D

uring the first half of 2014, the Indonesian economy continued to be under pressure both from global as well as domestic fronts. From the global economy there was overhang of US Federal Reserve quantitative easing (QE) and the slowdown in China. On the domestic side the main issues were the structural current-account deficit and the costly fuel subsidy.

Back in 2013, Bank Indonesia (BI) responded to the global and domestic pressures by raising interest rates and allowing the rupiah to weaken.

And now in 2014 the effects are beginning to appear in lower economic growth. For the government budget, the cost of the fuel subsidy continues to rise.

With higher oil prices and rising consumption, the fuel price hike in mid-2013 has been erased and the fuel subsidy looms again as the biggest single-expenditure item.

In recent weeks, the rising political temperature has also forced investors and other economic players to reconsider their plans, at least for the rest of 2014. What can we expect to transpire in the coming months?

Indonesia cannot rely only on volatile portfolio inflows to finance its current-account deficit. A more stable source is foreign direct investment (FDI), but that necessitates continued investment climate improvement '€” something we cannot seem to maintain.

Hence, as the FDI slows down, and the portfolio flow was disrupted last year by our current-account deficit '€” which was rising anyway '€” this becomes glaring. A natural response to this kind of pressure would be for the currency to weaken.

Typically monetary authorities worldwide raise interest rates to slow down economic growth. A secondary objective is to maintain financial market sentiments.

For the first objective, on the real side a weaker currency is expected to both improve exports and make imports more expensive. Meanwhile, slowing the economy should reduce imports.

Therefore the improvement in the trade balance would eventually narrow the current-account deficit.

The fallacy of this as applied to Indonesia has to do with import and export elasticity. A weaker rupiah does not immediately translate to more competitive exports for two reasons: first, our major exports are in commodities, the prices of which remain depressed as long as Chinese growth remains weak; second, our non-natural resource exports depend on imports '€” up to 70 percent of manufactured exports use imported inputs.

Also, food and fuel imports have low price elasticity, which means higher domestic prices stemming from a weaker currency make little impact. These two items also have low-income elasticity, which mean that although economic growth declines their demand will only be marginally affected.

The decline in current deficit toward the end of 2013 and in early 2014 was mostly on account of mineral exporters front-loading their production and exports ahead of the unprocessed minerals export ban.

Meanwhile, for the second objective a weakened currency and higher interest rate managed keep sentiments in the financial market from sliding further. This has resulted in keeping the portfolio flow and foreign investment in government bonds from sliding.

On a monthly basis, Indonesian equity index rose 21 percent from the beginning of the year compared to the MSCI South East Asian Index, which rose only 7 percent. The present index level is, however, substantially lower than what it was during the peak in 2013 before the US Fed QE scare.

And the volatility in Indonesia is much bigger than in other Asian countries. Compared to April 2013, the MSCI Indonesian index is 21 percent lower now, vis'€“à'€“vis 9.2 percent lower for the Asian Composite.

The 10-year benchmark government bond yield, meanwhile, has declined to slightly below 7.9 percent in May from close to 9.1 percent in January 2014. Foreign ownership of government bonds remained steady at over 35 percent.

Both equity as well as the government bond market trading volume have recovered although are still below peak near the end of the second quarter of 2013. Overall we see that the equity as well as government bonds have recovered well and confidence remains intact.

Aside from the stable corporate fundamental performance from mid-last year, the government budget is also well maintained, at least in the short term. This is evident in the ability of the government to manage budget deficit well.

In order to contain ballooning expenditure due to rising energy subsidies, spending by line ministries was cut from Q2 this year.

Energy subsidies are one of the two glaring changes in the budget this year. The other is a tax revenue shortfall.

Energy subsidies were initially slated at Rp 285 trillion but have since been revised up to Rp 403 trillion and may be in danger of rising even further to Rp 453 trillion with the recent weakness in the currency. Meanwhile tax revenue reduced from Rp 1,310 trillion to slightly below Rp 1,150 trillion.

To maintain the deficit at 2.4 percent of gross domestic product (GDP) a total of Rp 43 trillion was slashed from the budgets of line ministries.

Fortunately, the deficit-financing plan has gone smoothly with close to 54 percent debt issuance accomplished in 1H14.