IO – The Covid-19 pandemic that has gripped the world for the last seven months is pushing Indonesia over a cliff into recession in the third quarter of 2020. Indonesia’s economic growth, which has shrunk -5.3 per cent in the second quarter, is projected to slide further into negative territory, between -1 to -2.9 per cent in the third quarter. When the GDP growth is negative for two consecutive quarters, this means that technically Indonesia is among the league of 45 other countries that have earlier fallen off the cliff of recession.
Amid the recession threat, the government has prepared various strategies to keep a short leash on Rupiah volatility so that it doesn’t fluctuate wildly, as in the first half of 2020. One of the strategic steps taken by the Monetary Authority in anticipation is to expand the liquidity supply agreement for the settlement of bilateral transactions in local currencies with several partner countries, such as South Korea, Japan, Australia, Malaysia, Thailand, Singapore, and most recently China.
At the end of September, the Governor of Bank Indonesia and the Governor of the Central Bank of China (PBoC) agreed to a framework for cooperation to encourage Local Currency Settlement (LCS) in bilateral trade transactions and direct investment. The LCS framework between BI and PBoC includes, among others, the use of direct quote and interbank trading for Yuan and Rupiah. The cooperation will also include information-sharing and regular discussions between Chinese and Indonesian authorities.
The LCS collaboration between BI and PBoC will definitely have broad implications for the economy, considering that China is Indonesia’s main trade and investment partner. The LCS agreement with China marks a milestone in the history of a more massive “Yuanization” which aims to reduce the dominance of the hard currency, namely the US dollar, which has been the scourge of Rupiah stability so far. Amid the increasingly tense trade war between the US and China, in particular, the LCS cooperation will also affect the balance of Indonesia’s economic relations with the world’s two largest economies. Although the LCS with China will help maintain macroeconomic and financial system stability in Indonesia, Indonesia must also prepare and anticipate various implications that will emerge in the future, especially with regard to geoeconomic and geopolitical aspects.
The Rupiah in a pandemic year
The volatility of the Rupiah in 2020 was caused by various factors, both economic fundamentals and non-economic sentiment, mainly related to the uncontrolled spread of Covid-19. Rupiah depreciation was the steepest in March and April, touching a level of Rp16,500 per US dollar when Covid-19 started spreading, causing panic among investors. In the first quarter of 2020, the Rupiah weakened by -14.88% on a point-to-point basis, triggered by increased risk-averse behavior of global investors, in the form of a reverse flow of global funds from developing countries to global financial assets and safe haven assets.
However, during the second quarter of 2020, the Rupiah exchange rate started to change course, by appreciating 14.42% point-to-point. The strengthening of the Rupiah was influenced by the sizeable inflows of foreign capital into the domestic financial market in May and June 2020, coupled with positive sentiment over the easing of global financial market volatility and expectations of domestic economy recovery. However, on average, the Rupiah still depreciated, by 4.53%, due to heavy pressure in April.
In July, the Rupiah again dropped by 2.36% (point-to-point) as global financial uncertainty rocked financial markets due to fears of a second wave of Covid-19 pandemic and increased geopolitical tension between the US and China. The same fear continued into August and September 2020, putting the Rupiah under heavy pressure. As of September 16, 2020, the Rupiah depreciated by 1.58% (point-to-point) compared to July 2020, or by 6.42% when compared to December 2019.
In Semester II of 2020, the Rupiah fluctuation was influenced by a range of factors such as Large-Scale Social Restrictions (PSBB) Phase 2 in Jakarta, the release of Quarter III GDP growth figure and a technical recession, as well as the Jobs Creation Bill which was passed into law and fueled massive demonstrations by labour unions and students. These situations are expected to create negative sentiment among investors, hence continuing Rupiah depreciation until the end of the year. However, the government has set the 2020 projection for the Rupiah exchange rate at Rp14,400 to Rp14,800 per US dollar.
The Rupiah exchange rate in 2021 is projected at Rp14,600 per US dollar. This optimism was generated by heightened expectations for national economic recovery, which is predicted to return to positive territory. All international institutions are quite optimistic that Indonesia’s economic growth will rebound to a positive level again in 2021, citing projections from the World Bank (4.8%), IMF (6.1%), ADB (5.3%), Bloomberg (5.4 %), and OECD (5.3%). Meanwhile, the government and the House have enacted the 2021 State Budget Law with a growth target of 5%. Furthermore, the Rp356.6 trillion worth of stimulus program in the National Economic Recovery (PEN) program in 2021 will also boost positive sentiment on economic growth.
