151201 indonesia by ABN AMRO

Indonesia Watch

Group Economics Emerging Markets Research

01 December 2015

Still many challenges in 2016 Arjen van Dijkhuizen Senior Economist Tel: +31 20 628 8052 arjen.van.dijkhuizen@nl.abnamro.com

 We expect growth to pick-up to 5% in 2016 and 5.5% in 2017  Higher government spending compensates for sluggish private demand  FX reserves under pressure, we expect more rupiah weakness in 2016  Indonesia to remain vulnerable to China and Fed lift-off related risks Introduction In 2013, during the general emerging market turbulence in the run-up to the Fed tapering of unconventional monetary stimulus (taper tantrum), Indonesia was classified as one of the so-called fragile five emerging markets (EMs). Two years later, we still think that Indonesia is relatively vulnerable amongst emerging markets and certainly within emerging Asia. Indonesia is a commodity exporter with strong trade ties with China and still has a number of external fragilities. In this report, we will analyse recent developments and explain our outlook for 2016 (and 2017). Economic growth has stabilised around 4.7% While Indonesia’s average economic growth rates are still satisfactory by general EM standards (averaging almost 6% in 2005-2014), growth has gradually fallen since 2010. In 2015, growth has dropped below 5%, although stabilising around 4.7% yoy in the past three quarters. GDP growth in Q3 was driven by domestic demand, particularly by government consumption. With some delay, the government in the course of this year started to allocate the budgetary savings stemming from the 2014 fuel subsidy cuts. The infrastructure budget was raised by more than 50%. As a result, government consumption grew by 6.6% yoy in Q3 (H1-2015: 2.4%). This fiscal boost also helped fixed investment, which showed the strongest increase (+4.6% yoy) since Q2-2014. Growth of consumption remained quite steady at 5% yoy, as the decline in inflation was positive for consumer sentiment. Net exports still contributed positively to GDP growth in Q3, although to a smaller extent than in Q2. However, that is not so much a sign of external strength, but more a reflection of the fact that imports (-6.1% yoy) contracted more sharply than exports (-0.7%). El Niño and haze hit production in agricultural sectors Looking at the supply side, the construction sector (boosted by government spending), services and manufacturing were the main contributors to GDP growth in Q3. Meanwhile growth in the mining sector remained sharply negative (-5.6% yoy). The agricultural sector also showed a sharp slowdown in Q3, as weather conditions were impacted by El Niño. Palm oil and food production were hit by limited rainfall. Moreover, the lack of rain in

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Indonesia Watch - Stilll many challenges in 2 2016 - 01 Dec cember 2015

combin nation with the use of fire to clear c new farm and plantationn land caused one o of the worst haze h events in recent history, harming the agricultural a andd forestry secto ors.

Economic E has s stabilised around a 4.7%

Month hly indicators s point to weaaker economic activity

% yoy

indeex

6 60

8 5 55 7 6

5 50

5 4 45 4

% yoy, 12 1 months moving g averages

-10

-20

4 40 08

Economiic growth (lhs) Sou urce: Bloomberg.

1 12

14 4

HSBC Manufaccturing PMI (rhs)

-40 08

Retail sales (lhs) Motorcycle saless (lhs)

Industrial prod duction (lhs) Car sales (rhs))

Source: Thomson T Reuters Datastream.

