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by Gundy Cahyadi, Economist from DBS Group Research

  • A stronger and sustainable GDP growth will help the case for further rating upgrades
  • That higher investment-to-GDP ratio has yet to translate to stronger GDP growth suggests a need to improve productivity
  • The government’s commitment to reforms is definitely a positive

Markets are now focusing on Moody’s and Fitch following the long-awaited Indonesia upgrade from S&P in May. Both have assigned “positive” outlooks to Indonesia in the last six months with upgrades last coming in 2012 and 2011 when Moody’s and Fitch put Indonesia back into investment grade status. Stronger and more sustainable growth bolster the case for upgrades.

At 5%, the economy is currently growing below its potential, which we reckon to be closer to 6.5%. Even if it is higher than similarly-rated economies, there is some catch-up when compared to India and the Philippines, which have a similar rating to Indonesia. Income levels matter too.

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In 2016, Indonesia’s GDP per capita was twice that of India’s and some 25% higher than in the Philippines. Typically, a more developed economy is likely to grow at a slower pace than less developed ones. Arguably, Indonesia may not be able to grow as fast as India or the Philippines.

Additionally, the demographic boost is also relatively weaker for Indonesia. The share of working age population is set to rise steadily in both India and the Philippines up until 2050. In Indonesia, we are going to see the turn happening earlier, around 2035

Greater investment could give Indonesia the edge. Interestingly, as a share of GDP, investment has risen steadily in Indonesia from 29% in 2007 to 34% last year. At 34% of GDP, Indonesia’s ratio is higher than both India’s and the Philippines.

Weak productivity seems to explain why investment has yet to produce stronger GDP growth. One way to estimate productivity is to calculate the incremental capital output ratio (ICOR), which measures how much investments are needed to generate an extra dollar in the economy.

And as of 2016, Indonesia needs about seven dollars of investments to generate an extra dollar in the economy, well above those in India (4.5) and the Philippines (4.3). This ratio has also been creeping up higher over the past decade in Indonesia.

Reforms take time to produce results

The government has introduced 15 reform packages over the last two years in a bid to raise productivity. The changes range from standardizing regulations across provinces to improving public infrastructure. Various incentives are also provided to help the manufacturing sector, aimed at reducing the economy’s over-reliance on commodities. Further liberalization would be helpful.

The S&P upgrade is expected to spur more foreign direct investment in coming years. The government can leverage on the investment grade status by further lowering restrictions on foreign ownership limits across various industries.

Indeed, some policy changes could be forthcoming before the year-end. Implemented properly, reforms will bear fruit. Resources spent on education and training will raise labor productivity. Infrastructure development would help lower logistics costs, which are still high compared to the rest of the region.

While one cannot expect rapid results from structural reforms, the government’s commitment to them is a plus for the outlook and explain why Moody’s and Fitch have placed Indonesia on a “positive” outlook. An upgrade may not be imminent but that day continues to move ever closer.



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