JAKARTA (TheInsiderStories) – Last week, Indonesia’s President Joko Widodo announced in the 2019 budget that the government will seek to narrow the fiscal deficit to 1.8 percent of gross domestic products (GDP) next year from 2.1 percent estimated for 2018.

These targets indicate the government’s continued commitment to fiscal discipline, which should support market confidence. However, much of the consolidation will be driven on the spending side and mainly to capital rather than current expenditure. A lack of revenue measures will also prevent any improvement in debt affordability metrics which are already at weak levels.

Fiscal Consolidation Path Maintained, But Capex Takes Brunt of Cuts in 2019

The budget maintains its original estimate of a fiscal deficit of 2.1 percent of GDP in 2018, based on a 14.2 percent year-on-year increase in revenues and a 10.5 percent rise in spending. Based on data for the first seven months, revenue and spending stood at 52.5 percent and 51.6 percent of full-year targets, respectively.

“We expect headline budget deficit targets to see slight slippage, with spending being adjusted should revenues underperform,” said Anushka Shah, VP-Senior Analyst and Amelia Tan, Associate Analyst, Sovereign Risk Group, Moody’s Investors Service Singapore Pte. Ltd. in the latest report released on Friday (24/08).

However, they said, risks of a significant slippage are low, especially as statutory regulations require budget deficits to be less than 3.0 percent of GDP in any year and as adherence to this ceiling has been very strong. Between 2007 and 2017, deficits averaged 1.6 percent of GDP, which are the lowest among Baa-rated sovereigns.

The targeted moderation in the deficit to 1.8 percent for 2019 reflects a slight deceleration in revenue and spending growth to 12.6 percent and 10.0 percent year-on-year, respectively. These targets are based on 5.3 percent year-on-year GDP growth, which is marginally more optimistic than our estimate of 5.2 percent.

Still, targets may be challenging to achieve, particularly when set against a track record of revenue underperformance and the absence of any major revenue reforms.

Spending trends indicate a move away from the recent thrust on capital spending, and towards recurrent expenditure, particularly personnel, social and interest spending. A continuation of populist measures in the run-up to elections scheduled in April 2019, as well as higher than budgeted interest costs could further inflate this spending.

And although subsidies are projected to fall, an announced freeze in diesel and electricity prices earlier this year somewhat back-tracks on subsidy reforms undertaken in 2014 and could result in fiscal strain, which we take into consideration in our headline deficit assumptions that are based on higher growth in expenditure.

By contrast, infrastructure spending is projected to rise by just 2.5 percent year-on-year in 2019, compared to 8.2 percent estimated in 2018. Indonesia’s infrastructure needs remain significant despite the recent ramp-up in spending and cuts suggest some deterioration in spending quality.

It could also signal the  government’s intentions to start to fund this spending off budget, with state-owned enterprises bearing more project-related risks. Moody’s assumptions factor in the fiscal deficit narrowing to 2.2 percent of GDP vs. an estimated 2.4 percent of GDP in 2018.

Lack of Revenue Measures Will Prevent Improvement in Already Weak Debt-affordability Metrics

Although the government is targeting an optimistic increase in revenue to 13.3 percent of GDP in 2019, revenue collection rates will remain the lowest among investment-grade sovereigns. This is due to a variety of reasons, including the absence of measures to offset the drop in oil and gas-related receipts since their 2013 peaks, tax evasion and weak compliance.

The last major revenue reform was the introduction of a tax amnesty scheme that ended in March 2017 which generated 1.1 percent of GDP. Most revenue measures for 2019 continue to focus on strengthening collection through improvements in administration and compliance.

Slow revenue improvements have weighed on debt affordability. Moody’s projects the ratio of interest payments to revenue at 13.4 percent in 2018, which is higher than the median for Baa-rated sovereigns of 8.2 percent.

Moreover, the recent spate of policy rate increases and currency depreciation mean debt-servicing costs are likely to rise, further straining these metrics.

Fiscal Disciple Will Support Market Confidence

Indonesia’s adherence to fiscal rules underpins a debt burden estimated at 29.3 percent in 2018, which is well below the median for Baa rated peers (48.5 percent) and among the lowest of the G20 group of countries.

However, the structure of government debt exposes the sovereign to external shocks. Around 41 percent of general government debt is denominated in foreign currency, exposing the sovereign to substantial exchange-rate risk. Moreover, much of this foreign-currency funding is through market sources of financing.

These vulnerabilities have become increasingly evident in recent months, with dollar appreciation coupled with wider emerging market sell-offs adding significant pressure on the rupiah. Policy makers have been taking various steps to quell depreciation, including tightening policy rates, and pursuing steps to curb capital outflows.

However, persistent currency depreciation would have a credit negative effect on the government’s fiscal metrics and weigh on debt affordability. As a result, supporting market confidence via fiscal discipline is crucial for Indonesia’s credit profile.

Email: linda.silaen@theinsiderstories.com