Indonesia – further reforms in 2017 to promote economic growth

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Having undergone an encouraging degree of economic recovery in 2016, Indonesia’s economy, the largest in South-East Asia, looks set to strengthen further in 2017.

Exhibit 1: Indonesia quarterly GDP growth (in %)

Source: BNPP Investment Partners, Bloomberg as of January 2017.

In our view, further momentum should be helped by the successful tax amnesty programme, the supportive policy environment and the evidence of how effective the recent implementation of structural reforms has been. Higher government infrastructure spending will still be the main engine of growth for 2017 and private consumption should remain on a strengthening path. We should also see private sector investments gathering pace in 2017 – the IMF forecasts growth will be driven by private consumption plus a gradual pickup in private investment in response to a recovery in commodity prices and lower interest rates.

Focusing on the execution of reforms for 2017

After the delivery of successful reform packages in 2016, further execution is expected to be implemented by the government in 2017. The cabinet reshuffle and the appointment of Sri Mulyani as finance minister in July 2016 strengthened investors’ confidence about the government’s ability to execute reforms. Sri Mulyani restored the credibility of the budget by cutting the tax revenue target. The best demonstration of this was probably the passage and successful outcome of the tax amnesty scheme’s first phase, which should boost government revenue. We see the pace of execution of structural reforms as being critical in strengthening Indonesia’s economic stability and growth recovery.

Despite some tension between religion and politics, we remain confident about President Jokowi’s ability to consolidate in challenging political environment

The last weeks of 2016 were marked by two protests organised by hardline Islamists in central Jakarta a few months before the 2017 Governor of Jakarta elections to be held in February, with Jakarta’s vice-governor Ahok facing demonstrations amid allegations of blasphemy. The anti-Ahok rallies ended peacefully after President Jokowi intervened. Our view is that over the last few months President Jokowi has once again proven himself to be a pragmatic political actor, and that his handling of the protest against Ahok has arguably enabled him to consolidate his power.

The Jokowi administration should continue to pursue a pro-growth strategy focusing on the investment climate

The government has released a string of reform packages over the past year mainly to improve the business environment, which should favour more foreign direct investment (FDI) inflows. The 14 stimulus packages introduced in the last 17 months are mainly focused on loan-to-value relaxation, reducing red tape, lowering final taxes and fostering investment. In particular, the revision of the negative investment list is one of the major initiatives designed to improve the business climate as it has paved the way for increased foreign investment into 35 sectors, which were previously more difficult for foreign investors to access.

The government’s ongoing reform agenda has generated positive results

For instance, Indonesia significantly improved its ease-of-doing-business ranking in the ASEAN region, as underscored by the World Bank. Indonesia also saw one of the region’s largest FDI inflows over the past year. Q3 2016 net FDI inflows rose to USD 5.2 billion from USD 3.0 billion in Q2 2016. In our view, reinforcing a stronger business climate should help attract further FDI inflows in 2017. Last but not least, Fitch Ratings has raised Indonesia’s credit rating outlook to positive on the prospects of reforms in 2016 supporting economic growth. We continue to expect further positive effects and more policy packages, in line with the government’s shift towards a more targeted approach to reforms.

Further GDP recovery expected, led by a stronger momentum in infrastructure for 2017

Infrastructure investment remains the growth theme for 2017. Coupled with structural reforms, it should sustain the ongoing domestic demand recovery. Indonesia’s GDP growth recovered well over 2016, averaging 5% in the first three quarters of 2016, up from 4.8% in 2015. We expect the growth rate to reach 5.0% YoY in 2016 on the back of increased infrastructure spending, and we think it will rise further, to 5.2% YoY in 2017, with the same drivers.

To support this in 2017, the government allocated additional spending to the infrastructure sector in its revised 2017 State Budget. Infrastructure spending rose to IDR 387 trillion (about USD 30 billion) from IDR 347 trillion (about USD 26 billion) in the draft budget. On top of this, the revenue from the tax amnesty scheme not only allowed the government to improve spending in 2016, but is also paving the way to broaden the tax base in 2017. However, the government has to define new ways to increase fiscal revenue in 2017, given the one-off tax revenue coming from the tax amnesty scheme, amounting to about IDR 107 trillion (approximately USD 8 billion).

