Pressures on Indonesia’s current account came to a head in May 2013 as portfolio investments reversed their flow and began leaving the country. Authorities have reacted to curb further growth in the deficit. With Bank Indonesia (BI) responsible for monetary tightening, the government has followed with a series of measures to balance the trade position. Although the impact of fiscal measures will become evident only over the medium term, policies have yielded some early fruits. Over the long term, however, only a coherent industrialisation policy will sustain a balanced current account.
With sustained growth in manufacturing investment and continued reliance on commodities for the bulk of its exports, Indonesia’s current account has been under pressure since the fourth quarter of 2011, when it swung to a deficit of $2.3bn. With commodities such as coal, crude palm oil (CPO) and rubber accounting for 63% of total exports in 2012, according to BI, these have continued to fall since their peak of $57.76bn in the third quarter of 2011. This has been largely caused by slowing demand in China, Indonesia’s biggest export destination, and a drop in prices for key commodities. “The price index of our goods exports declined by nearly 15% in 2012, mainly due to slower growth in our major trading partners, including India and China,” Luky Alfirman, head of the Ministry of Finance’s centre for macroeconomic policy, told OBG. Exports fell from $203.5bn in 2011 to $190bn in 2012.
Meanwhile, foreign direct investment (FDI) grew consistently from $19.5bn in 2011 to $24.6bn in 2012 and roughly $14bn in the first half of 2013, 47.9% of which focused on the secondary sector and manufacturing particularly, according to BKPM. According to BNP Paribas, FDI covered 77% of the current account deficit (CAD) in 2012. With little production of intermediate goods, however, investment in the final stages of manufacturing has driven growth in imports: in 2012 a mere 7% of imports consisted in consumer goods, while 20% were capital goods and 73% intermediate and raw materials. As exports slowed from 13.6% growth in 2011 to a 6.6% contraction in 2012, imports continued to expand by 13.3% in 2011 and 8% in 2012. As Indonesia recorded its first annual trade deficit since the 1960s, of $1.63bn in 2012, its current account swung from a small surplus of 0.2% of GDP in 2011 to a 2.8% deficit in 2012 and 4.4% by the second quarter of 2013. While the current account typically comes under pressure in the second quarter given higher imports, firms’ debt servicing and repatriation of profits, the second quarter of 2013 witnessed the largest quarterly deficit given the run-up to Ramadan in July. The trade deficit reached its nadir of $2.3bn in July 2012, according to Statistics Indonesia. With worsening trade figures coinciding with a global outflow from emerging markets caused by indications from the US Federal Reserve of possible tapering of its quantitative easing programme, portfolio flows reversed starkly and the rupiah’s depreciation accelerated from June onwards.
The central bank’s response evolved rapidly during the crisis. Initially it attempted similar moral suasion as in past currency depreciations, in 2008 and in 2011, through open market operations and attempts to steer the market through rate indications. This led to an 11.5% drop in its foreign currency reserves in April-August, from $104.8bn to $92.7bn, alongside a widening gap between BI-quoted exchange rates and those offered by commercial banks and the Singaporebased non-deliverable currency forward market. Investors’ concerns over the domestic foreign-currency liquidity and their ability to repatriate capital has exacerbated capital outflows and preserved pressure on the currency. Although August reserves were sufficient to cover five months of imports and debt servicing, their rapid fall prompted a revision of tactics. The central bank had already tightened the overnight lending rate ( FASBI) and its benchmark interest rate by 25 basis points each in June 2013, anticipating the fuel subsidy reduction’s impact on inflation. From July, however, BI accelerated its monetary tightening significantly: it hiked the two policy rates by 50 basis points in late July, 50 basis points in late August and another 25 basis points in both mid-September and mid-November – cumulative 175 basis point hikes in the FASBI (to 5.75%) and the benchmark rate (to 7.50%) in the six months from June, the highest rates since early 2009.
This was combined with macro-prudential measures to dampen domestic lending growth, as BI reduced banks’ loan-to-deposit ceilings from 100% to 92% and raised their secondary reserve requirements, those covering banks’ holdings of government securities, from 2.5% to 4%. This contributed to a slowdown in lending growth, which in turn helped curb imports (see Banking chapter). BI also cut the minimum holding period for central bank certificates (SBI) from six months to one month in a bid to attract more foreign investors. Furthermore, the bank introduced new measures to support domestic foreign-currency liquidity by easing US dollar purchase rules for exporters, waving the requirement for proof of underlying transactions to attract more US dollar liquidity onshore, lengthening its US dollardenominated time deposit facilities to 12 months and reintroducing US dollar swap auctions from late July.
“The value of foreign exchange swaps by BI has mushroomed since they were first introduced in July 2013, rising by over $3bn in September alone,” Helmi Arman, economist at Citibank Indonesia, told OBG. The central bank has also suggested the idea of a US dollar-denominated SBI, a unique concept worldwide, to attract more dollar liquidity onshore. While the interest-rate hikes were warranted given rising inflation prompted by the fuel price hikes implemented in late June – with y-o-y inflation accelerating from 5.9% in June to 8.6% in July and 8.8% in August – economists disagree on whether BI has tightened too fast.
