Asia is one of the largest contributors to global economic growth but there is a Catch-22 situation. The higher the economic growth from increases in investment, the higher will be the current account deficit. And M Chatib Basri writes if the current account deficit is financed by portfolio investment, it can increase a country’s vulnerability because these funds can be withdrawn at short notice.
Asia has the potential to continue to be one of the main contributors to global growth. But this does not mean that the road ahead will be easy. Financial risks stemming from volatile capital flows are presenting challenges right now. And ageing populations across the continent look set to cause headaches that could last for generations.
In the short term, Asian countries including Indonesia, India and the Philippines, are at risk of financial instability arising from the volatility of capital flows. Since portfolio investments play a substantial role in financing these countries’ current account deficits, they are vulnerable to capital flight when investment in other economies becomes more attractive. And the US Federal Reserve’s normalisation of monetary policy – which involves raising the target range for federal funds and reducing its holdings of securities –is providing exactly that shock.
Although a variety of reforms, such as getting rid of the fuel subsidy, have been put in place, Indonesia remains particularly vulnerable to this type of external shock. In Indonesia, panic is usually triggered by the bond market, due to the relatively large role of foreign holders in funding the government’s deficit. Historically when a shock occurred in the United States – as happened during the Taper Tantrum or in the current normalisation of monetary policy – bond market investors withdrew their portfolio investment, triggering turmoil in financial markets.
A large current account deficit is not necessarily a bad thing, as long as it is financed by long-term and productive foreign direct investment (FDI), such as that in export-oriented sectors of the economy. But if it is financed by portfolio investment, it can increase a country’s vulnerability because these funds can be withdrawn at short notice. This is part of what makes the ‘Fragile Five’ countries — India, Indonesia, South Africa, Turkey and Brazil — so volatile.
Economic vulnerabilities make portfolio investors nervous, and that induces them to withdraw their portfolio from emerging economies. In the future, if Indonesia does not resolve this problem, it will continue to be dogged by the volatility of capital flows. For now, Indonesia should consider introducing a tax on speculative international financial transactions or other macro-prudential policies to minimise the impact of volatile short-term capital flows. But the depth of this problem necessitates structural shifts.
In Indonesia, there is a strong correlation between investment and imports of capital goods and raw materials. The higher the economic growth from increases in investment, the higher the current account deficit. Thus, Indonesian economic growth in the short-term is always constrained by the current account deficit. When external shocks occur, like that which is happening now, capital outflow from portfolio investment spikes and the rupiah weakens significantly. But if the current account deficit were financed by FDI the risk of capital volatility would be smaller, since capital wouldn’t be able to leave as quickly.
Thus, to stimulate economic growth while also maintaining economic stability, Indonesia must improve efficiency and productivity – therefore the same investment will generate higher returns and be less susceptible to shocks from changes in other countries’ policies. Indonesia should focus on economic deregulation to increase efficiency, and improve human capital, infrastructure development and governance to improve productivity. Another option is to steer FDI towards the export-oriented manufacturing sector.
Fixing short-term capital volatility will only go so far if long-term structural issues – such as demographic shifts – are not managed. In the long run, the fiscal burden of an ageing population must also be considered a financial risk.
Many Asian countries have ageing populations. This often affects fiscal health. An increase in the dependency ratio, resulting from an increase in the proportion of older citizens, negatively impacts government savings because expenditure on pensions and health services rise while revenues fall. For example, as the population is aging, the fiscal allocation on social spending in Singapore and Hong Kong is rising dramatically. Japan and South Korea are facing clear financial pressures due to their ageing populations.
It is true that both India and Indonesia will benefit from a demographic bonus in 2025 and are expected to be ranked among the top 10 countries in terms of economic size. But in the case of Indonesia, this demographic bonus will run out in 2050, and by 2060, while its situation will not be as severe as that in Japan or South Korea, Indonesia will also have an ageing population.
The challenge is for Indonesia to stimulate higher economic growth more quickly. Why? Because although Indonesia will be one of the 10 biggest global economies in terms of economic size, by 2050 its per capita income will still be relatively low if economic growth remains flat at 5 per cent. If Indonesia is unable to grow faster, it risks growing old before it grows rich. This could be very difficult to manage because Indonesia’s fiscal burden will be very heavy. The same issue will likely be faced by many other Asian nations, especially China.
Even though Asia is one of the largest contributors to global economic growth, these financial risks could damage potential growth in coming years. To address these issues, countries like Indonesia must focus on increasing economic productivity and efficiency, upgrading human capital, building infrastructure, improving governance and mobilising tax revenue for public spending. If these steps are not taken, Asia’s and Indonesia’s contribution to global economic growth cannot be guaranteed.
M Chatib Basri is a senior lecturer at the Department of Economics, University of Indonesia and formerly Indonesia’s minister of finance. This comment first appeared in East Asia Forum and can be assessed in full at https://bit.ly/2OHwa5E