Indonesia Watch. Plenty of risks, but real crisis not likely. Group Economics Emerging Markets Research. Group Economics: Enabling smart decisions

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1 Indonesia Watch Group Economics Emerging Markets Research 2 August 218 Arjen van Dijkhuizen Senior Economist Tel: arjen.van.dijkhuizen@nl.abnamro.com Plenty of risks, but real crisis not likely Indonesia is facing pressure from current EM turmoil, reflecting generic factors but also country-specific vulnerabilities Current account deficit and external debt rise, FX reserves have fallen while foreign investors hold large share of government bonds Bank Indonesia has raised rates to contain rupiah weakness We had already lowered our 218 growth forecast to 5%, from 5.5% While Indonesia faces risks, it is not as vulnerable as Argentina or Turkey Indonesia is facing pressure from current turmoil, but not in the same camp as Turkey This year, emerging markets are facing a tougher external climate, as ongoing Fed rate hikes, rising trade tensions between the US and key trade partners particularly China and a weakening of the Chinese yuan triggered a rise in risk aversion and capital outflows from EMs. While countries like Argentina and Turkey have been the hardest hit due to country-specific vulnerabilities, other EMs including Indonesia are feeling the heat as well. The rupiah lost almost 1% versus the US dollar this year, despite attempts by Bank Indonesia to support the currency with rate hikes and FX interventions. After a strong decline over the past years, the CDS premium has trended upwards again in the course of this year (although remaining at relatively low levels so far). In our view, the fact that Indonesia is hit by the current EM turmoil does not only reflect the general factors mentioned above, but also some country-specific external vulnerabilities and political uncertainties. That said, as the government pro-actively tightens policies to keep external imbalances under control and FX reserves despite a recent drop are still providing substantial buffers, we do not consider Indonesia to be in the same camp as Argentina or Turkey. Indonesia is feeling the heat from EM turmoil Current account deficit is rising IDR per USD Sovereign, 5yrs, USD, bp USD bn % yoy, 12mma Exchange rate (lhs) CDS premium (rhs) Current account (lhs) Exports (rhs) Imports (rhs) Group Economics: Enabling smart decisions

2 2 Indonesia Watch - Plenty of risks, but real crisis not likely 2 August 218 External imbalances are increasing as imports continue to outpace exports Supported by resilient domestic demand, import growth has continued to grow strongly. Import growth averaged 2.5% yoy in the first seven months of this year, above the already high rate for 217 (16%). This partly reflects higher oil prices, as Indonesia is a net oil importer. Export growth is also still solid, but at 11.% yoy in January-July 218 clearly below import growth. As a result, Indonesia s surplus on the trade balance has fallen. Combined with rising deficits on the income and services balances, this has driven the current account deficit to a four-year high of USD 8bn in Q2-218 (equivalent to 2.7% of GDP). On an annual basis, the current account deficit is expected to rise from 1.7% in 217 to around 2.5% this year. While that level remains quite manageable, it becomes closer to the levels seen during the Fed taper tantrum in 213 (just above 3% of GDP), when Indonesia was classified as one of the fragile five. Moreover, inflows of FDI, a relative stable form of external financing, have fallen compared to 217. We expect the current account deficit to remain below the critical level of 3% GDP in the coming years, as the authorities are already taking measures to keep external imbalances under control (e.g. sharp policy rate hikes and measures to curb imports). In that sense, Indonesia s external imbalance is less pronounced as in hard-hit countries like Argentina or Turkey. Indonesia s debt to export ratio is relatively high Foreign debt ratios, 218 estimates Debt/GDP (%) HUN MAL POL SAF THA MEX RUS KOR IND CHN TUR CHL IDN BRA ARG Debt to exports ratio Source: EIU, ABN AMRO Group Economics Foreign investors hold large share of government bonds % of outstanding LCY government bonds Indonesia Japan Malaysia S. Korea Thailand Source: AsianBondsOnline while external debt is rising, foreign holdership is high and FX reserves have fallen Other external risks stem from the fact that external debt has risen quite sharply over the past few years, more or less doubling since 21. The external debt ratio looks manageable in GDP terms (around 35%). However, Indonesia has a relatively high external debt to exports ratio (estimated at 1.6 in 218), although not as high as Argentina, Brazil and Turkey. The debt service ratio is also quite high at over 25% of exports. Another risk stems from the fact that foreign holdership of Indonesian government bonds is relatively high compared to Asian peers, making Indonesia more vulnerable to changes in risk sentiment amongst foreign investors. Indonesia still has sizeable FX reserves, serving as a buffer against external shocks. These cover around 5 months of imports and two times short-term external debt. That said, after reaching a record high of USD 125bn in January, FX reserves have fallen by almost 1% in the succeeding six months. That reflects pressures from capital outflows as well as BI interventions to defend the rupiah. Bank Indonesia has raised policy rates several times in reaction to external pressures Bank Indonesia has a dual mandate: managing inflation and keeping the currency stable. BI also takes other factors into account, such as GDP and employment growth, the current account

