Sunday, 4 January 2015

Year-end global mini turbulence and what to expect in 2015

Arisyi Fariza Raz
The Jakarta Post
29 December 2015

Available at:
http://www.thejakartapost.com/news/2014/12/29/year-end-global-mini-turbulence-and-what-expect-2015.html

Toward the end of 2014, it seems like the global economy wants its own notable ending following the occurrence of some issues.

The first is regarding the possibility of monetary tightening in the US through the US Federal Reserve fund-rate hike next year in response to strengthening US economic conditions. Prior to the Fed’s meeting last week, the global market had feared the Fed rate would increase earlier next year following strengthening US macroeconomic indicators.

As a consequence, hot money flew back to the US from all over the world, resulting in a sharp appreciation of the US dollar against many other currencies. Some fragile emerging economies (those with current account and fiscal deficits) might have experienced much worse than that. Rapid capital outflows might affect their investment accounts in the balance of payments, which corrected their asset prices and further pressured their currencies against the US dollar.

Fortunately, Janet Yellen, the Fed’s chief, expressed a more “dovish” statement during the meeting by saying that the Fed could be patient on the rate rise. This statement finally eased the shock for the time being — at least until next year.

Secondly, in a different place, the global oil oversupply has caused economic turbulence in oil-dependent economies, particularly Russia. The tumbling price of oil, which is its main export, has affected Russia’s economy severely. Its central bank forecasts that gross domestic product (GDP) may shrink by around 5 percent next year if the price does not show any significant improvement.

Following falling exports, its currency, the ruble, depreciated sharply against the US dollar. To respond to this issue, the central bank raised its interest rate from 10.5 to 17 percent,  hoping that this could stop the falling ruble.

China and Japan have their own problems. China’s economic growth is expected to slow to 7.1 percent in 2015 from an expected 7.4 percent this year. This was mainly propelled by slowing export growth amid the global economic slowdown. Some economists have also recommended the government to cut its growth target to around 7.0 percent from 7.5 percent in 2015.

Meanwhile, Japan is still threatened by economic recession and its re-elected Prime Minister Shinzo Abe has yet to finish structural reform to put its economic growth back on track.

All of these phenomena, albeit happening in the different parts of the globe, are somehow posing the same risks to emerging economies, because of a more interconnected global economy and the influence of global sentiment on domestic markets.

It means that emerging economies will start 2015 with a lot of work to do. First, the Fed fund-rate hike next year will pose another wave of threats to emerging economies. Also, the falling oil price and the condition of oil-exporter economies, particularly Russia, may spread negative sentiment to other emerging economies, which could trigger further capital outflows and depreciate their currencies.

Therefore, emerging economies, particularly the fragile ones, need to pay more attention to these threats. To prevent another shock due to a wave of capital outflows when the Fed fund rate finally increases, emerging economies must strengthen their structural economic conditions. For instance, they have to maintain their trade balance to minimize the risk of sharp currency depreciation.

On top of that, similar to previous years, the global economy is expected to grow very slowly next year. Even though the US economy is showing some improvements, other economic centers (such as China, Japan, the UK and Europe) are still struggling to grow faster.

Hence, the prolonged slowdown of these economic giants may reduce the exports of emerging economies to these economies. Therefore, industrialization has to be carried out immediately to shift from commodity led exports to industry led exports, which have more value-added and export competitiveness. Value-added and competitive exports are expected to improve export performance and the current account balance.

Amid these possible risks, fortunately, falling oil prices might give some advantages to some emerging economies that import oil and/or whose fiscal budgets are burdened with oil subsidies. This will give them some fiscal room and potential to minimize its trade balance.

To conclude, emerging market economies will welcome 2015 with caution due to some possible risks (whether carried over from 2015 or some new threats that will be anticipated in 2015) that are expected to happen throughout the year.

However, they have seen gloomier years. There is a chance that these economies will look better next year compared to 2014.
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The writer, a graduate of the University of Manchester, the UK.

Monday, 3 November 2014

Financial Inclusion to Increase Banking Liquidity

Arisyi Fariza Raz
The Jakarta Post
30 October 2014

Available at:
http://www.thejakartapost.com/news/2014/10/30/financial-inclusion-increase-banking-liquidity.html

Throughout 2014, the Indonesian banking sector has been facing tightening liquidity. One of the liquidity measurements, the loan-to-deposit ratio (LDR), has been fluctuating a couple percentage points below the minimum reserve requirement-LDR ceiling of 92 percent.

