Indonesia: Navigating a Difficult Global Economy
What is going on in the global economy, and how can Indonesia prosper in such a difficult environment?
The year of Indonesia’s G20 presidency has been a challenging one for the global economy. Indonesia has been recovering steadily from the COVID-19 pandemic, but problems in the rest of the world are affecting us here. We can see that most clearly in higher prices for food, palm oil, and now gasoline and diesel. It is also visible in the weakening of the rupiah and higher interest rates. So what is going on in the global economy, and how can Indonesia prosper in such a difficult environment?
The Global Economy: A Gloomy Outlook
The global economy is facing an unusual combination of three shocks. The first is the COVID-19 pandemic. While most countries have opened up as people have come to live with the virus, China is pursuing a zero-COVID policy that requires widespread testing and periodic lockdowns to keep the virus from spreading. This has hurt consumer confidence and investment, which were already affected by a weakening property market. Outside of China, consumers in 2020 and 2021 shifted their consumption patterns from services to goods. Since supply chains cannot be adjusted overnight, prices for many goods rose quickly in these economies, adding to inflation.
The second factor is that this inflation has been surprisingly persistent. Supply chain dislocations and recent increases in commodity prices have been a problem. But governments all over the world also borrowed money to support households’ spending during the pandemic. As economies reopened, this pent-up demand began to push up prices. Most people expected inflation to come down quickly, but unfortunately, it has remained high. To control inflation, central banks have had to raise interest rates, slowing down economic growth.
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Finally, the third major factor is Russia’s invasion of Ukraine. The war has pushed up prices for food, fertilizer, and fuel around the world, adding to inflation. Higher food prices disproportionately hurt countries that rely on imports of grains and other foods dislocated by the war. Higher fuel prices affect everyone, but Europe was particularly dependent on Russian energy imports, making it particularly vulnerable to the dislocations caused by the war and subsequent sanctions. As those fuel imports have fallen, energy prices in Europe have risen much faster than elsewhere, weakening the European economy along with the American and Chinese economies.
Thus each of these three factors disproportionately affects one of the world’s three major economies. In China, a slow reopening is hurting confidence in the world’s second-largest economy. In the United States, higher interest rates aimed at bringing down inflation are raising risks of recession in the world’s largest economy. And across Europe, the energy crisis is squeezing household budgets and weighing on growth. This combination of slow growth in the world’s biggest economies, high inflation especially for commodities, and sharply higher interest rates are likely to make 2023 an even more difficult year for the global economy than 2022 has been. How does all of this affect Indonesia?
Indonesia: A Bright Spot
First, the good news. Indonesia’s economy has recovered well from the pandemic. Growth began to return last year, and this year the economy has done quite well. Growth in the first half of the year was 5.2 percent (yoy); this is strong enough to create more jobs and revive incomes but not so fast that it can’t be sustained. Growth has also been broad based: consumers have begun to shop again, and companies have begun to invest. Exports have also been strong, which is particularly impressive given the slowing growth in China and the U.S. But Indonesia is open to the rest of the world, and the problems of the world affect us here.
We can see this first with global inflation. The IMF forecasts inflation this year to be 6 percent (yoy) in the U.S., 8.8 percent (yoy) in the Euro area, and 14.6 percent (yoy) on average in Latin America. With inflation running so high, these countries all had to raise interest rates to bring inflation under control. In Indonesia, inflation has risen, but the IMF expects it to be 7.2 percent (yoy) this year; lower than many countries. Also, while inflation is domestically driven in many countries, such as the US, much of these pressures are imported in Indonesia. A major cause is commodity prices, such as cooking oil, that have been pushed up both by last year’s strong economic growth and also by Russia’s invasion of Ukraine.
Another area where we can see the effect of the weak global economy is the exchange rate. In January (2/1/2022), the rupiah exchange rate with the dollar was IDR14,266. Now (8/11/2022) is around IDR15,698. While the depreciation is noticeable, it remains small when compared to other countries: the British pound has weakened by 14.4 percent against the dollar, the Chinese renminbi by 13.5 percent, and the Australian dollar by 9.5 percent. Weaker currencies make imported goods more expensive, pushing up inflation. But since the rupiah has performed relatively well compared to other currencies, Indonesia is actually experiencing less imported inflation than many other countries.