To accelerate economic recovery amid the pandemic, the government has taken extraordinary steps in the fiscal sector, through Law No.2/2020 which grants the government full authority to increase the budget for Covid-19 handling and economic stimulus by widening the state budget deficit to 3% of GDP until 2022. In the 2020 State Budget, the fiscal deficit reaches 6.34% of GDP and in the 2021 State Budget it is pegged at 5.7% of GDP or Rp1,006.37 trillion.
On the other hand, economic recovery will hinge on several other domestic factors, such as people mobility in line with the implementation of the Covid-19 health protocol in several regions, the speed of budget realization by the central and local government, progress on restructuring and credit guarantees, as well as acceleration of the digital economy and finance, especially in empowering MSMEs.
Nevertheless, amid the optimism for economic recovery next year, there are still many risks that can potentially disrupt the stability of the Rupiah, such as the continuing trade war between the US and China, especially if incumbent US President Donald Trump is reelected. In addition, the increased need for stimulus in many countries will lead to competition for funds and liquidity on the global market. This condition is expected to push up interest rates and will lead to the fluctuations in capital flows on the global market.
Furthermore, the stability of the Rupiah next year will also be highly influenced by aggressive fiscal policies undertaken by authorities in many countries to promote their own economic recovery. The fiscal stimulus is aimed at, among others, mitigating the impact of Covid-19 pandemic and promoting economic recovery through increase in health budget, expansion of social safety nets as well as lifeline for business, including tax relaxation and economic recovery stimulus. On August 8, 2020, Executive Orders were signed in the US to ensure sustainability of stimulus for unemployment insurance, business assistance, and health spending. Meanwhile, China is continuing its ever-expansive fiscal stimulus, which is estimated to reach 17% of GDP in off-budget financing.
Appraising the impact of Yuanisation
The decision of Bank Indonesia to strengthen relations with the Central Bank of China (PBoC) in the form of LCS is of course based on very strategic considerations. This was primarily to reduce pressure on the stability of the Rupiah, which had been overshadowed by dependence on the US dollar. From the beginning of 2020 to the end of September 2020, the Rupiah has weakened by up to 6.84% against US dollar. An LCS agreement with China will reduce the need for US dollars considering that China is Indonesia’s largest trade partner. This means that the use of local currency in every settlement of trade transactions and direct investment between Indonesia and China can reduce dependence on the US dollar.
Although Bank Indonesia has signed a Memorandum of Understanding for the establishment of an LCS agreement with PBoC, there are still several things that need to be prepared, including finalizing a further cooperation framework which includes: (1) provisions related to foreign exchange transactions, (2) appointment of a bank to act as Appointed Cross-Currency Dealers (ACCD), (3) reporting and monitoring mechanisms.
At the operational level, the LCS agreement between Indonesia and China will be supported by a bank appointed by the authority to facilitate a transaction settlement in Rupiah or Yuan. In this case, BI and partner authorities have appointed several banks that meet the requirements to facilitate the settlement of Indonesian business actors with their Chinese counterpart in Rupiah or Yuan, or what is known as Appointed Cross Currency Dealers (ACCD) to ensure the implementation of LCS is in accordance with the operational guidelines. By appointing select banks, BI and partner authorities can better monitor their implementation.
The common practice is that importers/investors convert their local currency to US dollars before conducting any trade or investment. This poses an exchange rate risk. For example, when the US dollar strengthens against the Rupiah, importers in Indonesia must pay more, even though the products purchased come from countries that do not use US dollar. With the use of local currencies, the exchange rate risk against the US dollar is eliminated. However, the other risk that should not be overlooked is that when trade and investment transactions with China continue to increase, the dependence on Yuan will also rise. Furthermore, Indonesia’s trade balance with China tends to suffer a deficit. In 2019, Indonesia’s trade balance deficit reached US$3.19 billion, relatively better than the US$8.69 billion deficit recorded in 2018.
