Surfing The Wave Of A Recession: Is it possible to avert an economic disaster?

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Illustration: Agung Wahyudi/IO

IO – All countries in the world, including Indonesia, still have to fight hard against the ravages of Covid-19 which has continued to inflict damage since the beginning of this year. As per July 12, 2020, the Covid-19 positivity rate in Indonesia has reached 75,699, with 3,606 sufferers succumbing to the virus, making it the highest number in ASEAN. Indeed, Indonesia has set a new record, with 2,647 infections in a single day on July 9. Unlike many other countries that have shown success in containing Covid-19, Indonesia has seen the curve continue to trend upward, with no signs of slowing. The soaring positive caseload of Covid-19 in Indonesia is a consequence of the government’s decision to relax Large Scale Social Restrictions (PSBB), from the beginning of June. The policy was taken to counter the huge economic and financial pressure borne by society due to the implementation of PSBB. 

With this in mind, it is not surprising that an Australian publication, The Sydney Morning Herald, predicts that Indonesia has the potential of becoming a new Covid-19 hotspot. The evidence has shown that Indonesia is still relatively a laggard compared to other countries in ASEAN in combating Covid-19, such as Singapore and Malaysia, which have seen the curve go down. One area in which Indonesia is lagging is the number of Covid-19 tests, with only 2,123 tests conducted per million population by far, ranked 163rd in the world. By comparison, look at Russia (107,445), the US (80,750) and India (4,530). (Figure-1) 

The relaxation of PSBB in various regions carries the risk of pushing up the number of Covid-19 cases in Indonesia, as people’s mobility increases, especially in areas categorized as red zones or even black zones. According to the Health Ministry’s data on distribution of Covid-19 deaths in Indonesia per June 3, East Java has become a major concern, as it recorded the second-highest number of positive cases after the capital Jakarta, where the fatality rate remains high. 

New Normal; toward a recovery or recession? 

The heavy economic toll that must be borne by Indonesia is predicted to sweep the country into a wave of recession, defined as “economic contraction in two consecutive quarters in the same year”. In the first quarter of 2020, Indonesia’s economy could still grow at 2.97%, despite being the lowest rate since 2001. However, Finance Minister Sri Mulyani predicted that the economy in the second quarter could sharply contract in the range of minus 3.5% to minus 5.1% while improving in the third quarter to a range of minus 1% to 1.2%. 

Additionally, the International Monetary Fund (IMF) estimates that the world economy could contract (suffer negative growth) by 4.9%, much deeper than its previous projection of minus 3%. The IMF also revised its projection for Indonesia’s economic growth from 0.5% to minus 0.3% in 2020, while according to the Japan Center for Economic Research (JCER), Indonesia is likely to face a recession with growth registering at minus 3.2% (Q2), minus 1.2% (Q3), and minus 0.1% (Q4). Based on these predictions, it projects Indonesia’s economy to shrink by minus 0.3% in 2020. Likewise, DBS, the largest bank in ASEAN, also estimates that the Indonesian economy will be in negative territory this year, sinking to minus 1%. (Figure-2) 

To avoid a deeper recession, the government’s decision to restart the economy is indeed fully understandable. However, behind the relaxation of PSBB, there is of course always a trade-off between the risk of higher Covid-19 caseloads and the efforts to resuscitate the economy. Economic recovery will be highly dependent on the slowdown of Covid-19 cases, which can be illustrated using a letter-shaped curve. 

The most progressive economic recovery model should look like the letter V, where after suffering contraction, the economy rebounds relatively quickly to pre-pandemic levels. The next model is a U-shaped curve where the economic slowdown persists for quite a long time, followed by a slow recovery. Next, the Z curve, which illustrates that an aggressive stimulus will boost economic recovery even past the pre-pandemic level. Then there is W curve which shows that when social restrictions are brought back, the economy, which has previously been trending upward, will contract again. The last curve, L-shaped, is the most extreme one as the economy struggles to recover because Covid-19 cases continue to climb, coupled with economic paralysis in different sectors and the loss of the government’s credibility in the eyes of investors and the general public. (Figur-3) 