There are many factors that cause this tightening. 

First, a substantial demand for credit that occurred during the economic boom had led to credit expansion, thus undermining the banking sector’s liquidity. 

Second, the global economic slowdown resulted in a capital flight, which, in turn, eroded banks’ third-party funds that are sensitive to short-term returns. 

Third, high domestic demand in the real sector led to increased imports, thus reducing demand for the rupiah. Consequentially, savings could not increase rapidly and deposit growth rates slowly flattened. Many experts and analysts expect this trend to continue until the end of the year. 

Even though, overall, this figure is still within an acceptable level, particularly after gradual improvement in the last couple of months following the government’s fiscal expansion, which increases banks’ third-party funds (particularly those of regional banks and state-owned banks), the banking sector needs to formulate a new strategy to be able to grab more funding in the long run.

Liquidity is a very crucial aspect of the banking business. In the worst-case scenario, if a bank has a liquidity issue, it may not be able to fulfill its obligations to its savers. When that happens, the trust for that bank may collapse, thus resulting in a massive funds withdrawal from that bank. This is followed by an even more severe liquidity issue, which, in the end, could harm the bank’s business sustainability.

If this problem is faced by a big bank (i.e. a domestically, systemically important bank), the problem can cause systemic risk. When that happens the whole banking system could face a bank run, leading to a failure in the whole banking system.

Hence, considering these risks, maintaining liquidity positions, whether that of the whole banking system or of individual banks, has become a very important aspect for the financial system and the economy as a whole.

Looking from the LDR point of view, banking sector liquidity can be affected by deposits or loans. In other words, when liquidity tightens, it can be caused by either higher credit growth, slower deposit growth, or both. When the economy is growing, demand for credit will increase. As a consequence, assuming ceteris paribus, the LDR will get higher. Higher demand for credit is inevitable in a growing economy. Therefore, banks have to seek more deposits from households or corporations to maintain their liquidity.

Higher expenses also reduce the propensity to save. As a consequence, this causes lower deposit growth, which eventually reduces the banking sector’s liquidity.

Generally speaking, financial inclusion is one of the possible solutions to this tightening liquidity trend since banks can find new sources of funding from the previously unbanked market. Currently, access to financial services in Indonesia is still relatively low when compared to regional peers.

As a comparison, statistics from the World Bank’s World Development Indicators database show that Indonesia’s credit-to-GDP (gross domestic product) ratio was only 37.9 percent in 2013. The figure was substantially below Thailand’s (154.4 percent), Malaysia’s (124.3 percent) and Singapore’s (128.9 percent). 

Meanwhile, during the same period, Indonesia’s savings-to-GDP ratio was only 31.6 percent, still relatively below those of its peers, such as Thailand (32.5 percent), Malaysia (35.4 percent) and Singapore (52.1 percent). 

Considering Indonesia’s huge population base and its considerable number of unbanked people, there is still a lot of room to get new sources of funding and increase the liquidity position. For instance, banks can extend their services to previously unreached markets, such as in rural areas. However, expanding access to banks is usually costly and thus it increases the cost of funds and undermines profit margins. However, there are several ways it can be done in order to improve the efficiency of branch expansion. 

First, if service extension is carried out on a massive scale, then economies of scale can be applied and thus the marginal cost of service extension becomes lower. As a consequence, this can push down a bank’s cost of funds.

Moreover, thanks to technological advancement, the costs of branch expansion can be pushed down even farther. For instance, branchless banking can be implemented as a convenient method for banks to extend their services in remote areas without much additional cost.

Financial innovations also matter. Banks need to invent financial products suitable for rural populations. These products should be flexible, particularly in terms of complexity, access and returns, in order to make them suitable for potential rural savers. Moreover, inventing a financial product that is linked to local cooperatives may also make it more attractive for rural dwellers.

Simultaneously, this should be accompanied by socialization. Societies in rural areas are mostly financially illiterate and tend to avoid financial services. Hence, providing education about financial products may persuade them to utilize financial services, particularly savings accounts.

Fortunately, financial authorities have acknowledged the necessity of finding new sources of funding for banks. They have also supported this movement by providing financial infrastructure, formulating accommodative financial regulations and establishing a customer protection framework to encourage banks to extend their services to rural areas.

