Global Recession and Policy Choices
The government must give priority to “what must be done” and not to “what it wants to do.” The situation may put us in a quandary, but we must not go wrong in policymaking.
This may be a treatise on a situation going awry. We indeed are in a quandary because we are to choose the lesser of two evils. We are coping with an anxious world. The storm is impending.
Larry Summers, former treasury secretary of the United States and professor at Harvard Kennedy School, has glumly said the level of risk in global markets today is reminiscent of the conditions seen in 2007 ahead of the great recession. He warns, "This is certainly not a time for firefighters to book a vacation."
Summers may have been overly gloomy in seeing the prospects, but he may be right. And there is a reason for that. I once wrote in early August (5/8/2022) about the possibility of a global recession and its impact on Indonesia. Frankly, I fear if my analysis comes true or happens quickly. Just take a look at the inflation of producers for industrial products in Germany. It reached 46 percent in August compared to the same period in the previous year.
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At the consumer level, inflation in Germany has reached 10.9 percent, which is its highest in 70 years. If winter is bad this year, gas consumption will grow even higher.
This will raise energy prices and tip the German economy into a recession. We know Germany is the growth motor of the European Union (EU). If Germany plunges into a recession, it is not impossible Europe will be dragged down.
In addition, central banks in Europe and the US will raise interest rates to cope with inflation. This will hit investments and consumer spending. Economic growth will contract and pull the US and Europe into an economic recession. Economic contraction in the US and Europe will reduce the demand for exports globally, including China, which will also be experiencing a downturn in economic growth. The implication is that ASEAN exports to China, including Indonesia, will decline.
Impact on Indonesia
This situation will be exacerbated further by the expected decline in commodity prices, notably for those that have so far become "the saviors" for the Indonesian economy. My prediction is that, by the end of this year, Indonesia's exports will still be relatively strong. The economic slowdown will start next year. What is the impact of this global recession on Indonesia? What can be done?
There are a few things we may need to pay attention to. First is trade. Global recession, particularly the slowdown in China's economy, will bring down Indonesia's exports. However, geopolitical tensions due to the Russia-Ukraine war will increase coal prices. This is reasonable given the fact that, as I mentioned above, European countries like Germany have a high energy-dependence on Russia.
The impact of a global recession on Indonesia will not be as bad as it will be on Singapore, South Korea, Taiwan or other export-oriented countries.
If gas is difficult to procure, they will have to switch their energy source to coal. Despite starting to dip, I believe, coal prices will remain relatively high. This helps us. How much will our exports adversely take a hit? It depends on the net effect of the decline in exports due to the global recession with the windfall in coal prices brought about by the Russian war.
In my estimation, the impact of a global recession on Indonesia will not be as bad as it will be on Singapore, South Korea, Taiwan or other export-oriented countries. Why? Indonesia's export portion of gross domestic products (GDP) is relatively small compared to Singapore, South Korea or other export-oriented countries.
We fortunately will gain a kickback from our lack of integration into the global economy, something we should actually be pursuing. However, we have to admit that the limited integration into the global economy will cause us to get back on our feet more slowly than others when the global economy recovers.
Second is finance. Economist Jeffrey Frankel of Harvard Kennedy School predicteds that the US dollar will continue to strengthen. There are several reasons for this. Despite slowing down due to a recession, economic growth in the US will still perform better than European countries.
With the US economic growth relatively better than Europe and many other countries, the US dollar will strengthen. In addition, the US terms of trade will also strengthen thanks to price increases in energy and commodities. As a net exporter of commodity products — of energy as well — the US will receive the windfall. The strengthening US terms of trade — meaning that the demand for US exports is stronger than the country’s need for imports — will also strengthen the US dollar.
In addition, the strengthening US dollar will also help the impact of higher interest rates in the US compared to other countries. Given such a buildup, I will not be too surprised if the currencies of a number of countries, including the rupiah, weaken against the US dollar. These repercussions have been evident in the last few weeks.
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Under these conditions, Bank Indonesia's (BI) policy options are limited: raising interest rates to control inflation and maintain rupiah stability, intervening in the exchange market to prevent extreme volatility of rupiah and going for macroprudential measures. However, we are aware that foreign exchange reserves cannot be spent lavishly in a measure to maintain the exchange rate. Therefore, the rupiah will certainly experience a weakening. What must be done is to keep the fluctuations under check so as they do not hit too sharp. I often say, when economists start predicting exchange rates, it's a sign that they have a good sense of humor, because they will prove themselves wrong.
The prospects are tough, but I believe the impact of taper tantrum 2.0 this time will not be as severe as in 2013. There are several reasons for this. First, the outflow of capital has occurred since the beginning of the COVID-19 pandemic outbreak in April 2020.
The outflow of foreign portfolio investors, thus increasing the role of domestic investors in the Indonesian bond market through BI and other banks, has caused the share of foreign ownership in Indonesian government’s bonds to go down from 32 percent (April 2020) to 14.6 percent (at the end of September 2022).
