There are obvious differences between Australia's and Indonesia's experiences with their CADs. However, there are also some similarities. Indonesia faces many of the same perceptions about the riskiness of the CAD such as fears around capital flight, exchange rate volatility and fiscal sustainability that Australia experienced in the 1980s.
Since the GFC, Indonesia has proved to be an attractive destination for international investment as perceptions of risks have been offset by the market's search of higher returns. This investment has produced the financial inflows, particularly portfolio inflows, necessary to finance Indonesia's CAD. However, the eventual normalisation of global monetary policy is likely to prompt markets to re-evaluate riskiness of various investments. In this environment, Indonesia may be subject to periods of investment withdrawal, subsequent currency volatility and uncertainty about financing its CAD - similar to that experienced in mid-2013.
Indonesia has shown that it is well equipped to use monetary policy and currency reserves to counter short-term risks to its economic stability. In the longer-term, these approaches will have limited effectiveness. By generating imbalances elsewhere in the real economy they are likely to unintentionally worsen the CAD, distort investment and counter Indonesia's objective of avoiding the middle income trap insofar as they weigh on economic growth. In contrast, measures that improve an economy's efficiency, such as the recent decisions taken by the Indonesian Government to reduce the diesel subsidy and remove the gasoline subsidy, will have long-term positive effects on economic growth and the CAD. They also send a clear signal to investors on the Government's genuine intent to transform the Indonesian economy.
Australia's experience of policy reform demonstrates that there are further strategies that Indonesia can adopt to mitigate possible instability arising from its CAD, removing the need for continual short-term management aimed at the headline figure itself. Australia has improved market perceptions by an extensive agenda of general economic reform, which does not include policy measures to target its external position. While some of these reform measures helped to reduce Australia's CAD, many did not – though all contributed to the flexibility and productivity of the macroeconomy. This ensured that the CAD was driven by sound foundations. These reforms provided the freedom to sensibly exploit Australia's comparative advantages which contributed to the sustainability and stability of the external position.
It is important that the Indonesian economy is allowed to develop in such a way that natural comparative advantages assert themselves, and at the same time policy is transparent and foreseeable to investors. A well-articulated and transparent framework for policy (and its formulation) is crucial to facilitating this.
Many general macroeconomic reforms are available to Indonesia – some of which may contribute to reducing the CAD in the short-term. Recent developments relating to fuel subsidies are an impressive and substantial first step. Taxation reform (such as the removal of unnecessary tax incentives and strengthening both tax policy and administration) and the balancing of the Government's budget are steps that can be taken in the short-term and which will further build on the recent reforms to fuel subsidies. Such reforms would provide investors with confidence in the Government's approach to domestic and international investment. This certainty will be important to change market's perceptions about the risk of investing in the Indonesian economy. Such commitments and reforms will benefit the CAD, benefit the Indonesian economy through providing further fiscal space for needed infrastructure and social spending, and benefit market perceptions of the Indonesian Government and economy.
In the longer term, while the process of reform may be difficult, promoting structural reform to build a flexible and productive economy will be crucial to prevent the CAD from becoming a restraint on growth. Through this lens, while the CAD is not a problem in itself, it can be an important motivation for reforms that are worth doing in their own right – be it financial system reform, prudent fiscal policy or improving the quality of public and private investment. Through these reforms, Indonesia can building a stronger more flexible economy, achieve prosperity and avoid the middle income trap.