Indonesia Economic Prospects (IEP), June 2022: Financial Deepening for Stronger Growth and Sustainable Recovery

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          The Indonesian economy accelerated at 3.7 percent at the end of 2021 as the country stepped off from the COVID Delta wave. The momentum continued in early 2022 at 5 percent (YoY), shifting anchors through towards more private consumption and investment. However, due to the challenging global environment, the country is starting to feel the pressures of rising prices and tightening external finance.

          Higher energy prices raise food prices through agricultural input costs. Cooking oil and other food prices have also shot up due to global supply shortages and rising demand. Most firms have resumed operations but with below capacity. Large firms, export-oriented firms, and businesses in high value-added services have recovered more quickly than MSMEs.

          The budget deficit narrowed in 2021 (from 6.1 percent of GDP in 2020 to 4.6 percent in 2021) thanks to a recovery in revenue and slowing expenditure. Government debt levels rose slightly from 38.6 percent of GDP to 40.7 percent in 2020-2021. The 2022 budget saw a reduction in extraordinary COVID support as the authorities refocus efforts on healthcare and dealing with the effects of the war in Ukraine.

          The Indonesian economy is projected to accelerate at 5.1 percent in 2022 and to 5.3 percent in 2023 due to the release of pent-up demand, improved consumer confidence, and improved terms of trade. Inflation is projected to rise to 3.6 percent (annual average) with the pick-up in domestic demand and higher commodity prices.

          The report recommends sustaining structural policy reforms to support growth going forward and reduce reliance on near-term macroeconomic stimulus and energy subsidies to contain cost-push inflation in the short-term, which in turn could help avert sharp monetary tightening that would stifle the domestic recovery.

         As such, four structural reform areas could play a bigger role in stimulating the economy: tax reforms to enlarge quality public spending; prioritizing business enabling environment for MSMEs; rethinking trade policies to develop greener downstream industries; and deepening the financial sector.

          The June 2022 edition of the Indonesia Economic Prospects delves further into the topic of financial sector deepening. A stable and smooth-functioning financial sector is key to the recovery from the COVID-19 crisis and longer-term economic growth, including through investments in public services, such as health care and education.

       Although there has been substantial progress in the Indonesian financial sector, whose macro-prudential fundamentals have proved to be strong during the recent COVID crisis, the sector is suffering from several shortcomings which hold back financial development and, ultimately, inclusive and sustainable economic growth.  As of today, the Indonesian financial sector is relatively small, costly, and exposed to global risks but policymakers have the opportunity to address key binding constraints.

          Growing the institutional investor base and ensuring access to digital financial services (DFS) can expand the sources of funding. This in turn would enable expanding the lending/usage of financial services for individuals and micro, small and medium enterprises (MSMEs) through transaction accounts and DFS. It would also facilitate the development of new sustainable finance market instruments for a transition towards a more sustainable economy.

        Digital finance, competition, and a sound financial infrastructure play a key role in allocating resources more efficiently by channeling savings into the most productive investment opportunities in a less costly, faster, safer, and more transparent way. Digital finance can improve efficiency by fostering financing at scale and greater risk diversification through innovative product design. Competition in the financial sector constrains market power for individual institutions and improves the efficiency of risk pricing while encouraging innovation. A sound financial infrastructure provides the enabling environment for an efficient financial sector.

          Financial stability is a crucial enabling factor for the financial sector to perform its key functions of efficiently allocating resources, assessing, and managing risks, and supporting the real economy. The strength of financial regulation and supervision, including an integrated supervision framework and legal protection for supervisors, as well as crisis preparedness and resolution frameworks are important elements to ensure the stability of the financial sector. Climate-related risks, to which Indonesia is particularly prone, may also pose risks to the stability of the sector.

The report also recommends three pillars of comprehensive reforms to strengthen the country’s financial sector. They are:

1. Increasing demand and supply of finance by

(i) increasing access to and usage of financial services; 

(ii) broadening and improving the quality of financial market products 

and (iii) mobilizing long-term savings.

2. Improving the allocation of resources through the financial sector by 

(i) promoting competition in the banking sector; 

(ii) strengthening the insolvency framework; 

and (iii) protecting consumers

3. Strengthening the capacity of the financial system to withstand financial and non-financial shocks by

(i) strengthening the effectiveness of fin. sector oversight; 

(ii) strengthening crisis preparedness and resolution framework; 

and (iii) promoting climate and natural disaster-related risk management.

Published 18/07/2022

By Michael Saichuk