In 2016, a combination of a weak external environment and domestic resilience contributed to strong economic growth in Indonesia with a manageable current account deficit of 1.83 percent of gross domestic product (GDP) in the third quarter. In terms of domestic resilience, strong domestic consumption still accounts for 56 percent of GDP followed by investment with 32 percent in the same period.

Unlike the 2013-2014 period when the current account deficit was much deeper (4.3 percent of GDP in the second quarter of 2014), a narrow current account deficit in 2016 may moderate foreign investors’ risk perception of Indonesia.

Nonetheless, as short-term portfolio investment still dominates the structure of Indonesia’s financial account, the risk of foreign capital reversals cannot be entirely neglected when a series of taper tantrums by the United States Federal Reserve that started in December 2016 continues.

Learning from the 2013-2014 period, Indonesia can still rely on three straightforward approaches to deal with capital outflows after the taper tantrum, i.e. (1) prudent fiscal expansion; (2) monetary tightening; and (3) an import-limiting strategy. Yet, a combination with macroprudential policies is also worthwhile depending on the severity of problems and the source of instability.

Notwithstanding the importance of coping with short-run macro fluctuations due to the US taper tantrum in 2017, taking advantage of the recent positive momentum might also be equally important for Indonesia to achieve an economic growth target of 7 percent in 2019. Strengthening economic growth without necessarily aggravating macro instability due to the ballooning current account deficit therefore becomes a major agenda item.

This can be achieved at least in two ways: (1) continuing prudent fiscal expansion, and (2) producing additional saving to finance private sector investment.

With the limited source of state revenues, an external debt issuance of US$3.5 billion by the government announced on Dec. 8, 2016, has indeed provided room for prudent fiscal expansion in 2017 if the fiscal deficit does not exceed 3 percent of GDP.

During economic slowdown, the Keynesian framework suggests the occurrence of the “crowding-in effect” in which higher government debt will have less impact on interest rates, while its positive impact on government spending and private sector investment is more pronounced. As long as demand is there, higher government debt will lead to an increase in economic growth through higher private sector investment.

Anticipating this hypothesis, invigorating domestic demand is crucial. Aside from fiscal expansion related to the provision of basic infrastructure for growth; a temporary and targeted safety nets policy to some groups will also be needed, so that the aggregate consumption and growth momentum in 2017 can be maintained.

On the other hand, the Neoclassical framework warns that rising government debt might have a drawback for private sector investment due to the so-called “crowding-out effect”.

In a country with limited savings to finance private sector investment, the crowding-out effect occurs because higher government borrowing increases interest rates, exacerbating upward pressures on the cost of borrowing for private sector firms.

Consequently, private companies will have a lower incentive to borrow. This will then reduce private sector investment. This drawback may then offset the positive effect of higher government spending financed by debt on economic growth, not to mention that future generations may also be required to pay higher tax for the government to pay its debt and interest. Domestic consumption may subsequently decline, dragging down economic growth even deeper.

This is why besides continuing prudent fiscal expansion strategies, producing additional savings is also key to avoid the crowding-out effect and to keep the current account deficit moderate.

With the current level of productivity, it is estimated that savings and investment should attain 44 percent of GDP to reach economic growth of 7 percent in 2019.

In such a short time span, it is indeed challenging to boost savings, especially when the saving and investment ratios only account for 32 percent of GDP in 2016, not to mention a lack of financial literacy and inclusion across the country. Yet, boosting savings might also be costly in the short run, in the sense that it can reduce growth potentials due to declining consumption.

On the whole, the road toward a new equilibrium with higher economic growth is not quite straightforward for Indonesia in 2017 with the country solely relying on domestic resources. Given that Indonesia is in a better position than other developing countries in terms of growth prospects, opportunities to attract foreign direct investment (FDI) to boost economic growth remain large.

FDI can be a new source of growth. For this to happen, it needs prudent financial liberalization including capital account openness for FDI and capital market deepening for both stock and corporate bond markets combined with strong investor protection, efficient bureaucracy, a conducive business climate and so on.

This is particularly relevant when the role of the banking sector is limited due to liquidity tightening in the deposit market that prevents credit growth expansion.

When every domestic source of investment and growth seems limited in 2017, only the role of financial liberalization, institutional and governance quality, as well as law enforcement matters the most to attract long-term foreign investors, in order to spur economic growth beyond expectations.

2017 is therefore a year of preparation to strengthen the landscape for increased long-term foreign investment in Indonesia. Of course, financial literacy and inclusion should continue to boost national savings for macroeconomic stability and growth.

***

The writer is financial economist and head of the management study program at the School of Business, Sampoerna University. The views expressed are his own.

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