hly indicators confirm slugg gishness in prrivate sector Month The monthly activity and confidence e indicators are e confirming thhat, except for government g spending, economic activity is rathe er sluggish. The forward-lookking Manufacturing PMI nce mid-2014 and a has hovere ed below the neeutral 50 mark for more has fallen sharply sin e index fell bac ck to 46.9 in No ovember and iss one of the we eakest in than a year now. The so point to a slo owdown in ecoonomic activity. Growth of emerging Asia. Othe r indicators als s has dropp ped clearly sinc ce July compared to the leve ls seen in rece ent years. retail sales Car sa ales and motorccycle sales, wh hich are more cyclical, c also haave cooled sha arply in the past tw wo years and a are still in contraction territory. The slowdow wn in consumerr spending data is s in line with the e clear drop in consumer con nfidence in receent months. Me eanwhile, growth h of industrial p production also o fell in September, although bbeing more sta able than consum mption indicato ors in recent ye ears. We ex xpect growth tto pick up in 2016 2 and 2017 We ex xpect Indonesia a’s economic growth to come in at around 44.7% this year (we ( round our GD DP forecasts att full or half percentage points s), with strong government co onsumption to conttinue compenssating for subdu ued private dom mestic demandd. Indonesia’s public finance es are still favo ourable, with bo oth the budget deficit (aroundd -2.5% of GDP P in 2015) and pu ublic debt (just below 30% of GDP in 2015) at manageablee levels. We also expect external demand to sstrengthen in 2016 and 2017, on the back oof a stabilisation n of Chinese an ongoing rec covery in advan nced economiees. This should create import demand and a positiv ve feedback efffects on private e domestic dem mand as well. A All in all, we exp pect economic growth to rrise to 5% in 20 016 and 5.5% in 2017. Some piecemeal refforms under Jokowi, J not ye et a structurall breaktrough President Joko Wido odo (“Jokowi”), elected in July y 2014, has no strong power base b in parliam ment. This mea ans he has to continuously c co onvince other pparties to suppo ort his policy agenda. He made a sstrong first imp pression by low wering politicallyy sensitive fuel subsidies in late 2014. The pre esident’s main policy p goals are e to stimulate iinfrastructure development d and to improve Indon nesia’s manufa acturing base and a broaden exxport capabilitie es. In reactio on to the econo omic slowdown n, the governme ent – which waas reshuffled in n August –

Indonesia Watch - Stilll many challenges in 2 2016 - 01 Dec cember 2015

introdu uced several sttimulus measures in Septemb ber and Octobeer. These measures – in the forrm of deregulattion, tax incentives and SME support – aim to strengthen the t business environment. The sh harp reduction of the waiting time t for a land--use registratio on permit is e attempts to re educe red tape e. At the other hhand, in July th he a nice example of the govern nment introducced new import tariffs on seve eral consumptioon goods. This confirms Indone esia’s still overa all quite protec ctionistic stance e. Hence, the ccountry’s ambittion to join the US S-led Trans-Pa cific Partnership – a regional trade agreemeent among twe elve Pacific Rim co ountries – lookss to be only rea alistic in the lon nger term. All i n all, the reform m momentum looks to h have improved d under Jokowi, although he hhas not yet brought the ural breakthrou ugh that foreign n investors had hoped for. structu Sticky y inflation and d looming Fed rate hikes ma ake Bank Indo onesia cautiou us In May y-August, inflattion moved abo ove 7% again, driven up by foood prices, rupiah weakn ness and highe er import tariffs.. Still, despite ongoing o rupiah weakness, infflation has come down d in the au utumn, falling to o 6.3% yoy in October. O We exxpect headline inflation to averag ge 6.5% this ye ear, falling to around 5% in 20 016-17, althouggh currency we eakness and El Niño o still pose upw ward inflation riisks. Meanwhile, core inflationn has remained stable around d 5% this year.. With inflation sticky and Fed d rate hikes loooming (we expe ect lift-off in Decem mber and have pencilled in an nother 75 bp off Fed rate hikess in 2016), Ban nk Indonesia (BI) ha as remained ca autious. In Feb bruary 2015, BII undid the tem mporary 25 bp rate r hike of Novem mber 2014 whicch immediately y followed the government’s g fu fuel subsidy cuts. Since then, the main policyy rate was kept at 7.5%. Shou uld inflation fall towards 5%, we w see some room for f one or more e rate cuts in th he course of 20 016 (possibly eextending into 2017), 2 provide ed that markett sentiment rem mains relatively constructive.

In nflation

Trade e remains weak, current aaccount has im mproved

% / % yoy

n USD bn

% yoy

80 60

0 40

-4

-8

20 0 -20

-12

2 09

Headlinne inflation Sou urce: Thomson Re euters Datastream m

14 4

Core inflation

15 Policy rate

-40 10

1 12

C Current account balance (lhs)

14 E Exports (rhs)

15 Imports (rhs)

Source: Thomson T Reuters Datastream.

