Indonesia - The Limit Of Fiscal Policy

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1. SPECIAL REPORT ECONOMIC RESEARCH May 4th , 2016 Trinh D. Nguyen, (852) 3900-8726, trinh.nguyen@ap.natixis.com The limit of fiscal policy: Indonesia Q1 GDP disappointed Hard to fight against gravity President Joko Widodo has a tall mandate – fueling economic growth amidst slowing domestic and external demand. Even with front-loaded fiscal spending in Q1 2016, the performance of the economy disappointed markets by expanding only 4.9% versus 5.0% in Q4 2015 and expectations of 5.1%. Chart 1 shows in the dark purple line GDP growth and in the columns percentage points contribution to YoY GDP growth. Notice the disappearance of the orange column, which is trade. As the commodity cycle stays weak and Indonesia is slow to diversify to other goods, exports remain a drag to growth. Household consumption is still sticky, although decelerating. Investment, too, slowed despite Bank Indonesia’s efforts to lower funding costs through rate cuts. Chart 1 (ppt contribution to YoY GDP) Statistical discrepancies Trade balance Inventories Fixed capital formation Government expenditure Household expenditure 5.2 Real GDP (RHS) 5.1 5.0 4.9 4.8 4.7 4.6 4.5 4.4 8 6 4 2 0 -2 -4 CEIC, Natixis Chart 2 %YoY Household expenditure Fixed capital formation 13 11 9 7 5 3 1 -1 -3 Government expenditure Real GDP (RHS) 7.0 6.5 6.0 5.5 Not a lot of fiscal room to help The big question regarding this disappointing growth result is whether there is more fiscal room to help the economy. And this is complicated – while Indonesia has demand, it has not solved the financing side of the equation. Year-to-date, fiscal spending rose 6% YoY in Q1 2016 while revenue contracted -13% (Chart 3). The government already stated that the Amnesty Tax Bill will bring in about IDR45.7trn – less than 0.5% of GDP. The government is also planning on raising tobacco excise in 2017, although not stating the amount. Meanwhile, tax cuts such as raising the threshold for non-taxable income to IDR54m/year from 36m/year effective June will hurt the state coffer. 45 Chart 3 %YoY Expenditure: Unaudited: ytd 45 35 Revenue & Grant: Unaudited: ytd 35 25 25 15 15 5 5 -5 -5 -15 -15 Given the low estimate for the Amnesty Tax revenue and measures to stimulate demand through tax cuts, the government will likely revise its budget. Finance Minister Bambang Brodjonegoro already told reporters that the deficit will likely widen to 2.5% of GDP versus expectations of 2.1% earlier. Given lower revenue, expenditure will likely be slashed to by IDR50.6trn. We believe that the realized budget will just reach the 3.0% constitutional limit for this year. Please see Table 1 for a summary of our estimates of the revised budget. 5.0 4.5 Table 1. A summary of government budget assumptions Real GDP CPI Oil Revenue and grant Expenditure Deficit % of GDP Realized Mar-16 Jul-15 Nov-15 Mar-15 Jul-14 Nov-14 Mar-14 Nov-13 Jul-13 Mar-13 Nov-12 Jul-12 Mar-12 Jul-11 Nov-11 CEIC, Natixis Assumptions Mar-11 4.0 2013 6.8 4.9 100 1,529,673 1,683,011 -153,338 -1.6 -2.2 2014 6.0 5.5 105 1,667,141 1,842,495 -175,355 -1.7 -2.1 2015 5.8 4.4 105 1,793,589 2,039,484 -245,895 -2.1 -2.5 2016 5.3 4.7 50 1,735,546 2,045,125 -309,579 -2.5 -3.0 Source: CEIC, Natixis; Assumptions are government’s; IDRbn; 2016 realized is our estimate.