And a third area where global conditions affect Indonesia is interest rates. Central banks in advanced economies are raising interest rates to deal with inflation, and that spills over into Indonesia. Over the past year, the Fed has raised its policy rate from zero to 3.25 percent. Indonesia, with lower inflation, started later and has only raised its policy rate from 3.5 to 4.75 percent. With US rates rising faster, some investors have sold Indonesian bonds and bought American ones, weakening the rupiah and raising the interest rate on Indonesian government bonds. As the Fed continues to raise rates to bring down U.S. inflation, Indonesian interest rates will likely continue to rise, making borrowing more expensive here.
Russia’s ongoing war in Ukraine has already led to higher global food and fuel prices. If it remains unresolved, or if it becomes even worse, these pressures will strengthen further.
Unfortunately, things may get worse. After the Global Financial Crisis of 2008, many countries reduced their spending due even though inflation was very low, extending the period of high unemployment following the crisis and delaying recovery. This time around, the potential mistakes are different: central banks may tighten monetary policy too much, causing a global recession. Or conversely, if governments stimulate their economies at a time when inflation is running high, it makes the job of central banks harder, and could lead to even more inflation. High interest rates could also lead to worse financial conditions, especially in emerging market economies. If central banks in the advanced economies have to keep interest rates high for even longer than we expect, then more capital outflows from emerging markets could lead to weaker exchange rates, less investment, and higher inflation. Finally, Russia’s ongoing war in Ukraine has already led to higher global food and fuel prices. If it remains unresolved, or if it becomes even worse, these pressures will strengthen further.
How Can Indonesia Continue To Do Well?
What can Indonesia do under such difficult circumstances? There are many ways to make economies more resilient in a difficult global situation, and fortunately, Indonesia is already doing many of them.
First is to ensure that fiscal and monetary policy are working in the same direction. On the fiscal side, Indonesia has for a long time aimed to have budget deficits below 3 percent of GDP. Suspending this ceiling during the COVID-19 pandemic was the right thing do, but now that the economy is recovering, the government has proposed a 2023 budget that will bring the deficit back below that level. This will help keep inflationary pressures down and conserve resources that Indonesia will be able to draw upon if the global situation deteriorates even more. On the monetary side, Bank Indonesia faces a difficult challenge. As explained above, inflation in Indonesia is largely imported, and therefore harder to control. The BI has already raised interest rates by 125 basis points, which will gradually cool the economy. But more immediately, this has the effect of pushing up domestic interest rates, keeping more capital in Indonesia and protecting the exchange rate. Some weakening of the rupiah is inevitable – and again, most countries’ currencies have weakened by more – but a sudden shift in the exchange rate can be destabilizing. When monetary and fiscal policy work together, the economy remains more stable.
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Increasing Indonesia’s resilience to future disruptions also helps. Keeping inflation under control is key because high inflation makes it harder to respond to shocks. The natural reaction to any economic shock is to spend more money to support the economy. But this additional spending can add to inflationary pressures, leading to the contradictory monetary and fiscal policies noted above. So the BI’s preemptive policies on inflation are crucial. Similarly, policies like the Tax Harmonization Law and the measures to raise fuel prices have raised revenue and reduced expenditure. Both of these keep debt lower. Continuing prudent debt management will help provide sufficient buffer in case of urgent spending needs, such as during the pandemic. Continuing to develop Indonesia’s social safety net will also help: the recent increase in fuel prices was cushioned by the government’s announcement of direct transfers, subsidies for public transit, and wage support. During the pandemic, programs to support small businesses, villages, and individuals also helped many people through a difficult time. With the outlook for the global economy so uncertain, making sure that the most vulnerable Indonesians can be protected should be a priority.
What is the bottom line? Unfortunately, the world economy is in a difficult position, with challenges coming from high inflation, a war, and the ongoing pandemic. Indonesia, however, so far is doing relatively well. Good economic management, supportive policies, and high commodity prices have kept Indonesia somewhat insulated from the global economy. Since no country is isolated from the global economy, Indonesia may at some point face a more challenging outcome. But strong policies that support growth and inclusion will always reduce the damage from such outcomes, and that is where Indonesia should focus its efforts.
James P Walsh, IMF senior resident representative for Indonesia
This article was translated by Hendarsyah Tarmizi