentum and very solid macroeconomic fundamentals. But dark clouds are gathering on the horizon. The world economy has entered a dangerous and uncertain phase, as the IMF managing director Christine Lagarde has stressed. Growth in the advanced economies over the next few years is likely to be sluggish at best and financial markets will probably remain extremely volatile.
In this difficult environment, the government and Bank Indonesia (BI) will need to be vigilant and proactive to safeguard financial stability and, if downside risks to global growth materialize, to cushion the economy through countercyclical macroeconomic policy. A positive for Indonesia is that growth in emerging Asia, though slowing, is expected to remain robust at 7.7 percent in 2012, with China experiencing a soft landing.
Indonesia’s economic outlook strong
The IMF projects Indonesia to grow by 6.3 percent in 2012, following an estimated 6.4 percent in 2011. Private consumption will continue to be an important growth driver. Confidence is at two year highs, unaffected by the recent market volatility. Retail spending remains strong, except for automotive sales, which have been impacted by parts shortages caused by the Thailand floods, but there should be some catch up in 2012.
We expect growth to continue becoming more balanced, driven less by private consumption. The pipeline of new investment projects is bulging and the IMF projects investment spending to rise over 10 percent in real terms in 2012. Investment in machinery is growing especially rapidly, as many companies seek to expand capacity to take advantage of Indonesia’s large and growing domestic market. FDI has risen over 60 percent in the first three quarters of 2011. Inflows were diversified across many sectors, including manufacturing. Few multinational companies can today afford to ignore Indonesia.
Even spending on infrastructure, long stagnant, seems to be taking off. Government capital spending increased 32 percent in January-October, though execution is still less than budgeted. A number of large projects are finally being implemented, including the first major public private partnership (the central Java power plant) and roads and airports in Jakarta and Bali. But these are first, baby steps compared with needs and much greater challenges that lie ahead in the implementation of the US$ 480 billion Master Plan (MP3EI).
Risks remain
But what if the downward risks to the global economy materialize and growth falls below the 4 percent in 2012 currently projected by the IMF. What if investors and banks retrench and flee from emerging markets into safe havens such as US and German government paper? How will Indonesia be affected?
The good news is that Indonesia is somewhat less vulnerable than most other countries. Growth is less dependent on external demand than in other Asian countries, including China. In addition, Indonesia is not very integrated in global financial markets. Banks fund themselves mainly from deposits with little reliance on foreign loans or inter-bank markets.
But the budget is dependent on foreign financing. Although the deficit and public debt are low by international standards, the shallow Indonesian financial system cannot generate sufficient financing and the government has to borrow offshore. As a result, foreign investors hold 35 percent of Indonesia’s local currency foreign debt. Demand for these bonds has tended to be volatile and highly dependent on global risk sentiment, resulting in interest and exchange rate volatility and complicating monetary policy.
Moderately slower global growth compared with the IMF baseline of 4 percent in 2012 should not have too much impact on Indonesia. However, even less favorable scenarios cannot be excluded. A sharper slowdown, such as in 2009, coupled a harder landing in China and a moderate credit crunch would lower growth to 5-5.5 percent, according to World Bank estimates.
Even worse, a protracted global recession with persistent flight to safety by international investors could result in a longer period of slower growth and increase financial stability risks. Regarding the latter, the biggest risk is for outflows from the bond or equity markets to destabilize the foreign exchange market. A shift out of local currency by residents could result in rising inflationary expectations, an erosion of the deposit base, and even liquidity problems for some banks.
Preparing for the worse
The government and BI are concerned about global growth prospects and financial stability. They are monitoring the situation closely and are preparing in case the downward risks materialize. What can they do to maintain financial stability and support growth?
First, maintaining strong macroeconomic fundamentals is essential — any policy reversal could exacerbate capital outflows. Thus, the government continues to pursue a cautious fiscal policy and further reduce the already low public debt ratio. The consumer price index has been edging down recently, but if inflation prospects deteriorate, BI should be prepared to tighten its policy stance.
Second, continued exchange rate flexibility will be important in managing volatile flows. In addition, the government and BI need to let bond yields respond to market conditions if issuance targets are to be met.
Third, the government is working to ensure legislative approval of the Financial Safety Net Law (FSSN), which is critical to provide a legal basis exists for decisions that would need to be taken if a crisis were to occur. Otherwise, a problem in a small bank could spread and undermine the system as a whole.
Fourth, continuation of the current reform initiatives, especially infrastructure development, will further encourage domestic and foreign investment and provide the best possible cushion against a slowdown in external demand.
The government is right to prepare contingency fiscal measures. The introduction of measures to assist those losing jobs in export industries, or accelerating the conditional cash transfer program, would not only compensate for the impact of a growth slowdown but would also make growth more inclusive.
In conclusion, Indonesia is in a better condition to face global turmoil than most countries. Nevertheless, a severe and/or protracted global recession would still put financial stability at risk and provide a major setback to the government’s plans to reduce poverty and unemployment. Thus, it is essential to prepare for the worse. With its solid macroeconomic fundamentals, Indonesia has capacity to minimize the negative impact of a global slowdown, assuming timely and appropriate responses from the government and BI.
The writer is senior resident representative, International Monetary Fund, Jakarta
