Abstract
KEY ISSUES Context: Indonesia has strengthened policy and reserve buffers since mid 2013, in the face of global headwinds from the commodity down-cycle and episodes of volatility affecting emerging market economies. Policies have aimed at containing external and inflation pressures, helping to preserve macroeconomic and financial stability. With growth slowing, the new government is keen to jump start supply-side reforms aimed at raising potential growth while strengthening the external position. Upfront actions to curb fuel subsidies have opened fiscal space to support infrastructure spending. Near-term outlook: After slowing in 2014, growth is projected to tick up to 5.2 percent in 2015, factoring in an anticipated jump in public investment in infrastructure. Inflation has temporarily risen on earlier fuel price increases, but is expected to return to within the target band by year end. Notwithstanding soft commodity prices, the current account deficit is projected to narrow further in 2015. Risks to the outlook arise mainly from a deeper•than-expected slowdown in emerging market trading partners and surges in global financial market volatility, which could exacerbate strains on the domestic banking and corporate sectors. Policy mix: The current policy mix aims at improving growth potential while consolidating recent stability gains and containing vulnerabilities. Fiscal policy should be geared towards securing space for more social and capital spending, underpinned by a broad-based strategy for increasing nonoil tax revenues, while pursuing moderate deficit reduction over the medium term. Monetary policy needs to remain focused on anchoring inflation expectations and facilitating external adjustment, supported by continued exchange rate and bond yield flexibility. Bank funding pressures, while showing signs of easing, will need to be managed through stronger policy coordination and improved market functionality. Financial stability is expected to be preserved through enhanced risk assessment and effective prudential measures, anchored by a strong crisis management framework. Structural reforms should be aimed at easing supply bottlenecks and improving the investment climate in order to create new jobs, bolster medium-term growth prospects, and strengthen the external position.
1. On behalf Indonesian authorities, we would like to thank the IMF mission team for the constructive and candid discussions during the Article IV consultation. The discussions focused on the new administration’ policies to manage vulnerabilities and boost potential growth in the medium-term. We are encouraged by staff’ recognition that the authorities’ sound macroeconomic management has bolstered policy credibility and strengthened the external resiliency of Indonesian economy.
2. As clearly described by staff, the Indonesian economy continues to demonstrate its resilience and is on better footing to weathering the unfavorable and headwinds of global development. Macroeconomic stability is preserved and economic rebalancing progresses to a more sustainable path, underpinned by economic stabilisation policy and structural reforms. Financial system stability is also maintained with the support of steadfast banking system resilience and sound financial market performance. To arrive at this stage, the authorities have continuously strengthened the economic fundamental, including taking bold and pre-emptive macroeconomic policies to withstand a spillover impact from global economic adjustment.
3. Moreover, successful elections in mid 2014 have brought momentum and optimism to the country. The new government has put structural reforms as its priority to address infrastructure bottlenecks and sustain a balanced growth in the medium-term. This has brought back investor confidence as reflected in substantial capital inflows in 2014. Moving forward, the authorities have set out clear strategies to secure macroeconomic and financial stability. They have also laid solid foundation to maintain a balanced and sustainable growth in the longer term. These include maintaining prudent fiscal management by managing the fiscal deficit at the low level, and keeping debt to the GDP ratio at the sustainable level. Exchange rate will also be kept flexible, to function as a shock absorber, as well as a facilitator of external adjustment.
Recent Economic Development and Outlook
4. The Indonesian economy grew 5.02 percent (yoy) in 2014; remain strong despite slowing from 5.6 percent in 2013. The lower economic growth in 2014 was inevitably as a result of slower-than expected global growth which in turn affects export performance. Furthermore, domestic demand growth moderated, in line with the authorities’ policies to prioritize economic stabilization. In 2015, the authorities expect the growth to accelerate to 5.4 -5.8 percent, higher than staff’s projection of 5.2 percent. Strong household consumption and greater fiscal capacity to support economic activity will swiftly catalyze higher economic growth.
5. CPI inflation escalated to 8.36 percent in December 2014, mostly due to the rise in administered price components. The fuel price adjustment in November 2014 has temporary put upward pressure on inflation. Nevertheless, the core inflation was relatively well managed at 4.93 percent, showing that the monetary policy stance could contain the second round effect of fuel prices hike. The authorities believe that the inflation has reached its peak in December 2014 as illustrated in declining level of CPI inflation in first two months of 2015, which fell to 6.3 percent (y/y) in February. Going forward, the authorities are assured that the inflation will be contained and reach the target of 4±1 percent in 2015.
6. On the fiscal side, the authorities continue to maintain sound fiscal management and keep debt to GDP ratio at a safe level to secure fiscal sustainability. Recognizing the importance of infrastructure to lift the potential output in the medium-term, the focus of fiscal policy is increasing budget allocation for infrastructure investment and poverty alleviation.
