By Helmi Arman, Analyst
Capital account pressures could restrain the effectiveness of fiscal policy in mitigating the economic downturn next year. Is there a way out?
In recent months, Indonesia’s balance of payments has become an increasingly important point of analysis for economists.
The current account — the difference between exports and imports of goods and services, along with the net amount of income and remittance flows — has been in the spotlight as there was a current account deficit equivalent to 1 percent of gross domestic product (GDP) during the second quarter of this year.
This caused alarm in the markets and some economists began to predict that Indonesia’s long-standing current account surplus, which has been sustained for nearly 10 years, would fall into negative territory for the first time in 2008, with potential to become more negative in subsequent years.
Many became concerned since current account deficits tend to put downward pressure on the currency.
For our part, we were never really convinced that the current account would go deep into the red. The deficit in the second quarter appeared temporary, in relation to oil prices which were then at an all-time high. Surging oil prices worsened Indonesia’s oil trade deficit, pushed up freight costs and boosted the repatriation of income from foreign oil companies.
Fortunately our view appears to be vindicated somewhat by the latest balance of payments data published by Bank Indonesia, which showed Indonesia’s current account deficit shrinking by half in the third quarter; i.e. as oil prices began to decline.
Going forward, the full-year current account surplus might even widen in 2009 instead of shrinking. Judging from past experience, imports tend to fall severely as exports drop and economic growth contracts. Next year should be no exception, especially given the severe weakening of the rupiah.
Therefore in our view, it’s not the current account balance that should be in the spotlight; it is the capital account (or “financial account” in modern day economic jargon).
The capital account faces numerous challenges next year. For example the global commodity price bubble had been a catalyst for foreign direct investment into the plantation and mining sectors for years. Now that the bubble has burst, the flow of resource-based direct investment inflows could also grind to a halt.
Secondly with the ongoing global credit crunch, there is considerable uncertainty surrounding the prospect of portfolio or short-term investment inflows — which the government depends upon to finance its budget shortfall.
(Note that the main buyers of Indonesian government bonds over the past years have largely been foreign investors).
As a result, despite the abrupt improvement in bond market sentiment over the past week, there is still considerable doubt concerning the effectiveness of fiscal policy to act as a buffer against next year’s forthcoming economic downturn.
The government appears to realize this and has been engaged in efforts to secure alternative funding sources for next year’s budget deficit, which is planned at around 1 percent of GDP.
Officials boast confidence that funding from foreign governments and international organizations would be available if needed, by an amount of US$5 billion, which is roughly equal to the targeted amount for net bond issuances needed next year.
However we should be cautious that even $5 billion may not be enough to cover the whole nine yards. In these turbulent times, what one should focus on is the gross — as opposed to net — amount of needed financing.
Nearly $4 billion worth of bonds mature next year and it is not safe to say that all of this would be reinvested back into the bond market, especially if domestic interbank money markets remain dormant and banks prefer to hold vast amounts of liquidity.
If this turns out to be the case, then the choices at hand fall down to two. The government can run a lower than planned budget deficit — which means that fiscal policy would be pro-cyclical instead of countercyclical. Or it can take a simpler way out and ask the central bank to monetize the budget deficit — by way of purchasing government bonds.
The latter option would of course be controversial. The term monetizing or “printing money” is traditionally considered taboo by the markets, since it is associated with complications such as hyperinflation.
But monetizing, at least under a temporary time-frame, does seem like a viable alternative nowadays. It is not like Indonesia is running double-digit fiscal deficits as in Zimbabwe. One percent of GDP is still considered benign from a fiscal sustainability standpoint, even by the most conservative standards.
Furthermore the impact of money base expansion on the broader money supply and inflation probably would not be proportionate, given that private sector credit growth is bound to be slow and falling commodity prices have suppressed the momentum on consumer prices.
Finally even the most advanced economies in the world have been engaged in some form of “printing” (money) in recent months; i.e. expanding their monetary base by opening up various facilities. It does seem that everybody else is doing it. So why can’t we?
The author is currently an economist at Bank Danamon Indonesia [The Jakarta Post]