3 3 Indonesia Watch - Plenty of risks, but real crisis not likely 2 August 218 balance, the bank intermediation function etcetera. Inflation has fallen back to moderate levels by Indonesian standards, averaging 3.3% yoy in January-July 218. Core inflation has fluctuated between 2.5-3% yoy over the past half year. Notwithstanding this benign inflation picture, Bank Indonesia has proven to be one of the more hawkish central banks in the EM universe this year, in an attempt to defend the rupiah. In May-August, BI hiked its main policy rate by a cumulative 125 bps (5 bps in May and June and 25 bps in August). As a result, the real policy rate has risen sharply in recent months, to around 2% currently, indicating that monetary policy has really become tight. The future course of monetary policy will to a large extent depend on whether external pressures will fade or not. Should these pressures intensify, BI may well raise the policy rate one or more times this year to keep capital outflows in check and defend the rupiah. FX reserves have come down this year USD bn Source: Thomson Reuters Datastream BI raised policy rates in reaction to external pressure % / % yoy Real policy rate CPI Policy rate Heavy election calendar in 219 For the first time in history, in April 219 Indonesia will hold presidential and parliamentary elections at the same time. General expectation is that President Joko Widodo (Jokowi) will succeed in gaining a second term, as he has succeeded in improving economic stability and has a strong approval rating. That said, Jokowi has been less successful in pushing through more difficult institutional reforms, as these are obstructed by vested interests in parliament. It is expected that should Jokowi indeed gain a second term, strengthening the business climate, attracting FDI and diversifying the manufacturing sector will remain key priorities. Still, the 217 Jakarta local elections as well as the recently held regional elections signal that religious issues will play a more prominent role in next year s elections. This is also visible in foreign policy. Jokowi s approach is focused on deepening commercial and strategic ties with key countries in Asia, as he wants foreign policy to serve domestic economic priorities more directly. However, in the run-up to the 219 elections, Jakarta is putting more focus on Islamic diplomacy. Meanwhile, economic growth accelerated a bit in Q2, helped by stronger public spending Since 21, Indonesia s economic growth rate has fluctuated in a narrow range around 5% annually, with the biggest contribution coming from private consumption and investment. In Q2-218, growth rose marginally (to 5.3% yoy, the highest level since end 213), driven by a pick-up of government consumption and a further acceleration of private consumption. Government spending was boosted in the run-up to the local elections held in June, partly reflecting an increase in holiday bonuses for public servants and state pensioners. Private consumption profited from an increase in disposable income (including the impact from the higher holiday

