Emerging markets have been experiencing financial volatility since the first half of 2018, as the US Fed increased interest rates. Anxiety about ‘trade wars’ has intensified, increasing uncertainty about global economic prospects. The United States has just announced additional tariffs on roughly $200 billion of Chinese imports across 200 product categories. Tariffs of 10 percent came into effect on September 24, 2018. These tariffs will increase in January 2019, if an agreement is not reached by then.
Some emerging markets have been under substantial pressure. The Argentine peso has depreciated by 50 percent this year; the Turkish lira by 40 percent. Predictably, foreign investors have exited emerging markets, including Indonesia.
The Government’s reaction to these events has been quick, decisive, and coordinated. The Ministry of Finance is delivering lower deficits in 2018 and 2019, while an electoral campaign is ongoing. Bank Indonesia has raised interest rates three times despite inflation being within its target and has not defended a level for the Rupiah.
The Rupiah has depreciated moderately by about 9 percent this year – which caused some to predict further capital outflows and greater currency devaluation. They point to the “twin” fiscal and current account deficits.
They also seem to invoke the specter of 1997 – which still seems to haunt some people. The fact is clear that 2018 is not 1997 or 2013, for that matter. Indonesia is in a much stronger position today than in the past. While there are risks coming from overseas, let me be clear: Indonesia has strong fundamentals and an adequate policy response function.
To start, the moderate depreciation of the Rupiah this year is a source of strength. The fixed exchange rate regime in 1997 contributed to the build-up of imbalances: the exchange rate was fixed but domestic prices rose faster than in trading partners, the real exchange rate became overvalued, stimulating demand for imports and hurting the competitiveness of exports. Ultimately, a capital account crisis took place.
With a flexible exchange rate now, moderate devaluation makes imports more expensive, exports cheaper, and the dollar value of profit transfers lower. These elements reduce the current account deficit automatically.
Second, the current account deficit is not as large as in the past. In the first half of this year, the deficit was 2.3 percent of GDP, compared to 2.7 in 1997 and 2.9 in 2013. Today’s current account deficit has not been driven by consumption. Rather, it has been mostly caused by imports of capital goods required for investment. For instance, mining companies have been funding infrastructure projects which need new equipment, which will expand the productive capacity of the economy.
Turning to the other ‘twin deficit,’ Indonesia’s fiscal policy has been and remains prudent and responsible. Deficits have been kept well below the 3 percent of GDP limit and government debt is around 30 percent of GDP -- among the lowest levels of any emerging or advanced economy. Total external debt was contributor to the 1997 crisis. It has come down from 49 percent of GDP in 1997 to 35 percent of GDP in 2018, a large share of this debt is denominated in Rupiah.
There are many more areas of strength. The banking sector is well-capitalized, the corporate sector is less indebted today than in 1997 and must hedge its foreign currency debts; BI has more reserves today than in 1997 or 2013, and more lines of credit, in an amount about 10 times the current account deficit.
Nonetheless, the authorities may wish to consider increasing the economy’s resilience to external volatility by reducing the structural current account deficit and reliance on volatile portfolio flows. There are opportunities to do so, including:
First, Indonesia punches below its weight with respect to exports, and would benefit from greater integration with the global economy.
Second, although energy subsidies have been reduced in favor of targeted transfers to the neediest, prices of electricity and some fuels are not yet fully aligned with the market, which stimulates their imports and dampens coal exports.
Third, Indonesia attracts less FDI compared to peers, in large part due to significant restrictions to foreign investments.
Expanding exports, reducing fuel imports, and boosting FDI, especially in export-oriented industries, would strengthen Indonesia’s current account and reduce its reliance on portfolio flows.