Indonesia: Jokowi's second term holds promises

Cyclical prospects unexciting, but foundations being laid for recovery

Overall economic growth held up at around 5% y-o-y in the third quarter, hardly changed from the outcome in the second quarter. However, some of the lead indicators were not comforting. The latest purchasing managers’ surveys showed that the pipeline of new orders was down for the third consecutive month in October, falling at the fastest pace in about four years. There are two factors that are key to any revival in economic growth:

First, the weakness in global demand is hurting Indonesia, even though Indonesia is not as trade-dependent as, say Singapore or Malaysia. Indeed, the decline in export growth was faster in October when it fell 6.1% compared with the 5.7% decline in September. Weak commodity prices are the main problem — export volumes actually rose 8.5% but were offset by falling prices. Barring an upturn in the global economy strong enough to boost prices of the thermal coal and base metals that Indonesia exports, external demand is unlikely to provide much impetus in the next few quarters.

The second reason for the downturn was lacklustre investment. October’s trade figures showed little evidence yet of a pickup in capital spending — imports of capital equipment fell 11.4%. This slowdown in investment reflects the lagged impact of the decision in 2018 to defer infrastructure projects in response to market fears of a rising current account deficit that had caused the rupiah to fall. However, there might be a bit more hope on this front. Infrastructure projects will be a priority for the new administration. While the purchasing managers’ surveys showed business confidence at a six-month low in October, the uncertainty over the cabinet is now over, and reviving business confidence should see private-sector capital spending also recovering.

Indeed, government data showed a healthy growth in planned investments. Investment approvals by the investment promotion authority have risen around 18% — domestic investment approvals increased 19% in the third quarter, while planned foreign investment also bounced back. Another interesting feature was that investment spending is becoming better distributed geographically. Realised investments outside Java expanded 24% over 2018 while rising at half that pace for Java.

Finally, the fundamentals of the economy have improved, allowing for higher-quality growth. Inflation is running at historically low rates: Taking out volatile food prices and administered prices, core inflation slowed to 3.2% on Oct 19 from 3.3% on Sept 19. Moreover, the external accounts are in good shape — the current account deficit eased to 2.7% of GDP in 3Q2019 from 3.2% a year earlier.

This means that financial markets will have more confidence in the economy, which in turn gives policymakers more space to cut policy rates as well as to step up fiscal spending. Bank Indonesia has cut rates four times in as many policy meetings and could cut again early next year. Central bank governor Perry Warjiyo has signalled the bank’s intention to maintain an accommodative monetary policy stance. The government has also announced an 8.5% uplift in provincial minimum wages, with more such increases likely in 2020 that should sustain consumer spending.

In short, while policymakers need to be careful about getting the balance of policies right in the near term, this is not a big problem. We think economic growth will be steady between 2019 and next year, hovering around the 5% level. The more interesting question is whether Jokowi can achieve his dream of a much more vibrant pace of growth.

Current trajectory one of ‘lazy’ growth — not good enough

Indonesia’s economic growth has been running at close to 5% for the past few years, not a bad performance considering the desultory state of the world economy and certainly better than other large emerging economies such as Brazil, Mexico, Turkey, Nigeria or South Africa. But this is “lazy” growth, economic growth that results from Indonesia’s good luck with demographics, natural resource endowments and urbanisation.

We would argue that this is not good enough. Bangladesh (once dismissed as a “basket case” by former US Secretary of State Henry Kissinger) has sustained economic growth rates of 6.5% on average in the past 15 years, with growth rising early this year to above 7%. Closer to home, both Vietnam and the Philippines are sustaining economic growth above 6%. Not matching such growth rates represents a wasted opportunity for Indonesia to deliver to its people even faster improvements in their welfare. In fact, it is only when economies grow at super-charged rates that the poorest segments of the population enjoy substantial improvements in incomes — because tighter labour markets then produce stronger wage growth and productivity growth strengthens, allowing wages to rise faster.

