The COVID-19 pandemic is expected to deliver the biggest contraction in global economic activity since the Great Depression. Indonesia is not immune. The Indonesian government has said it expects the economy to grow between –0.4 per cent and 2.3 per cent in 2020. In a downside scenario, the World Bank has suggested output could contract by 3.5 per cent in 2020 and only see a partial recovery in 2021 — remaining around 8 per cent below what it otherwise would have been but for the virus.
Even these projections could prove too optimistic, especially if there is insufficient support from fiscal policy. Growth declined to 3 per cent in the March quarter compared to the same period last year. On a seasonally-adjusted quarterly basis, growth collapsed to zero (Figure 2A). Given activity in January and February was probably normal, activity in March must have seen a very sharp contraction. And all this was before social distancing restrictions were imposed on 10 April. For the second quarter, Indonesia’s headline purchasing managers index for manufacturing (a key forward-looking indicator) suggests that output will have collapsed to a similar degree or worse than that in many other major emerging economies (Figure 2B). A wide range of economic indicators confirms the bleak picture across the economy.
Indonesia’s outlook depends — as it does for all economies — on what happens with the virus itself. Official figures at the time of writing show Indonesia has over 50 000 COVID-19 cases, with more than 2700 deaths. However, those figures could represent a significant underestimate. The lack of credible numbers makes it difficult to assess whether Indonesia is heading in the right direction. In any case, the government is lifting restrictions out of concern for the economy and livelihoods. Yet, this might only offer limited economic relief as consumers and businesses remain cautious, while the very real risk of a surge in infections could mean a more drawn out recovery and even a return to public lockdowns.
On economic policy, the government has taken the necessary step of temporarily allowing the budget deficit to go beyond the legal limit, normally 3 per cent of GDP, until 2022. That allowed it to raise its 2020 deficit target to 6.3 per cent of GDP, including a range of COVID-19 response measures. These focus on expanded social protection, financial support to state-owned firms, credit assistance to small private businesses, cuts to corporate income tax, and more healthcare spending to combat the virus. However, the total package — amounting to 4.2 per cent of GDP — is one of the smallest in Asia (Figure 2C). It also pales in comparison with those in most advanced economies, where the total size of fiscal and credit support has generally been 10 per cent of GDP or more. Bank Indonesia has also cut interest rates 75 basis points to 4.25 per cent, but refrained from going further out of concern for the value of the rupiah — leaving interest rates elevated compared to others in the region and globally (Figure 2D). In any case, lower interest rates would do little to address the core problem, which needs to come from the fiscal side.
The key factor limiting Indonesia’s fiscal response has been the lack of policy space to go further. Indonesia’s economic officials worry, with cause, that they would be unable to raise adequate funds from capital markets to finance a much larger budget deficit. At a time when Indonesia, and many others, need to be borrowing more, market appetite has either dried up or gone into reverse. Even funding the targeted deficit for this year will be difficult, given the nervous bond market. Indonesia’s finance ministry will need to raise around US$100 billion this year alone. It has successfully floated some US$4.3 billion in USD-denominated bonds overseas, but may have reached the limit of investor appetite.
Indonesia has thus taken the unorthodox step of authorising Bank Indonesia to help finance part of the deficit by buying government debt securities directly in the primary market as a last resort. Bank Indonesia has so far said it would fund up to Rp 125 trillion (US$8.25 billion) of the deficit, though policy discussions have begun for expanding this further.
Given the well-established orthodoxy against the direct monetisation of budget deficits, it would not be surprising if foreign investors reacted negatively. The persisting view is that this would produce a surge in inflation and capital flight. Money-funded budget deficits may have become the norm in most advanced economies since the 2008–09 crisis, with no sign of runaway inflation. But the presumption has been that this is something emerging economies like Indonesia cannot, or should not, replicate.
So far, investors do not seem too unnerved, possibly because they recognise it is a temporary necessity with the benefits outweighing the risks. A number of other emerging economy central banks have also launched bond purchase programs, though Indonesia appears to be towards the forefront of this trend. It helps that the scale of bond purchases is still small, at 0.8 per cent of GDP in planned primary purchases, or 1.7 per cent of GDP if recent secondary market purchases are also added. That compares to expected central bank bond purchases in leading advanced economies of 15–23 per cent of GDP by the end of 2020.
Sticking to a modest amount of deficit financing by Bank Indonesia, however, might not be desirable. For one, Indonesia’s fiscal response looks too small compared to the scale of the virus shock. Without adequate fiscal support, the economic slump from the virus will be much deeper and longer lasting. Household and corporate balance sheets will be damaged, bankruptcies will proliferate, and the financial system will take losses. Weak demand will persist as cautious consumers and businesses cut back spending, banks reduce credit, tourists stay absent, and global demand remains depressed. Institutional weaknesses create some obstacles, but there is scope for useful additional fiscal stimulus — for instance, increased transfers under well-running social protection programs and expanding these to include middle-class households.
Even if the government goes no further in virus-related fiscal response measures, there could still be considerable pressure on Bank Indonesia to go well beyond its current plans. If capital inflows do not return in a sizeable way, this will likely leave the government with a large financing shortfall. Indonesia’s finance ministry must raise more than US$9 billion each month on average for the rest of the year. Foreign investors dumped more than that in government rupiah bonds in March alone. A second risk is a larger-than-expected drop in government revenue (as economic activity collapses), which could see the budget deficit expand well beyond the targeted level. The deficit will very likely also need to remain sizeable into 2021 and beyond. The government may continue to look to Bank Indonesia to help fund this. Importantly, in all cases, the undesirable alternative to increased central bank financing would be to withdraw fiscal support from an already depressed economy.
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