Over the last several months markets have been sending a series of pointed signals about the Indonesian economy. The rupiah has depreciated significantly against the dollar, the domestic stock exchange has seen a sustained sell-off, and bond markets have forced up interest rates on government debt. There are many factors at play here, but this is mainly driven by concerns about the overall investment climate, policy uncertainty, and unsustainable government spending and borrowing.
In March, President Prabowo sat for an interview with Bloomberg where he defended his policies and said that markets were not understanding him. I think markets do understand him. What markets are doing right now is sending a signal that they don’t have the same level of confidence in these policies as the President does. This actually speaks to a fundamental tension between state and market in the Indonesian economy that has existed for decades and which, under the current administration, is now taking on a new dimension.
This is not the first time that the Indonesian state has challenged conventional market wisdom, and inserted itself into the economy in ways that made investors uneasy. Prabowo’s predecessor, Joko Widodo, frequently pursued policies that rattled markets. During his two terms in office Jokowi stepped up government spending and borrowing, expanded the balance sheets of state-owned enterprises and directed them to speed up big projects like toll roads and airports.
The fiscal deficit rose to 2.5 percent of GDP in 2017, and the current account deficit was over $30 billion in 2018 and 2019, much wider than at any point during Prabowo’s presidency. Jokowi used trade policy to achieve developmental objectives, banning the export of unprocessed nickel ore to force investment into downstream industries.
Generous subsidies for fuel and fertilizer remained in place, for the most part, throughout Jokowi’s time in office even when global prices were surging. During the pandemic, the fiscal deficit soared to over 6 percent of GDP, temporarily blowing through the legal limit. Not only that, but the central bank monetized a large portion of this debt, a highly unorthodox move for an emerging economy like Indonesia.
Markets understood what Jokowi was doing, and they often did not like it. Yields on Indonesian government bonds rose sharply in 2018, and the rupiah came under pressure as well. At various points throughout his presidency markets signalled that they weren’t sure about some of these policies and demanded higher rates of return to offset the increased risk. In principle, this is not so different from what we are seeing today. The important question is not whether the state intervenes in the Indonesian economy. What matters is the degree and purpose of intervention, and how markets respond.
Jokowi’s policies were often accepted by markets, perhaps begrudgingly, because he had competent and credible technocrats running key posts at the Ministry of Finance and Bank Indonesia. His policies focused on physical infrastructure, so even if government or SOE debt increased they produced tangible results such as toll roads which can generate revenue. Export bans, like with nickel, were clearly telegraphed as a tool to increase higher value investment and not merely as mechanisms to keep foreign currency in the country.
This tension between state and market is always there in Indonesia, and Jokowi was adept at threading the needle and striking a careful balance. Despite policies that frequently challenged markets, investment remained robust throughout the majority of his time in office. With the current administration, we are seeing a sharper turn toward state intervention and economic nationalism and this is causing a strong market reaction.
The big question is how the government responds to signals being sent by markets. And after initially digging in, it has started to make adjustments in response to the pressure. The central bank has done precisely what you would expect to stem capital outflows and currency depreciation: it raised interest rates. The government said it will trim some of its big spending programs and cut certain fuel subsidies. There has also been a subtle but noticeable shift in how officials are treating the situation in public comments and appearances.
These actions have helped stabilize things for now, although markets and investors remain wary. Importantly, it shows that when confronted with a sufficiently strong market reaction the government can change course. In this case rising bond yields, capital outflows, a weakening currency and mounting public pressure forced the government to make changes it initially did not want to. This is unlikely, however, to be the last time the Indonesian state and the market clash on key issues of economic and public policy. How future showdowns are resolved is something we should be watching very carefully in the years ahead.