External Sector Assessment
7. Coherent stabilization policies in monetary and fiscal front, as well as improved investor confidence have significantly enhanced the Balance of Payments (BOP) in 2014. The BOP recorded a surplus of US$ 15.2 billion, against a deficit of US$7.3 billion in 2013 as the current account improved and financial account recorded a sizable surplus. The current account deficit narrowed to US$26.2 billion (2.95 percent of GDP) from US$ 29.1 billion (3.18 percent of GDP) in 2013. It is worth to note that the improvement in the current account was supported by higher the non-oil/gas trade balance as a result of stronger manufacturing exports, and declining imports due to subdued domestic demand. Furthermore, the large influx of foreign capital made the financial and capital account register a surplus of US$43.6 billion. This includes a rise in Foreign Direct Investment (FDI) inflows that extended to manufacturing, agriculture, mining, and transportation & communication sectors.
8. The authorities view that Indonesia’s external position is in line with its medium-term fundamental. The current account deficit is within the range as suggested by the EBA, a model that the authorities have replicated to ensure their assessment is comparable to Fund’s suggested best practice. The current policies, including the flexible exchange rate, have facilitated external adjustments in the current account toward a sound level as well as better composition. Manufacturing sectors have improved and could ultimately compensate a decline in commodity export following a decrease in commodity prices. Furthermore, Indonesia is on the crossroad to move up from middle income country group. Increasing the economic activity still requires more import contents that may lead to the current account deficit. In this regard, staff could have provided more granular recommendation on how to balance between effort to promote economic activity and to maintain healthy external balance.
Monetary Policy and Exchange Rate Policy
9. The authorities are cognizant of the importance of anchoring inflation expectation and managing external shocks. In this regard, Bank Indonesia (BI) launched the policy mix by adopting tight monetary policy to control inflation, maintaining flexible exchange rate to promote an adjustment on the current account, and introducing capital flow management (CFM) to dampen short-term excessive volatility. The rise in policy and lending facility rates to 7.75 percent and 8.00 percent following the fuel prices adjustment in November 2014 had brought down the spike in inflation rate; meanwhile flexible exchange rate and CFM have supported the authorities in narrowing the current account deficit and strengthening external resiliency.
10. On February 2015, BI lowered the policy rate and the deposit facility rate 25 bps to 7.50 percent and 5.50 percent respectively. This decision was taken after the authorities’ comprehensive assessment concluded that a drop in the expected oil prices along with benign development in domestic food prices and manageable domestic demand will present considerable downside risks to expected inflation. Hence the authorities are confident that inflation will remain under control and will fall at the lower end of the 4±1 percent target range in 2015 and 2016.
11. The authorities would consistently adopt flexible exchange rate in line with its economic fundamental value. This would help to facilitate external adjustments and safeguard current account sustainability. The authorities’ also share staff’s assessment on the importance of strengthening monetary policy transmission; thus, they would further enhance the monetary operations frameworks. Recognizing the importance of deepening financial market, the authorities move forward with efforts to address shallow financial market. These include amending BI’s regulation on hedging activities to increase hedged market liquidity, and introducing Islamic Foreign Currency Term-Deposit. Bond yield flexibility will also be continued to complement primary response against external shocks as currently practiced.
Fiscal Policy
12. As acknowledged by staff, the government’s fiscal rule has provided a solid nominal anchor. The authorities deliberately adopt prudent fiscal policy by maintaining the deficit below 2.5 percent and managing public debt at a low level. In 2014, the fiscal deficit was targeted at 2.4 percent of GDP and public debt was successfully retained below 30 percent of GDP. Initiatives to maintain strong fiscal position were in place, ranging from enhancing revenue to improving the quality of spending. In terms of optimizing revenue, tax reforms will continuously be pursued. Meanwhile, on improving the quality of spending, the recent fuel price adjustment was the main policy measures to cut spending. The reforms on energy subsidies provide significant fiscal space to anticipate undesirable impacts from global economic development, as well as to invest in infrastructure projects. Considering the impact of rising fuel prices to the low-income and vulnerable people, the authorities launched a compensation program by distributing cashless smart cards system that covers education, cost of living, and health insurance and medical benefit.
13. Moving forward, the authorities reiterate its commitment to maintain sound fiscal management. Fiscal policy will focus on improving budget structure to buttress real sector activities and reduce poverty while maintaining macroeconomic stability and boosting potential growth in the medium term. Continued efforts to improve the current account would also be enforced by providing fiscal incentives for industries that produce intermediate goods and re-investing their dividends, as well as strengthening reinsurance and local shipping industry. In light of this, the authorities expect the fiscal deficit to be around 1.91 percent of GDP in 2015.
14. The authorities are mindful that continued decline in oil prices will have an impact on non-tax revenue. They will strive to substantially increase tax revenue in order to offset lower non-tax revenue. In this connection, the authorities will persevere to maintain sustainable revenue sources by revamping tax administration, increasing compliance of individual taxpayers, strengthening enforcement and reducing tax distortion in strategic sectors, broadening tax based, optimizing custom and excise policies and enhancing the VAT system.