In this context, there needs to be a consensus to define the “new normal” that will guide economic recovery amid a continuing threat of rapidly-spreading Covid-19. An alternative new normal model that can be considered for future economic recovery is the curve in the shape of M, where indicators are set up on when to reopen the economy and close some economic sectors when Covid-19 cases pass a certain threshold. Conversely, the economy can be reopened when an economic contraction has touched the minimum threshold. What we don’t want to see is that instead of leading to economic recovery, the new normal currently underway will drive the economy into a protracted recession as illustrated by the Z curve. (Figure-4) 

Taking a stimulus pill to protect from recession 

The growing wave of Covid-19-induced economic pressure seems to be sweeping us into uncharted territory. The government, initially optimistic by projecting the economy to be growing at 2.3% in 2020, has now started to be more realistic, admitting that the year’s growth will be in negative territory, judging from the realization of GDP growth in the first quarter, which was only 2.9%, below the 4.5% it predicted. The potential for protracted economic paralysis in the following quarter is the reason why the government maintains more rational macroeconomic assumptions. 

One reliable indicator that can show the risk of a recession is the performance of Indonesia’s manufacturing sector in the second quarter, which declined sharply. This illustrates that the economic contraction is inevitable. Bank Indonesia (BI) reported that the Prompt Manufacturing Index (PMI) in the second quarter was 28.55%, a significant drop from 45.64% in the previous quarter and 52.66% year on year. It was the lowest PMI ever since BI began recording and announcing the data in 2010. In the third quarter, BI projected that the PMI will improve to 45.72%. This, nevertheless, is still in the red zone. The manufacturing sector is very important in measuring the overall health of the Indonesian economy because it is the largest contributor to Gross Domestic Product (GDP). The manufacturing sector contributed 19.7% of the country’s GDP in 2019, and 19.98% in the first quarter of 2020. 

In anticipation of the recession risk, the government has carried out a fiscal intervention through budget revisions, either in terms of spending, revenue, and financing. The Central Government has implemented various policy adjustments and rationalization to tax revenue, expenditures of ministries/institutions, and regional transfer funds. To provide a legal basis for the 2020 State Budget revision, the government has issued Government Regulation in Lieu of Law (Perppu) No. 1/2020 which essentially “permits” deeper state budget deficit of more than 3% of GDP until 2022. The regulation, better known as the Perppu Corona, has been approved by the House of Representatives to be codified into Law No.2/2020 on State Financial Policy and Financial Stability in Handling Covid-19 Pandemic and/or in Facing Threats that Endanger the National Economy and/or the Stability of the Financial System. 

In general, Law No. 2/2020 consists of two main policies, namely State Financial Policy which includes taxation, and a Financial Sector Policy. The State Financial Policy stipulates adjusting APBN deficit limits; use of alternative funding sources; reallocation of central and regional budgets; and the implementation of the National Economic Recovery Program to ensure the sustainability of the real and financial sectors. On the other hand, Financial Sector Policy includes expanding the authority of the Financial Sector Stability Committee (KSSK) and the scope of the KSSK meeting; strengthening the authority of Bank Indonesia, strengthening the authority of the Financial Services Authority (OJK) and the Deposit Insurance Corporation (LPS) to prevent risks that can endanger the stability of the financial system. 

Further, the government has issued two Presidential Regulation (Perpres) as derivative regulations for the revision of 2020 State Budget posture. In the first revision, through Perpres 72/2020, issued on April 3, the deficit was widened from Rp 307.2 trillion or 1.76% of GDP to Rp 852.9 trillion or 5.1% of GDP. This was due to the decline of projected tax revenue by 24.72% from Rp 1,865.7 trillion to Rp 1,462.6 trillion. Likewise, the Non-Tax State Revenue (PNBP) target was cut by 19.86% from Rp 367 trillion to Rp 297.8 trillion. Furthermore, the increase in the state budget deficit was driven by an increase in central government spending, by 17.33% from Rp 1,683.5 trillion to Rp 1,851.1 trillion. Meanwhile, the allocation of regional transfer funds and village funds was cut by 10.85% from Rp 856.9 trillion to Rp 762.7 trillion. 

