Source: Barclays

Commentary: Jokowi Faces Precarious Path for Infrastructure Boom


APRIL 03, 2015

Singapore. It’s never too late for structural reform to blossom. Following a decision to appoint a national police chief that was seen as bowing to the political elites, President Joko Widodo is instead turning to his economic agenda to affirm his reform credentials.

The immediate priority is to ease bottlenecks in infrastructure that will allow the economy to achieve 5.7 percent growth this year and 7 percent over the medium term.

On energy, Joko has eliminated Rp 190 trillion of fuel subsidies, concluded oil import agreements from cheaper sources (other than Singapore), and signed memoranda of understanding with foreign partners to build refineries.

In tandem, a drive to attract foreign manufacturers was started with the launch of a one-stop service to coordinate the processing of business permits.

Focus is now turning to two perennial impediments — power shortages and poor inter island connectivity.

With the need to build power plants and ports, planned infrastructure spending Rp 205 trillion ($15 billion) will exceed subsidy spending of Rp 58 trillion for the first time in the country’s history in 2015.

On the fuel subsidy reform front, after cutting fuel subsidies on Nov. 18, the government moved to a fixed subsidy regime on Jan. 1, after oil prices collapsed.

Apart from the benefits of more predictability in the fiscal balance, we believe the long-term positive stems from the decision to phase out RON88 fuel altogether.

RON88, which is specially blended for Indonesia in Singapore, is expensive and polluting.

As Indonesia moves to RON92 in the next two years, we expect this will significantly reduce the import dependency on RON88, and boost production in Indonesian refineries which are currently scheduled to be upgraded to produce products with higher specifications.

Attention is now turning to electricity. The government is likely to lower electricity subsidies this year, which cost Rp 103 trillion in 2014, or 5.5 percent of the budget.

It is likely that the electricity subsidies will be reduced in second half after Ramadan, earlier than expected. The move to a market driven tariff will pave the way for more investment in the electricity sector.

The state utility PLN itself has gone through a major management shakeup. In late December 2014, Sofyan Basir, the head of a state bank, was appointed to replace Nur Pamudji as chairman, while a former anti-corruption agency official was named president commissioner.

Things have moved quickly since. By early March, PLN had announced it would start building 10,000 megawatts of new capacity in Java and Sumatra this year, the first phase of Joko’s plan to install 35,000 MW of new capacity during his five-year term.

The remaining 25,000 MW will be built in less-developed Eastern Indonesia.

Coupled with the weaker currency, the removal of electricity subsidies could push the path of inflation slightly higher.

Given also that fuel prices (RON88) have started to rise to Rp 6,800 per liter in March after bottoming out in January, we fine tune our inflation forecast higher by 50 basis points from between 4.9 percent and 5.4 percent, compared with 6.4 percent predicted in 2014.

The outlook is still benign, with inflation projected to average 6.5 percent in the first quarter, roll down to 6.3 percent in the second quarter, 5.6 percent in the third quarter and re-enter the official target range of between 3 percent and 5 percent from November.

The current account could improve significantly this year. The revival of manufactured exports after the elections was the key driver late last year, leading the non-oil and gas trade surplus to widen to 2.2 percent of gross domestic product in the fourth quarter.

We expect this trend to continue in 2015, providing a real offset to coal and energy exports.

Indeed, the January and February trade balance posted a large surplus as lower oil prices compressed imports to a larger extent than exports.

Given the trade surplus for the first two months of 2015 already totalled $1.48 billion, compared with  $399 million in the same period last year, the first quarter current account deficit could come in below the 1.5 percent mark that BI expects.

If the realization rate of infrastructure projects falls short of the 60 percent that Ministry of Finance expects, the full-year current deficit could come in lower than 3 percent of GDP, as capital equipment imports are likely to fall short of expectations.

Source: Barclays

With lower dependence on imported fuel and as industrial exports pick up, Barclays forecasts the current account deficit could narrow to 2.4 percent in 2015.

If Bank Indonesia’s focus remains on current account management, it will retain a weak currency bias to support export competitiveness.

As long as inflation remains benign, expect Bank Indonesia to reduce its policy rate once more — by 25 basis points in late second quarter — after the release of the first quarter balance of payments in mid-May.

This will follow the unexpected rate cut to 7.5 percent on Feb. 17, barely three months after delivering a surprise inter-meeting rate hike on Nov. 18 last year — a day after the government hiked subsidized fuel prices.

In the March meeting, Bank Indonesia decided to keep policy rates on hold on concerns over rupiah volatility, inflation and current account deficit. However, the risk to our view of a cut in second quarter is if we see resurgent pressure on the rupiah.

There is also a drive to free up additional fiscal resources, partly to offset a potential drop in non-tax revenue (assuming lower oil prices persist).

The government is now expanding the use of online tax filing, which could require Indonesia to first integrate the databases of different ministries (labor and real estate, among others).

To drive this cross-agency effort, there are proposals for the tax office to be carved out as an autonomous agency within the purview of the President’s Office.

Separately, the Ministry of Finance is embarking on a major push to boost personal income tax collection — by increasing significantly the number of tax officers. There are also plans to crack down on transfer pricing — the booking of activity in lower tax centers offshore, such as Singapore and Macau.

That said, we continue to expect GDP to grow at a relatively modest pace of 5.3 percent in 2015, below Bank Indonesia’s forecast of between 5.4 percent and 5.8 percent, slightly faster than the 5 percent in 2014 (a five-year low).

The reason our growth forecast is lower reflects our caution about factoring in boosts to growth, given the significant lags involved in the types of infrastructure plans laid out for Indonesia.

The life cycle of these large projects is such that growth will be hampered initially by the need to increase capital equipment imports.

Rather, we believe that the growth dividend from the infrastructure investment will be concentrated between 2016 and 2018.

This could pave the way for more investments, setting the stage for a fresh investment-led virtuous cycle. With a young population, trend growth could exceed 7 percent — a step up from the 5.7 percent average over the last six years.

The payoffs from better infrastructure are immediately obvious in tourism and foreign direct investments — two areas where Indonesia is below its full potential.

To spur tourism, the government has also announced waivers for visa requirements for another 30 countries in addition to the existing 15, effective from April.

Indeed, regional peers such as Malaysia and Thailand have granted visa-free entry for 164 and 56 countries, respectively.

With the total number of visitors still lagging significantly behind regional peers, with Indonesia booking 9.4 million arrivals last year compared to Malaysia’s 27.4 million and Thailand’s 25.2 million, the government aims to make every effort to catch up with Malaysia and Thailand in two years.

Wai Ho Leong is a senior regional economist at Barclays and is based in Singapore.