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Analysis: Anticipating economic challenges after COVID-19
Indonesia, while not officially in recession yet, is predicted to record another contraction in the third quarter of 2020. In the preceding quarter the economy shrank 5.32 percent year-on-year (yoy).
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he COVID-19 pandemic is turning into a global economic crisis as most countries have fallen into recession. The pandemic has severely hit global demand, which in consequence has disrupted the global value chain, lowering total trade and discouraging investments. It also increases risk and uncertainty in the global financial market.
Indonesia, while not officially in recession yet, is predicted to record another contraction in the third quarter of 2020. In the preceding quarter the economy shrank 5.32 percent year-on-year (yoy).
The pandemic creates a low inflation and interest rate environment in Indonesia. The inflation rate has been below the 2020 target of 3±1 percent with core inflation, a good proxy for domestic demand, continuing to weaken. In response to that, BI’s seven-day reverse repo rate has been cut by 100 basis points (bps).
As imports decelerated more than exports amid plummeting domestic demand, the country has posted a huge trade surplus, notably shrinking the current account deficit (CAD). Yet the country is suffering from capital flight triggered by uncertainties surrounding the pandemic.
To stimulate economic recovery, the Indonesian government has introduced a large stimulus package called the National Economic Recovery (NER) program, causing the budget deficit to widen.
The government as a result is accumulating higher external loans and increasing global bond issuance to finance the deficit.
Following the global lockdown easing, optimism about a global recovery has gradually risen. The positive progress made toward developing a COVID-19 vaccine has also aided the confidence.
Apparently, this is not fully the case of Indonesia. Despite various attempts to curb the virus spread, the nation is still reporting an increasing trend of daily new cases. While the real sector has bottomed out, a longer pandemic may slow down or even hamper the pace of recovery.
Both fiscal and monetary measures have been amplified to accelerate the recovery, particularly to strengthen domestic demand and encourage businesses to reoperate. Whilst these have yielded a positive result indicated from a back-to-the-expansion-zone manufacturing Purchasing Managers' Index (PMI), the consumer confidence index remained pessimistic.
The government’s strategies to keep the economy running undeniably need to be recognized. But the success in mitigating the pandemic through stricter health protocols is actually as important as reviving economic activity. Only by flattening the case curve will business and consumer confidence be restored, and the economy have a resilient recovery.
In the 2020 NER program, the government indeed has allocated substantial budgetary funds to the health sector to cope with the pandemic. The government will continue the program in 2021, including putting an end to the pandemic through vaccine procurement.
This policy move is already in the right direction, but it is imperative to ensure the effective implementation of mitigation measures at the grassroots level to successfully overcome the pandemic and enable Indonesia to catch up with the global recovery. Solid cooperation and coordination between central and local governments, the private sector and the general public hence play a very crucial role.
This, however, does not mean the recovery road ahead will not have any bumps. Other economic challenges post COVID-19 are already waiting. An agenda not only to recover but also to restart the economy must be addressed in order to boost economic growth going forward.
As the pandemic eases and recovery progresses, domestic demand will improve eventually, inflicting a demand-pull inflation. The impact of an increased money supply from fiscal stimulus and quantitative easing (QE) on inflation will also come into effect. In the short run, hiking the inflation rate is actually desirable as it signals recovery.
The dilemma comes from whether the government adjusts subsidies thus increasing administered prices to narrow the budget deficit, which in the end may discourage demand. From the external side, widening the CAD is inevitable as economic activity accelerates because domestic production still highly depends on imports. This will thereby put pressure on the rupiah exchange rate.
Higher external debt as a result of an increased budget deficit, moreover, may later weaken the currency as it generates more debt services to pay. High inflation and a depreciating currency consequently could persuade the benchmark rate to hike, limiting the real sector's ability to recover.
On the bright side, Indonesia actually may still attract capital inflow to finance a widening CAD as it offers relatively high real rate returns, thanks to a near-zero Fed Funds Rate through 2023, and the global liquidity remains flush. This gives room to maintain a loose monetary policy to promote growth.
However, the inflow can turn into outflow if the recovery is considered late and sluggish compared to other countries.
Looking further ahead, the possibility of the Fed's QE tapering beyond 2023 needs to be anticipated. As happened in 2013, the tapering will put higher pressure on the rupiah exchange rate. This may also raise the imported inflation risk, forcing the benchmark rate to increase.
Both short-term and long-term grand strategies hence are necessary to break this vicious cycle and ensure the nation has a lasting recovery and robust growth.
In the short run, policies to flatten the pandemic curve and enhance the social safety-net, mostly for low-to-middle-income classes, need to be accelerated to boost confidence and demand respectively.
In the medium run, inflation can be allowed to reach the upper bound of the target ranges, by maintaining the stability of volatile (food) prices, to accommodate stronger demand. Administered prices, meanwhile, are preferable to remain unchanged.
To manage the budget deficit the government needs to increase tax revenue by expanding the tax base through a bottom-up approach, including a single identification system establishment. Stronger demand, furthermore, shall hike tax revenue eventually.
In the medium-to-long run, structural transformation is essential to restart Indonesia’s economy toward robust and resilient growth. To deal with the recurring issue of a broadening CAD, dependency on natural resource commodity exports and imported inputs has to be reduced.
Export diversification to more value-added products and non-traditional markets and import substitution with local production thus need to be optimized.
The tourism industry is also required to be safer and more sustainable to attract more international travelers. In addition, Indonesia needs to diminish its reliance on portfolio investment inflow to support growth, and instead should entice more foreign direct investment (FDI) focusing on digitalization and export-oriented industries (Industry 4.0).
To make the most effective use of FDI in promoting long-term growth, it should foster the development of small and medium-sized enterprises (SME) through supply chain linkages between foreign affiliates and domestic SMEs. Strategies to enhance the digital and technology skills of the workforce therefore become crucial.
Ultimately, improving ease of doing business and competitiveness, including regulation synchronization between central and local governments, legal certainty and bilateral and regional economic cooperation optimization, need to be accelerated in order to ensure the success of structural reform.
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Economist at Bank Mandiri
