Short Insight: Indonesia – Stable growth despite turmoil

by: Arjen van Dijkhuizen

  • Economic growth stable around 5%, manufacturing PMI has dropped sharply
  • Relatively low FDI inflows show structural challenges remain
  • We see room for another policy rate cut in Q1-2020
  • Rupiah stable and CDS premium down despite political turmoil
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1.     Economic growth stable around 5%, PMI has dropped sharply

Over the past years, Indonesia’s growth rate has been remarkably stable around 5%, notwithstanding shocks such as the escalation of the US-China conflict and EM market turmoil in 2018. In Q3 2019, growth came in at 5.0% yoy, marginally below the pace reached in previous quarters. Government spending was the biggest drag on growth in Q3, slowing from 8.3% yoy in Q2 to 1.0% in Q3. That reflected a natural correction to a pre-election spending surge. Private consumption slowed from 5.2% yoy in Q2 to 5.0% in Q3. Consumer confidence has fallen since May and growth of retail sales has clearly come down in recent months. Fixed investment slowed from 5% yoy in Q3 to 4.2% in Q2. Indonesia’s manufacturing PMI has dropped sharply over the past months, to a four-year low of 47.7 in October. A similar drop was visible in 2015, but back than that did not go hand in hand with a material slowdown in GDP growth. Looking ahead, we expect economic growth to stay close to 5% in 2020, assuming that the monetary policy easing implemented this year will support domestic demand.

2. Relatively low FDI inflows show structural challenges remain

Given that growth in most of EM Asia and other emerging regions has generally slowed this year, Indonesia’s growth resilience is itself a sign of strength. Indonesia does not seem to have profited much from the US-China conflict related acceleration in the shift of supply chains. Over the past years, Indonesia’s inward FDI to GDP ratio has remained relatively low from an ASEAN perspective. Vietnam, for instance, has been more successful in developing an electronics industry. Jakarta’s special tax policies to attract FDI have proven insufficient to overcome bottlenecks in the areas of infrastructure, wages, trade policy and restrictions on foreign workers. Jokowi’s first government has put efforts in upgrading infrastructure. However, progress slowed at the end of its first term, due to the spread of corruption cases and delays to land acquisition. Under a 2nd Jokowi government, we expect further improvements of the investment climate, infrastructure and education, although if unresolved structural weaknesses will keep a lid on potential growth.

3. After 175 bp rate hikes in 2018, BI cut rates by 100bp this year

CPI inflation has remained well within the target range for 2019 of 2.5-4.5%, dropping to a 6-month low of 3.1% yoy in October. That was partly thanks to the easing of food price inflation (to 4.8% yoy), which had been on the rise in the past half year. Core inflation (excluding food and energy) has been fluctuating in a close range around 3% yoy for a while, coming in at 3.2% yoy in October (August/Sept: 3.3%). On the monetary policy front, Bank Indonesia (BI) was forced to hike rates by 175 bps last year, to 6%, following Fed rate hikes and US-China conflict related risk aversion affecting EMs. This year is different: against the background of subdued inflation, a stagnant economy, Fed rate cuts, a stable rupiah and the current account deficit remaining below 3% of GDP, monetary policy has been eased again. Since June, BI has cut rates four times by 25bp, to 5% in October. At its latest meeting on 21 November, BI kept the key policy rate on hold. Still, BI lowered the reserve requirement ratio for banks from 2 January onwards by 50 bps. That will free up around USD 1.8bn in bank liquidity. Meanwhile, the real policy rate (key policy rate minus inflation) has come down from a peak of 3.5 ppt in March 2019 to 1.9 ppt in Sept/Oct. We see some additional room for easing and have penciled in one more 25bp rate cut for Q1 2020.

4. Rupiah stable and CDS premium down despite political turmoil

In 2018, the rupiah lost 6% versus USD, while the CDS premium rose back from 85 bp end 217 to a peak of 152 bps end November. Calm has returned this year, reflecting a dovish shift of the Fed and some signs of de-escalation between the US and China. In May 2019, S&P upgraded Indonesia’s sovereign rating to BBB, coming in line with Moody’s and Fitch. The rupiah has gained back somewhat and has been stable versus USD over the past months. We expect modest rupiah appreciation versus USD in 2020. The CDS premium has fallen back to historic lows. Regarding the turmoil last year, next to generic factors country specific risks also play a role. Indonesia has a relatively high foreign debt to export ratio and also faces domestic political risks. In the April 2019 elections, president Jokowi secured a 2nd term (that formally started in October), beating the hardline Muslim candidate (and former general) Subianto. Political stability was impaired when Subianto refused to accept his defeat and encouraged his fans to stage protests in Jakarta (his claim was rejected by the Constitutional Court in late June). Tensions between Indonesia’s moderate Islamic identity and more hardline values will persist. Political unrest flared up again in September. In major cities, mass protests led by students were hold against new laws in the areas of corruption fighting and the criminal code. These evolved into the largest protests since the riots in 1998 that brought an end to the Suharto regime. Protests have also flared up in Papua, following an arrest of 43 Papuan students in Surabaya.