The Impact of Europe on Indonesia
Bernard Tan | January 03, 2012

What impact will the simmering crisis in Europe have on the Indonesian economy in 2012? The Indonesian economy at the end of Q3 2011 was in pretty good shape. While failing to meet consensus estimates, the economy grew a strong 6.5% year on year and inflation eased to 4.42% in October on the back of falling food and commodity prices. This figure is predicted to decline further through to the first quarter of 2012.

Cumulative investment realization from January to September 2011 was Rp181 trillion ($20.1 billion). Of this, Rp129 trillion ($14.3 billion) was foreign direct investment. This was a quarter-on-quarter increase of 15.7%.

The Kadin-Roy Morgan index for Indonesian Consumer Confidence hit a record high of 146.8 in October, a full 14.5 points higher than it was a year earlier. A mind-boggling 84% of Indonesians expect to be better off financially over the next twelve months, also a new record high.

With such heady optimism, it is easy to succumb to over-exuberance about Indonesia. Nevertheless, at higher levels of officialdom, a sense of nervousness has crept in, none more so than in the central bank which, in a surprise move in November, cut its benchmark rate by a full 50 basis points as an insurance against any slowdown in the economy. Their eyes are firmly on Europe and the headwinds it may generate in 2012.

This sense of caution is prudent for there are indeed serious downside risks that the European crisis poses for Indonesia, with the transmission mechanism being primarily first through the banking system and the financial markets. I name three.

First is the drying up of dollar liquidity. As European and American banks scramble to shore up their balance sheet, many have reduced counter party limits to those most exposed to a sovereign default. In turn, many have also reduced their exposure to higher risk credits in emerging Asia, including Indonesia.

The threat of a further S&P downgrade of individual banks and sovereigns across Europe will increase the sense of vulnerability which will exacerbate this trend. Liquidity in Asia will become even tighter and this will translate into a higher cost of USD throughout the region. While Bank Indonesia (BI) is attempting to compensate for this by stimulating rupiah lending, this will not be able to make up the gap.

The second factor is the persistence of volatility in both the stock market and the rupiah exchange rate. Both are key barometers of confidence in Indonesia. Throughout 2011, we saw bouts of nervousness and risk aversion, which translated into selling spurts of Indonesian securities - plunging the IDX and the rupiah down by double-digit amounts - only to see them recover just as quickly when risk appetite returned.

Volatility is never good for investor confidence. While there will be windows, this will still make it difficult for firms to tap the capital market, and restrain the influx of FDI.

Lastly is the impact on commodity prices. Like Australia, Indonesia is particularly sensitive to such shifts. Prices are already off their highs - and although they are also off their lows - markets remain nervous, undecided as to whether the softening of demand from Europe will lead to a sharp or gradual slowdown in China and India. What is clear is that commodity prices will remain soft in 2012. These three factors will act as a retardant on the growth of Indonesia.

Painful slowdown

BI has projected the growth rate for next year at 6.3%, down from this year’s 6.5%. The overriding assumption is that the world will avoid a black swan – i.e. the brewing European crisis will not end in a financial meltdown. Rather, we will witness a long and painful slowdown in Europe which will give it time to work out its problems.

This scenario is the consensus scenario. Indonesia, as in 2008/9, will ride the crisis better than most. First, with 60% of the economy driven by domestic spending - a figure very much higher than many countries including China - domestic consumption will act as a strong bulwark against a collapse in growth.

Second, investments should continue to flow, in particular FDI. With opportunities in the developed world limited, and as Indonesia moves towards investment grade, there is sufficient evidence to show that investors are looking at Indonesia differently.

In the past, investments were made in Indonesia since it was seen as a low-cost manufacturing base to export to the world. Today, investments in Indonesia are made to cater to the high-growth Indonesian market as a market in itself.

Lastly, unlike many European countries, the government of Indonesia has the capacity to spend its way out of trouble, given its healthy budget situation of having only a tiny deficit in its budget of just under minus 2% and a solid government debt-to-GDP ratio of about 25%.

In fact, the criticism is that for a developing country, the Indonesian government spends too little and in the wrong places. A fiscal stimulus - what many are calling for - would not only boost the economy, but if spent on infrastructure and education, would lay the foundation for stronger growth in the Indonesian economy in the years to come.

Bernard Tan is managing director and president commissioner of DBS Indonesia

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