The preceding article introduced in broad terms the relationship between the US Federal Reserve’s quantitative easing program and the continuing prosperity of emerging economies worldwide. Of these emerging markets, five were singled out as being particularly vulnerable: Morgan Stanley’s “Fragile Five” of Brazil, Turkey, Indonesia, India, and South Africa.
This week’s article will focus on Indonesia, one of the markets worst-hit by the sudden reversal in global capital flows, and arguably the most fragile of the group.
The Indonesian rupiah has been locked in a downward spiral for most of 2013, losing approximately 20 percent of its value against the USD from January to mid-November. While some of this can be attributed to a correction ahead of the inevitable taper in the United States, there are also intrinsic economic headwinds that are scaring off some investors.
For one, Indonesian economic growth seems to be coming down to earth. GDP growth for the third quarter of 2013 came in at just 5.6 percent, its lowest level since 2009. This reversal of fortune is due in part to softness in one of the much lauded pillars of the Indonesian economy: domestic consumption. Unlike many of its export-dependent neighbors, Indonesia’s economy depends on domestic household spending for a large part of its economic growth (domestic consumption accounted for over 60% of Indonesia’s GDP in 2012).
Consumption rates are falling because Indonesian consumers have less and less money to spend. Fuel prices have risen by around 44 percent since the government removed a subsidy program earlier this year. High levels of inflation (between 8-9%) have also eaten into household budgets, triggering a series of central bank rate hikes that serve to further damage the country’s growth potential. In an effort to stem high inflation and currency depreciation, the Bank of Indonesia has raised its benchmark interest rate from 5.75 to 7.50 percent between June and November, and some analysts are predicting the rate will hit 8 percent by the first quarter of 2014.
Current Account Deficit
Another factor behind the upward swing in interest rates is the government’s firm commitment to bring Indonesia’s current account deficit (CAD) under control. So far, the rate hikes have met with some success: Indonesia’s third quarter CAD came in at $8.4 billion, or 3.4 percent of GDP, down from $10 billion in the second quarter. However, it will be difficult to build on these successes, as export growth will remain stunted by low commodity prices and tepid growth among major trading partners such as China.
One of the consequences of a deep and protracted CAD is a drag on foreign exchange reserves, and in Indonesia’s case the news is mixed. On the positive side, the Bank of Indonesia has been very proactive in trying to insulate its forex reserves, signing bilateral swaps with various neighboring countries and foregoing the forex-heavy lever of direct intervention. These efforts helped to produce a surprise increase in reserves between July and August, bringing the total to around $95.7 billion as of the end of September. But the outlook becomes markedly negative when observed over a broader term. Indonesia’s forex reserves have dropped $17 billion over the year, granting it the dubious honor of fastest-depleting central bank in Asia.
Given that the CAD is a structural problem that defies any quick and easy solution, it follows that the Bank of Indonesia will have its work cut out for it in protecting the country’s forex reserves, which are already on the low side at being enough to cover just six months of imports.
In addition to the various economic factors that are giving investors reason to pause, political questions are also looming large. President Yudhoyono will step down next year after ten years in office, allowing for a new leader to emerge out of presidential elections scheduled for July. There is no clear frontrunner in the polls yet - in fact most of the party candidates haven’t even been announced – but there is more than enough time between now and the elections for the campaign to be shaped by economic considerations. If a taper announcement came sometime in the first half of 2014, the Indonesian election could take place against the backdrop of a rude economic awakening.
With the field of candidates still pending and ample time for the country’s economic fortunes to swing one way or another, Indonesia’s immediate political future is exactly what investors don’t want to see: a huge question mark.
The Crisis Checklist
Early interpretations of the Asian financial crisis tended to emphasize the importance of hot money flows out of Asian economies – a similar situation to the movement we’re seeing from quantitative easing. However, later studies focused more on the weak economic fundamentals of crisis-hit countries. Assuming that the truth lies somewhere in between, here is a checklist of current economic indicators and how they compare to the period leading up to the Asian financial crisis:
Current Account Deficit (2013): 3.4% of GDP
Current Account Deficit (1997): 3.62% of GDP
GDP Growth (third quarter 2013): 5.6%
GDP Growth (1996): 7.98%
Inflation Rate (2013): 8-9%
Inflation Rate (1997): 11.62%
Non-Performing Loan Rate (2013): 2-3%
Non-Performing Loan Rate (1996): 13%
Foreign Reserves (2013): Approximately 6 months
Foreign Reserves (1996): 3.64 months
External Debt (2011): 25% of GDP
External Debt (1996): 56.74% of GDP
In Indonesia’s case, the checklist is inconclusive. On some fronts, the Indonesian economy is uncomfortably close to where it was before disaster struck in 1997. On others, tangible progress has been made to reduce the possibility of a future crisis. It must also be emphasized that one of the biggest consequences of the Asian financial crisis – that of greater regulatory awareness – doesn’t necessarily show up on quantitative metrics. The Indonesian government is armed with the lessons of recent history as it actively tries to right the ship ahead of a taper in the United States. This must also be counted as a mitigating factor.
Looking ahead, there is every reason to believe that the next leader of Indonesia will be able to pick up where President Yudhoyono left off and add a few more chapters to the Indonesian success story. However, the combination of looming uncertainty (both in regards to Indonesian politics and the macroeconomic impact of the taper) and sustained pressure on forex reserves means there might be a shock or two in the meantime.
Zachary Fillingham is a contributor to Geopoliticalmonitor.com