Hopefully, banks will be able to carry out this program. Extending financial services to rural areas not only potentially increases banking liquidity, but also enhances financial inclusion. From the macroeconomic point of view, this will result in financial stability, as well as enhanced economic development.


______________
The writer, a graduate of the University of Manchester, UK.

Monday, 4 August 2014

Private External Debt and Financial Stability

Recently, there is a growing concern on the news about the ballooning private debt in Indonesia. As of April 2014, Indonesia’s private external debt has reached USD 145.6 billion, exceeding its public external debt amounting USD 131 billion. In terms of growth, it exhibits 12.9% year-on-year growth, higher than 12.2% and 11.6% in March and February, respectively.

The mounting private external debt also increases Debt-to-Service Ratio (an indicator to determine a borrower’s ability to repay its debts), which stood at 46.3% in Q1 2014, higher than 36.8% in Q1 2013.

There are several reasons that cause the ballooning external private debts. First, some companies prefer to obtain external debts due to the cheaper costs since credits in US dollar incur relatively lower interest rates compared to Rupiah. In addition, some firms also usually hedge their external loans to avoid currency volatility risk. As a consequence, these firms could carry out their business plans more efficiently.

Second, Indonesian banking sector’s Loan-to-Deposit Ratio (LDR) has also surpassed 90%, indicating strong demand for local credit. If the ratio is getting closer to 100%, it means that banks already maximize its intermediary function by extending all of their deposits to loans. In other words, current condition shows that local banks capability, particularly medium- and small-sized ones, to extend credits becomes more limited.

Third, subsidiaries from international corporations residing in Indonesia usually have easier access to obtain parent loans or inter-group loans since they offer relatively cheaper interest rates and less rigid terms and conditions. Therefore, these companies usually use this kind of facility during its early establishment or business expansion.

Fundamentally, the utilization of external debt to finance a firm’s business is totally acceptable. However, it could create a problem if it is not utilized properly. Bappenas (2004) points out three main problems associated with the utilization of external debt: 1) maturity gap, 2) currency mismatch, and 3) non-existent of currency hedging.

First, if a firm obtains short-term debt to finance long-term project, then it will experience maturity gap since its it will incur cash outflows in the short-term to repay its debt, while its cash inflows from the project will come in the long-term, resulting in liquidity problem and difficulty to repay the loan.
Another potential problem is currency mismatch. This problem happens when a firm’s revenues and reporting currency are denominated in rupiah, while it obtains loans in foreign currencies. If rupiah becomes more volatile and tends to depreciate against foreign currencies, then its loan’s current value will soar, undermining leveraging performance.

This issue can be exacerbated further if a firm does not have any currency hedging such as currency swap facility. If a firm does not have hedging facility and depends on external debts as its financing source, then, when rupiah depreciates, its interest expenses will grow since it has to pay in dollar against its rupiah income. As a consequence, its profitability will be impaired and overall business performance will deteriorate.

When this happen at bigger scale, this issue can create a systemic risk. Defaulting firms could disturb financial stability, particularly if they also have loans in local banks. These firms will be unable to pay the loans that they owe to local banks, including those denominated in rupiah. As a consequence, they could disrupt banks’ solvency.

In addition to firm-level problems, external debt can also pose a threat at macro-level. When external debts level becomes too high, their repayments will result in capital outflows, pressuring Indonesia’s Balance of Payments and triggering rupiah volatility.

Looking at current condition, many still believe that Indonesia’s private external debt condition is still within an acceptable level despite showing an increasing trend. Even though it has not created a serious threat yet, serious actions have to be taken by both authorities and firms.

In one hand, related authorities should closely monitor the movements of private debt. More actions can also be taken, such as preparing stress-testing analyses to project the possible outcome of various levels of private external debts in order to formulate the anticipation measures.

On the other hand, firms also have to be aware of their own business conditions. Even though business growth is important, carefulness and prudence are also crucial for business to create a more sustainable growth. Several actions can be taken to minimize the risks caused by the spiking external debt. A way to do this is by carefully examine its project and the type of loan that should be used to finance the project to prevent any currency mismatch or maturity gap. Another possible method is by utilizing hedging facilities such as interest swap or currency swap in order to minimize market risk.

