Global Risk and Recovery
Indonesia's economic recovery continues with inflation under control. Even with rising global risks, the economic recovery is likely to continue. High economic growth can still be achieved.
The currently heightening global risk is related to the interest rate increases by the United States Federal Reservce and other central banks due to high inflation.
Inflation in the US is 8.4 percent, Europe 7.5 percent, the United Kingdom 9 percent, and even higher in many developing countries. The Russian-Ukrainian war has pushed up food and energy prices. Covid-19 lockdown measures in Shanghai, China, suppressed Chinese and global economic growth because it disrupted global supply chains and hampered consumption. A number of circles have even predicted stagflation, or simultaneous recession (negative growth) and high inflation.
The heightened global risk is indeed affecting the Indonesian economy. However, as a commodities producer, Indonesia is also benefiting from the sharp increase in exports, a trade surplus, and increasing public consumption, which have led to continued economic growth amounting to 5.01 percent in the first quarter of 2022. Meanwhile, inflation has increased to 3.47 percent, nearly equivalent to the Bank of Indonesia (BI) policy rate of 3.5 percent. The policy rate should be sufficiently higher than inflation. Controlling inflation by increasing energy subsidies, which continue to rise, is certainly very burdensome for the state budget and harms the economy.
The Fed’s delay in anticipating inflation has prompted it to increase its interest rates by 0.5 percent. The capital market has experienced a decline, with bond yields rising or prices falling. The gold price has risen as an alternative investment.
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However, the value of cryptocurrencies, which are expected to be an alternative investment, has also decreased in positive correlation with the capital market, while commodity prices have increased. The value of the US dollar has increased to become a safe haven for investment. This has led to capital outflows from developing countries and depressed the value of their currencies against the US dollar.
A number of analysts and investment banks are starting to forecast stagflation in the US and EU. At the very least, there is the possibility of low growth and high inflation. It seems that the central banks of developed countries have not been very aggressive in raising their interest rates to deal with the high inflation, for fear that a recession will occur. The global risk is increasing as the Russian-Ukrainian war continues. With the halting of oil imports from Russia, oil prices have again risen to above US$100/barrel. Food prices have also risen because Russia and Ukraine are major producers of wheat. Combined with the lockdown in Shanghai, the Chinese economy has slowed and global supply chains have been disrupted.
This high global risk will likely remain until 2023 due to the uncertainty over rising food and energy prices as an impact of the ongoing Russian-Ukrainian war. Supply chain disruptions will not be resolved quickly.
Meanwhile, the US and EU central banks may not be aggressive in raising interest rates amid the increasing global risk. The monetary policies of developed countries are still relatively relaxed, even though interest rates have begun to increase and fiscal policy is still expansive with a high deficit (still in the Buenos Aires Consensus), and they have not implemented monetary and fiscal tightening, eliminated subsidies or privatization (not yet returning to the Washington Consensus).
Implications for Indonesia
Indonesia's economic recovery has continued thus far, with inflation still under control, although it is starting to increase with the rupiah under pressure. However, Bank Indonesia (BI) must begin to raise its interest rates to anticipate inflation and stabilize the value of the rupiah. This step will not interfere much with sustainable economic recovery.
Public consumption can continue to increase, even though low-income households are being depressed by rising inflation. Therefore, direct subsidies and social assistance with the right target must be increased to help this group. The direct subsidy system must continue to be improved in effectiveness and accountability. Energy subsidies should generally be reduced, because they disrupt resource allocation and burden the state budget. The state budget assumes an oil price of $63/barrel, while the market price is already above $100.
With the higher oil price, the Finance Minister proposed increasing the energy subsidy allocation by Rp 74.9 trillion. A rational policy should ideally aim to adjust the domestic fuel price, at least to a certain degree, with a balanced economic rationale and sociopolitical response. As such, it should be substituted with direct subsidies that only target low-income households.
Credit cycle
Indonesia’s credit cycle is closely related to the cycle of commodity prices and public consumption. Credit growth has reached around 7 percent and could increase again in line with the rising prices of Indonesia's main export commodities, namely crude palm oil (CPO) and coal. The high credit cycle (upswing) is also in line with post-pandemic recovery and growth in public consumption. This credit cycle becomes stronger when investment increases.
Efforts to improve the investment climate are starting to show results, with increasing foreign and domestic investments. The increasing global risk is certainly affecting investment flows, both in portfolio and foreign direct investments. However, with the investment climate continuing to improve, direct investments can still be expected to increase, especially those related to global supply chains. Portfolio investments have been more negatively affected due to capital outflows.
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The increased commodity prices contribute to export revenues on the one hand, but burden the public with rising prices on the other hand. High coal prices make it difficult for state-owned electricity company PLN to source domestic supplies. High CPO and cooking oil prices burden the public. The policy of banning exports to control prices and domestic supplies creates new problems, like we experienced when coal and cooking oil exports were banned, even though exports have since resumed.
If we are consistent and on target with direct subsidies, a policy of raising taxes on commodity exports is more appropriate, with the revenue used for subsidies that target the lower classes. Of course, the domestic market obligation will still apply.
Priority on the real sector
During the period of economic recovery, the economic sectors that are showing high growth are transportation, communications, trade, and mining. The manufacturing industry is already on an upward growth trend. Growth in the transportation, telecommunications and trade sectors will continue in the post-pandemic period, practically in line with the market mechanism that has developed. Growth in the mining industry is largely determined by cyclical increases in commodity prices.
Food and beverage production also has a well-established market mechanism; likewise the automotive and chemicals industries. The electric vehicle initiatives and related supply chains, including prioritized mineral processing, are related to investment and development of the industry’s structure and of course, the price cycle of mineral raw materials.
Experience in strategic industry development and import substitution, such as in the chemical, steel, and aluminum processing industries, shows the difficulty of establishing competitive industries. Even if raw materials are abundantly available, the cycle and fluctuation of market prices make it very difficult for industries to adapt.
Even though inflation is high and interest rates are also high to balance it, a policy of reducing subsidies by substituting direct and targeted subsidies should be carried out as much as possible.
Serious financial problems come with delays in technology adaptation, and the domestic market experiences losses when imports resume. Therefore, selective and focused industrial policies are very important. The nickel processing industry can be prioritized in the development of its upstream and downstream infrastructures. Meanwhile, exports other minerals should still be allowed, and if the processing and downstream industries are to be developed, they must be competitive from the outset in line with the market mechanism and not just rely on political will, such as by banning mineral exports.
Even with the increasing global risks, Indonesia's economic recovery is likely to continue. Economic growth of above 5 percent or higher can still be achieved by relying on consumption, investment, and taking advantage of high commodity prices. An improving credit cycle in line with consumption recovery and rising commodity prices has benefited Indonesia.
Even though inflation is high and interest rates are also high to balance it, a policy of reducing subsidies by substituting direct and targeted subsidies should be carried out as much as possible. The same goes for improving the investment climate. As regards developing the priority industries, especially the electric vehicle industry along with the spare parts sector, the integrated development of upstream and downstream industries can be prioritized. Industry priorities must be focused and strict to avoid failure because they are uncompetitive.
Umar Juoro, Senior Fellow at the Habibie Center
This article was translated by Hyginus Hardoyo.