Bridging Indonesia’s Infrastructure Gap

Web Posted on : Mon, 20 Jun 2016

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Indonesia emerged from a turbulent 2015 with a relatively robust growth outlook despite facing major economic headwinds (see our commentary A brighter outlook bolsters Indonesia amidst the global turmoil). Low commodity prices depressed government revenues, slowing growth in China weighed on trade, and expectations of higher U.S. interest rates caused periodic bouts of capital outflows. Against this backdrop, however, Indonesia’s growth outlook remains buoyant around 5% for 2016 and international sentiment continues to be positive. This bullish outlook is largely the result of support for the Jokowi administration’s widely heralded infrastructure investment programme – a USD480bn (or 50% of GDP) package spread over four years (2015-19), targeting energy and transportation infrastructure. The early indications have been encouraging. Investment, led by public spending on infrastructure, has added approximately two percentage points (pps) to real GDP growth of around 5% in both Q4 2015 and Q1 2016.

The government’s focus on closing the infrastructure gap is justified. In comparison with other major emerging market (EM) economies, Indonesia stands out for having underdeveloped infrastructure. It ranks 62nd among 140 countries in terms of infrastructure quality according to the World Economic Forum, behind major regional EMs such as Malaysia (24th), China (39th) and Thailand (44th). The depleted infrastructure stock in the country is the product of chronic underinvestment. Public capital spending has averaged 3.5% of GDP from 2011 to 2014, compared to over 10% in China and Malaysia and above 5% in Thailand. As a country that is comprised of thousands of islands, underinvestment in infrastructure has severely impacted connectivity between households and firms. Indonesia suffers from heavy road traffic, delays and lack of capacity at ports, overcrowded airports, insufficient railways, power and water shortages and a sluggish data network. This adds to the cost of doing business, so much so that cement is ten times more expensive in the Papua islands than in Jakarta. But more broadly, it erodes competitiveness, discourages investment and reduces Indonesia’s growth potential. Adding to and improving the quality of the infrastructure stock could be a significant boost for the Indonesian economy. In the near-term, it would increase domestic demand and employment, and over the long-run, it could boost economy-wide productivity growth.

Sources: CEIC; Haver Analytics and QNB Economics

The pace of infrastructure investment has been rapid, increasing by 43.6% in US dollar terms and rising to 2.5% of GDP in 2015 – this in just the first year of the government’s programme. However, despite these encouraging early signs, there are some risks and challenges to executing such an ambitious spending programme. We identify four major challenges.

The first challenge is the potential for political gridlock. In 2015, opposition parties represented over 50% of parliament and materially handicapped the government, allowing the passage of just three laws. The Jokowi administration has since built more effective relations and courted enough allies to hold a majority coalition in the parliament, with expectations of passing around 40 new laws in 2016. Maintaining this broad political support will be critical to the government’s ability to effectively manage the infrastructure programme.

The second challenge is how it will be financed. Lower oil prices have reduced the government’s revenues significantly. In 2014, revenue as a share of GDP was 16.5% compared to 14.8% in 2015 and the International Monetary Fund (IMF) forecasts a further decline to 14.0% in 2016. The government has taken important steps to mitigate against lower oil prices by reducing fuel subsidies. Nevertheless, revenues remain vulnerable to an external shock such as a slower-than-expected growth in China, which in turn could affect Indonesia’s export revenues.

The third challenge is Indonesia’s fiscal rules. Indonesia has longstanding fiscal rules stipulating that the government deficit cannot exceed 3% of GDP and total debt cannot exceed 60% of GDP. The government posted a deficit of 2.5% in 2015 and the IMF currently forecasts a deficit of 2.8% in 2016. Hence, the government may have limited fiscal space in the event of higher debt financing costs from a US interest rate hike or other unforeseen shocks, and the authorities could be forced to curtail some investment spending.

The fourth challenge is execution capacity. Indonesia has designated the use of State Owned Enterprises (SOEs) and initiated Public Private Partnerships (PPPs) to assist in managing the infrastructure investment programme. This has the advantage of cost-sharing and increasing efficiency, but also requires a high level of coordination and a mature governance regime. Poorly integrated planning, budgeting and coordination can result in cost overruns, low productivity outcomes or outright project delays and cancellations.

In conclusion, Indonesia’s investment programme has shown positive early signs of success. It also has the potential to allow Indonesia to weather downside risks from financial volatility and weaker external growth. We remain optimistic about Indonesia’s infrastructure programme and outlook, and therefore stand by the forecast in our September 2015 Economic Insight report for real GDP growth of 5.0% in 2016.

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