When economists start predicting exchange rates, it's a sign that they have a good sense of humor, because they will prove themselves wrong.
The current relatively lower dependence on external financing sources has made Indonesia relatively more stable compared to 2013. In addition, the current account balance is also experiencing a surplus. This surplus has occurred for two reasons: The Covid-19 pandemic has resulted in an increase in the ratio of savings to the GDP, because the imposed restrictions on mobility have brought about a decrease in consumption and increased savings has made the current account balance better. It happens in many emerging market countries.
The other reason that can be provided for the Indonesian case is the increase in commodity and energy prices due to the Russian war. However, it should be borne in mind that when economic activity returns to normal, the ratio of savings to the GDP will begin to decline, which will subsequently increase the deficit in the current account balance. In addition, the global recession, as I discussed above, will reduce commodity and energy prices (excluding coal) so that the trade balance surplus will also decrease.
This will more or less affect the exchange rate. If the rupiah weakens, it is necessary to pay attention to the risk of balance sheet effects. Calvo and Reinhart (2002) point out that one of the concerns of a weakening exchange rate is the balance sheet effect. What does it mean? The weakening of the rupiah will increase the debt burden in the US dollar. The increase in the debt burden of a company due to the weakening rupiah will force it to slash its investment portion.
In addition, there is a risk of a currency mismatch if most foreign investments go to the domestic but not export-oriented sector. Put it simply this way: foreign investment enters the domestic market-oriented sector with the revenue in rupiah, while the repatriated profits are in US dollars. It will increase the burden on the rupiah due to the weakening of the rupiah.
In addition, the weakening of the rupiah will make capital expenditure more expensive, while the balance sheet is being depressed. As a result, a company will endure a contraction. The company may delay its investment, opting to wait for the condition to improve in the future. The implication is that economic growth will slow down. Are we entering a recession? I don't think so. It’s only that economic growth will be slowing down.
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Third, we know that the COVID-19 pandemic has disrupted economic activities. The risk of non-performing loans (NPL) has increased. Thanks to the Financial Services Authority (OJK)’s intervention by providing space for banks to relax credit restructuring, the NPL risk looks low.
However, a loan at risk (LaR), which is credit with collectability under special monitoring, is still relatively high. If the relaxation ends, the NPL risk will increase. High interest rates will also expose in-high-debt companies to more liquidation risk. All these can disrupt the company's financial capacity, including state-owned companies (SOEs). An SOE suffering financial disruption will carry the risk of contingent liabilities, which will eventually affect the government's burden.
Fiscal and monetary challenges
Fourth, what can be done? Indonesia's economic growth next year, as I mentioned above, may slow down. The surplus on the current account balance will also decrease. It reminds me of a concept in macroeconomics known as the Swan Diagram and the Dornbusch Diagram.
Both diagrams refer to Rudiger Dornbusch of the Massachusetts Institute of Technology and Trevor Swan of the Australian National University. The two economists point out that to address internal imbalances (in the case of slowing economic growth), an expansion in demand is required, such as fiscal expansion.
However, a fiscal expansion will disrupt the external balance (shown by an increase in the current account deficit). To overcome external imbalances, it is necessary to tighten monetary policy by raising interest rates, by which internal and external balance is expected to be achieved.
The problem is that the reality in many developing countries, including Indonesia, makes Dornbusch and Swan’s prescription not easy to adopt. A fiscal expansion is difficult to pursue because the fiscal deficit will be kept below 3 percent by 2023.
The government must give priority to “what must be done” and not to “what it wants to do.”
In addition, the decline in commodity and energy prices (excluding coal) will make state revenues in 2023 not as high as in 2022. It is true that the decline in oil prices will reduce the subsidy burden. But it eases only slightly. We are still to cope with the burden of subsidies and fuel compensation relatively largely, not to mention the burden of debt installments, if the rupiah weakens and interest rises. All these will make fiscal contractionary in 2023.
On the other hand, inflationary pressures and an increase in the US Federal Reserve's interest rate will force BI to raise interest rates. The impact of the contraction will be predictably huge. That is why I am referring to this article as a treatise on a situation going awry.
In such a difficult situation, the government and BI must implement a policy mix, in which monetary is carried out tightly but not excessively. The rupiah will certainly weaken, but it must be kept under check to prevent it from fluctuating overly sharp.
From the fiscal aspect, with a deficit expected below 3 percent in 2023, spending allocations must be done more prudently. Social protection programs are a priority. Spendings should be directed to sectors that have a high multiplying impact. The government must give priority to “what must be done” and not to “what it wants to do.” We are being faced with an anxious world in awry situations. The situation may put us in a quandary, but we must not go wrong in policymaking.
Muhamad Chatib Basri
Muhammad Chatib Basri, Lecturer at Economics and Business School, University of Indonesia
This article was translated by Musthofid.
