Indonesian Strategy:Watch the (mushrooming)fiscal deficit

Event

Kontan has reported Indonesia’s 9M15A fiscal accounts, which show that acombination of slowing government revenues and rising government spendingtriggered a significant QoQ blow-out in Indonesia’s fiscal deficit in 3Q15A to6.1% of GDP (5.6% seasonally-adjusted), from a small 0.2% surplus in2Q15A (1.0% seasonally-adjusted deficit), bringing Indonesia’s 9M15A deficitto 3.0% (exactly in line with Indonesia’s constitutional 3% deficit ceiling).

This is a crucially important datapoint, because it highlights that to the extentIndonesia’s economy did show tentative signs of a bottoming/recovery in3Q15A (which has contributed to a huge rally in the JCI since early October),it was quite likely driven by temporary and unsustainable fiscal stimulus,rather than structural factors. This is an issue which has been givensurprisingly little focus by investors/economists, and appears to have escapedthe attention of many, and it introduces a clear risk Indonesia’s growth couldunexpectedly slow into year-end/2016on forced contractionary fiscal policy,replacing recently-emboldened ‘animal spirits’ with renewed uncertainty.

Impact

4.6% seasonally-adjusted QoQ fiscal stimulus: Government incomedeclined by 29.3% QoQ in 3Q15A (or by 4.6% of GDP), as a temporary pickupin O&G revenues alongside 2Q15’s short-lived oil price rebound reversed,coupled with weaker QoQ tax and SOE dividend income. Meanwhile,government expenditure rose by 16.8% QoQ (or by 1.7% of GDP), led by a77.2% QoQ increase in capital spending. While seasonality played some role,we estimate that the deficit still rose by 4.6% QoQ on a seasonally-adjustedbasis (6.3% QoQ gross), providing a substantial degree of stimulus to say theleast. Furthermore, we highlighted here that the deficit had risen to 5.5% ofGDP in Jul-Aug, so the deficit appears to have deteriorated further in Sept.

That the economy showed some tentative signs of stabilisation/improvementin 3Q15A is therefore hardly surprising. Instead, the real surprise is howfeeble the QoQ improvement has been given the extent of this fiscal support,which yielded a mere 6bp QoQ increase in Indonesia’s 3Q15A real GDPgrowth rate from 4.67% to 4.73% (albeit that Indonesia’s 1H15A real GDPgrowth rate was likely overstated in our view). Continuing sluggishness in theeconomy was also recently confirmed by yet another weak reporting season.

Challenges moving forward: The minor pick-up in leading indicators thissubstantial dollop of fiscal stimulus has generated (e.g. modestly highercement volumes) has contributed to a substantial rally in the JCI, on risinginvestor confidence that Indonesia’s growth cycle is now bottoming, andindeed that a (slow) recovery may be underway. However, Indonesia will infact move into 4Q15facing the combined challenges of(1) the need toimplement contractionary rather than expansionary fiscal policy; while(2) alsohaving to confront the contractionary impact of recent rupiah strength (whichwill impact government rupiah resource tax/royalty income as well as exports).

Outlook

Investors and economists appear to have been too busy celebrating therecent pick-up in leading indicators to have noticed that the key driver of thepickup in leading indicators is potentially unsustainable. Any reversal of therecent increase in investor confidence could therefore trigger a sell-off.