In the first revision of 2020 State Budget, there was a surge in the primary deficit by 4,215% from Rp 12 trillion to Rp 517.8 trillion. The high primary deficit illustrates a condition where the government is increasingly dependent on taking on new debt just to pay debt interest. The scale of the primary deficit is a continuation of the tradition of primary deficit since 2012, but this time it set a new record, surpassing the 2015 primary deficit in 2015 which was “merely” Rp 142.5 trillion. (Figure-5) 

As 5.1% of GDP deficit was deemed insufficient, the government increased the budget deficit to 6.3% of GDP by again revising 2020 State Budget through Perpres No.72/2020 issued on June 24, where the budget deficit was increased from Rp 307.2 trillion to Rp 1,039.2 trillion, or up 238.3%. The surge in the budget deficit was mainly due to an increase in spending outside the ministries/institutions by 47.16%, from Rp 773.9 trillion to Rp 1,138.9 trillion. On the other hand, tax revenue was again cut, by 24.72%, from Rp 1,865.7 trillion to Rp 1,404.5 trillion. The implication is that the tax ratio has shrunk from 11.6% to 9%. Furthermore, the PNBP target was reduced by 19.86% from Rp 367 trillion to Rp294.1 trillion. 

The second revision to the 2020 State Budget posture has resulted in the primary deficit skyrocketing from Rp 12 trillion to Rp 700.4 trillion, an eye watering increase of 5,736.67%. Judging from the 2020 State Budget, while it can be justified under extraordinary conditions, the government must still be extra careful in revamping it by taking into account various risks and consequences in the future. Moreover, a very dramatic increase in the fiscal deficit this year doesn’t necessarily align with expectations of economic recovery in the coming year. If economic conditions in 2021 are still under severe downward pressure, there is a risk that the fiscal deficit will continue to widen at an abnormal level of above 3%. Therefore, efforts to save the State Budget in the short term must not sacrifice long-term fiscal health, which will become a burden for future generations. 

The basic justification for increasing the budget deficit in 2020 is the government’s desire to provide support for the handling of Covid-19 and a stimulus to households and businesses affected by Covid-19. Through a stimulus in the form of various National Economic Recovery (PEN) programs, the government hopes that the economic turbulence caused by the pandemic will not push the economy off a cliff of deepening recession. The problem is that the cost of national economic recovery, which was designed as an instrument to save the national economy, has continued to balloon over time, from an initial Rp 405.1 trillion to Rp 695.2 trillion, after three revisions. (Figure-6) 

Overall, the total Covid-19 handling costs allocation of Rp 695.2 trillion in the 2020 State Budget are distributed into six clusters, consisting of health (Rp 87.55 trillion), social safety net (Rp 203.9 trillion), business incentives (Rp 120.6 trillion), MSMEs (Rp 123.46 trillion), corporate financing (Rp 53.57 trillion), and ministries/institutions and regional government spending (Rp 106.11 trillion). The cost of national economic recovery of that size is aimed at pumping massive funds into the economy to boost both consumption and production. (Figure-7) 

Nevertheless, efforts to boost the economy through expansive fiscal stimulus also carry their own significant risks, especially if the effectiveness of economic recovery cost does not produce expected results, either due to misallocation or delayed execution. The reason is that the government has great expectations that the pandemic and its economic and social impacts will begin to subside in 2021; the government thus projects that economic growth next year will be around 4.5% to 5.5%. In fact, the assumption of rapid economic recovery is full of uncertainty, because it is highly dependent on many factors, ranging from the successful handling of the Covid-19 public health aspect, vaccine discovery, global economic recovery, and so on. 

The problem is that there is a potential of increasing fiscal risk when an uncontrolled deficit this year doesn’t yield significant economic improvements in the coming year. As a result, tax revenue is still difficult to rely on, which may cause the budget deficit to swell again in 2021. Furthermore, the most severe risk that haunts fiscal sustainability going forward is a dead end toward bringing back the budget deficit to below 3% after the Perppu Corona expires in 2022. 

In an abnormal situation as experienced during the pandemic, the contraction that occurred in all sectors demands the government move quickly by providing ‘rescue breath’ or emergency lifeline so that the economic actors can survive. The economic rescue measures taken by the government can be classified into two main objectives. Firstly, stimulus for the demand side, through boosting people’s purchasing power through social aids, subsidies, pre-employment incentives, and so on with a total budget of Rp 205.2 trillion. Secondly, stimulus for the supply side, that will be disbursed to ultra-micro and MSMEs actors, corporations, SOEs, and local governments with a total budget of Rp 402.45 trillion. 

