More Headwinds for the Indonesian Economy

Concern is rising over the state of Indonesia's economy, with inflation rising at a 5.6 percent clip in March after a 4.31 percent increase in February and the rupiah continuing to shed value, falling to Rp9,738:US$1.

Economic troubles are arriving from a variety of different directions just as Finance Minister Agus Martowardjo was unexpectedly moved to the governorship of Bank Indonesia, the central bank. This increases the danger of creating a policy vacuum at a time when policy continuity is a major concern. No candidate has been announced to replace Agus, but whoever it is will be the third finance minister since President Susilo Bambang Yudhoyono was reelected in 2009. Analysts say the central bank has left its benchmark policy rate at 5.75 percent, a record low level, far too long, further threatening the value of the rupiah.

The government's fiscal position is also under increasing pressure from an unsustainable US$22 billion annual domestic fuel subsidy and a new food law that threatens to curb imports and push food prices higher. The statistics bureau also announced a trade deficit for February of US$330 million, twice as large as forecast in a Reuters poll. Exports were 4.5 percent lower than in February 2012. The country has been running a monthly trade deficit for seven months.

It doesn't look to get better soon, with major exports falling sharply in value. Indonesia is the world's biggest producer of palm oil, whose price is down 29.9 percent year-on-year. Copper is off 10.2 percent, crude oil 12.6 percent and coal 3.9 percent, and the long-term trend for all commodities is down.

While all this has been happening, Yudhoyono himself moved last weekend to take over the chairmanship of his floundering Democratic Party, which has endured more than a year of scandals that have claimed much of the party leadership including former chairman Anas Urbaningrum, who has been named a suspect in bribery cases brought by the Corruption Eradication Commission.

The president reportedly has set out to purge the party's central executive board of Anas loyalists and is seeking to reorganize the body, raising considerable criticism over the fact that he appears to be spending his time playing politics and trying to straighten out his party in advance of 2014 elections rather than governing a country facing economic uncertainty, much of it brought on by policies his government put in place that are having a detrimental effect on both domestic and foreign investment.

Bloomberg reported that global holdings of local sovereign debt fell Rp560 billion ($58 million) last month through March 27, the first decline since August 2011, apparently over fears of higher inflation and a falling rupiah, as international investors began to have second thoughts.

Despite these troubles, the country continues to remain a favorite of fund managers. Investors can point to the fact that Indonesia managed 6.2 percent gross domestic product growth in 2012 and appears set to maintain a level somewhere around that figure or higher in 2013.

Manufacturing activity rose in March and new export orders increased, supported by a small boost in production triggered by strengthening new orders, according to an HSBC Markit survey.

Domestic consumption, which generates 65 percent of GDP, helped the country attract a record Rp221 trillion in foreign direct investment last year, a 26 percent increase from 2011 despite the government's heavy-handed approach to multinationals, particularly in resource extraction.

But "borrowing purchasing power today in order to acquire capital goods that can increase income-producing capacity in the future is rarely a problem. Rather, that is how economies grow," economist Rob Parenteau of the Hong Kong-based Asianomics financial advisory firm wrote on March 17 in a subscriber-only newsletter. "The problems tend to arise when a) debt is used to fuel present consumption, at b) interest rates heavily influenced by a price controller - namely, the central bank, that c) bear little or no resemblance to the interest rate that would accurately reflect the time preferences of consumers and the marginal productivity of real capital."

Although capital spending remains strong, there is an increasing shift toward unproductive debt creation, Parenteau wrote, with both the government and households and firms deficit spending at 1.8 percent and 1 percent of GDP respectively. The significant depreciation of the rupiah in 2012 suggests that foreign portfolio preferences for Indonesia's financial assets are not that strong.

The government announced in mid-March that it would attempt to restrict government vehicle access to subsidized fuel in cities. However, it is uncertain if that measure will have much of an impact on the annual energy subsidy.