After ten years of strong growth, the Indonesian economy is slowing considerably. This is because of the falling Chinese demand for commodities, the gradual normalisation of US monetary policy and an inevitable decline in government expenditure.

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GDP growth is now around 5%, but without major policy changes, a slowdown to 4% seems increasingly likely. The last time Indonesia experienced 4% growth was in the aftermath of the world credit crisis of 2008.

The economy is suffering from an overdependence on foreign capital and Indonesians’ lack of confidence in their own financial system. Credit growth, currently still at 15%, can only remain strong if banks are able to raise more foreign capital, which is starting to prove difficult.

US interest rate rises in the coming quarters will put pressure on the capital flows to the high-yield emerging markets such as Indonesia.

The Indonesian central bank is keeping interest rates high to prevent a major capital shortage and a financial crisis. The rupiah is vulnerable, if only because of the substantial deficits in the current account and the government’s budget. The major reason for these deficits is the high fuel subsidies, which account for no less than 25% of total government expenditure. Without big cuts to these subsidies there will be no cash available to invest in the infrastructure that the country so badly needs. By keeping interest rates high, the central bank is putting pressure on the government to solve the subsidy problem.

Fortunately, a new president has been elected and will be installed next month. Joko Widodo, commonly known as Jokowi, is regarded as a reformer. But it remains to be seen whether he is capable of gaining sufficient support for the policy changes that are urgently needed. The subsidies probably will be cut but the new president has little choice: the budget deficit is close to the statutory 3% limit in Indonesia.

Failing to intervene in the subsidies will automatically mean that other expenditures will have to be cut and investments in infrastructure will not go ahead.

Decisive action from the new president would give a welcome boost to confidence in Indonesia, prompting an increase in private investments that could counter the negative impact of the budget adjustments, declining Chinese demand for commodities and negative capital flows. Unlike many other emerging countries, Indonesia has, in any event, a new government with a pro-reform president who proved his credentials as governor of Jakarta.

Economic growth will probably fall further, but there are good prospects for improving the growth outlook. Consequently, Indonesia is one of the most attractive emerging markets at the moment.

Maarten-Jan Bakkum , September 2014

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