The challenge for fiscal discipline in the face of recession 

In addition to fiscal expansion in the midst of extraordinary situations, the government must also be extra careful in doing its fiscal “acrobatics”. When the wave of recession can’t be held back any longer, the fiscal stimulus arsenal must be effectively prepared, both in terms of its targeting accuracy and timeliness. We should be cautious in that the costly stimulus that has been rolled out at the expense of the state budget deficit will instead set a trap of permanent fiscal deficit above 3%, which we all fear will become a “new normal of deficit”. 

Thus, even though Indonesia faces the prospect of a recession in the days ahead, disciplined fiscal consolidation is still necessary in the form of a policy aimed at easing the burden of public debt and the government’s budget deficit. Fiscal consolidation becomes crucial, especially in the aftermath of crisis and start of recovery, where the government budget is likely to deviate from fiscal discipline normally applied in normal times. Fiscal consolidation is important so that in the long run fiscal sustainability is maintained and able to support long-term economic growth. Fiscal consolidation depends on three things, namely, increased state revenues (mainly from taxes), spending efficiency, and government financing management strategies. 

First, the relationship between GDP and tax revenue, illustrated by the elasticity of tax revenue to GDP (tax buoyancy) is not always asymmetrical and constant. This reflects a percentage of tax revenue growth per a percentage point of economic growth. The elasticity rate is assumed to be not constant between the normal, crisis and recovery periods. Fiscal planners usually use long-term elasticity figures, which are not necessarily the same as short-term ones. Sancak, Velloso, and Xing (2010) found that the difference in elasticity occurred in the short term, and suggested that fiscal planners also include business cycle factors in the model. The study by IMF in 2015 also warns of the impact of the crisis on tax compliance. 

In addition, conditions can worsen if there is a lag time between economic recovery and government budget recovery. At least there are institutional and behavioral reasons for this hypothesis. The economy is driven by companies and individuals who are flexible and respond to incentives. Meanwhile, fiscals, especially tax, are very complex and are linked to a given political environment, a budget cycle, a bureaucracy and the capacity of state officials to execute policies. 

The good news is that, according to an empirical study by Dudine and Jales (2017), emerging economies have a fast recovery rate in tax revenue post-recession compared to developed countries. However, the results of the study need to be interpreted more carefully, because the speed of recovery is thought to differ between different types of tax revenue. The relatively faster types of tax according to the study are Personal Income Tax (PIT) and Tax on Goods and Services (TGS), while Corporate Income Tax (CIT) is slightly slower. In the Indonesian context, the 2018 data from the National Public Procurement Agency (LKPP) shows that the ratio of Non-Oil and Gas Corporate Income Tax (54%) is slightly higher than the Non-Oil and Gas Individual Income Tax (45.3%). 

The time lag will ultimately pose a risk to projected tax revenue in the aftermath of 2022. Moreover, reflecting on the performance of tax revenues in a normal situation of the past five years, it only grew by 6.22% on average. And with the mere 1.74% growth of tax revenue in 2020 there should be careful expectation in the capacity of the economy to generate tax revenue after the pandemic. In addition, the government must anticipate the potential for tax losses of up to Rp 87 trillion in 2023, due to the reduction of corporate income tax rates from 25% to 20% in the Omnibus Bill on Taxation, the enactment of which is currently being accelerated by the government and the House. 

Indonesia must also be cautious of the hysteresis conditions that can have long-term impacts. Simply put, the hysteresis hypothesis occurs when the impact of a shock in the short term exerts a permanent long-term effect. This hypothesis was originally developed for labor market conditions where cyclical unemployment affects the state of workers over the long run. Aside from the workforce, the Covid-19 pandemic can also impact companies that are starting to embrace technology that reduces demand for labor, which ultimately will also impact the structure of income tax revenue. That said, the net benefits can also be positive in the long run. 

In the context of Perppu No.1/2020, it can also be considered an institutional hysteresis which according to Blanchard, Cerutti, and Summers (2015) is a policy and regulatory change adopted in response to a crisis situation. It is assumed that this situation could affect the long-term relationship between GDP and tax revenue. 

Secondly, fiscal consolidation can also fail due to out-of-control and inefficient government spending. In the last five years, central government expenditures grew by an average of 5.85%. With the issuance of Perppu No.1/2020, central government spending in 2020 surged 23.5% compared to the realization in 2019. The government also needs to pay close attention to the amount of social safety net spending, which reached Rp 110 trillion, as it represents a tradeoff on tax revenue, because it is tax-exempt. 