4 Indonesia Watch - Plenty of risks, but real crisis not likely 2 August 218 bonuses) as well as an improving consumer sentiment. A slowdown in investment growth, including in construction, and a negative contribution from net exports (with imports growing twice as fast as exports) were a drag on growth in Q2. Economic growth accelerated a bit in Q2 partly supported by a pick-up in government spending % yoy Index, 5 = neutral mark % yoy Economic growth (lhs) Manufacturing PMI Source: Bloomberg, Thomson Reuters Datastream Q-217 Q1-218 Q2-218 Govt. cons. Private cons. Investment Exports Imports Source: I.H.S. Markit, Bank Indonesia, Statistics Indonesia We expect annual growth to stay around 5% this year, edging up to 5.5% in 219 Earlier this year, we lowered our 218 growth forecast to 5.% (from 5.5%), reflecting the fact that Indonesia was also feeling the heat from the market turmoil.. Given Bank Indonesia s more hawkish stance we think that a growth pace of 5.5% will not be within reach this year. Recent economic indicators lend support to this view. Indonesia s manufacturing PMI has fallen back to just above 5, with the export subindex clearly below the neutral 5 mark. The latest hard data (for June) were also weak, but that may reflect the fact that that month had a lot of public holidays. All in all, we expect annual growth to stay around 5% in the coming quarters. For next year, assuming public spending to be boosted in the run-up to the April 219 elections and headwinds from the external environment to fade somewhat, we expect growth to edge up a bit higher averaging around 5.5%. To conclude: Indonesia has plenty of vulnerabilities, but a large-scale crisis is not likely All in all, it is clear that Indonesia faces several external vulnerabilities and a couple of political uncertainties. That explains why the country has been affected by the recent market turmoil facing EMs, next to the generic factors that are at play. However, we are of the view that Indonesia is clearly not in the same camp as countries like Argentina or Turkey. Its external imbalances are less significant, partly reflecting pro-active government policies, and its FX reserves still provide ample coverage of imports and short-term external debt. External ratings lend support to our view. Indonesia has been granted investment grade status by all three leading rating agencies. S&P was the last one to upgrade Indonesia to investment grade in May 217, while over the past year both Moody s and Fitch upgraded the country further (to a level that is two notches above speculative grade). These upgrades were driven by an improvement in macro-economic policies, some deepening of structural reforms and increased external and fiscal resilience. To conclude, although Indonesia will remain vulnerable to escalating trade wars, further Fed tightening, negative surprises from China or negative political surprises, we think the country s fundamentals should be strong enough to prevent a Turkey-style crisis.

5 5 Indonesia Watch - Plenty of risks, but real crisis not likely 2 August 218 Key forecasts for the economy of Indonesia e 218e 219e GDP (% yoy) CPI inflation (% yoy) Budget balance (% GDP) Government debt (% GDP) Current account (% GDP) Gross fixed investment (% GDP) Gross national savings (% GDP) USD/IDR (eop) EUR/IDR (eop) Economic growth, budget balance, current account balance for 218 and 19 are rounded figures Source: EIU, ABN AMRO Group Economics his document has been prepared by ABN AMRO. It is solely intended to provide financial and general information on economics. The information in this document is strictly proprietary and is being supplied to you solely for your information. It may not (in whole or in part) be reproduced, distributed or passed to a third party or used for any other purposes than stated above. This document is informative in nature and does not constitute an offer of securities to the public, nor a solicitation to make such an offer. No reliance may be placed for any purposes whatsoever on the information, opinions, forecasts and assumptions contained in the document or on its completeness, accuracy or fairness. No representation or warranty, express or implied, is given by or on behalf of ABN AMRO, or any of its directors, officers, agents, affiliates, group companies, or employees as to the accuracy or completeness of the information contained in this document and no liability is accepted for any loss, arising, directly or indirectly, from any use of such information. The views and opinions expressed herein may be subject to change at any given time and ABN AMRO is under no obligation to update the information contained in this document after the date thereof. Before investing in any product of ABN AMRO Bank N.V., you should obtain information on various financial and other risks and any possible restrictions that you and your investments activities may encounter under applicable laws and regulations. If, after reading this document, you consider investing in a product, you are advised to discuss such an investment with your relationship manager or personal advisor and check whether the relevant product considering the risks involved- is appropriate within your investment activities. The value of your investments may fluctuate. Past performance is no guarantee for future returns. ABN AMRO reserves the right to make amendments to this material. Copyright 218 ABN AMRO Bank N.V. and affiliated companies ("ABN AMRO ).