To date, the majority of Indonesia’s international trade is carried out with countries in Asia and the Middle East, comprising around 74% of Indonesia’s total trade value. Meanwhile, trade with America and Europe was ranked second and third, at 10.5%, respectively. However, Indonesia’s trade is still denominated in hard currency, around 95% for exports and 85% for imports.
The dominance of hard currency as the settlement currency in trade, investment and domestic financial market has created a high dependence, thus contributing to the volatility of the Rupiah. This can have an impact on macroeconomic stability, particularly in terms of exchange rate. Higher volatility of the Rupiah against the hard currency could disrupt the ability of business actors to meet their foreign debt or trade obligations. One solution to reduce dependence on hard currency is by promoting the use of local currency in Indonesia’s trade and investment settlements with other countries, especially with regional countries, through LCS cooperation, for example with China.
It is undeniable that China has become Indonesia’s most strategic partner, especially in the last five years, both in terms of trade and direct investment. The average trade between 2015-2019 shows that China is the largest export destination and origin country of import. This significant relationship is reflected in the average exports (oil and gas and non-oil and gas) worth US$21.9 billion (13.5% of Indonesia’s total exports) and the average imports (oil and gas and non-oil and gas) worth US$36.2 billion (22.7% of Indonesia’s total imports). This means that during the 2015-2019 period, Indonesia’s trade deficit against China reached an average of US$14.3 billion.
Although China ranks first as Indonesia’s bilateral trade partner, the use of local currency (Yuan) for export transactions is still relatively small: only US$585.3 million in the period of January-July 2020 or only 0.65% of Indonesia’s total exports. By contrast, the use of US dollar still dominates Indonesia’s export transactions, reaching US$85.8 billion or 94.13% of Indonesia’s total exports. On the other hand, the use of Yuan for import transactions is slightly higher at US$2.57 billion or 3.31% of Indonesia’s total imports in comparable period. Meanwhile, import transactions denominated in US dollars was 85.68%.
Through LCS cooperation with China, the use of the Yuan in trade transactions will increase. Moreover, China is Indonesia’s primary non-oil export destination (16.68% in 2019). Additionally, Indonesia’s manufacturing industry also depends on China because more than 25% of production input comes from China. When the economic recovery in Indonesia begins, driven by improved performance in the manufacturing industry, it means that demand for imported raw materials and of course, Yuan, will certainly increase.
Moreover, the impact of Yuanization will also be felt in direct investment where China is the second largest origin country for foreign direct investment (FDI) in Indonesia (17.9% or US$ 2.4 billion in Semester I of 2020). Share of China’s FDI in Indonesia has continued to rise significantly in the last five years, considering that in 2015 China wasn’t among Indonesia’s top five FDI partner countries. However, in 2016, FDI from China suddenly shot to the 3rd position (still 9.2% of total FDI). By then the value of China’s FDI in Indonesia continues to soar in the following years, reaching 16.8% in 2019 or equivalent to US$4.7 billion.
Through various forms of infrastructure collaboration between the Indonesian and Chinese governments, direct investment from China will certainly increase. In addition, with the passage of the Job Creation Law which opens up more opportunities for foreign investment and foreign workers, it is predicted that the use of Yuan will rise in Indonesia-China bilateral trade.
Furthermore, behind the LCS cooperation between Indonesia and China, of course we cannot overlook and interpret this step as a series of Yuanization where the dominance of the US dollar is potentially replaced by Yuan on the international trade arena, especially in the midst of an ongoing trade war and China’s ambition to accelerate its One Belt One Road (OBOR) project. Through the liberalization of its international capital flows, China intends to strengthen relations and bargaining power with major partner countries so that when trade, investment, and even infrastructure development financing from China increase, that’s when we all have to be ready for the realignment of Indonesia’s geoeconomic and geopolitical stance. (Abra Talattov)
Abra Talattov, SE, MSc graduated from the Faculty of Economics, Diponegoro University. He joined INDEF as a young economist in 2011. He is currently Head of Center of Food, Energy, and Sustainable Development (FESD) at INDEF. He obtained his Master of Science (M.Sc) degree from the University of Malaysia Terengganu. He has also served as the Manager of Economic Development at the Jakarta’s SDG Secretariat since 2019.