Arisyi Fariza Raz


Thursday, 3 July 2014

Why Indonesia needs to borrow (a little) more, not less

Renan Raimundus
The Jakarta Post
3 July 2014

Available at:
http://www.thejakartapost.com/news/2014/07/03/why-indonesia-needs-borrow-a-little-more-not-less.html

Most news stories about public debt in Indonesia are quite negative in tone, portraying that increasing government debt is taboo. Critics attacked the rise in public debt from Rp 1.6 quadrillion (US$134.31 billion) to Rp 2.4 quadrillion from 2009 to 2013, creating the impression that public debt is getting worse every year. On the contrary, Indonesia’s public debt to gross domestic product (GDP) ratio has significantly decreased to 24 percent of GDP as of April 2014 from more than 150 percent almost one decade ago.

The ratio is far lower than most developing countries, such as Vietnam (54.9 percent), Thailand (45.27 percent), the Philippines (49.2 percent), India (67.7 percent) and most Latin American countries. The government even plans to further reduce the public debt ratio to 16.9 percent by 2020. It is not too much to say that Indonesian public debt discipline is among the strongest in the world. The steady decrease in the public debt as a percentage of GDP ratio suggests that Indonesian public debt is on a sustainable path, giving big room for more fiscal stimulus.

On the other side, many perceive Indonesian economic growth as unsustainable. Relatively high growth above 6 percent has already caused the economy to overheat, with imports rising steeply to meet domestic demand for consumer goods, basic materials and capital goods, while export revenues depend mainly on primary commodities whose prices tend to fluctuate. The economy has been driven mostly by strong domestic consumption, but production capacity cannot keep up with the strong demand. 

At the heart of these problems is poor infrastructure development. Average travel time in Indonesia is 2.6 hours/100 km, compared to only 1.1 and 1.35 hours/100 km in Malaysia and Thailand, respectively. Average dwelling time in an Indonesian seaport is eight days, far longer than Hong Kong (two days) and Singapore (1.1 days). Indonesian rural electrification ratio is only 32 percent, compared to 65 percent in the Philippines, 85 percent in Vietnam and 99 percent in Thailand. Other infrastructure indicators also suggest poor conditions in Indonesia, compared to regional neighbors.

One might question why Indonesia has two contradictory stories — the story of a healthy fiscal condition and the story of poor economic and infrastructure development? One of the fundamental impediments to infrastructure development is a lack of funding for projects. The government identified the need for infrastructure investment of up to Rp 1.9 quadrillion between 2010 and 2014. However, state and regional budgets could cover only Rp 914.6 trillion of the total investment needed. 

There are two reasons why Indonesia needs to raise public debt for the necessary funding. First is that many necessary infrastructure projects to develop the country simply are not attractive to the private sector. These projects, such as non-toll roads, public transportation networks, water treatment facilities and public hospitals, are called public goods. 

As public goods, they do not give sufficient investment return to private investors, because the cost of provision is very high and the payback period is quite long. Hence, the government should step in to finance infrastructure to provide such public goods. If the government budget is not sufficient for such investment, it can borrow from domestic or foreign markets.

Second is that public debt, both domestically and internationally, is the cheapest way to raise the necessary funding for development. As government obligations are perceived as risk free, the cost of borrowing is far lower than that of commercial banks and equity investors. Foreign currency denominated loans from foreign government agencies are much cheaper. 

The MRT Jakarta project is financed with a loan from the Japan International Cooperation Agency (JICA) at an interest rate well below 1 percent and with a much longer maturity period than a typical commercial loan. If the government chose to finance the MRT project with private investment or borrowing from financial markets, the cost could be 10 times higher or more, and Jakarta might not be able to afford the project. 

Given the importance of public debt for economic development, why does raising the debt considered taboo?

One reason is that after the Asian Financial Crisis 1997, Indonesia has been struggling to increase its credit rating, and the rating indeed has improved. Fitch Ratings finally upgraded Indonesia from Junk to BBB- in 2011. Moody’s also upgraded the rating from Ba1 to Baa3, and S&P increased the rating from BB to BB+. 

