There are a number of similar opportunities for reform available to Indonesia, with direct and indirect effects on the sustainability of the external balance. This paper offers a set of policy options under three broad categories that would improve the stability of Indonesia's CAD: (i) fiscal reform; (ii) using investment to promote stability; and (iii) a transparent, productivity-led growth strategy.
Fiscal reform
In terms of direct measures to influence the CAD, Indonesia has already made progress to improve the sustainability of the CAD by significantly reducing fuel subsidies. Broadly speaking, reducing recurrent Government expenditures like the fuel subsidy will reduce the public sector call on the CAD. It is important to note that a fiscal deficit led by productive public investment is not inconsistent with a stable CAD, but expenditures that distort private consumption and investment decisions do not enhance the sustainability or stability of the CAD.
The recently announced fuel subsidy reforms will provide fiscal relief allowing for much needed infrastructure, health and education spending and is a very positive first-step in reforms. Further to this, a clear, credible medium term fiscal strategy would also assist by signalling a more coherent strategy for the future. Further reforms should also incorporate fiscal targets that distinguish between infrastructure spending, social spending and tax reform objectives. Tax reform as part of the fiscal strategy will be essential. Efforts to broaden Indonesia's tax base using efficient taxation mechanisms such as reforms that maximise revenue from existing consumption taxes would contribute to market confidence. Further, efforts by Indonesia to improve compliance of personal taxpayers have the potential to deliver significant revenue gains.
Increasing revenues would also have potentially beneficial effects on Indonesia's CAD. Efforts to broaden the tax base in Indonesia, particularly via personal income tax and consumption taxes, would firstly contribute towards market confidence in the Government's ability to more credibly guarantee any foreign debts incurred in financing the CAD. Secondly, broadening the tax base could potentially lean against consumption somewhat – having a commensurate effect on imports. The type of revenue broadening is important. Selecting the most efficient, least-costly-to-growth taxation strategies are crucial.
This could also reduce market anxieties about a ‘twin deficits' scenario.8 While Indonesia's budget deficit rules are an important existing feature of the policy landscape that promote confidence in the Government's ability to manage shocks, limited revenue-generating capacities will eventually curtail the ability of the Government to undertake productive investment that would benefit growth. Australia has allayed such market anxieties through public commitments to fiscal prudence, such as the Charter of Budget Honesty (similar to Indonesia's deficit limit, in its intent), coupled with various public mechanisms for evaluating fiscal sustainability and economic/budgetary pressures (such as the Intergenerational Report and the Tax Expenditure Statement).
Investment to promote stability
As noted earlier in this paper, one of the most important things that can be done to mitigate the risks of capital flight is to reduce the country-specific risks of investing in a country. Indonesia will remain an attractive destination for investment for the foreseeable future, and it would be detrimental to Indonesia's growth potential to leave investment opportunities unfulfilled for the sake of trying to reduce the risks of capital flight.
There are examples where a lack of principle-based policy changes and uncertainty surrounding policymakers' reactions contributes to uncertainty for both foreign and domestic investors in Indonesia. For example, new industry and trade laws enable Ministerial authorities to act independently to significantly intervene in markets. There would be benefits from the adoption of a coordinated and strengthened policymaking and regulation process. Aside from allowing all senior Government Ministers to consider new regulations and policies, Indonesia may also benefit from adopting strong, statutorily independent institutions such as Australia's Productivity Commission, which has a role to play in generating support for the settings of the macroeconomy and the importance of reform at the microeconomic level. This would be somewhat different to Bappenas' (the National Development Planning Agency) remit, with Australia's Productivity Commission having deliberate independence, and requirements for the dissemination of a policy narrative based on productivity, rather than broad-ranging policy delivery.
Economic reforms are generally not easy – a move toward greater efficiencies will typically involve depriving one or many interest groups of resources for the good of the wider economy. Thus, it takes political commitment and consensus building to achieve these goals. In Indonesia's case, there is a role for institutions to establish a coherent policy narrative between regional governments and the central Government.
