Rekindling the buoyancy of the tax base is a key challenge for the new administration.

The rejection by the Constitutional Court on Aug. 21 of the legal challenge to president-elect Joko '€œJokowi'€ Widodo has cleared the final hurdle to him taking office in October. Indonesia'€™s still callow democratic process has been stress-tested by this year'€™s election but it has ultimately passed with flying colors.

For the first time in its history, Indonesia has seen an essentially peaceful democratic transition as a two-term incumbent is required to step down. With a common touch and track record of effective governance, hopes for the Jokowi presidency are unsurprisingly running high. However, the new president will face a daunting outlook with a string of structural reforms urgently needed to rekindle Indonesia'€™s floundering macro-economic performance and the currently benign global backdrop almost certain to become more challenging in the near future.

Last year'€™s flirtation with a balance-of-payments crisis has given way to a period of eerie, but essentially, artificial calm in financial markets. The hot money that took flight last year has come gushing back in this year with the equity market enjoying near record net inflows and foreign ownership of the government bond market pushing back up to record highs. Balance of payments data reveal that net portfolio inflows in the first half of 2014 were a stunning US$16.8 billion; more than double the previous record for net portfolio inflows set in the first half of 2011. Record inflows have left both the rupiah and the stock market as the region'€™s strongest year-to-date.

But frothy markets unhelpfully fuel complacency and the misplaced sense that Indonesia'€™s macro-economic difficulties are in the rearview mirror. While more prudent monetary policy formation by Bank Indonesia (BI) has undoubtedly helped rebuild confidence, foreign investors'€™ renewed love affair with Indonesia largely reflects the return of the global carry trade as the fears of the early and aggressive rise in US interest rates, which triggered last year'€™s rout, have receded for the time being. Ten-year Treasury yields, for example, have retracted about 60 basis points of last year'€™s 140 bp sell-off.

Under the dovish leadership of new US Federal Reserve chair, Janet Yellen, the Fed has, in the short term at least, successfully convinced markets of the impossible. Namely that it will both delay the onset of policy tightening and that it will then tighten more slowly thereafter. In other words, the US Fed will somehow contrive to stay permanently '€œbehind the curve'€. With the end of the central bank'€™s bond-buying program now preset for October and, with the US economy in general and the labor market in particular showing distinct signs of accelerating, the risk of another spike in US interest rates is high, and rising.

In theory, with local bond yields substantially higher than a year ago and the rupiah cheaper especially in real terms, Indonesia should be more insulated from higher global rates. But, with foreign ownership at record highs and daily trading volumes ebbing to multi-year lows, the '€œexit door'€ for foreign capital to leave the local bond market is smaller than at any time since 2007. Moreover, despite the tighter policy settings put in place by BI and gross domestic product (GDP) growth sagging to a five-year low of 5.1 percent by the middle of this year, Indonesia'€™s current-account deficit, at about 3.25 percent of GDP, remains uncomfortably wide.

The relative, and not just the absolute size of the deficit, also matters. While Indonesia'€™s external financing requirements are well below those of some emerging markets such as Turkey and South Africa, they are nonetheless now the highest in the Asia Pacific given the dramatic improvement in India'€™s external borrowing requirements over the last year. When the current tide of global liquidity inevitably retreats, balance of payments strains are likely to quickly re-emerge with interest rates spiking higher, foreign exchange rate reserves sliding and heavy selling pressure on the rupiah.

While higher global interest rates are likely to impart a fresh shock to Indonesia'€™s capital account, the prospect of a continued slowdown, even a hard landing in Indonesia'€™s dominant trading partner, China, threatens yet more pressure on the current account. The free lunch that Indonesia enjoyed on the back of China'€™s post-2008 investment bubble and attendant sky-high commodity prices is producing persistent indigestion due to its legacy of an unhealthy reliance on commodity exports. Coal and palm oil alone continue to account for a quarter of Indonesia'€™s export earnings, roughly double their share before the global financial crisis (GFC). The combination of slowing Chinese demand, falling export prices and rupiah depreciation have seen Indonesia'€™s export earnings effectively stagnate over the last three years '€” almost as bad a performance as seen during the Asian crisis.

With China'€™s housing market seemingly entering an accelerating structural downturn given chronic oversupply, Chinese growth looks set to slow further, possibly sharply, dragging key commodity prices down further and so extending Indonesia'€™s export slump. Notably, both coal and palm oil prices are both again flirting with post-global financial crisis lows. Export woes are also being compounded in the short term by the ill-judged decision to ban unprocessed ore exports, leading to a collapse of export revenues in the sector and muffling the gradual underlying improvement in the current account that slower GDP growth is producing. Sliding export prices additionally depress corporate profits, crimp government revenues and weigh on consumer incomes.

Given the real risk of renewed balance-of-payments strains from the looming double whammy of higher global rates and further falls in commodity prices, the near-term priorities of the Jokowi presidency must be to ensure that both monetary and fiscal policy discipline is enhanced to minimize stress and reassure foreign investors. With even 5 percent GDP growth a struggle in the near term, airy campaign rhetoric about 7 percent GDP growth needs to be quietly shelved. Public support for the hard money policies of the Pak Agus Martowardojo-led Bank Indonesia would be helpful.

More importantly, speedy action on reining in the country'€™s over generous fuel subsidy regime is the totemic reform that would generate multiple pay-offs and help bolster confidence in the new regime. Comfortably the most generous in Asia, Indonesia'€™s fuel subsidies exacerbate the current-account deficit, cramp fiscal space, crowd out much needed spending on infrastructure improvements and add to inflation volatility when sporadically adjusted in lumpy fashion.