In addition, fiscal normalization is getting more difficult, because the capacity of government spending to stimulate economic growth through capital expenditure is increasingly eroded. The commitment of the central government to allocating capital expenditures is increasingly being questioned, because the proportion continues to shrink from 18.21% in 2015 to a mere 11.31% in the 2020 State Budget. This condition stands in contrast to debt interest spending, that received red-carpet treatment, because its share of central government spending continues to rise, from 13.18% in 2015 to 18.38% in 2019. 

Thirdly, the key to maintaining fiscal health is inseparable from the authority’s ability to implement effective debt-financing strategies. After the 1998 crisis, the government shifted the source of debt financing from bilateral and multilateral loans to government bonds (SBN). Now, of total government debt of Rp 5,192 trillion as of March 2020, the proportion of SBN has reached 82.67%. It is worth noting that the measure to close the deficit by relying on SBN also poses a big risk to fiscal sustainability, especially in terms of interest expense. Especially considering the fact that the Indonesian government is known to be ‘generous’ in giving out high interest for SBN. 

The increased need for debt financing, which reached Rp 1,439.8 trillion for the year, amid massive capital outflow, will also be a driving factor in rising cost of funds. As a proof, the yield for 10-year government bonds continues to accelerate, from 7.09% at the beginning of January 2020 to 8% by early May 2020. Furthermore, a large deficit in the current year risks significantly increasing debt interest payments in the following year, due to the fact that the SBN debt scheme doesn’t have any “grace period”, unlike bilateral or multilateral loans. 

While it is understandable that the government adopts a whatever-it-takes fiscal policy in the short term to contain the economic fallout from the pandemic, in the medium and long terms the direction of the fiscal policy must start to take fiscal sustainability into account. Fiscal health is the main arsenal for the government to fund health, a social safety net and economic stimulus policies during and post-pandemic. Perppu No.1/2020 opens the space for fiscal policy acrobat needed to deal with a pandemic in the short term. This is understandable, given the dilemmatic situation. However, in the medium and long terms, the direction of Indonesia’s fiscal policy needs to return to its institutional path, which is rule-based, governed by the State Finances Law and upholding fiscal discipline. 

Going forward, when fiscal expansion is deemed necessary to rescue the post-pandemic medium-term economy, the government should also carry out a fiscal “quarantine” aimed at testing the extent of fiscal resilience in conducting stimulus maneuvers so that it will not backfire on the long-term fiscal health. In this respect, several key principles need to be heeded. There are three recipes that the government should implement to achieve fiscal consolidation, namely, transparency, credibility and accountability. 

The government needs to formulate and communicate to the public a medium-term fiscal policy specifically designed for the pandemic situation and recovery period, which includes the direction of the deficit for at least the next three to five years. The added benefit is that transparency regarding Indonesia’s medium-term measures to relieve itself from budgetary constraints can increase market confidence, which in turn can reduce the cost of funds for APBN. Hiding crucial information risks increasing other hidden costs. In addition, Perppu No.1/2020 should include a provision spelling out how the fiscal deficit trend must be minimized until 2022. The goal is for the state budget to not fall into a deficit trap, so that deficit normalization below 3% can be achieved in 2023. 

Credibility also means that macroeconomic assumptions in the formulation of APBN must apply conservative and very rational figures, and their implications for government spending and activities. If there is a “windfall” in the form of increased revenue later on, it can be used to accelerate the adjustment process. In addition, let’s not ignore the risk of a “double whammy” in a disaster-prone Indonesia. 

Accountability, by inviting public participation through the parliament and civil society in fiscal reporting and budgeting. Even though the government and the House are the ones spearheading the budgeting function, the space for public aspirations must be opened widely, because it is undeniable that every political decision on the budget has direct consequences on the community in the grass root level. One breakthrough that can be made to optimize the House’s budgeting function is to form a new institution similar to the US’ Congressional Budget Office (CBO) which is expected to be able to provide more objective and comprehensive information and insight about the proposed state budget, submitted by the Executive Branch. (Abra el Talattov)

Abra el Talattov, is Researcher at INDEF (Institute for Development of Economics and Finance. He writes for the Independent Observer.