Last year's peaceful presidential and parliamentary elections underscored Indonesia's reputation for political stability, one of the country's most important assets as an emerging economy. Just a decade and a half after shaking off the authoritarian rule of General Suharto, who had held power for 31 years, this is an impressive achievement – and one that business leaders know to appreciate. The immediate effect of the political handover is harder to appraise. It will be impossible for the new president, Joko Widodo, to meet all the expectations vested in him, but at a time when the economy is going through somewhat of a rough patch, investors will want to see some progress on key promises the new leadership has made. These include infrastructure development and bureaucratic reform.

While the external environment, i.e. the global economy, will continue to have a profound impact on Indonesia's economy this year, only domestic structural reforms can secure the country's economic performance in the future. Budget reforms, streamlining administrative procedures from the national level down to the local level and opening more business activities for foreign direct investment could help to tackle the recent economic challenges. Seeing the inception of meaningful reforms could positively impact Indonesia's financial markets this year. Without appropriate reforms, on the other hand, the country could be in for a rude awakening when the ASEAN Economic Community (AEC) launches at the beginning of 2016.

Macroeconomic assessment

GDP: Indonesia's economic growth has been on a slowing trend in 2012 and 2013, but then stabilized at its new-found lower level, hovering around 5% on an annual basis throughout 2014. The slowdown to a significant degree reflects lower volumes and prices for key Indonesian export commodities, such as thermal coal (See The Coal Sector in Indonesia), crude palm oil (See An Overview of Indonesia’s Palm Oil Industry), rubber (See Indonesia's Downstream Rubber Industry – Waiting for Investors) and metals. Due to ample global stocks, commodity prices are unlikely to recover soon. There has also been no indication of the new government reversing policies to restrict the export of unrefined minerals. Unless the government significantly boosts spending on infrastructure or private investment increases sharply, GDP growth will in all likelihood remain well below 6% in 2015; even the government target of 5.7% looks optimistic.

On a side note, the importance of GDP growth should not be overrated. In Indonesia's case, arguably more important than national GDP growth is the question of whether areas outside of the country's economic centres can catch up in terms of development. So-called secondary cities have attracted lots of investment in recent years (See Indonesia’s Economic Potential; A Look Beyond Java). Their continued progress – as well as the advancement of less developed regions – will be more indicative of Indonesia's economic performance than the headline GDP figure, for it is here where most of the untapped potential lies. Also, the sources of GDP merit close attention. Indonesia's emerging economy is in a state of transition, with future growth set to depend less on the primary sector and consumer spending, and more on processing and manufacturing industries as well as services.

Inflation: Price stability in Indonesia was not helped in recent years by a depreciating Rupiah and successive increases of state-administered energy prices, and 2014 offered no respite in this respect. Starting the year at above 8%, the annual rate of inflation dropped to 4% in August, only to rise sharply again and close the year at the same level it did 2013. Since a chunk of the increase stemmed from cuts in energy subsidies and further major cuts are not on the cards, consumer prices should be less volatile in 2015. However, inflationary pressure could result from global crude oil prices, which may well rise from what are exceptionally low levels at the beginning of the year. The central bank will likely fail once again to keep full-year inflation between 3% and 5%.

Current account balance: Due to a sharp year-on-year decline in imports, Indonesia recorded a trade surplus in January 2015. While on the face of it, this appears to be a good start to the year, it largely reflects low oil prices and weaker domestic demand due to the country's economic slowdown. A wider measure of Indonesia's exchange with the rest of the world, the current account, has been in deficit since the fourth quarter of 2011. The weaker rupiah and lower fuel subsidies make imported goods (particularly oil) more expensive and hence reduce import demand. Along with growing manufacturing exports, this should help to eventually restore the current account balance, though this is unlikely to happen as soon as 2015.

Rupiah unlikely to gain much ground in 2015

The fate of the Rupiah in 2015 will depend on external factors at least as much as on internal ones. As an emerging market currency, the Rupiah tends to rise and fall with monetary policies in major economies, particularly the US and EU. The strong impression of the US economy at the start of 2015 increases the odds of the Federal Reserve raising interest rates in the course of the year, which should lift the dollar versus the Rupiah as a result of capital flowing out of Indonesia and into the US.

It should be noted that the Rupiah's decline versus the US Dollar in 2014 reflected the latter's strength rather than weakness in the Indonesian currency. Measured against the Euro, the Rupiah actually rose in value, and continued to do so in early 2015. But this, again, is the result of market forces impacting the Euro rather than the rupiah, particularly a dodgy economic recovery in the euro area. On the Indonesian side, Bank Indonesia's surprising key interest rate cut in February suggested that the lower Rupiah is seen as little cause for concern and that both the central bank and the government may be quite happy with an exchange rate of almost 13,000 RP to the US Dollar.

Structural reforms needed to secure foreign investment

Due to the current account deficit, the government needs to maintain foreign investment inflows to secure the balance of payment. However, foreign portfolio investment in Indonesian stocks and bonds is constantly at risk of being pulled out of the country in response to external events, particularly monetary tightening in the US and EU, which could happen later in the year. This makes foreign direct investment (FDI) – which is less susceptible to global market sentiment – all the more important. FDI is also crucial for Indonesia to modernize its infrastructure, including transportation, energy and communications and accomplish the country's ambitious development goals (See Indonesia's Maritime Ambitions Require Massive Upgrade of Seaports).

The surprising decision to slash petrol subsidies at the beginning of the year was hailed as a sign of the new administration's resolve to bring about structural reform even in the face of popular opposition and vested interests. In a country that relies heavily on oil imports, fixed petrol prices were essentially a bottomless pit, tying up budget resources that could be put to better use elsewhere. Less than three months after Widodo took office, the move suggests that the president does not shy away from tackling political hot potatoes, though the real test of his determination will come when oil prices rise and the public feel the pinch of the new fuel price policy.

Further substantial steps, including bureaucratic reform, will be necessary to convince investors that the new government has the mettle to take on endemic corruption, infrastructure bottlenecks, protectionist trade and investment policies, restrictive labour market regulations and other issues that have persisted for many years. The financial markets reacted very positively to Widodo's electoral victory in July 2014 (See New Government May Reinvigorate Indonesia's Investment Appeal), but later in the year turned more cautious again on doubts about how much of a difference one man could make. Investors will be watching the new administration closely as they assess whether it is the optimists or the pessimists that have Widodo weighed up accurately. Aside from the world economy, it is this assessment that will impact Indonesian markets in 2015 and beyond.

Global Business Guide Indonesia - 2015

Indonesia Snapshot

Capital: Jakarta
Population: 259 million (2016)
Currency: Indonesian Rupiah
Nominal GDP: $936 billion USD (IMF, 2016)
GDP Per Capita: $3,620 USD at Current Prices (IMF, 2016)
GDP Growth: 5.0% (2016)
External Debt: 36.80% of GDP (BI, Q2 2016)
Ease of Doing Business: 91/190 (WB, 2017)
Corruption Index: 90/176 (TI, 2016)

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