Indonesia achieved much higher growth in 1988 to 1996, so there is no reason why it cannot do so again. But, going beyond “lazy” growth requires some hard thinking about where Indonesia is not performing well. Some tough questions need to be asked:

• With the relocation of production out of China gathering pace, why is so little coming to Indonesia?
• Why does Indonesia get foreign investment to produce for the domestic market but less so in the export-oriented activities that are better at driving productivity and innovation?
• Why is that when Indonesia achieves higher investment, the current account deficit tends to rise and scare financial markets — forcing Bank Indonesia to raise rates and slow growth?
• Why is oil-rich Indonesia a net oil and gas importer? Indonesia is estimated to have oil reserves in excess of seven billion barrels and natural gas reserves of around 150 trillion cubic feet as well as an estimated 450 trillion cubic feet of coal bed methane and 575 trillion cubic feet of shale gas. Yet, the country imports over 50% of domestic consumption.
• Why does Indonesia — the land of Borobudur and Bali’s unsurpassed magic, Komodo dragons and some of the best diving and beach resorts in the world — get fewer tourists than Malaysia, Singapore and Thailand?
• Why has the improvement in human capital been limited despite higher budgetary allocations to education? The government is mandated to spend 20% of its budget on education but PISA (Programme for International Student Assessment) scores show Indonesian pupils performing poorly compared with those from China, Malaysia, Thailand and Vietnam. While Indonesia produces 278 engineers per one million of population, Malaysia and Thailand produce more than a thousand. And, why is about 79% of non-agricultural employment still in the informal sector, deprived of labour protections?

There is one dominant factor that explains much of the above — the difficult business environment in Indonesia. A range of factors account for this:

• Foreign investors perceive a nationalistic bias in policies that makes them feel less welcome. The same nationalism leads to other policies that scare away foreign investment, such as immigration rules that disallow skilled and experienced managers to be brought in by foreign investors and protectionist trade policies that raise costs to uncompetitive levels. The result is very damaging. For example, in the oil and gas sector, mature fields need higher-technology enhanced recovery techniques that foreign oil firms possess, but policies deter them. In the UK, policies have been crafted to allow specialised firms to extract oil from mature fields; nothing like that is happening in Indonesia. In the field of tourism, nationalistic policies meant that Indonesia was a latecomer to open skies and visa-free immigration rules, though this is now being rectified;
• Labour market rules are seen as unfriendly and inflexible; and
• Corruption and poorly drafted regulations lead to all manner of difficulties in dealing with the bureaucracy.

So, where there is easy money to be made in the case of investing to serve the local market, investors might come in, but where it is investing in more competitive export-oriented activities, investors are more wary.

Another area of weakness is institutional capacity, one reason why savings rates remain too low and why Indonesia’s current account deficit tends to be funded by volatile portfolio capital rather than more stable foreign investment. Indonesia lacks the institutional ecosystem that could raise domestic savings from pension funds, insurance companies and other agencies that can mobilise savings.

Nevertheless, portents are good: growing impetus for reforms

The good news is that Jokowi and his team seem to appreciate the scale of the challenge and what is needed to address it. The administration seems to be preparing the ground for growth-enhancing reforms:

• A potential game changer is a substantial rewriting of labour market rules. Within weeks of his re-election, Jokowi signalled that he was prepared to undertake such reforms. Trade unions and their political allies voiced their displeasure, but preparatory work has begun and more and more officials have come out with statements that suggest some real changes are likely by next year. Labour market reforms alone will not be a silver bullet to Indonesia’s development blues, but it will go very far in raising foreign investment.
• Jokowi has also instructed ministers to strike down overlapping regulations that damage the investment climate in Indonesia. He reiterated the need for a whole-of-government approach to bureaucratic reform, as the authorities will begin with the elimination of the fourth-echelon bureaucrats for starters.
• Jokowi has also indicated that there would be further cuts to poorly targeted subsidies.
• The newly appointed Coordinating Minister for Economic Affairs Airlangga Hartarto has indicated that he will support a sweeping revision to the negative investment list by January 2020, with a view to reducing restrictions on foreign investment.

Conclusion: grounds for optimism on faster growth

Jokowi does seem deadly serious about bringing in potentially ground-breaking economic reforms — including labour market reforms and continued infrastructure spending. But there have also been some setbacks. For instance, many observers have been disconcerted by recent legal changes that seemed to weaken the capacity of the anti-corruption agency. The charitable interpretation is that the president has had to be cold-bloodedly pragmatic in making trade-offs. To secure unpopular but potentially transformational labour market reforms, he may have calculated that he had little choice but to make some concessions in other areas and that he would be able to contain the ill effects on corruption through other means. The president himself has maintained an impressive record of personal integrity, which suggests that he will not stand aside if corruption deteriorated. Moreover, the massive pushback from students and non-governmental organisations also suggests that an alert civil society will mount vigorous responses to combat any worsening of corruption.

Overall, even with these concerns about corruption, we believe that Jokowi can pull off an acceleration in Indonesia’s long-term growth rate.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy