Emerging markets tend to intrigue investors and policymakers alike, if for no other reason than they are typically quite dynamic economically and politically. For investors, the changing landscape can represent a plethora of opportunities to sniff out sustainable trends early and profit from what are often dramatic swings in market expectations. For policymakers, emerging markets in a sense represent live experiments where change happens quickly, which is difficult to replicate in countries that are already developed. Perhaps nowhere is this confluence of factors more evident in a major world economy than in Indonesia.
Indonesia—the world’s third largest democracy and most populous Muslim-majority country—is a large and diverse country that has been in the midst of powerful change in recent years. It is made up of more than 17,000 islands, which are home to the world’s fourth largest population that speaks hundreds of different languages. It is not surprising therefore that Indonesia is a decentralized country, and as many advocates of states’ rights in the United States would attest, this can provide a competitive and creative policy-making environment. Indonesia therefore consists of many economic experiments within a greater one, all tied together by a growing sense of national identity.
From an investment standpoint, the sum of these many small parts certainly has a lot of long-term structural tailwinds to offer. Indonesia is endowed with a diverse abundance of natural resources, including coal, palm oil, gas, and various mineral ores such as large deposits of nickel and bauxite. With a large, young, and growing population, the country boasts one of the best demographic profiles on the planet. Indonesia is also distinguished by the low degree of leverage within the economy, a structurally falling cost of capital, and rising productivity, which have all contributed to rising incomes and the emergence of a solid middle class that is a robust source of domestically generated growth and economic resilience. It also has a few important drawbacks, most of which are self-inflicted and therefore correctable. These include rampant corruption, excessive regulation, rigid labor and foreign investment laws, poor infrastructure, and high logistics costs.
While Indonesia’s structural strengths set the stage for relatively high rates of potential growth, many of these positive attributes can be viewed as double-edged swords that create their own problems and imbalances from time-to-time. Sometimes this leads to intense pessimism, which can provide excellent opportunities for long-term investors. For example, Indonesia’s resource bounty has arguably created an over-reliance on these sectors for growth, lessening any sense of urgency for policymakers to engage in meaningful reform to the business operating environment in order to improve the country’s competitiveness. Likewise, the other side of the robust pool of domestic demand is that it can lead to the need for more and more imports.
The result of all of this is that Indonesia started to experience some pressure associated with the end of the commodity boom after the global financial crisis, which manifested itself in a worsening balance of payments situation. Many analyses attempt to crudely categorize countries as being either a commodity importer or a commodity exporter, but understanding Indonesia’s macroeconomic backdrop requires a more nuanced view. The country is a big exporter of coal and metals, but has become a net oil and gas importer in recent years due to a long standing harmful energy subsidy regime (which artificially boosted demand) and various supply side rigidities that hinder production. This led to a swing of the current account into deficit in the wake of the commodity price fall.
Unfortunately for Indonesia, this shift in the macro backdrop occurred at a very inopportune time, as it left the country vulnerable to shifts in global monetary policy that would likely roil most developing countries, even in the best of times. In May 2013, the U.S. Federal Reserve announced its intention to taper the amount of its monthly asset purchases, presumably as a precursor to hiking interest rates, and Indonesia experienced a reversal of capital flows, which led to a large scale sell-off in asset markets (what became known as the “taper tantrum”). This was exacerbated by Indonesia’s unusually high foreign ownership share of the local bond market, prompting an aggressive monetary policy response in the form of higher interest rates to defend the currency. The country became known as one of the “fragile five,” a moniker that was generally used to describe those countries running sizeable current account and fiscal deficits, and which therefore relied on foreign capital for funding. Talk of a late 1990s-style balance of payments crisis became fashionable. When the dust finally started to settle in September 2013 when the Fed decided not to taper, Indonesia had suffered one of the worst stock market corrections of any major market.
In 2014, the market experienced a reversal of sentiment aided by the election of Joko Widodo (known as Jokowi) as president, a political outsider whose pragmatic and effective style as governor of Jakarta fed hopes of a willingness and ability to tackle Indonesia’s vested interests and push through game-changing reform. Although progress has been slower than initial market expectations, and not without a few setbacks including some colored by economic nationalism (arguably an unsurprising consequence of uniting thousands of far-flung islands under one national identity), we judge that Jokowi’s performance thus far has been positive. He has dismantled the distortive subsidy regime, which is freeing up more money for infrastructure spending, implemented various tax cuts, reduced red tape, and further opened up several important sectors to foreign investment. These should collectively improve the country’s long-term outlook, but have not come without some less desirable concessions, including various targeted export bans and some local content rules. We believe this is the reality of politics in fractious democracies, and that it is crucial to focus on the long-term direction of the trend. Importantly, our view is that Indonesia’s reform story under Jokowi has been one characterized by two steps forward, one step back, rather than one forward and two back.
Meanwhile, the imbalances in the economy have largely corrected, with inflation having trended aggressively downward in recent years following subsidy cuts and associated price hikes. The current account deficit has reached a much more manageable level after the weakening of the currency. Politics has seen positive momentum too, with Jokowi consolidating support in the legislature. Also, the president’s most recent cabinet reshuffle included the return of Sri Mulyani Indrawati—a reform-minded economist who is well respected by markets—to the position of finance minister. Many eyes have now turned to the potential benefits of a recently passed tax amnesty law to encourage offshore money back into the country. This is undoubtedly an important piece of the puzzle given that fiscal policy is currently somewhat constrained by weak revenue and deficit laws, but given the notable shift in policy seen in 2016, we believe its success should be viewed as icing on the cake.
Our judgment is that Indonesian policymakers are learning from new experiences. Specifically, Indonesia is a country that has shifted from a structural current account surplus driven by a commodity boom to a deficit. Policymakers haven’t had to think much about how to fund a deficit until recently. Now, the reality is setting in that Indonesia is a poor country with a lot of potential, but low savings. Foreign investment will therefore be critical to fund the current account deficit, especially when infrastructure investments pick up and boost capital goods imports. We believe that policymakers and business elites alike do not want to return to the balance of payments issues and currency volatility of 2013 if they can help it.
Attracting foreign investment will be mandatory if Indonesia is to reap the benefits of its favorable demographics. It is also important to understand that Indonesia is facing fiercer competition regionally, with recent reform momentum in other low-cost labor countries such as the Philippines, Vietnam, and India. In a slow-growth world constrained by high debt, excess capacity, and a lack of a rising tide to lift all boats, we expect a dog fight between these countries in terms of reforms to facilitate business and compete for foreign investment. Likewise, foreign investors will be watching, given the dearth of profitable growth opportunities in the developed world. As meddlesome central bankers and populist demagogues descend on developed countries, the world could very well be at the beginning of a competitive race for economic freedom and prosperity in many Asian countries, and we expect Indonesia to keep pace. To the victor belong the spoils.