2. SP EC IA L R EP ORT Plenty of help from monetary policy On the monetary side , thanks to slowing inflation, Bank Indonesia (BI) has done plenty to boost domestic demand. Chart 4 shows in bright purple line inflation slowing to 3.6% YoY in April. The central bank already slashed rates by 50bps in Q1 and lowered the reserve requirement ratio by 100bps. In addition to this, BI announced that it will streamline the interest rate corridor by keeping the bottom rates steady and lowering the lending rate by 100bps. The banking system in Indonesia needs liquidity, as indicative by the high loan-to-deposit (LDR) ratio, but few banks can/want to access BI lending facility. M2, a measure of deposits, is growing slowly by only 7.4% in March. Even with slowing credit growth, liquidity remains tight. Banks, at a basic level, make money by lending to the private sector at a rate higher than their funding costs (deposits). As a result, market deposit and lending rates have not dropped despite BI easing. Banks want to protect their margins. BI’s OMO facility does not show much lending from the central bank to banks (Chart 5). As a result, from August 19 onwards, the lending rate will drop to 6.25%. This is to ease liquidity conditions and encourage banks to use the lending facility by the central bank. Chart 6 An illustration of changes to come 7- Day reverse repo Fasbi Policy rate Repo 7.50 7.25 7.00 6.75 6.50 6.25 6.00 5.75 5.50 5.25 5.00 4.75 4.50 Reference rate Now 9.00 CPI Lending Chart 7 Lending has slowed and lending rates rising Household Consumption Industrial Lending rates for consumption 35 9 8.00 From August 19 There is a general reluctance by Indonesian banks to access the repo facility as they can either a) attract deposits at 7.3% - a rate comparable to the current 7.25% repo rate; b) or avoid dealing with BI due to the stigma associated with needing to access liquidity with the central bank. But BI is hoping to change that by slashing the repo by 100bps. This would deepen the repo market and reduce fragmentation to reduce money market shocks and reduce volatility in the interbank market. It recently announced that BI will set up a new department to deepen financial market. Chart 4 Overnight deposit rate Reference Basically a 100bps cut of the repo rate while everything remains the same. The floor stays while the ceiling drops. 15 30 8 25 7.00 7 20 6.00 6 14 15 13 10 5.00 5 5 4.00 4 0 12 12 3.00 2010 2012 2013 2014 2015 Source: Bloomberg, Natixis, Monetary Operation: OMO: Bank Indonesia Certificates (SBI) Indonesia IDR bn 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 Source: CEIC, Natixis 15 16 Chart 8 But the bank system is starving for liquidity Deposit rates Lending rates 2016 Chart 5 BI mops up liquidity and injects little Open Market Operation: Reverse Repo Indonesia IDR bn 14 Source: CEIC, Natixis 3 2011 13 LDR 15 14 13 12 11 10 9 8 7 6 5 4 103 100 97 94 91 88 85 82 79 76 10 11 12 13 14 15 16 Source: CEIC, Natixis Finally, implications for markets and the economy Despite aggressive monetary easing, we expect growth to marginally expand by 4.9% in 2016 versus 4.8% in 2015. While BI wants to help, it cannot fight gravity – and that is a credit cycle that is slowing and deposits growing marginally (Chart 7). From a public investment side, there is not a lot of that the President can do to N° xx I 2
3. SP EC IA L R EP ORT boost spending . Yes, fiscal spending can step in to help but at the expense of a wider deficit. And this is where revenue-side reforms need to come center stage. Thus far, we have not seen enough long-term reforms to address the weakening revenue ratio. And should the government try too hard to defy gravity, the sustainability of the economy will be an issue. For example, in an effort to boost private investment and spending, Indonesia’s Financial Services Authority, known as OJK, is trying to push to cap the deposit rate and for lending rates to drop to single digits by year end. Banks have reported that while cost of funds have declined, they are unwilling to raise loan growth target given the slowing domestic growth environment. BI’s move to lower the repo rate may or may not lead to more injection of liquidity to banks. But OJK, should it continue with the deposit rate, will certainly be negative for financial stability for Indonesia. High deposit and lending rates reflect market conditions and risk premium – a price signal that will be lost should OJK gets what it wants. OJK’s interventionist measures are worrying for several reasons. One this could cause a shortage of deposits, causing M2 to slow further from its already meagre growth rates. Second, should banks lower interest rates in response to government pressures, then banks’ asset quality may deteriorate due to lending to economic segments that are may not be able to pay for the true costs of funding. Third, this could cause misallocation of resources and lead to inefficiency. Another move that OJK has made is instructing all domestic pension funds to invest at least 30% of their money in the domestic bond market within two years. Clearly, the move is to increase domestic investors in the bond market that is dominated by foreign investors (44% foreign investor ownership ratio). But domestic investors do not want to touch domestic bonds due to the fact that they can get better return elsewhere. As a result, only 2% of domestic pension assets are allocated to Indonesian government bonds. These funds are supposed to raise their allocation to 20% by end 2016 and 30% by end 2017. Insurance funds, too, have the same mandate. OJK recently stated that it will review banks’ deposit cap rate, which we hope will not be implemented. The economy is clearly tired, and there is not much fiscal room to help due to a widening funding gap. As a result, the central bank has eased monetary conditions through rate cuts to support banks’ liquidity conditions and spur domestic demand. While this will lower funding costs, Q1 2016 lacklustre economic results show that it is very difficult to fight gravity and GDP will likely grow by 4.9% in 2016. References Nguyen, T. Money, markets and central banks: An Indonesian perspective. 26 April 2016. Natixis. Nguyen, T. Indonesia: The hole in the fiscal-led growth story – a widening funding gap. 26 April 2016. Natixis. N° xx I 3
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