Crisis and recession are almost certain

Anthony Budiawan Managing Director of Political Economy and Policy Studies (PEPS)

IO – The spread of Covid-19 in early 2020 pretty much depressed economic activity in China, and thus across the global economy. It is still too early to estimate its impact on world economic growth because it depends on when this crisis can be overcome. The longer the virus runs, the more severe the economic damage will be.

The problem now is that the spread of the Coronavirus beyond China is actually getting worse. The number of cases and death toll of Covid-19 outside China has suddenly jumped sharply. The emergence of cases in South Korea, Italy, Iran is very worrying.

In the midst of such uncertainty, both the Chinese and global economies definitely plummeted in the first quarter of 2020. Some even predict the Chinese economy could experience a contraction (alias negative growth). The impact on the Indonesian economy will also be fatal because Indonesia’s economic structure is both delicate and inferior; thus, a crisis will be difficult to avoid.

There are two kinds of crises that are likely: a financial one and an economic one. The prolonged economic crisis has turned into a recession. The origin and development of these two crises are different.

The financial crisis has caused the Rupiah to start a downward slide, as the dollar outflow far exceeds the dollar inflow. As a result, foreign exchange reserves are running low. Demand for dollars is blooming, so the dollar exchange rate rises (and the Rupiah exchange rate falls).

The flight of dollars abroad is due to two factors. First, the trade balance deficit and the current account balance. This deficit is quite large, reaching 30 billion US dollars in 2018 and 2019. And the current account deficit in 2020 will not be any lower. We can make an assumption that it will be approximately the same, which is around 30 billion US dollars. There are two sources which should be used in order to patch up this deficit, namely, direct investment (FDI) and portfolio investment (stocks and debt securities).

FDI in 2018 and 2019 was 12.5 billion and 20 billion US dollars, respectively. In an uncertain global environment, 2020 FDI will be limited to a maximum of 15 billion US dollars. The remaining 15 billion US dollars must be somehow replaced by portfolio investments. The problem is that foreigners now tend to delay all their investments, preferring to hang onto their money. According to Bank Indonesia (BI), during February 2020 foreigners had invested around 2.2 billion US dollars, a sum equivalent to Rp30.8 trillion. That breaks down as IDR26.2 trillion in SUN sales, IDR4.1 trillion in the sale of shares, and the remainder in corporate bond sales. In such a situation, it is estimated that there will be a US dollar supply deficit sufficiently large to cover the current account deficit. And the Rupiah exchange rate inevitably will be depressed.

Second, Indonesia needs dollars to repay debt (SUN and corporate bonds) falling due in 2020 and owed to foreign investors. SUNs due are estimated at Rp. 428 trillion, or around 31 billion US dollars. Of this amount, 60 percent, or around 18.6 billion US dollars, is held by foreigners. The government certainly has no dollars to pay them with. Thus, that debt to foreign creditors (US $ 18.6 billion) can only be paid off by issuing new SUNs, which must also be purchased by foreigners. Unfortunately, with global conditions weakening, the risk of failing to attract more debt is quite large. Just last month, foreign investors instead sold 2.2 billion US dollars’ worth of SUN (and corporate bonds). If the government fails to attract urgently-needed new debt, the Rupiah exchange rate will spiral downward more steeply.

How much the Rupiah exchange rate will drop depends on the size of our dollar deficit (aka Indonesia’s balance of payments deficit, aka a decrease in foreign exchange reserves), related to the two factors mentioned above. The greater the dollar deficit, the worse the Rupiah exchange rate. In 2018, the dollar deficit nearly reached 10 billion US dollars. The Rupiah exchange rate responded by dropping to Rp15,300 per US dollar. It is very likely that the dollar deficit this year will be far greater than that of 2018, since nearly all foreign investors are holding back on investing, even if there are attractive prospects. If the Covid-19 situation worsens, the deficit could reach 15 billion US dollars. And the Rupiah exchange rate hits another record low.

The economic crisis is different from the financial crisis. They can however complement each other, and interact with one another. A financial crisis can trigger an economic crisis, and an economic crisis can trigger a deeper financial crisis.

The economic crisis occurs when demand (or consumption) falls: household consumption, government consumption, investment and exports all have the potential to fall in the first quarter. The economic crisis of 2020 began with a decline in exports, especially to markets in China, which was the epicenter of the Coronavirus. The value of Indonesian sales to China in 2019 amounted to 25.85 billion US dollars, comprising 16.68 percent of Indonesia’s total non-oil and gas exports. This is indeed a very large number. In addition, exports to other countries will decline in turn, tracking a dip in the world’s economic performance. The drop in exports to China will certainly impact Indonesia’s economic growth negatively.

The decline in exports has major consequences. State tax revenues will fall, meaning government consumption will suffer a contraction. In January 2020 state expenditures fell 9.1 percent, effectively depressing economic growth from government consumption.

Third, investment growth will also stall, as domestic demand and exports slow down. Foreign investment will tend to dry up as financial conditions abroad tighten up.

The weakening on the demand side can see many companies suffering losses, triggering debt defaults and layoffs, which in turn squeezes consumption and economic growth. This is called a cycle of economic crisis which, if prolonged, degenerates into a recession.

Government exports, investment and consumption are almost certain to contract. An economic crisis is almost certain. To avoid such a crisis, the government must immediately launch some kind of stimulus.