Bofa ML has written a note on the widening current account and fiscal deficits faced by Indonesia. According to them, “while the magnitudes of the deficits are modest, we are increasingly concerned about the direction and speed at which the twin deficits are deteriorating. The rupiah’s prospects will be kept in check, and may face downside risk, if the deficits continue to worsen.”

Indonesia’s current account deficit widened to US$2.9bn, or about 1.3% of GDP, in the first quarter (Chart 5). This is much larger than the US$1.6bn deficit (or 0.7% of GDP) in the final quarter of last year. The current account deficit is now wider than the ratio reached during the 2008 financial crisis (0.8% CA deficit in 2Q/3Q 08) and close to the 2005 episode (1.6% in 3Q 05). In October 2005, pressures from widening fiscal and current account deficits eventually led to the government conceding to a +87.5% hike in subsidized fuel prices.

Rupiah weakness was associated with both the 2005 and 2008 episodes – when the current account fell into deficit. In the 2008/09 global financial crisis episode, the rupiah was sold off in the risk-off environment, depreciating some +30%, to about Rp12,400 against the US dollar from Rp9,100. During the 2005 episode – which is a more Indonesia-specific event – the rupiah weakened by about 10% (to low of Rp10,775), before recovering as the current account return to surplus after the sharp fuel price hike.

There appears to be three main reasons for the wider current account deficit, all of which may persist or worsen. The wider current account deficit is not purely due to robust domestic demand, but also a result of worsening terms of trade and an unsustainable fuel subsidy policy.

First, the terms of trade has probably worsened over the past 6 months, as export prices such as coal plunge, while import prices such as oil prices rise (Chart 7). Coal prices has fallen some 17% from their highs in Feb last year, while oil prices are still up some +10% from recent lows despite the recent pullback.

Second, high global oil prices and fuel subsidies has widened the oil trade deficit. The oil trade balance saw a higher deficit of US$5.4bn in the first quarter versus US$4.3bn in 4Q last year. Robust domestic demand and deferment of plans to raise fuel prices point to a widening oil trade deficit in coming months. Third, services account is another component of the current account which is persistently in deficit, largely due to transportation services, mainly in freight. The services deficit narrowed in the first quarter (to US$2bn from US$3.1bn in 4Q).

The fiscal deficit will also widen this year. We expect the fiscal deficit to widen to 3.2% of GDP in 2012, if the government fails to hike fuel prices or ration fuel. This is a significant increase from the fiscal deficit of 1.3% of GDP last year. The jump will be largely due to escalating fuel subsidies, which is expected to increase to Rp208.4tn in 2012, by our estimate, from Rp165.2tn in 2011.

For now, Indonesia has been able to manage the pressure on foreign reserves from a larger current account deficit. Foreign reserves actually rose by US$5.9bn in April, to US$116.4bn. Increase is foreign reserves was largely attributed to a US$6bn jump in USD bond issuance in April (of which US$5.5bn was sovereign or quasi- sovereign). This includes sovereign (US$2.5bn), Pertamina (US$2.5bn), Eximbank (US$500m) and BNI (US$500m).

Indonesia’s strong balance sheet (external public debt only 8% of GDP) and investment-grade status is helping to fund the gap. But investors may get cold feet if both the current and fiscal deficits continue to worsen. And the government fails to demonstrate its capacity and political will to address these growing imbalances, particularly in dealing with an unsustainable fuel subsidy policy. India’s political paralysis and the twin deficits should be a timely warning. Capital account inflows are moreover fickle, and can dry up quickly if global financial conditions deteriorate. Such a scenario is no longer remote as Europe’s debt crisis threatens to escalate.

Source: Bofa ML

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