It is, however, interesting to observe that given Indonesia’s significant improvement in the level of its public debt, its credit rating improvement has not been significant. The investment grade is still lower than that of Thailand, the Philippines, India, Malaysia and many other developing countries with significantly higher debt to GDP ratios. This is because even though we improve significantly in public debt discipline, we fail miserably in many other aspects of the economy, such as infrastructure development, fuel subsidies, bureaucratic reform and corruption eradication. 

Another reason is the public perception that increasing public debt, especially internationally, equals selling the country’s freedom and control to foreign interests. It is therefore politically costly to reach a political consensus on new public debt from foreign countries. 

In reality, every country borrows internationally, and there is hardly any serious issue regarding national integrity arising from those borrowings. China has been borrowing heavily from the World Bank to finance its phenomenal growth, and so are other developing and developed countries around the world. The United States borrows internationally as well, and China is the US’ largest creditor. 

Indonesia is no different from the rest of the world. If loans can be negotiated fairly for Indonesia, it is a win-win solution. Foreign countries might benefit by providing loans to Indonesia in one form or another. But in the end, if the debt is used properly, the biggest beneficiaries are Indonesians themselves, through better infrastructure provision and economic growth.

No country in the world runs without debt, and raising debt is not necessarily a bad policy. It is important to differentiate the purpose of debt, whether it is for consumption or investment. Borrowing for the purpose of consumption will create a burden for the country. 

Therefore, borrowing to finance the fuel subsidy, for example, cannot be justified. On the other hand, borrowing for investment will generate a multiplier effect for the economy, stimulate growth, create employment, increase income, generate more tax revenue in the future and finally pay off the debt itself. 

Thus, what Indonesia needs is not less debt, but a better allocation of debt, shifting away from consumption toward investment. That way, more public debt can be justified for the sake of development and prosperity.

The writer is a graduate from the University of Tokyo Graduate School of Public Policy. He is currently an associate at PT Tusk Advisory, an advisory firm specializing in infrastructure delivery.

Wednesday, 4 June 2014

Is the middle-income trap real?

Arisyi Fariza Raz
The Jakarta Post
4 June 2014

Available at:
http://www.thejakartapost.com/news/2014/06/04/is-middle-income-trap-real.html

In the first quarter of this year, Indonesia’s economy grew annually by 5.2 percent, much lower compared to 5.7 percent in the previous quarter. Given the current economic situation, the government became less optimistic by aiming this year’s growth at 5.5 percent. 

Bank Indonesia (BI), the central bank, gave an even more conservative opinion by predicting this year’s growth to be around 5.1-5.5 percent.

In the short run, this slowing growth rate may be partially caused by contractionary monetary and fiscal policies implemented by the central bank and the government in anticipating several internal and external short-run economic shocks. 

On top of that, however, there are some structural factors, such as productivity, competitiveness and knowledge that may affect economic performance in the longer term.

These structural factors may not have an immediate impact, but they have long-run implications for the economy, risking it to become a victim of the middle-income trap.

According to development economics theory, the middle-income trap is referred to as a phenomenon in which rapidly growing economies stagnate at middle-income levels for many years, thus falling to reach the high-income level.

When discussing Indonesia’s risk of becoming trapped as a middle-income country, an International Monetary Fund (IMF) working paper written by Sehkhar Aiyar et al. (2013) provides some quite revealing facts. The study shows that Indonesia’s growth trajectory has performed relatively poorly compared to its regional peers.

In fact, even though on regional average East Asian economies have performed better than Latin American economies, Indonesia’s trajectory was below its Latin American counterparts.

The paper also points out that inadequate transportation and communication infrastructure are among the main variables that put Indonesia at higher risk of facing a growth slowdown. 

It further suggests that Indonesia’s trade category, even though still lagging behind other East Asian middle-income economies, still could serve as a buffer against growth slowdowns.

Despite this growth buffer, this issue still may pose a serious threat to the economy. As mentioned above, the middle-income trap is a structural economic issue that can have long-term implications for the economy. Therefore, immediate policy actions have to be undertaken to address this issue.

Apparently, infrastructure investment should become one of the primary focuses of the government’s policy. However, on top of infrastructure investment, the government should also improve the quality of education at all levels.

According to endogenous growth theorists such as Lucas (1988) and Romer (1986; 1990), education or knowledge is one of the essential inputs for long-term economic growth since it provides positive externalities that can offset the diminishing returns effect of other inputs, i.e. capital and labor.

