Indonesia'€™s gross domestic product (GDP) growth has slowed down, to below 6 percent last year, and it may get worse this year. The external reasons were lower exports due to lower commodity prices and less foreign direct investment (FDI) inflows. On the domestic side, necessary stabilization policies, namely fuel price adjustment and higher interest rates, reined in consumption and investment.

In the short term, Indonesia will be facing strong external headwinds, particularly with the oncoming US Federal Reserve tapering of its liquidity injection and persistently weak commodity prices. Domestically, the growth slowdown trend and the virtual policy standstill prior to the upcoming elections are the main challenges.

The good news is, in the medium term, Indonesia has an opportunity to escape the middle income trap and at the same time reduce external vulnerability.

Lost opportunities

In the aftermath of the global financial crisis (GFC) in 2008 the prevailing view was that emerging market (EM) economies would take up the slack in global growth. We now know that view was incorrect, as the higher growth in EM was mainly due to higher commodity prices and capital inflow from developed countries.

One would think that before the global financial crisis, EM governments would have prepared for the demise of the commodity boom. Even during the post-financial crisis global liquidity glut they should have foreseen its eventual end and embarked on structural reforms and broadened their export bases. This could be done by channeling the huge capital inflow into infrastructure and at the same time reallocating labor to more productive sectors.

But most EM governments failed to take advantage of this opportunity for two main reasons: complacency and an inability to overcome domestic vested interest. As the huge capital inflow raised EM currencies, it lowered inflation and created room for lower interest rates.

The upshot was an investment boom that included the property sector. During this favorable period, it was next to impossible to conduct structural reforms on account of strong opposition from interest groups.

Hence, many EM economies now face the twin problems of a sudden halt in capital flow and rising current account deficits. Along with capital flow reversals comes currency depreciation leading to higher inflation.

Short-run policy options

In the past, the problem of lower growth coupled with higher inflation was called stagflation. This problem cannot be solved using the traditional method of monetary easing coupled with fiscal stimulus. Both policies can raise economic growth, but can also lead to risks of higher inflation. If you reverse the policies, inflation can be contained but at the cost of growth. Hence, the authorities face a tough choice: overcome inflation or raise growth first.

Choosing inflation over growth is problematic as expectations of even higher prices can cause an inflationary spiral. Hence, the safer choice is to reduce growth first. This has the added benefit of taming the current-account deficit by reducing imports.

A related policy is to allow the currency to depreciate further. This, however, should be done carefully, as a weaker currency works its way into inflation through the import channel, especially for basic necessities like food.

In the fiscal sphere, lower growth translates to lower nominal income and tax revenues. Hence, keeping an eye on the deficit will be important. The government should also continue to implement measures aimed at imports by slashing subsidized tariffs on non-essential imports. It should also continue to prioritize job-creating sectors to reduce the risk of higher unemployment.

The financing situation will initially become challenging. Globally, a lower appetite for EM debt will mean higher interest rates on Indonesian global bond issuance. In the domestic market, lower financial sector growth and the higher interest rate environment will also raise the cost of debt issuance. The risk is not overly large, however, because of the low public debt to GDP ratio.

Medium-term opportunities

In medium-term, Indonesia has five aspects going for it, which if taken advantage of can raise sustainable growth levels and at the same time reduce external vulnerability.

First is the opportunity to invest in infrastructure. Owing to the fact that there is so little of it, infrastructure investments will, at least initially, bring huge returns. For example, just by removing the port bottleneck in Indonesia, trade flow could be raised dramatically.

Second is the low leverage both in the state as well as private sector balance sheets. This would make it possible to raise leverage without jeopardizing sovereign and corporate ratings, while the impact would be a high return on investment.

Third is the rising middle class. This has already been manifest in domestic consumption beyond food. Just take a look at the dramatic rise in convenience stores, shopping centers, restaurants and other leisure service providers in cities like Jakarta. This segment of the population will continue to provide a stable source of GDP growth. But owing to its importance, maintaining its confidence will also become essential.

Fourth is the movement of labor from low to higher productivity sectors. Examples include the shift from agriculture to manufacturing, and from the informal sector to more formal work arrangements. The government can hasten this shift by providing training and job information as well as reducing the administrative barrier to labor movement.

Fifth is technological adoption. As supply chain linkages become global, having the appropriate technological know-how in each country becomes essential along with the skilled labor. Government agencies and large corporations can provide the drive for innovation by jump-starting research centers and disseminating their output. Initially, basic research may not be as important as the adaptation of existing techniques to local circumstances.

Another important issue for Indonesia is to shift fiscal subsidies on commodities, especially energy, to that directed at citizens. This should be done in stages, say within a five-year timeframe. Aside from providing room for investment in infrastructure and education, it would also rationalize energy usage.

Bottom line

Implementing these measures will be difficult for Indonesia in the near term as many Cabinet ministers will be busy campaigning for their parties. It is therefore up to the next government to implement these longer-term measures.

But to keep up the pressure, academics, private sector groups and the general public will need to push this agenda forward.

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