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The government has to adjust policies given the spillover effects of weak global economic recovery, slowing economic growth, declining exports and volatile capital flows.
The International Monetary Fund’s (IMF) World Economic Outlook Update of July 2012 predicts that downside risks related to a weak global economic outlook continue to loom large because of political uncertainties in advanced economies.
Implementation of the recent agreements to solve the banking and fiscal crises in the eurozone requires banking and fiscal unity. In addition, the peripheral countries need to adopt wide-ranging structural reforms to raise the productivity and competitiveness of their economies.
Political gridlock in the US and Japan deters the needed fiscal expansion to push economic growth. Like in Indonesia, growth momentum has slowed in leading emerging economies due to a combination of external environment and domestic capacity constraints.
The slowdown of the global economy will negatively affect Indonesia’s economy through the balance of payments (BOP), government budget and the banking system.
Exports will decline as well as government revenues, which are too dependent on the tax revenues from raw materials, mining and plantations. Short-term capital flows have begun to reverse, flowing back to their home countries or to safe-haven bonds (Germany, Japan, the US and Switzerland).
Non-performing loans in the banking system are on the rise with defaults on loans in the mining and commercial agriculture sectors. The impact on the BOP has already been felt in terms of growing deficits in the balance of trade, the current account and reversing capital flows.
Both the volumes and prices of raw materials exported from Indonesia have declined sharply because of slowing global demand for manufactured products from Japan, Korea, China and India, the main destinations for Indonesia’s exports of raw materials and energy.
During the past 10 years, Indonesia’s exports have mainly been raw materials from the mining and agriculture sectors. The more prosperous portions of the population in those countries demand higher quality foods, including ocean products and cooking oil made from palm oil from Indonesia.
Those countries also need coal, oil and gas and other sources of energy to generate electricity for their manufacturing, agricultural and household needs.
On the other hand, our imports of consumption goods, raw materials and capital goods continue to rise. These imports include rice, wheat and soy beans, flowers and fruits, motorcycles and automobiles and refined petroleum products.
The protracted drought in the US and floods in other agriculturally productive countries have raised the prices of imported agriculture products. The current account of the BOP includes royalties to foreign brands: McDonalds, Starbucks, KFC, Carrefour, Circle K, foreign movies and songs.
This greater dependency on imports is partly because of inconsistencies in government policies. Backed by the boom in raw materials and surges in short-term capital inflows, Bank Indonesia allowed the rupiah to appreciate. Such a policy reduces price of imports and subsequently reduces the inflation rate and improves our image and rating in international financial markets.
On the other hand, the strong external value of the rupiah is bad for growth and job creation as it means domestic producers cannot compete with imports.
The prices of imported goods from China are particularly cheaper because of the China-ASEAN free trade agreement (CAFTA) that reduces tariff rates and eliminates non-tariff barriers. While the prices of imports decline, there are no government programs to raise technical productivity and competitiveness of local producers.
The global economic recession will not only reduce foreign demand for unskilled workers from Indonesia, but it will also reduce workers’ remittances. Some of them are likely to come home and subsequently increase the unemployment rate.
A combination of slowdowns in both the volume and price of raw materials and the financial crises in advanced countries will reduce long-term and short-term capital inflows to Indonesia.
During the past 10 years, foreign investors were mainly invested in palm oil plantations, coal mining and the takeover of Indonesian banks. Although SBI, SUN and securities issued by national companies offer higher returns than securities in advanced countries, investors are worried about the ability of the issuers to service their debts.
Government revenues from royalties and income taxes from mining and plantation are expected to drop. The low tax ratio (14 percent of GDP) indicates that after 67 years of independence, the capacity of the government to collect taxes remains very low.
The lower export volumes and prices of raw materials are also expected to increase the number of non-performing loans (NPL) at the banks exposed to mining and plantation businesses.
To maintain growth momentum, the decline in exports should be compensated for with the raise in domestic-oriented aggregate demand. This includes government expenditures, investment and private consumption expenditures.
Aside from the size, the structure of the expenditure is equally important in strengthening the domestic economy and minimizing import leakages.
Expansion in domestic expenditures, in the short-run, should be structured to have the highest multiplier effect to expand both the economy and create employment. In the medium and long term, it should increase both the efficiency and productive capacity of the economy.
The space for fiscal expansion is wide open at present as the government’s annual budget deficit (1-2 percent per annum) is below the limit of 3 percent.
Borrowing is the most feasible at present because our tax administration is so poor and cannot generate revenue to finance the needed government expenditures.
To benefit from low interest rates on the international market, the government can borrow by issuing both local currency bonds and foreign currency denominated bonds. At present, the debt level of Indonesia is 27 percent of GDP, lower than the maximum 60 percent.
Expansion of government expenditures should be focused on infrastructure and education to relax the present productive capacity constraints on our economy.
Without adequate infrastructure and skilled workers, Indonesia cannot process its raw materials into higher value-added products. In addition, Indonesia cannot participate in the process of global production sharing that has flourished in the region, from China to India.
At it breaks up the production process into geographically separated stages, global production sharing opens up opportunities for countries to specialize in different stages of the production process, depending on their relative cost advantage and other economic fundamentals.
As a result, the trade in parts and components and final assembly within a production network in the region has grown faster than total trade in manufacturing.
To be able to increase portion of the budget devoted to development requires a reduction of consumption expenditures, particularly the subsidies for petroleum products and electricity. The subsidies are regressive because the beneficiaries are mainly the rich who can afford to have air conditioning, electric appliances and big cars.
To benefit from the high price disparity between the international market price and the subsidized price in Indonesia, a part of the petroleum products is smuggled to neighboring countries.
The strategy to eradicate poverty should be changed from rice distribution and cash transfers for the poor and to creating jobs with a respectable income. During the New Order, the employment rates and income of the poor increased, among other things, by increasing production through Bimas and PIR local economy empowerment programs and labor intensive industrialization.
Aside from addressing infrastructure shortages, upgrading the quality of the workforce and arriving at a realistic exchange rate, the fiscal stimulus and monetary expansion can only create employment and raising growth if there are improvements in the business climate and rule of law designed to make our markets more effective and efficient with lower transaction costs.
In addition, labor laws need to be revised to allow for greater absorption of our surplus labor, business permits need to be streamlined and land use has to be revised to allow more economical use.
The writer is a professor of Economics at the University of Indonesia.