Practically, the availability of education or knowledge provides more resourceful human capital with better productivity. As productivity increases, the cost of producing an additional unit becomes relatively cheaper, thus improving competitiveness in the market.

In other words, the availability of capable human capital will make Indonesia’s market more competitive. Accordingly, it will also attract investment, including in infrastructure, which can help the economy to avoid the middle-income trap.

Regarding the importance of education, the Organization for Economic Cooperation and Development (OECD) has raised the argument regarding improvements in elementary and secondary education in Indonesia. Through its country note published in 2013, the OECD points out that Indonesia should focus its policy on widening access to education, particularly for low-income households.

Indeed, the government is doing something to deal with this issue. The School Operational Assistance (BOS) and the Social Safety Net (JPS) are among the policies that are being implemented to enhance elementary and secondary education participation rates in the country.

However, these policy actions are still insufficient. The government needs to be more aggressive to promote the country’s educational development since its performance is still very poor even by regional standards. This is reflected in data published by the OECD that show that in 2008 the lowest quintile of the population aged 5 years and upward did not even have elementary education.

In addition to elementary and secondary education, tertiary education is also important because it helps economic development through innovation. A report by Asian Development Bank Institute (ADBI) in 2013 argues that the role of innovation on economic development can be two-fold. First, it contributes economic development through product innovation as the result of research and development activities. 

Second, it also creates process innovation that improves the process production of existing products.

In other words, this suggests that tertiary education in Indonesia needs to be promoted because it can trigger innovations that can be beneficial to economic development.

Unfortunately, this ADBI report also shows some unsatisfactory data by revealing that Indonesian graduates in industrial fields (such as engineering, manufacturing and physics) accounted for only 16 percent of all graduates.

This figure is in stark contrast to South Korea, a country that succeeded in escaping the middle-income trap and the joining high-income group in the 1990s. During that time, graduates in industry fields accounted for 35 percent of all university graduates.

Concretely, tertiary education in Indonesia can be improved by giving more scholarships to university students, encouraging high quality research through incentives and coordinating cooperation between researchers and the private sector and industries. 

Through these actions, education is expected to be able to deliver in its role as the source of innovation, which, eventually, creates economic growth.

In short, the availability of education or knowledge will create qualified human capital, which emphasizes product and process innovations as well as increased industrial capability. Then, positive externalities, which are the by-product of education and knowledge, will act as a more sustainable growth engine that will help the economy escape the middle-income trap.

The writer is an economist and is a graduate of the University of Manchester, the UK.

Monday, 2 June 2014

GARCH Model

Kemarin saya iseng-iseng membaca mengenai model GARCH (Generalised Autoregressive Conditional Heteroscedasticity) dan tidak sengaja menemukan learning video menarik di youtube dari channel "Sayed Hossain Academy".

Secara umum, GARCH adalah model yang menjelaskan seberapa besar volatilitas dari satu variabel dapat dijelaskan oleh lag dari informasi internal (error term) dan/atau lag dari volatilitas sebuah model.

Sebagai contoh, model GARCH(1,1) dapat dijelaskan sebagai berikut:



Dimana sigma kuadrat adalah volatilitas dari satu variabel, lag sigma kuadrat adalah lag volatilitas dari satu variabel, dan lag u adalah lag error term.

Untuk penjelasan mengenai teori bisa membaca buku Ben Vogelvang yang berjudul "Econometrics: Theory and Applications with eViews" halaman 192-197 cetakan tahun 2005.

Baiklah, tanpa menunda, berikut video tersebut:






Dan bila ingin mengetahui penjelasan lebih lanjut mengenai penentuan term GARCH(p,q), dapat melihat ke link ini.

Monday, 5 May 2014

Indonesia's Election and Economic Prospects

Arisyi Fariza Raz
The Jakarta Post
5 May 2014

Available at:
http://m.thejakartapost.com/news/2014/05/05/indonesia-s-election-and-economic-prospects.html

The unofficial quick count results of the April 9 election showed that the Indonesian Democratic Party of Struggle (PDI-P) led with 19 percent of the vote, below the initial predictions of 25 percent or higher in various polls prior to the election.

The failure of the “Jokowi-effect” (the announcement of Jakarta Governor Joko “Jokowi” Widodo as the PDI-P’s presidential candidate) to boost the party’s vote means the party may need to form a coalition. 

