Things are gradually improving for Indonesia’s economy. Policymakers have successfully assuaged financial markets of their macroeconomic stability credentials (for now) and economic growth seems to have stabilised at a still robust 5%.
Hopes are high that the bottom of the cycle has been reached and growth will start to accelerate. Some expect growth to lift towards the mid 5% range over the next few years. President Jokowi is of course hoping to do much better to reach the 7% plus target he originally set upon winning office.
His agenda of deregulation and infrastructure investment is certainly on the mark in terms of policy focus - there’s no doubt these are among the most pressing issues. Much will depend of course on successful implementation. So far there appears to be good progress on the former while progress on the latter may be improving.
This gives some hope. But even if Jokowi is very successful in this agenda, the economy may quickly run into another constraint – its current account (balance of trade and other income) and fiscal deficits. These ‘twin deficits’ played a key role in the growth deceleration that started a few years ago and have so far only been partially unwound.
The fiscal deficit is now the problem
The current account deficit (CAD) has fallen from a peak of 3.2% of GDP in 2013 to just under 2% today. A common rule of thumb is that Indonesia needs to keep the CAD below 3% of GDP to avoid instability risks, so there is now some head room but not a lot. Meanwhile the fiscal deficit has become even bigger and is now virtually at the legal limit (3% of GDP), expected to come in at 2.6% of GDP this year.
The two deficits are of course interrelated. Many blame the still large CAD on supply side problems limiting the response of manufacturing exports to a more competitive exchange rate. That’s certainly part of the story. However, the fiscal deficit seems to be the bigger culprit.
To see why, recall that a current account deficit implies that national savings are insufficient to finance total investment, with the difference made up by tapping foreign savings. A fiscal deficit means the government is a negative source of net savings in this equation.
The chart below shows how Indonesia’s CAD has evolved, including how different sectors have contributed. The sectoral breakdown for 2016 is not yet available so I have just shown the overall CAD and the government contribution as these are readily available. The relative contributions from corporates and households in 2016 probably did not change much in any case.
As the chart shows, a large deficit emerged in 2012 following the end of the commodity price boom in late 2011. At first the deficit was driven primarily by the corporate sector, as ultra-easy global liquidity conditions allowed Indonesian firms to binge on external debt. Government net savings also worsened as lower commodity prices weighed on resource-based public revenue.
Markets were willing to finance the CAD for a while. But Indonesia’s inability to sustainably finance a large CAD quickly reasserted itself with the ‘taper tantrum’ that began in May 2013. Indonesia managed the adjustment quite well (through tighter monetary policy and allowing the exchange rate to fall) but this was of course achieved through slower growth.
Importantly, the entire adjustment was borne by the corporate sector while the government fiscal position continued to worsen. Recent reforms to cut energy subsidies have only contained, rather than curtailed, the fiscal deficit.
Source: Indonesia Central Statistics Agency
No easy ways around stability-growth trade-off
Thus, Indonesia has basically stuck to the confines of the well-worn trade-off between maintaining stability and pursuing faster growth. If markets have been assuaged, it largely reflects the continued adherence by Indonesian policymakers, particularly the central bank, to a paradigm which prioritises stability over growth. Much has changed, but memories of the Asian Financial Crisis still loom in the background for policymakers and markets alike.
So what does this mean for Jokowi’s hopes of using deregulation and infrastructure to spur much faster growth? In a nutshell, it would likely see the CAD quickly returning to the warning territory of 3% of GDP. Unless, there is deep fiscal reform and in particular tax reform to significantly raise public saving.
Consider Jokowi’s infrastructure agenda. The World Bank estimates this will involve an increase in public spending of about 2.6% of GDP a year. But government ambitions are much higher. Recognising its limited fiscal resources, even more is to be financed via capital raisings by state-owned enterprises and public private partnerships.
This ostensibly gets around the budget constraint but it does nothing about the CAD constraint. Regardless of the funding source, the increase in investment will directly add to the gap between national investment and savings, and thus the CAD. To prevent a rise into danger territory, or alternatively a significant crowding-out of private investment, national savings need to rise.
The same logic means that thoughts of relaxing the legal budget deficit limit to allow more growth enhancing investment (sometimes suggested since public debt levels are quite low) will also not work.
Increasing government saving through fiscal reform is thus the obvious solution. Cutting poor quality spending like energy subsidies is a useful starting point which government is pursuing. But there is simply not enough there to provide the level of funding needed. Especially once the need to increase funding for other growth priorities like education is added to the mix.
Increasing Indonesia’s low tax take will thus need to be a big part of the solution. Currently it sits at a mere 11% of GDP. It should be several percentage points higher. There is plenty of scope through both policy changes and better enforcement. Unfortunately, reform in this area is progressing slowly, undoubtedly due to the politics involved.
What about higher private net savings? If anything, this would likely deteriorate in the event of a marked growth acceleration. Faster growth would increase the return on investment, encouraging higher investment, and higher expected future incomes would reduce the imperative to save. This same dynamic would likely hold if the growth acceleration was primarily driven by successful deregulatory reforms.
Accelerating the development of the financial sector could help mobilise higher private savings, but takes time to bear fruit, especially without sparking instability risks of its own.
All this means that even deeper fiscal reform would be needed if the CAD were to be contained while creating room for a private sector response to any significant growth acceleration.
Perhaps Indonesia doesn’t need to worry so much about the current account? For instance, greater reliance on foreign direct investment (FDI), rather than more volatile ‘hot money’ portfolio flows, could provide much more stable CAD financing. Deregulation and better infrastructure should help attract more FDI, though the liberalisation of FDI restrictions themselves has been limited so far. Still, a large CAD would require large portfolio inflows, with their attendant risks.
Markets might be more lenient towards Indonesia in the future. It has built up some policy credibility and a reform-driven widening of the CAD would be interpreted more positively. Global liquidity conditions are also still very accommodative.
But the problem with a large CAD is not that it cannot be financed at all. Rather, it’s that sudden changes in market sentiment are common and tend to have destabilising effects. A large CAD leaves the economy exposed. For instance, uncertainties about the path of future monetary tightening by major central banks means the prospects of a re-run of the ‘taper tantrum’ is a real risk.
As long as stability is prized over growth, twin deficits it would seem are still a binding constraint.