In mid-November, Indonesia’s new president announced that his administration will reduce fuel subsidies. To control any inflationary pressures, the Bank Indonesia (BI) raised its policy rate by 25bp to 7.75%. We see both moves as conducive to boosting GDP growth and investor opportunities.
Fuel subsidies reduction: Jokowi is a lucky man
Plummeting oil prices created an opportunity for Indonesian President Joko Widodo’s new government to get to grips with Indonesia’s expensive addiction to fuel subsidies. The new administration has seized the opportunity, implementing its first major reform since taking power in mid-October, and hiked fuel prices by some 30%. The sharp falling in oil price this year mean prices hikes scheduled to occur again in 2015 have not been necessary so the reform has been easier to implement than expected.
Weaning Indonesia off an expensive habit
Fuel subsidies were forecast to cost the Indonesian government Rp 276 tn in 2015 (USD 22.6 bn). These subsidies have long been considered a drag on the economy, benefiting the middle/upper classes at the detriment of the poor. Yet it has been impossible to remove them.
This reform should reduce Indonesia’s budget deficit by about 1% and facilitate reallocation to more productive sectors, such as infrastructure, education and health care. Indonesia’s GDP grew by 5.01% YoY in Q3 2014. Enabling greater investment in infrastructure through reforms such as this should boost GDP growth.
Bank Indonesia responds with policy rate hike
In response to the government’s decision to reduce fuel subsidies, Bank Indonesia announced the same day a 25bp hike in its policy rate to 7.75% and a 50bp hike in its lending rate to 8%. The deposit rate was left unchanged at 5.75%. The aim of such a rapid response was to ensure that any inflationary impact from higher fuel prices would be minimised and short-lived.
Figure 1: The events leading up to the policy rate hike
Source: Bank Indonesia
Moves should help reduce deficits and control inflation
In our view, the fuel subsidy and policy rate moves should together help improve Indonesia’s outlook. We view this move as a positive step since it suggests Mr Widodo is serious about economic reform in Indonesia and will not shy away from difficult reforms.
1) Current account deficit: As Indonesia is a net oil importer, we believe the lowering of fuel subsidies should help narrow the current account deficit to below 2.5% of GDP.
Figure 2: Indonesia’s current account balance as a % of GDP
2) Budget deficit: The final budget savings should be around 1.6% of GDP on the back of fuel subsidies being reduced. This gives more control of the budget so the Government can manage the deficit in order to keep it below the 3% limit imposed by Indonesian law.
3) Inflation: We expect inflation to be at 7.5%-8.0% YoY at end-2014 and after any impact from the fuel price hike has faded, inflation should return to the 4%-5% YoY we have seen in recent months.
Figure 3: Indonesia inflation (if you click on the drop down menu in the top left-hand corner, you can see the inflation rate for East Asia and Pacific (developing only), as a comparison)
Support for GDP growth and earnings
GDP growth: Bank Indonesia recently reiterated its 2015 GDP growth projection of 5.4%-5.8%. We think around 5.4%-5.6% is more likely, unless government spending and investment come on stronger than expected.
Figure 4: Indonesia’s GDP growth forecast as an annual % of GDP (if you click on the drop down menu in the top left-hand corner, you can see the GDP growth forecast of East Asia and Pacific as a comparison)
Earnings growth: Achieving the reform on fuel subsidies gives us more confidence that the government can do more. We see the acceleration of infrastructure projects as the next big challenge, as it would help to revitalise growth. Further reforms should help remove the bottlenecks that are blocking many industries, such that we see earnings possibly growing at 12% YoY in 2015.
President Widodo’s administration is getting off to a good start – watch this space for more updates.