Early signals from the Jokowi camp are that a sorely needed Rp 1,500 (12 US cents) increase in the subsidized price may be pushed through relatively quickly. While welcome, this would be a second-best solution given the risk that renewed rupiah depreciation over the next year could once again quickly erode the savings and so do little to improve fiscal space on a sustained basis.

Another unhelpful, albeit temporary, spike in headline inflation would also result. The first-best solution, long advocated by the Finance Ministry, would be to pivot quickly to a fixed subsidy regime. By capping fuel subsidies, this would boost fiscal space, increase the scope for more capital spending and inject a degree of market discipline by increasing the degree of pass-through of international price fluctuations to the domestic market.

Early, and ideally, decisive subsidy reform is an essential component to one of the key macro-challenges facing the Jokowi administration: halting the increasing signs of erosion in Indonesia'€™s still solid public finances. Consistent fiscal discipline and its corollary, a steadily declining debt-to-GDP ratio over the last decade, has provided the foundation for Indonesia'€™s recent return to investment-grade status with two of the three main sovereign ratings agencies.

Besides the ballooning fuel subsidy bill worth an estimated 3.5 percent of GDP in 2014, long-range fiscal discipline is also threatened by a weak revenue performance that the new president must seek to reverse urgently. Since 2008, general government revenues have slid by a worrying 3.5 percentage points of GDP, leaving Indonesia trailing even traditional regional laggards such as India and the Philippines.

Falling oil and gas revenues have been a key driver reflecting the secular decline in output of the oil sector in particular. But non-oil and gas revenues have also sagged, growing by less than nominal GDP in both 2012 and 2013. Revenue growth so far in 2014 has also remained disappointing. Rekindling the buoyancy of the tax base is therefore a key challenge for the new administration but one that Jokowi looks well placed to meet.

His track record as the mayor of Surakarta in Central Java saw him able to boost revenues consistently despite his inability to raise local taxes without permission from the central government. More efficient collection of taxes and fees allied to improved government efficiency via increased transparency, reduced corruption and use of technology were the keys to success. Ability to replicate these local achievements at the national level will be vital for the new administration.

Ultimately, however, revenue buoyancy will largely hinge upon the new administration'€™s success in reviving the economy'€™s flagging growth performance. With a solid spine of consumer demand growth worth about 4 percentage points per year, a revival of export revenues is critical in order to restore 6 percent, let alone 7 percent, GDP growth. In turn, this requires greater export diversity and the creation of a thriving manufacturing export base to allow the country to fully work off the lingering after-effects of the still fading commodity boom.

Further real exchange rate depreciation is a necessary, but far from sufficient, lubricant to this dynamic. Given the strong likelihood of fresh shocks to both current and capital accounts in the coming months, the aforementioned preservation of monetary and fiscal policy discipline is vital to ensure that any future currency weakness is as orderly and controlled as possible. Encouragingly, surging capital inflows so far this year have allowed BI to rebuild its foreign exchange reserve war chest, increasing its scope to manage future shocks.

Ability to attract larger amounts of foreign direct investment (FDI) is also critical to medium-term prospects for the export sector. The pay-offs from FDI are multiple: more export revenues, more jobs, more tax revenues and reduced reliance on hot money flows to cover external financing needs. Recent trends in FDI have been broadly encouraging with net inflows reaching a record $14 billion in 2013 and their composition starting to shift away from the traditional dominance of the commodity sector toward sectors such as automotive, chemicals and electronics.

Beyond stable and disciplined macro-economic management, there are two keys to extending the acceleration in inflows.

First, a more permissive, streamlined and less capricious regulatory regime is needed. Without a speedy resolution to the ban on raw material exports, the increased regulatory uncertainty risks deterring fresh FDI not just into the commodities sector but more broadly. But attracting FDI is necessarily a zero-sum game and other countries are forging ahead to try and steal a march. India'€™s new government is in the new process of rolling back restrictions on foreign investment in key sectors such as insurance and defense. More eye-catching, the Philippines recently announced a radical liberalization on investment in the financial sector, allowing foreign banks to own 100 percent of local lenders. By contrast, Indonesia limited foreign financial institutions to 40 percent ownership in local banks back in 2012.

Second, improvements in Indonesia'€™s long-standing infrastructure deficiencies, particularly in terms of logistical costs and performance, are needed. With the World Bank recently ranking Indonesia'€™s logistics worse than Pakistan'€™s, better infrastructure quality is sorely needed if pretensions of becoming a global manufacturing base are to have any hope of being realized. Simpler, more streamlined land acquisition regulations, which remain laborious despite the passage of a new law in 2012, would also help.

Again, Jokowi'€™s track record in his brief time as Jakarta governor offer grounds for optimism. Success in improving tax buoyancy and fuel subsidy reform is also critical to create the space for greater infrastructure. The Public Works Ministry, with a 12 percent cut to its initial budget this year, once again predictably bore the brunt of the need to make room for the spiraling fuel subsidies. Overall, the new administration must raise the game on attracting FDI or fall behind increasingly determined rivals such as the Philippines. China, which has attracted net FDI inflows of about 4 percent of GDP for more than 20 years, remains the gold standard to which Indonesia can and should aspire.

 

The views expressed here are solely those of the authors