OECD Economic Outlook, Volume 2018 Issue 2

Indonesia

Economic growth is projected to remain above 5% in 2019-20. Rising incomes will lift private consumption. Tighter financial conditions will weigh on firms’ investment but ongoing infrastructure investment will provide support. Slower growth in trading partners will be a drag on exports, but improvements in regulations and connectivity, along with greater price competitiveness from currency depreciation, should support gains in market share. Inflation is set to remain relatively subdued notwithstanding the rupiah depreciation and higher fuel prices. Higher import prices have widened the current account deficit.

Bank Indonesia has raised interest rates by 175 basis points since mid-May to contain capital outflows. Further pre-emptive tightening is projected as US interest rates rise. The budget deficit is set to narrow slightly. Reforms to improve the efficiency of spending, shift social assistance towards targeted transfers and further lower costs of doing business would support inclusive growth.

The economy is growing at a healthy pace

Consumption growth has picked up, thanks to ongoing job creation and expanding government social programmes. Confidence indicators have edged down most recently but still point to continued growth. Low headline inflation, at around 3%, is also supporting real income growth. Core inflation is also low and administered energy prices are frozen for 2018‑19. Investment growth has eased from high levels but remains supported by infrastructure investment.

Indonesia

1. The Manufacturing Purchasing Managers Index is a survey-based leading indicator. An index above 50 indicates an overall increase and below 50 an overall decrease in economic activity.

Source: CEIC; Markit; and OECD Economic Outlook 104 database.

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Exports have grown faster than export markets. Increased imports of capital goods and higher oil prices pushed the trade balance into deficit during 2018. Consequently, the current account deficit has widened but it remains moderate, at 2.9% of GDP in the first three quarters of 2018.

Indonesia. Demand, output and prices

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Monetary and fiscal policies are prioritising stability

In the course of 2018, capital outflows have pushed up bond yields and lowered equity prices, tightening financial conditions. Yields on US‑dollar‑denominated debt have been driven higher by rising US interest rates, but the spread for Indonesian debt has widened only slightly. Rupiah depreciation adds to the cost of servicing foreign‑currency‑denominated debt. While the coal price is high, palm oil and rubber prices have declined.

Indonesia

1. Excludes administered and volatile food prices.

Source: CEIC; Thomson Reuters; and OECD Economic Outlook 104 database.

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Bank Indonesia has raised policy rates by 175 basis points since mid‑May to stem capital outflows. So far, bank lending rates – which are high relative to deposit rates – are little changed, thereby limiting the effect of this tighter monetary policy on the domestic economy. However, Bank Indonesia will likely need to increase interest rates during the projection period as US interest rates rise. Allowing additional gradual rupiah depreciation would reduce the steepness of the required policy tightening. Bank Indonesia has also been introducing new financial instruments to facilitate hedging, including a new overnight benchmark interest rate and interest rate swaps. Additional financial market deepening would enhance resilience.

The fiscal deficit is projected to narrow, which will widen the buffer vis‑à‑vis the 3%‑of‑GDP deficit cap and reduce borrowing. Improving the effectiveness of public spending could support growth. The international oil price has increased since the last budget but further increases in the subsidy for diesel should be resisted to avoid crowding out other spending. Restarting energy subsidy reform would free up additional funds for better targeted social assistance. More cost‑reflective fuel prices would lower fuel demand, curbing imports and improving environmental outcomes. Improving tax compliance, by investing in tax administration, would help fund infrastructure and social outlays.

The government has announced a range of measures to curtail imports, including: mandating increased use of biodiesel and hiking withholding taxes on 1 147 imported goods (mostly consumer goods). Boosting exports by streamlining regulations and reducing port waiting times, for example, would better support the economy.

Reinvigorating reform momentum could make the economy more resilient and inclusive amid rising global trade tensions. Continuing to reduce the cost of doing business, fight corruption and relax the negative investment list would help attract foreign direct investment. The new Online Single Submission system for licensing is welcome and should be improved based on user feedback. Experimenting with relaxed employment regulations and a discounted minimum wage for youth in special economic zones could increase formal employment.

Growth will remain solid

GDP growth is projected to remain above 5% in the next two years. Income growth will support a pick‑up in consumption growth. Investment growth is expected to remain robust, partly due to infrastructure investment projects that are already underway. Slowing trading partner growth will increasingly weigh on exports. Nonetheless, recent exchange rate depreciation will curb imports and improve export competitiveness, supporting output growth and helping to narrow the current account deficit. Earlier improvements to regulation and infrastructure will also support export growth. Higher import prices, including for oil, will likely increase inflation somewhat. Nonetheless, inflation is projected to remain inside the target band, which in 2020 will be lowered to between 2% and 4%.

A key downside risk to the projections is that capital outflows intensify, which would lead to further depreciation and likely require tighter monetary policy. Domestic demand would be softer if banks passed on more of the policy interest rate hikes to lending rates. Although Indonesia is less integrated in global value chains than other countries in the region, heightened trade tensions would slow growth through lower exports as well as indirectly via sentiment and commodity prices. A decline in oil prices would ease cost pressures, boost growth and narrow the current account deficit. Conversely, a rebound in the prices of commodities that Indonesia exports would raise incomes.