10 Takeaways From Indonesia

Indonesia, which consists of more than 17,000 islands spanning 735,358 square miles, is the world’s fourth-most-populous country (with about 280 million citizens)—and it shows significant potential for emerging markets debt investors.

In early May, I visited the island nation to explore the opportunities and risks. After meeting with central bankers, policy advisors, and investors, I believe I have a good sense of where the country is heading during the remainder of 2023. Here are 10 takeaways.

1. Economic Growth Could Stabilize

We believe external demand is likely to weaken due to lower commodity prices and global growth risks. However, household consumption, which was 53% of Indonesia’s economic activity in 2022, looks to have recovered to pre-COVID levels and is expected to drive growth this year, with leading indicators improving. Moreover, Bank Indonesia and Bank Mandiri (Indonesia’s central bank and largest commercial and state-owned bank, respectively) expect loan growth of 10% to 12% this year. The healthcare and telecommunications sectors may see higher loan growth.

All things considered, we believe economic growth could stabilize at close to 5% this year, compared with 5.3% last year.

2. Fiscal Policy Appears Sound

Indonesia’s Ministry of Finance has set a fiscal deficit target of 2.8% for 2023, meaning debt issuance will likely be lower than it was in 2022 (and the allocation is expected to be up to 25% in external debt, with the remaining in local currency debt). Low tax revenues are an issue, at less than 10% of GDP in 2022. Tax reforms to expand the tax base and increase tax collection will be crucial to financing higher economic growth through investments.

On the bright side, while lower commodity prices might drag exports, they seem unlikely to affect tax revenues significantly. Additionally, fiscal metrics appear sound, with the legal fiscal deficit cap of 3% and overall ratio of debt to gross domestic product (GDP) at 40%.

We expect inflation to stabilize at 3% to 4% this year, and Bank Indonesia might target even lower inflation in 2024.

3. Inflation May Be Tamed

Indonesian inflation has mostly been supply-side driven, with rice, chili, and onions the main drivers, and policymakers have used an array of tools to get it under control—including its “Operation Twist” bond intervention, which is designed to raise shorter maturity yields and increase the monetary transmission from central-bank rate hikes. But the individuals we spoke to on our research trip expect inflation to stabilize within Bank Indonesia’s target at 3% to 4% this year. We believe Bank Indonesia will likely target a lower inflation rate of 1.5% to 3.5% in 2024.

4. Rate Cuts May Be Coming

Indonesian rates may be too high given the inflation outlook, and we believe Bank Indonesia may be inclined to cut rates in 2023.

5. External Position Is Improving

Indonesia had a current account surplus of 1.0% of GDP in 2022 and expects a balanced current account for 2023. High commodity prices helped the current account in 2022. Improvement in the external position can also be credited to the Omnibus Law and digitalization efforts. Examples include easing foreign investment restrictions, faster infrastructure disbursement, and reduced labor market rigidity.

6. Commodities Present Short-Term Headwinds

About 60% of Indonesia’s exports are energy- and commodity-related. Resource nationalism is a risk during an election year, and short-term headwinds may come from lower commodity prices. The country needs to expand its focus, which is now on the downstream mining sector, to support external balances over the long term.

Export proceeds may have to wait until next year’s elections before they come back onshore.

7. Export Proceeds Are Slow to Return

Despite last year’s strong export performance, Indonesian export proceeds are still slow to get back onshore. Domestic banks don’t need U.S. dollars and have been offering relatively low rates on foreign exchange deposits. Meanwhile, the government is reluctant to impose capital restrictions. Export proceeds may have to wait until next year’s elections before they come back onshore as a result of uncertainties relating to potential tax or capital policy changes should a new government come to power.

8. Omnibus Law Reforms Helped—But More Is Needed

Indonesia’s so-called Omnibus Law, which passed in May 2022 under President Joko Widodo, revised more than 70 existing laws with the aim of removing red tape, improving the investment climate, and creating jobs. For example, it reduced severance pay from up to 32 months to 19 months and streamlined regulations for infrastructure spending.

While the legislation is a step in the right direction, more reforms are needed. Indonesia must attract FDI in labor-intensive sectors, boost domestic savings, and raise tax collection.

9. The Criminal Code Is a Concern

The Criminal Code is a concern even after the amendments of 2022. Unmarried cohabitation is illegal, access to reproductive healthcare is reduced, and freedom of expression is more limited. Moreover, there is now less pressure from the investment community to further amend these laws compared to a few years ago.

10. Elections Shouldn’t Change the Outlook

Indonesia’s general elections are scheduled for February 2024, and President Joko Widodo, popularly known as Jokowi , will stick to the constitution and not run for a third term. But the outcome may matter less than it has in the past. The investment climate has improved significantly during Jokowi’s two terms, and his likely preferred successor should continue to focus on infrastructure investment and human development.

Most people we spoke to on our research trip believe the focus on developing Indonesia’s downstream sectors (i.e., those involving the conversion of commodities into finished products) and increasing investment in healthcare and education will likely continue regardless of which presidential candidate wins.

For hard currency debt, we believe continued fiscal consolidation and less issuance should anchor spreads.

Investment Implications

Overall, there are more positive than negative points, especially relative to other emerging markets. We believe front-end local currency rates will likely see the most benefit in the current environment, though the currency may be slightly riskier due to the commodity linkage and as elections draw closer. Meanwhile, for hard currency debt, we believe continued fiscal consolidation and less issuance should anchor spreads.

Johnny Chen, CFA, is a portfolio manager on William Blair’s emerging markets debt team.