Widening Current Account Deficit: Any Possible Overheating Economy?

Indonesia has been ‘the favorite investment destination’ among global investors which is reflected by capital inflows into Southeast Asia's biggest economy due to abundant natural resources and a fast growing middle class. In fact, in the last five years, Indonesia's GDP has grown averagely about 6% yoy and the country has recorded trade surpluses due to strong demand from China and India. However, since January 2012, the trade balance began to worsen and this has been exacerbated by recent falls in commodity prices. Concern about overheating economy has been rising in Indonesia since trade balance deficit has widened the current account deficit. Does Indonesia’s economy show signs of overheating?

Indonesia’s trade balance deficit hit all-the-time new high in June 2012 because of significant falling demand in China and Europe. Indonesia recorded USD 1.32 bn of trade deficit that came up from USD 16.69 bn of import and USD 15.36 bn of export during that period. Export in June fell 16.44% from previous year, more than twice as bad as expected, while import rose 10.71% on year but slid 2.05% from May. In H1-2012, Indonesia’s largest deficit persisted in its trade with China, one of major trading partners, reached USD 4.045 bn, followed by trade deficit with Thailand and Japan respectively USD 3.070 bn and USD 3.057 bn.

Furthermore, because of trade balance deficit, the current account is also experiencing widening blamed on a weak global economy. Indonesia’s current account deficit in Q2-2012 stood at USD 6.9 bn (equivalent to 3.1% GDP) compared to USD 3.2 bn (equivalent to 1.5% GDP) in Q1-2012. However, the good news is that the surplus in capital account increased to USD 5.5 bn (equivalent to 2.5% GDP) in Q2-2012.  Combination of trade deficit and current account deficit has led to depreciation of IDR against USD reaching 4.6% since January 1, 2012 (the worst performance among other Southeast Asia’s currencies this year). Thus, foreign exchange reserves have been falling as a result of Bank Indonesia intervention. This has led to a drawdown in the country’s foreign exchange reserves, which has been declining from their peak in mid-2011 to US$106.6 bn (equivalent to 6.4 months of imports and external financing expenses) at the end of Q2-2012.

Back to the question “Is Indonesia’s economy overheating?” taken into account widening current account deficit and IDR depreciation? In our view, the dramatic turnaround from current account surplus last year to big deficit in H1-2012 is indication of continual growing domestic economy rather than economy overheating. In our view, current account deficit is being driven by strong investment performance which is supported by several indicators.

First, as reported by Central Bureau of Statistics, Indonesia posted stronger-than-expected 6.37% GDP growth thanks to fixed investment that rose by 12.31% on a year to year basis. This currently accounts for 32.84% GDP in Q2-2012, the highest share since the global financial crisis in 2008. This strong growth in investment reflecting accommodative monetary conditions and strong credit growth at 25.7% yoy as of June 2012 (equivalent to 25.7% GDP).

Second, investment is also sustaining GDP growth on the back of Foreign Direct Investment (FDI) inflows after Indonesia was awarded its second credit rating upgrade. FDI recorded new high   upgrade rose 30.2% yoy in H1-2012 to USD 12 bn, hitting a new record of USD 6.2 bn in Q2-2012.  The increasing FDI in H1-2012 were driven by mining (USD 2.1 bn), pharmaceutical (USD 1.4 bn) and transportation (USD 1.1 bn).

Third, the imports of capital goods in H1-2012 grew by 34.91% yoy to USD 19.4 bn. Moreover, its portion has increased to 20.1% total imports compared to 17.1% in H1-2011. An increase in investment and output of domestic industry has significantly induced the surge of import of capital goods. The imports of capital goods was driven by imports of machinery and mechanical equipment (USD 14 bn), electrical machinery (USD 9.5 bn) and iron & steel (USD 5.3 bn).

Facing deteriorating current account deficit which eventually could affect balance of payment, government should react immediately to contain the widening current account deficit in the future. Keeping BI rate at the level of 5.75%, Bank Indonesia as monetary authority has raised the deposit facility rate by 25 bps to 4% instead of hoping that both liquidity and IDR exchange rate is well managed. In our view, the government needs to control domestic demand, reduce import dependency particularly on capital goods and keep attracting foreign capital inflows. Furthermore, government could also take various fiscal policies in trade, industry, energy and fiscal to again promote exports in order to improve the balance of payment.