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Indonesia: a case study in debt monetization

Bank Indonesia’s decision to help fund the Indonesian government’s efforts to revive growth through sovereign bond purchases as part of a debt monetization program raised a few eyebrows. Will it work?

The COVID-19 impact

The COVID-19 outbreak has hit Indonesia’s economy hard. Indonesia was one of the few countries in the Asia region that didn’t opt for a stringent lockdown. The difficulty in implementing and enforcing social distancing measures and the absence of well-developed health infrastructure—a challenge for most emerging economies—meant that efforts to contain the pandemic haven’t been fully successful: Indonesia has one of the highest infection rates in the region across many metrics, including fatality rates.¹

It isn’t too surprising then that GDP turned sharply negative in Q2—its third straight quarter of negative growth. Crucially, it marks the first time the economy contracted since the Asian financial crisis in year-over-year terms.² Reflecting a similar trend globally, consumption growth in Indonesia weighed on overall economic growth during the quarter and the negative demand shock has exacerbated the preexisting disinflationary trend. 

Prompt policy response

In response, Bank Indonesia (BI) has been very active, cutting its benchmark policy rate by a cumulative 100 basis points year to date, flooding the market with liquidity to the extent that short-end Indonesian bond yields have fallen the most within the region since the start of the pandemic.² 

We’ve also seen significant activities on the fiscal front. In March, the government temporarily suspended the statutory limit of the budget deficit, which will be reinstated at 3.00% of GDP in 2023.³ The government also announced a debt monetization program in mid-July, assuring investors that it would be a one-off.⁴ 

"The proposed amendments effectively place the central bank under government direction and finance government debt at a discount."

In early August, the government proposed slower fiscal consolidation in its 2021 budget, with a deficit projected to peak at 6.34% of GDP this year, more than twice the previous 3.00% deficit limit.⁵ Recently, the government unexpectedly announced a proposal to change the BI charter.

The proposed amendments effectively place the central bank under government direction and finance government debt at a discount. Specifically, a monetary policy council, chaired by the finance minister and comprising other government nominees, will provide guidance on monetary policy. As part of the proposed changes, BI’s mandate may be expanded to include growth and jobs, besides financial market priorities and inflation. 

In our view, the key question investors need to consider is: Does Indonesia have the space to sustainably monetize debt? To answer this question, we must consider the key constraints facing any government attempting to do so.

Monetizing debt—factors to consider

Table outlining the key factors to consider when monetizing debt. The first is inflation and resource. In this instance, this factor isn’t a constraint for Indonesia in the short term, but it will be a constraint in the medium term. This is because there’s plenty of spare labor capacity in the economy for now. However, as a small, open, and emerging economy with limited resources that’s reliant on imports, Indonesia could be at risk of an inflation spike as the monetary base grows. The second factor is currency, and in this instance, it is a constraint for Indonesia. Indonesia has run sustained current account deficits—larger fiscal deficits typically mean even bigger current deficits that require larger external funding. Investors are likely to shift their allocations away from Indonesian assets if inflation begins to hurt yields on Indonesian assets. If this were to happen, the Indonesian rupiah would be subject to significant depreciation risk, raising imported inflation further. The third factor to consider is social/political issues. This is also a constraint for Indonesia. The Indonesian government is already debating an omnibus law featuring a job creation bill to change labor laws. Labor market reform is sorely needed in Indonesia to remove red tape and other inefficiencies, such as overlapping regulations. In our view, the plans being mooted could weaken the labor share of income relative to corporate profits and the government, for example, hourly pay, decreasing severance pay, introducing flexible hours, lowering minimum wages, and making it easier for businesses to hire and fire workers—we’ve seen income inequality as a result of such policies in the West. Understandably, we’re already seeing civil unrest and protesting against the bill in Indonesia.6 After years of deferring fiscal consolidation plans, it isn’t unreasonable for investors to wonder if there are appropriate governance structures in place to ensure that the additional spending will stop once the economy has recovered.

By virtue of having entered into the health crisis with sustained twin deficits (fiscal and external) and exposure to international financial markets, we believe Indonesia faces real—and financial—constraints if it wants to engage in extended debt monetization. Even so, there probably isn’t a more palatable alternative right now; the government needs to quickly step up spending to avert the unprecedented economic and health crisis. In our view, the government spending should prioritize policies aimed at lifting economic prosperity and building resilience against future shocks—for example, absorbing Indonesia’s severe youth unemployment⁷ through investment in permanent infrastructure and providing job guarantees for those working in sectors that compete directly with foreign imports or are involved protecting the environment.  

Long-term potential remains undimmed

From a macroeconomic perspective, we believe Indonesia holds a lot of promise: opportunity to grow domestic investment, favorable demographics, relatively low household debt, scope to accelerate foreign direct investments, geographic proximity to key markets, and an improvement in the country’s performance in the annual ease of doing business ranking. Productive use of the limited room to monetize debt could tap into all of that potential and go a long way to lift Indonesia’s GDP, both in terms of growth and level, back toward trend, or even above. 

Chart comparing Indonesia’s GDP growth with trend growth from 1980 to June 2020. The chart shows that in real terms, Indonesia has been growing below trend since late 1998.

 

 

1 “With world's lowest testing rate, Indonesia far from Covid-19 peak,” The Straits Times, September 3, 2020. 2 Bloomberg, Macrobond, as of September 14, 2020. 3 “Indonesia announces Rp 405 trillion COVID-19 budget, anticipates 5% deficit in historic move,” The Jakarta Post, March 31, 2020. 4 “Indonesia's debt monetization scheme only for 2020, says finmin,” Reuters, September 4, 2020. 5 “Indonesia's Widodo proposes $186 billion 2021 budget, 5.5% of GDP deficit,” Reuters, August 14, 2020. 6 “Workers once again protests against job creation bill,” The Jakarta Post, August 25, 2020. 7 Pre-COVID-19, the International Labour Organization estimated Indonesia’s 15- to 24-year-old unemployment rate to be ~17%, the second highest in Southeast Asia. The unemployment rate of this group has remained sticky above 15% since the 1998 economic crisis.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future, could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment

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Sue Trinh

Sue Trinh, 

Former Co-Head, Global Macro Strategy, Multi-Asset Solutions

Manulife Investment Management

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