While foreign-linked economists argue the rate hikes were warranted to preserve foreign investors’ yields amidst the currency correction and concerns over inflation and the CAD, most agree inflation will return to the 4.5-5.5% trend rate by June 2014 given the base effect. “We are seeing a new form of monetary policy from BI, targeting the current account rather than inflation,” Purbaya Yudhi Sadewa, Danareksa’s chief economist, told OBG. “This is strange given that the CAD is a natural by-product of our success in attracting FDI, similar to our consistent CAD in the 1981-97 period.”
While BI paused its tightening cycle in October, the bank increased rates by a further 25 points in November 2013. Although the bank shifted its monetary policy stance from influencing the direction to smoothing out short-term volatility, it has also expanded its firepower by securing new forex-swap lines from foreign central banks. Already a member of the Chiang Mai initiative, a multilateral swap initiative involving 10 ASEAN members alongside China, South Korea and Japan, BI also expanded bilateral swap agreements (BSAs). In August it extended a $12bn yen-denominated BSA, with Japan indicating in October its readiness to increase the swap’s value if needed. In early October China signed a RMB100bn ($16.1bn) yuan-denominated BSA with Indonesia, while South Korea signed a $10bn deal. While BI reacted swiftly, the government also announced fiscal measures to address the crisis. “There is a perception gap between global investors, concerned about yields and calling for interest rate increases, and what BI and the government are doing,” Anton Gunawan, Danamon Bank’s chief economist and executive vice-president, told OBG. “Indonesian authorities must also look at liquidity in the banking sector and the impact of rate hikes on employment – other policy measures, including macro-prudential policies, are necessary aside from interest rate movements.”
Although the onus for short-term action was squarely on BI in mid-2013, the government unveiled a package of measures in August 2013 that are aimed at curbing imports, strengthening consumption and supporting investment in labour-intensive and export industries particularly. “We are looking to readjust our current account by diversifying exports and curbing excessive imports,” Luky told OBG.
The measures focus on four key areas. Those measures concerning foreign direct investment (FDI) include the streamlining of licensing requirements, removing barriers on strategic investment projects and accelerating the revisions to the negative investment list, announced in late December 2013. Reforms aimed at curbing the CAD include tax incentives for export-oriented industries, higher taxes on imported luxury goods and raising bio-diesel fuel content to curb imports. The measures also include policies to preserve employment, including tax incentives for labour-intensive firms, revisions to the minimum-wage negotiation process and easing of some restrictions on bounded zones, doubling their domestic sales ceiling to 50% of output (see analysis). Finally, the government also sought to tame non-fuel inflation by moving from import quotas to price mechanisms for imports of beef and horticultural products, a suspension of prior policies that had fuelled food-price inflation.
Economists have welcomed these policy measures but warn that their impact may be limited in the short term. “The government’s August package tried to address the widening current account deficit, but this is a medium to long-term package,” Fauzi Ichsan, Standard Chartered’s senior economist, told OBG. “With commodities, mostly energy-related, accounting for over 60% of exports it is hard to see how they will grow in the coming year, while the package did not address the issue of the US dollar liquidity gap.”
A higher CPO content for domestic fuel provides an alternate outlet for high CPO production amidst depressed global prices, helping curb refined fuel imports – given that roughly 60% of fuel consumption is concentrated in Java and Bali, the measures will have a quicker impact. While politically-expedient, the higher luxury tax will only have a limited impact on Indonesia’s import bill. Meanwhile, measures to boost FDI will take longer to manifest; however, the revision of the negative list should help spur activity.
Addressing the structural causes of the CAD will take longer, given the need to establish domestic production of intermediate materials and capital goods required by growing investment in manufacturing. “Some of the measures enacted to curb the current account deficit are good, but they do not go far enough,” Anton told OBG. “We would need to see a coherent industrialisation vision to establish the necessary infrastructure and substitute some of the imported intermediary goods that have driven the deficit’s growth.”
Slowing economic growth, tighter domestic lending and reduced fuel imports, stemming from higher domestic prices, started to gradually impact key indicators in September 2013. “We expect pressure on the current account to moderate in the second half of 2013, given lower imports of capital goods, intermediate and raw materials, as well as lower fuel imports, as a consequence of the subsidy cut in June 2013,” Luky told OBG. “We forecast an annual CAD in the 3-3.5% range.”
Indonesia’s trade balance returned to a small ($132.4m) surplus in August, buoyed by weaker imports that dropped 5.69% year-on-year (y-o-y) and 11.4% month-on-month (m-o-m) while exports sustained their fall of 6.3% y-o-y and 12.8% m-o-m according to Statistics Indonesia – despite a 21.5% y-o-y rise in hydrocarbons exports. While lower fuel imports played a role in curbing trade imbalances, imports of capital goods also fell 17% y-o-y in seven months to August.
The slight improvement in the third quarter of 2013 provides some relief to Indonesian authorities, although they admit the coming year will consist of a confidence game with markets where they must demonstrate they are ahead of the curve. Long-term, the government will need to encourage investment throughout its production chain, focusing on developing onshore supply chains that can reduce pressure on imports of capital goods and intermediate materials. With no quick fix to Indonesia’s CAD, and amidst preparations for presidential elections in mid-2014, the onus will continue to be on BI to preserve credibility with the global markets.
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