More broadly, investors need to have faith that their legal contracts and property rights will be binding and upheld in the Courts of Indonesia. A veritable tome of economic literature and international experiences shows that property rights, investor protection and legal enforcement of these are an essential part of well-functioning markets, particularly when making long-term financial decisions.9 Reforms such as those included in Indonesia's new land acquisition law, if well implemented and enforced, are a step in the right direction. Another key factor for business and employees is conducive and supportive labour market policy that is supported by a strong legal framework.
Recent experiences with currency volatility driven by volatile portfolio investment flows reflect some of the uncertainties investors face when undertaking investments in Indonesia. Promoting an environment of increased policy certainty would, encourage investment into Indonesia and not necessarily at a greater risk of capital flight.
Removing impediments to longer-term investments in Indonesia (such as FDI) would also promote stability. Recent amendments to the Negative Investment List (the list of business areas closed to foreign investment, or otherwise restricted) appeared to reduce FDI access to a number of markets, which arguably adds to uncertainty about future investment opportunities – influencing perceptions about the riskiness of investing in Indonesia, and biasing investment toward short-term, flightier portfolio investment. Allowing more FDI to occur in conjunction with a deepening of Indonesia's domestic financial markets, and increasing the capacity for the banking sector to intermediate such investment (and manage currency risks) would also mitigate risks associated with capital flight. This could be achieved by financial sector deregulation, consolidation and the encouragement of foreign entry to boost competition.
Transparently-formed, productivity-led growth strategy
Concerns about the CA position highlight the importance of wide-ranging and comprehensive policy reforms to improve the structure of the economy. In the medium to longer term, building a stronger more flexible economy can help achieve prosperity and equality, and avoid the middle-income trap.
Indonesia's demographic dividend, which will continue over the next decade, provides an opportune time for substantial reforms to be undertaken. It can also be viewed as impetus for reform – future prosperity will be more difficult to achieve as the demographic dividend wanes.
One of the primary means through which Australia has achieved successes in policy transparency has come th
rough enshrining the independence of key bodies, such as the Reserve Bank of Australia and the Productivity Commission. Additionally, commitments to comprehensive and forward-looking public documents such as the Intergenerational Report unambiguously highlight challenges and risks that extend beyond the immediate political cycle.
Considering areas of policy reform, Indonesia's policymakers are well-aware of the importance of ongoing infrastructure investment to economic growth. Strengthening mechanisms for independent assessment and prioritisation of infrastructure needs, coupled with rigorous economic assessments to advise the Indonesian Government on projects would likely improve the cost-effectiveness of infrastructure delivery, as well as improve Indonesia's external competitiveness by removing internal impediments to growth.
In terms of education policy, attendance rates have improved dramatically over the past decade. The next step in enhancing Indonesia's considerable human capital is to focus on improving the quality of education outcomes, while maintaining quantity, perhaps with a focus on facilitating cooperation between the education sector and industry. The IMF has recently noted the importance of education as a ‘bridging' element between the present and future sources of economic growth and competitiveness. Improving the link between tertiary education and training, and the needs of industry may assist this transition.
Finally, beyond encouraging more deeply-integrated foreign investment into Indonesia as a source and signal of stability, there is evidence that Indonesia's capital market lacks diversified financial products and depth to support the growth of its industries and services. As the World Bank has noted, there is significant evidence that enterprises in Indonesia are credit constrained – limiting their ability to expand and drive growth. Current efforts by the Indonesian Government to better clarify and coordinate linkages between financial authorities should be welcomed. Seeking to strengthen the bank and non-bank financial system, they recognise that the Indonesian banking industry could benefit from deregulation and, in particular, increased competition from foreign banks. Beyond this, the Government could assist in building a capital market with more diverse products by considering investment requirements, high underwriting costs and weaknesses in the execution regime (which may be addressed through bank consolidation, where appropriate). As with Australia's experience, an Indonesian banking sector that is strong enough to intermediate a significant share of the CAD can directly increase its stability by ensuring positions are hedged.
8 Where public expenditure is contributing directly to the CAD, placing the risk of capital flight and currency volatility on the public balance sheet and thereby risking the solvency of sovereign borrowing.
9 Dam (2007) presents such a comprehensive tome, though the work of Gould and Gruben (1996) and Levine (1998,1999) focus on specific aspects of the relationship between property rights, law enforcement and economic growth, while and Mahoney (2001) examines the influence of different legal traditions on the development of financial markets.