State contractors’ spending should be a more crucial driver of infrastructure spending as state-owned enterprises (SOEs) are the direct beneficiaries of the positive momentum in infrastructure development. All the SOEs’ planned capital injections were completed in Q4 2016, in preparation for 2017. Most of the proceeds will be used to finance the government’s infrastructure project developments.

Exhibit 2: Increase in the government’s infrastructure spending between 2006 and 2017

Source: BNP Paribas Investment Partners, CLSA, as of December 2016

A more stable monetary environment to execute policies

The supportive monetary environment should continue to maintain stable liquidity conditions and help support the economic growth recovery. Taking advantage of more moderate inflation and a strengthening rupiah, Bank Indonesia (BI) cut its benchmark rate six times in 2016. It is holding its interest rates for now, in view of the likely path of US monetary and fiscal policy. Rather than tightening, we expect BI to focus on liquidity stability. We expect inflation to remain benign in 2017. We also expect the rupiah to remain stable, perhaps depreciating slightly over 2017, given the potential rise of the US dollar and US Treasury yields (see Exhibit 3 below for an overview of how the rupiah has traded versus the US dollar since January 2016). The depreciation of the rupiah should be manageable as the high yield offered by government bonds gives some buffer against capital losses. The policymaker has also adopted macroeconomic prudential easing measures, such as lowering loan-to-value ratios for vehicles and mortgages and cutting banks’ reserve requirements, to further support growth in a number of sectors.

Exhibit 3: The Indonesian rupiah is among the emerging market currencies that have rallied versus the US dollar since January 2016

Source: Bloomberg, as of January 2017

Compared with the 2013 ‘taper tantrum’, Indonesia has much stronger fundamentals now and is in a better position to weather capital outflow risks. The recent reforms have helped Indonesia to better withstand external vulnerabilities. The strong FDI inflows resulting from the reforms have helped to finance the current account deficit (CAD), which has nearly halved to 1.8% of GDP in Q3 2016 from 3.2% in 2013. Indonesia’s foreign currency reserves have risen to about USD 111 billion from a 2013 low of USD 93 billion. Indonesia may not be immune from the impact of foreign institutional investors’ outflows in face of the challenging outlook for the US Treasury yields and a likely strengthening US dollar but we expect the impact to be manageable, given the country’s solid fundamental backdrop. Indonesia should be reasonably well placed to tackle capital outflows triggered by higher US interest rates.

We believe the recent rally in base commodity prices, mostly during H2 2016, provides some benefits to Indonesia, but is not a game changer. The key ingredient for Indonesia’s GDP growth rebound will not hinge on commodities growth but will be led by infrastructure and consumption, in our view.  We believe further significant rises in commodities prices are unlikely, but rather that prices should remain stable given the ongoing supply reductions in crude oil and metals.

The next step in a sustainable growth recovery is likely to rely on a pick-up in private sector investment, taking over from strong government support. Although the pace of the private sector investment pick-up will probably be relatively mild for now, given hurdles such as the excess supply of properties and cement, it should accelerate if these areas improve. The need for sizeable and readily-available capital to fund infrastructure projects should make partnerships with the private sector a top priority in the near future. We believe that a more stable environment would help foster these initiatives.

As a result, this vibrant environment creates strong catalysts for a number of industries to outperform.

We expect the moderate improvement in earnings growth since the start of 2016 to have reached 7%-8% in 2016, and that this could rise further, to 13%-15%, for 2017. Industrials and construction companies should be the key beneficiaries from infrastructure development. Property companies should also benefit and be supported by the government’s macroeconomic prudential measures. The improvement in discretionary spending in this stable environment should also favour a recovery in the automotive industry. A revival in banks’ earnings is also expected for 2016, mainly supported by supportive monetary environment.


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Aliyahdin Saugi

Head of Indonesian equities at BNP Paribas Investment Partners

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