15. On the expenditure side, budget spending is intended to stimulate the economy through increasing capital expenditure to improve competitiveness and production capacity. The authorities would also reallocate budget to productive spending to generate employment and alleviate poverty. In this regard, additional budget would be allocated to village funds to induce productive activity in the remote areas and promote more inclusive growth, as well as capital injection to SOEs to support infrastructure development.
Financial Sector
16. Indonesia financial sector remains strong amidst challenging macroeconomic environment in 2014. Industry wide, banks are well capitalized and equipped with ample liquidity, with Capital Adequacy Ratio (CAR) is maintained at 19.36 percent, much higher than required minimum level. Credit and liquidity risks are also contained, underpinned by solid capital structure. Despite showing an uptick, Non Performing Loans (NPLs) were retained at low level of 2.2 percent. Meanwhile credit growth decelerated to 11.6 percent, in line with subsiding domestic economy activity. Sound banking system is confirmed by stress test conducted by the authorities which demonstrates that Indonesian banking sector possesses strong resilience to weather severe shocks.
17. While staff has concern on the possibility of renewed funding pressures in banking system in the event that deposit growth lags credit growth, the authorities are confident that the concern is unlikely to materialize. Heightened funding pressures in early 2014 were owing to segmented market and seasonal factor due to government fiscal contraction, while banking liquidity remains sufficient. The liquidity condition has been improved during the second half of 2014, in line with the fiscal expansion and improvement in deposit growth. Furthermore, demand for credit was low, thus it lessened funding pressures.
18. The authorities continue to employ macro-prudential policy to maintain financial stability. They will also launch measures to enhance funding resources for banks while promoting financial market deepening and extending loan to productive sectors. Steps to strengthen financial sector regulation and supervision continue to progress, among others, by developing integrated risk based supervision, increasing banks’ capital to meet Basel III standard, adjusting capital requirements and product enrichment for insurance industry and encouraging more firms to accumulate funds through capital market.
19. Meanwhile, risk form the corporate sector is expected to be contained as the authorities have issued regulation to promote prudent external debt management for nonbank corporations1. The purpose of this regulation is to further deepen the financial market as well as to mitigate risks on private external debt vulnerability, primarily currency risk, liquidity risk, and over-leverage risk. To confront the aforementioned risks, Bank Indonesia requires non-bank corporations holding external debt to fulfill three requirements, namely a minimum hedging ratio to mitigate currency risk, a minimum forex liquidity ratio to mitigate liquidity risk and a minimum credit rating to mitigate over-leverage risk. In addition to ensuring prudential principles, the minimum hedging ratio required by the regulation will also contribute in expanding the hedging market. While the corporate moves toward better prudent practices, banking sector has cushioned themselves with the sufficient capital buffers.
20. Furthermore, acknowledging the importance of crisis management framework, the work on finalizing the Financial Sector Safety Net (FSSN) Law is on progress and has become a top priority of the new government to be completed this year.
Structural Reforms
21. We concur with staff on the need of upfront actions to enhance structural reforms. In light of this, the new government has a strong commitment on structural reforms to improve productivity, explore new source of growth, develop financial markets and undertake a comprehensive energy policy. Fuels subsidy reforms taken at the end of 2014 demonstrated the authorities’ swift actions to advance structural reforms. The main focus of structural reforms is to address supply bottlenecks, diversify the economy from commodity sector and raise potential growth. In this connection, the new government has set up infrastructure investment plan for 2015-2019 that covers many sectors, such as transportation, energy, clean water and telecommunications.
22. The implementation of infrastructure development is complemented by efforts to improve business climate. In doing so, the authorities implement One Stop Service to streamline approval process, improve the quality of public service and governance, step up with the implementation of the Land Acquisition Law, increase productivity by providing incentives for research and development activity, as well as strengthen labor policy. The authorities would also develop agriculture and fishery sectors to support food security and generate employment.
23. Finally we are pleased to share that we continuously improve our AML/CFT compliance and this effort has been acknowledged by the FATF in its February 2015 public statement.
Conclusion
24. In summary, amidst the global uncertainty, Indonesia moves forward to transform into a better, more sound and sustainable economy. Nevertheless, the authorities recognize the challenges that lie ahead and do not want to loose sight. They will closely monitor the latest development of both domestic and global economy in order to maintain consistent and bold policy measures. The authorities also reiterate their commitment to remain vigilant and stand ready to take proactive measures to ensure that macroeconomic and financial stability are well preserved. Having said that, the authorities would benefit from staff’s advice that not only helps Indonesia to stay in current stage, but also takes Indonesia to reach a higher level. In that regard, they look forward to a continued constructive engagement with the Fund.
This includes Bank Indonesia regulation No. 16/20/PBI/2014 concerning Prudential Principles for the Management of Non-Bank Corporate External Debt to corporate borrowers of foreign loans on 28th October 2014 which was further amended with BI Regulation No. 16/21/PBI/2014 dated 29 December 2014.