Policies for a sustainable current account

1. Policies for a sustainable current account Petar Vujanovic Head of Indonesia DeskEconomic Department

2. Outline Session 1 established that there has been a rapid deterioration in the current account which continues to be perceived as a macroeconomic vulnerability. Outline of this presentation : • What does economic theory say? • What measures have been implemented and canvased by Indonesian government? • What is the OECD’s response to these policies? • What should Indonesia be doing?

3. Economic Theory Economic theory suggest a number of policy options for making adjustments to the external balance: • Expenditure-switching : Change the relative prices of exports and imported goods and services, causing consumers to change the pattern of their spending away from imports to domestically produced goods. And exports more competitive. • Expenditure-reducing : Reduce aggregate demand and therefore lower the demand for imports. • Supply-side adjustment : Improve the supply-side of the economy through structural and industrial policies

4. Expenditure Switching Change the relative prices of exports and imported goods and services, causing consumers to change the pattern of their spending away from imports to domestically produced goods. Make exports cheaper in an overseas market and make imports more expensive in the home (domestic) market. • Depreciation of the exchange rate. • Export subsidies. • Import tariffs. • Policies to lower the rate of inflation in the home economy.

5. Expenditure Switching:Depreciation and the J-Curve “Expect thing to get worse before they get better - but keep the faith!” A depreciation of the exchange rate can have the effect of increasing the current account deficit in the short-run : • For a devaluation to be successful in terms of reducing a current account deficit, the sum of the elasticity of demand for exports and the elasticity of demand for imports must be greater than one. • In the short run – the elasticity of demand for imports might be very low, as local substitutes are not available. And therefore the sum of the elasticities might be less than one and the current account might initially deteriorate after a depreciation. • Hard to know the direction of causality – is the large deficit causing the depreciation? • There is now some signs of a turn around in Indonesia’s current account.

6. Expenditure Reducing Reduce aggregate demand and therefore lower the demand for imports. • Higher taxation. • Reduce government spending. • Higher interest rates or a fall in the availability of credit. • Macro-prudential?

7. Structural determinates of CA The literature finds a number of fundamental determinates of the current account : • Fiscal stance (Richardian equivalence isn’t complete). • Demographics. • Relative per capita income (capital flows from rich to poor). • Oil prices. • Financial openness (conditional on income). • Initial net foreign asset position (eg. Switzerland).

8. Structural reforms Structural reforms aimed at improving the international competitiveness of the economy. • Kennedy and Sløk(2o05) find no robust link between structural policy and imbalances for 14 OECD countries. • Kerdian, Koske and Wanner(2010) use a panel 117 countries. Find indirect links to savings, investment and thus current account. Also find social spending lowers CA; stricter employment protection lowers CA. • Vogel (2011) suggests that structural policies aimed at supply-side may help to improve competitiveness but will be offset by income effect on imports. • Ivanova (2012) finds strict credit regulations, high business taxes, lower minimum wage and lower EPL, all increase the CA.

9. Where does this leave Indonesia? • Labour market. • Employment protection • Minimum wage • Credit markets & financial openness. • Relative per capita income (capital flows from rich to poor). • Oil prices.

10. Employment protection Going for Growth 2008 : A rigid labourcode provides strong protection to employees in the formal sector. This undermines productivity and competitiveness. Employment protection legislation, 2012 Index scale of 0-6 from least to most restrictive

11. Unit labour costs Unit labour costs in selected Asian economies Index = 100 in 1997, national currencies Source : OECD calculations using national sources

12. Minimum wage Minimum wage is determined at the provincial level.

13. Minimum wage in USD Average minimum wage Rupiah and US$ USD; end 2013 exchange rate Source : CEIC and OECD calculations.

14. Competitiveness Competitiveness in manufacturing sector 2000 to 2010 Source : National statistics and SER calculations.

15. Financial Openness Reinhardt, Ricci and Tressel (2010) find that, when accounting for the degree of capital account openness, the prediction of the neoclassical theory is confirmed: less developed countries tend to experience net capital inflows and more developed countries tend to experience net capital outflows, conditional of various countries’ characteristics. The findings are driven by foreign direct investment, portfolio equity investment, and to some extent by loans to the private sector.

16. Oil price Oil price, oil (net) exports and the current account balance USdollars (millions for export and current account) Source : OECD Economic Indicators database.

17. Proposed measures in Indonesia Most measures are aimed at promoting domestic valued-added: • Ban ore exports (with exemptions but with profit tax penalties over time). • Promote firms for import replacement – in particular imported intermediate goods for industry. • Relax the tax facility on imported goods for export purposes to stimulate growth in the export-oriented domestic industry • Increase taxes durable consumer goods (502 types of goods) from 2.5% to 7.5% (applies to only 3% of all imports). • Reduce fuel subsidy (first stage implemented). • Plan for fiscal incentives against profit repatriation. • Revising the negative foreign investment list.

18. What should be done? Depends on the diagnosis : • If the deficit is purely cyclical (terms of trade shock) then have faith hold tight – the flexible currency with help. • If it is a permanent change in the terms of trade – then it is structural. A permanent depreciation will help. But lower national income. • If it is related to trend decline in relative competitiveness - then it is structural. A permanent depreciation will help. But lower national income. My assessment : both cyclical and structural. • Fundamental structural reforms are required – and these in large part are no different to those that have been proposed by the OECD over recent years.

19. Structural reforms (1.) • Product market reform – pro-competition: • Lower public ownership in some sectors – including monopolies. • Improve business climate: • Reduce FDI rules. • Infrastructure bottlenecks. • Corruption. • Business regulations by local governments can be onerous. • Address capacity constraints for service delivery in local government. • More flexible labour markets : • Bureaucratic hire and fire rules and severance payments. • Restriction on short-term contracts. • Minimum wage & social protection.

20. Structural reforms (2.) • Education : • Improve quality of compulsory education. • Increase enrolment at secondary education, including through greater financial support for disadvantaged students. • Improve the quality of teaching including regular assessment. • Fiscal : More efficient tax system and free resources to finance infrastructure, education, and social programmes. • Fuel subsidies • Taxation of self-employed. • Improve enforcement of personal income tax. • Move to a resource rent tax. • Remove VAT exemptions.

21. Thank you