January 11, 2023
JAKARTA – Questions have been raised by many over what the economic prospects of 2023 look like. This is logical after the Indonesian economy grew strongly in 2022.
But to assess the 2023 outlook for Indonesia, one has to go through the following questions:
Will central banks continue hiking their interest rates this year in their fight against inflation? Will the continued monetary tightening lead to an economic downturn or even recession? Historically, it has taken several months before policy tightening has an impact on the economy, so will a slowdown or recession take place in the second half of the year? And if it does take place, how severe or moderate will the slowdown or recession be? Will the war in Ukraine end? What about China’s economy after its government abandoned its strict zero-COVID policy, lifted public restrictions and started opening its economy? Will this restore China’s economic trajectory toward higher growth, triggering price increases for raw materials and energy again?
Whatever the answers to the above questions, one thing is certain: the government has to stick to economic policy that will strengthen the resilience of the economy, which means continuing prudent macroeconomic policy plus a commitment to structural reform, especially in trade and investment.
Indonesian prudent fiscal policies that have been carried out for several years have kept the government deficit and debt at a manageable level and have contributed to macroeconomic stability.
Total revenues up to November 2022 grew 40 percent, with broad-based growth across major revenue categories. However, the tax ratio remained at 8 percent of gross domestic product (GDP), half of the average ratio of neighboring countries, which means there is still great untapped tax revenue potential. The country needs further tax reform to tap this potential. Raising tax rates will be politically unpopular in an election year, and even risk a backlash against the government, so the government is left with two alternatives: expanding the tax base or enforcing more compliance, especially in tax collection in the business sector.
The reinstatement of the legally mandated deficit cap at 3 percent of GDP this year and the possible lower economic growth will narrow the fiscal space. In the narrower fiscal space, improving the quality of spending will become critical, because every unit of spending should be well targeted to sectors that have maximum impact on economic growth. Expenditure should be made more cost effective and efficient.
Subsidy expenditure in 2022 reached Rp 551 trillion (US$36.7 billion), an unprecedented level, because as a percentage of total expenditure, subsidies doubled from 9 percent pre-pandemic to 18 percent in 2022. Huge subsidy spending in 2022 was partly justified by the soaring global price of fuel, the need to protect domestic purchasing power and to strengthen the social safety-net and the need to mitigate inflation. But in 2023, factors that justified the huge subsidy in 2022 will dissipate, and there is no reason to maintain a huge level of subsidy.
A spending pattern where nearly one-fifth of government spending is used for subsidies is unhealthy, because subsidy spending is regressive, while crowding out spending for sectors that could contribute more usefully to economic growth such as infrastructure, education and health.
The spending pattern in particular sectors should also be realigned. Government spending on agriculture, for instance, has been sufficient but not effective. Most of the spending went on subsidies for fertilizer and other inputs, less on research and development, irrigation or extension. The result is inefficient agriculture with high-cost rice production, so that Indonesian consumers have to buy rice at prices twice as much as the world prices.
In education, much is spent on increasing teachers’ salaries, certification and recruiting contract teachers. It has had little impact on learning quality as shown by lower Indonesian student performance compared with neighboring countries in the Organisation for Economic Co-operation and Development’s (OECD) Program for International Student Assessment (PISA).
A substantial proportion of local government investment spending has gone to relatively unproductive assets, such as office buildings, because government policy has been to increase the number of provinces and districts.
Because of the pandemic, the development of infrastructure became less prioritized as expenditure for containing COVID-19 and social protection became more pressing. Expenditure for infrastructure went down sharply from 17 percent of total expenditure in 2019 to 11 percent of total expenditure in 2022, and even this was mostly for Defense Ministry expenditure.
The current state of infrastructure, with developments having slowed down during the pandemic, can no longer accommodate the need for medium-to-long-term economic growth. Fiscal space created from subsidy reforms should be reallocated to infrastructure development
To achieve stronger medium-and-longer-term growth, a prudent macroeconomic policy is not sufficient. It has to be accompanied with reforms in trade and investment that are required to develop stronger and more competitive manufacturing industries, which are the driver of economic growth.
The growth of Indonesian manufacturing industries in the last decade has been lackluster, only half the growth of the previous decades. According to the World Bank, the share of Indonesian manufacturing exports in world exports has stagnated. While manufacturing industries in Malaysia, Thailand and Vietnam have reached higher level of technology and sophistication, manufacturing in Indonesia is still based on simple technology and assembling.
The development of manufacturing industries, including export-oriented industries, need good quality inputs, including inputs from import. But several government policies, including non-tariff measures (NTMs) and restrictions on services have constrained the modernization of our manufacturing industries. To overcome this problem, it needs economic reforms, but successful reforms require political commitment and political consensus, which in a democratic political system is not easy to achieve.
So, how the economy will shape up in 2023 and beyond depends on the ability of the government to mobilize political support for its economic reform programs.