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ndonesia will welcome a new government in 2014. Greeting it will be an economy that, in past attempts to accelerate growth, has ended up overheating. Challenges to rebalance and adjust in 2014 are considerable, an unenviable but essential undertaking.

We see the 2014 Indonesian economic outlook as having many opportunities, provided the new administration continues to '€œembrace adjustment'€ and reform to improve investor sentiment. In this context, recent moves by the authorities are very encouraging, as they seem to suggest an acceptance of the notion that lower growth and a weaker rupiah are necessary in the short term for the external account imbalances to adjust.

Stepping into 2013, we wrote in our last Annual Outlook that it was unlikely to be a year of smooth sailing for Indonesia as wages and inflation were rising, external balances were worsening, currency weakness was likely to persist and a lackluster outlook for commodities was going to impact a key engine of growth.

We asserted that Indonesia needed strong countercyclical policies, reiterating our long-held but unpopular view that the economy was undergoing overheating.

Our predictions came true during the year, but more severely than we had anticipated. In addition to this dynamic, Indonesia became vulnerable to a major shift in global market sentiment around the US Federal Reserve'€™s taper-related deliberations, with the ensuing capital flow volatility hurting the exchange rate. Most strikingly, in the post non-taper September-November rally, Indonesia did not participate conspicuously, revealing the market'€™s lingering discomfort with its economic prospects.

We will therefore approach our outlook for 2014 under the theme '€œEmbracing Adjustment'€. The economy has succumbed to the myriad imbalances in 2013, but the adjustments have yet to fully play out. Policies and economic developments have considerable room to go before a bottom is reached and the economy is termed once again fundamentally sound.

The year of adjustment takes on even greater importance as Indonesia goes into elections during the second and third quarters, which would bring in a new president after a decade.

Slow growth ahead

Growth has slowed in recent quarters, currently running at about 5.5 percent. The slowdown has been driven primarily by fixed capital formation, contributing only about 20 percent to growth lately as opposed to about 35 percent in 2011-2012. A slowing down across the investment spectrum (particularly transportation and machinery related investment) and a lack of buoyancy in the commodity sector has also impacted investment in mining. Interest rate hikes may have had a role to play too, but we think that has had a negligible impact so far due to monetary policy lags and limited transmission, given the relatively low credit/gross domestic product (GDP) ratio.

The lack of slowdown in consumption is interesting (growing 5 percent + for a couple of years) '€” but not a puzzle. Income growth has been substantial in recent years, with per capita GDP, in US dollar terms, rising by 65 percent between 2008 and 2012. Recent rupiah depreciation and rate hikes clearly have not been sufficient yet to have a meaningful impact on consumption behavior.

Into 2014, we can'€™t see investment or consumption improving. On consumption in particular, the shoe may finally drop with income and employment expectations dented and cost of financing higher.

Putting it all together, we see growth hovering in the low 5 percent range this year. Potentially, though, our forecast may turn out to be a tad conservative, owing to a positive surprise in respect to partner country demand, easing external account imbalances beneficially impacting the rupiah and, by extension, supporting consumer and business confidence. In addition, demand for imports may ease due to recently announced tariff adjustments. However, it remains to be seen how much the ban on exports of raw ores will counter the positive impact arising from increasing import duties to reduce imports.

External sector outlook

Indonesia'€™s deterioration in this sector has been dramatic. An economy that used to enjoy ample commodity and non-commodity exports, and consequently a comfortable trade- and current-account surplus, has become stuck in a worrisome deficit precisely at a time when investors are being choosy about deficit economies. Correcting this imbalance is critical in resolving Indonesia'€™s vulnerability in 2014.

Coal and palm oil demand will be key, although we worry that subdued demand levels will persist in the coming year. On the plus side, Indonesia can do something about its commodity production and demand for imported oil. Reversing insufficient investment in production and continuing to eliminate the fuel subsidy will be critical in rectifying the external account predicament.

Further fuel price increases are perhaps a no-go in an election year, but this challenge will have to be picked up by the new president almost as soon as he or she comes to power.

Rupiah weakness

Can the rupiah turn a corner in 2014? Our confidence is not high in this regard. Trade- and current-account adjustment appears to be still progressing at a slow pace, and likely periods of global market uncertainty around the Fed'€™s tapering will leave the rupiah vulnerable, in our view.

We therefore see the currency hovering around the 11,500-12,000 range this year, which of course will have some implications for inflation.

Inflation and monetary policy challenges

Past episodes of fuel price increases have had minimal impact on inflation. This time is different, in our view.

Monetary policy was ultra easygoing into 2013 and the fuel price increases and accompanying rate hikes came too late and were too modest to affect demand. Second, the sharp depreciation of the rupiah, coupled with still-strong consumption demand, will likely cause prices to rise appreciably in 2014. Third, although last year'€™s wage increases were relatively modest, the substantial cumulative increase in wages in the last few years will continue to impart inflationary impulse.

Under these circumstances, Bank Indonesia will likely be compelled to hike rates by another 50 basis points in the first few months of 2014, in our view, and then leave policy rates unchanged for the rest of the year. In a year when global rates will likely go up considerably, Indonesia will not be able to afford an accommodating monetary policy stance, even if growth falls to 5 percent.

The new government that takes over this year will have to embrace reforms in order to bring Indonesia'€™s economy back to an orderly, stable footing. Encouragingly, there is a growing and welcome recognition within policy circles that extraneous circumstances, as they relate to changes in the cost of financing emerging market imbalances, give countries like Indonesia a limited window of correction.

To conclude, the challenges for Indonesia are clear, and the new government will have its work clearly cut out.

The views expressed are personal.