Helped d by currency y depreciation n, current acco ount has impro roved since taper tantrum Fitting to the regiona al and global pic cture, Indonesian trade – bothh imports and exports – have been b weak in 22015, on the ba ack of the sharp p drop in comm modity prices, subdued s deman nd from China a and a generally weak global trade picture. S So far this yearr, Indone esia’s export va alues have falle en by an avera age 14% yoy, w while import values have even contracted c by 2 20% yoy. Since e Q2-2013, which marked thee start of the tap per tantrum, the current account d deficit has halv ved in US dollar terms, despitee a temporary increase in P terms, the current account deficit d has falleen less spectac cular, from 2014. In annual GDP 3.2% of o GDP in 2013 3 to an estimated 2.3% in 201 15. That said, I ndonesia’s currrent

Indonesia Watch - Stilll many challenges in 2 2016 - 01 Dec cember 2015

accoun nt deficit is not as high as som me other emerging markets ‘aat risk’. The red duction in external deficits is pa artly supported by currency de epreciation. Thhe rupiah lost more m than 50% versus the US d dollar between 1 May 2013 and the historic trough in late September S 2015, although recovvering a bit in recent r months. FX res serves under p pressure, we expect more rupiah r weakneess in 2016 After re ecovering sharrply in late 2013 and 2014, FX X reserves havve started fallin ng again in recent months, by an n average 6.5% % yoy in July-O October. This drrop stems from m capital outflow ws in the wake of general EM M turmoil and FX X interventionss by Bank Indonesia to defend d the rupiah. Ass a result, FX reserves r are no ow not far awayy from the leve els seen during the previous trrough in July 2013. 2 Still, while e Indonesia’s leevel of FX rese erves compa ared to other AS SEAN countrie es is relatively low in GDP terrms, they still cover shortterm external debt byy a wide margin and around 5.5 5 months of i mports. Going forward, we expectt further rupiahh deprecation versus v the USD D in 2016 (towaards IDR 15000 0 per USD end-off-period), follow wed by a recovery in 2017 (to 14200 end-of--period).

Rupiah R and C CDS premium show some rebound IDR per USD

FX res serves under pressure agaain

bp (Sovereign, 5 yr, USD)

16000 14000

n. USD bn

350 0

120

300 0

110

250 0

100

200 0

150 0

100 0

12000 10000 8000 10

Exchhange rate (lhs)

CDS prem mium (rhs)

Sou urce: Thomson Re euters Datastream m

60 10 0

13 3

Source: Thomson T Reuters Datastream.

To con nclude, Indon nesia still fragiile to China an nd Fed-related d risks Two ye ears after the ta taper tantrum, we w still think that Indonesia iss relatively vuln nerable among gst emerging m markets and certainly within emerging Asia. Indonesia is a commodity exporte er with strong ttrade ties with China and still has external vvulnerabilities: an ongoing current account deficcit and a moderrately high exte ernal debt, whille FX reserves s have gh part of the eexternal debt is s recently fallen again. Moreover, as a relatively hig denom minated in US d dollars, a strong g rupiah depreciation makes debt servicing more expens sive. These vu lnerabilities are e also reflected d in the rapid inncrease of the CDS premiu um in the coursse of this year, although we have seen somee correction in recent months s. Taking the m mix of vulnerab bilities in mind, we classified Inndonesia as on ne of our ABN AMRO’s A fragile six two months ago, together with Brazil, C Colombia, Malaysia, South Africa and Turkey (se ee our report The T top six eme erging marketss at risk, publish hed last Septem mber).

Indonesia Watch - Stilll many challenges in 2 2016 - 01 Dec cember 2015

Key forecasts f fortt he economy y of Indonesia 2013

2014

2015e

2016 6e

2017e

GDP (% % yoy)

5.6

5.0

4.5

5.0

5.5

CPI infflation (% yoy)

6.4

6.5

5.0

-2.2

-2.5

-2.0

Budge et balance (% GD DP) Govern nment debt (% GDP) G

2 29

Curren nt account (% GD DP)

-3.2

-3.1

-2.5

Gross fixed investmen nt (% GDP)

32.1

32.6

3 32.3

32.6

32.7

Gross national savingss (% GDP)

30.9

31.8

3 31.4

31.3

31.6

USD/ID DR (eop)

12189

1 12440

14300

1500 00

14200

EUR/ID DR (eop)

16796

1 15052

15015

1425 50

15620

Budge et b alance, current acc. for 2015, 2016 and 2017 7 are rounded fig gures

Source e: EIU, ABN AM MRO Group Ec onomics

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