Trihn D. Nguyen (Natixis) | What if an emerging market embarked on quantitative easing (QE)? And if that weren’t enough, as market rates to fund the debt are still high and revenue is lower, the central bank is asked to monetize the debt at zero costs? That is the case of Indonesia and one that raises the questions of implications and limits of monetization and QE.
This note is a follow up on our previous note that argues that Indonesia monetary policy, whether rate cuts or QE, is only helpful at the margin and will not solve the archipelagos structural issues of limited income sources and low growth. And the latest development of monetization is at best a short-term fix to a financing issue and at worst a potential risk of derailing efforts to address fundamental issues of the economy. Bank Indonesia (BI) monetization of 60% of the fiscal financing gap does not solve the ultimate missing link of the Indonesia growth equation: and that is limited income sources to raise purchasing power and one that will hold back future growth.
What exactly has happened?
Indonesia suppression measures to tame Covid-19 has led to the worst growth momentum in Asia by June 2020. The latest manufacturing PMIs show that it is the economy that is in the deepest contraction in Asia (Chart 1). In May, Indonesia imports fell as much as -42.2%YoY, suggesting a cliff fall of demand for an economy that is domestic demand driven (exports fell too by 29%YoY).
In response to suppression of activities and essentially the private sector, the government realized that it is the “only game in town.” As such it implemented a fiscal stimulus worth 4.4% of GDP that includes on-budget spending at 3.2% of GDP and 1.2% in discretionary spending. Added to this, revenue has fallen so the financing needs have increased by an estimated -6.3% of GDP (we estimate -7%).
Currently, 32% of government bonds are held by foreign investors and the price of that debt is 5.4% for the 2-yr and 7.2% for the 10-year. Even after Bank Indonesia (BI) embarked on rate cuts of 75bps in 2020 to 4.25% and outright purchases of government bonds, the government is asking the central bank to take one step further and buy 60% financing needs in 2020 at zero interest.
Implication: less profits for BI, more crowding out of the private sector, and still low growth
This move, which is essentially a private placement to the central bank, is a subsidy to the government and different from outright rate cuts or purchases of government bonds in the market is that it doesn’t help lower funding costs for the overall economy but only the general government at significantly below market rate.
The result will not be significantly boosting growth as the direct fiscal impulse is rather small compared to overall decline of the economy. And it will not change the fact that the decline of the private sector is so vast and the recovery so sluggish that the economy will likely contract in 2020. Worst still, when Covid-19 crisis abates, Indonesia faces still a challenging future where its purchasing power has weakened. Its sources of external income have declined from exports to services such as tourism and remittances. Meanwhile, structural reforms to diversify sources income have lagged neighbor economies, resulting in worsening competitiveness and erosion of participation in value chain.
Thus, the monetization of fiscal is not going to generate inflation because the private sector is weak and will likely remain sluggish into 2021 as the support is not adequate to offset the decline of activities. Moreover, it is being crowded out by the larger public sector. As most of the spending for 2020 Covid-19 support is not likely to generate high productivity growth in the future, the fiscal debt burden will still need to be paid, even at zero interest rate for some of the debt.
By focusing its attention to tinker on the margin, Indonesia risks losing an opportunity to realize its potential by tackling real structural reforms to raise purchasing power. While the monetization effort will not have the negative impact of higher inflation as growth underwhelms, its negative benefits of higher debt burden and potentially downgrades for credit ratings will not do much to help its long-standing challenge of raising the fiscal revenue ratios, expanding external sources of income, and increasing the purchasing power and welfare of its people