As a consequence, the presidential election that will be held on July 9, will be much more competitive and less predictable than initially expected. Political bargaining is expected to occur and thus the new government may lack solidity if too much give and take occurs.

Whoever wins the election, the new president must be aware of the country’s economic potential and the challenges it faces. 

He, with his new government, must be visionary in terms of the implementation of economic policies and addressing economic challenges.

As suggested by a report published by McKinsey in 2012, Indonesia has the potential to be one of the biggest economies in the world by 2030, surpassing Germany and the UK. However, Indonesia also faces internal and external challenges that may affect its economic development and growth sustainability.

One of the challenges is related to the establishment of the ASEAN Economic Community (AEC) later in 2015 or early 2016. The objective of the AEC is to create an ASEAN single market and production base, which consists of the freer flow of goods and services, investment, capital and skilled labor.

When the AEC becomes effective, Indonesia must fully open its market to other ASEAN economies and thus intra-regional competition will become fiercer. 

The inability to compete in this free market atmosphere may harm the existence of local businesses, since more competitive overseas businesses might be able to replace them easily.

Another challenge comes from uncertainty in the global economy. The US Federal Reserve has been constantly reducing its quantitative easing in line with economic improvements in the US. 

Even though the Fed’s chief, Janet Yellen, has signaled to the market that the US interest rate will remain unchanged in the short term, in the longer term, it may increase the interest rate if the unemployment rate has already hit the Fed’s appropriate level (between 5.2 and 5.6 percent).

When this happens, global liquidity will once again tighten and Indonesia may face another external shock like the one that happened in 2013. 

Hence, the government must be prepared to anticipate this shock by preventing it from spreading to the real sector.

Fiscal sustainability is another issue that will be faced by the new government. Even though the government has reduced its fuel subsidy by raising the subsidized fuel price from Rp 4,500 (39 US cents)to Rp 6,500 per liter last June, this is still not sufficient to maintain its fiscal sustainability.

Indonesia’s strengthened purchasing power and increased consumption has caused the demand for fuel to be relatively less elastic to price changes. If this trend continues, the fuel subsidy is expected to surpass the government’s budget allocation this year, threatening a widening fiscal deficit.

To address these challenges, the new government has to be alert to these issues and needs to implement clear policy stances to deal with them. 

One of the most important policies is to improve Indonesia’s export competitiveness. Export competitiveness can be improved by promoting the manufacturing sectors that have been experienced a downturn in recent years. 

Potential export-oriented industries have to be closely supported by the government through policy incentives.

It also has to spend more on infrastructure. Adequate infrastructure will improve export competitiveness through the reduction of business costs and an increase in production efficiency.

As suggested by Gustav Papanek, an economist, during an interview with Tempo magazine in March 2014, the government should spend at least around 5 percent of its revenues on infrastructure projects to have an effective impact on the economy. This figure is far above current spending, which is only 1 percent of total revenues.

Human capital improvement is also necessary to support Indonesia’s competitiveness in international trade. Capable human capital will attract more technologically advanced investments from overseas. This will create huge employment and ameliorate industry competitiveness through knowledge transfer.

In addition, sufficient human capital capability will provide positive externalities to the economy through the creation of accumulated knowledge, thus creating more rapid economic growth.

The new government will also need to review its fuel subsidy policy. As mentioned earlier, spiking fuel consumption undermines Indonesia’s fiscal and trade balances. 

One method to deal with this issue is by introducing a fixed fuel subsidy instead of a price-based fuel subsidy.

Through this scheme, the subsidized oil price will fluctuate according to the market mechanism, and the government will not need to incur additional costs when subsidized fuel consumption surges.

Another method, suggested by Papanek during his interview, is to convert fuel consumption from oil to gas. He further argues that this could be done effectively by providing incentives to every stakeholder, including banks and infrastructure providers.

In short, political power should not interfere too much in Indonesia’s economic development process. Despite the political bargaining for power among the parties, the new government must be fully aware of the challenges facing the economy. 

By addressing these challenges effectively, Indonesia will be better able to improve its export competitiveness and reduce its energy imports. As a consequence, its trade and fiscal balances will become more sustainable. 

Indonesia’s economy will be more resilient to external shocks and will able to grow more rapidly and sustainably.

_________________ 

The writer is an economist and is a graduate of the University of Manchester, the UK.