22 May 2024
Rewind back a year. India and Indonesia were both the darlings of the markets. Both were exhibiting renewed growth momentum, led by the emergence of new growth sectors. Both were also seeing falls in their headline inflation rates despite unfavourable weather conditions stoking food prices. And both were witnessing falls in their core inflation rates, led by similar drivers – declines in commodity prices, the import of Chinese disinflation, weak services demand, and hawkish central banks.
But that is where the similarities ended. Across other macro variables, a divergence has emerged. On the fiscal front, India continues on its gradual fiscal consolidation path while Indonesia awaits clarity on the new president’s fiscal plans. On the external front, India’s current account deficit has narrowed over the past year as its FX reserves have risen. For Indonesia, its current account deficit has swung from a surplus to a small deficit, and FX reserves have fallen. In terms of economic growth, the negative output gap has halved in India but remained unchanged in Indonesia over the past year.
What really went on? We believe the divergence has been led by the countries’ vastly different export mixes. Let us explain. About 50% of India’s non-oil export basket is composed of services, which have risen over the past few years. Unlike goods, services have not faced the wave of protectionism or commodity price volatility. And this matters. India’s current account deficit has narrowed from the prepandemic period, led by higher services exports. As a result, India’s reserve adequacy has improved, putting it more in control of the rupee’s stability. Furthermore, the rise in services exports has added an average 1ppt to GDP growth annually for the past three years, which in turn has contributed to higher tax revenues and allowed the Reserve Bank of India to focus on its inflation targeting mandate.
Meanwhile, in Indonesia, the current account balance has improved by 2.6% of GDP from the pre-pandemic period, but as commodity prices fell in 2023, the balance worsened. Notwithstanding the bout of dollar weakness over the last few days, Bank Indonesia has raised rates to stabilise the currency on two occasions in recent months. This has pushed up real rates and is arguably impacting the growth recovery.
What does this imply? We think this divergence underscores the importance of robust external accounts through constantly innovating to move up the production value chain (at a time of commodity price volatility), and having a diversified export mix (to better withstand protectionism). Though India has fallen into a sweet spot of higher services exports, that might fall in periods of global weakness and disruption. As for Indonesia, while it has evolved from exporting ores to exporting metals, it may be time to move even higher on the value chain.
India and Indonesia were the darlings of the markets a year ago. Both economies were exhibiting renewed growth momentum, led by new growth sectors and a slew of government reforms.
Over the past year, both India and Indonesia saw falls in their headline inflation rates despite unfavourable weather conditions (see charts 3 and 4)[@india-and-indonesia-01] . Indeed, despite 2023 being an El Niño year, leading to a rise in food inflation, both the economies witnessed a rapid fall in core prices. We believe four common factors helped to pull down the core inflation rates for both countries:
Falling inflation rates are where the similarities ended. Across the other macro-economic variables, a divergence of sort took hold between India and Indonesia over the past year:
Fiscal accounts – India has long been associated with an elevated fiscal deficit. However, after the spike during the pandemic years, the deficit levels are gradually falling in line with the government’s glide path (see chart 11).
Meanwhile, the fiscal deficit in Indonesia has been much lower and even surprised to the downside in 2023. But in 2024 and beyond, fiscal finances will depend on the new government’s plans. Until those are known (the new government will take office in October 2024), the fiscal backdrop may remain clouded by uncertainty.
External accounts – The current account deficit in India fell to 1.2% of GDP in December 2023 from 2% in December 2022. This was led by falling global oil prices as well as the continued rise in services exports. And since then, FX reserves have only risen (from USD623bn in December 2023 to USD642bn in early-May 2024).
In Indonesia, the current account balance improved sharply during the pandemic. But over the past year, it moved from a surplus of 1.1% of GDP in December 2022 to a deficit of 0.4% of GDP in December 2023, led by weaker goods exports. FX reserves have fallen so far in 2024 (from USD146bn in December 2023 to USD136bn in April 2024).
Economic growth – One way to think about growth is the catch-up since the pandemic, i.e., the closing of the output gap. On that front, the gap has been narrowing for India, with GDP at 13% below the pre-pandemic trend in June-2021, to 6% below the pre-pandemic trend in December 2022, and further down to 4% in December 2023.
Meanwhile, for Indonesia, the GDP gap narrowed from 8.8% below the pre-pandemic trend in September 2021 to 7.4% in March 2023 but has been stuck at those levels for the last year. It is fair to say that the economic recovery has been slow in Indonesia (see chart 13 and chart 14).
In short, over the last year, India saw improvements in its external finances and economic growth momentum while sticking to the fiscal consolidation path. And Indonesia saw some worsening in its external accounts while growth remained lacklustre and its fiscal situation in wait-and-watch mode.
What was it that contributed to this divergence between India and Indonesia over the past year? We believe it was largely led by one big difference between the two economies – their export mixes.
Let us explain. About 50% of India’s non-oil export basket is comprised of services, and they have been rising over the past few years (see chart 15). As we have written in the past, India’s services exports have moved up the value chain, and the country is now selling not just software services but also a host of professional services like legal, accounting and research and development (see chart 16). Services exports, unlike goods have not faced the wave of protectionism or commodity price volatility. In fact, even as the world is deglobalising in goods trade, it continues to globalize in services trade.
And this matters. Compared with the pre-pandemic levels, India’s current deficit has narrowed by 1.3% of GDP (FY19-FY24f, see chart 17). And during this period, net services exports have risen by 1.6% of GDP (and net goods exports have declined by 0.2% of GDP).
Had it not been for the rise in services exports, FX reserve accumulation, and the ability to keep the rupee stable would have been lower[@india-and-indonesia-02]. This trend of higher services exports improving India’s FX reserves adequacy has also been clear in the more recent data, i.e., over the last year.
Furthermore, we estimate that the rise in services exports has added an average of 1ppt to GDP growth annually over the past three years, playing an important role in narrowing the output gap referred to earlier. This has even contributed to higher tax revenues and the gradually improving fiscal situation. Finally, with growth being robust, the RBI has focused more squarely on its inflation targeting mandate.
Meanwhile in Indonesia, the current account balance has improved by 2.6% of GDP from the pre-pandemic period (2019-23). Higher oil and coal prices as well as higher metals exports have all played a role (see chart 18).
But as commodity prices fell in 2023, so did Indonesia’s goods exports, leading to a widening of the current account deficit over the last year (see chart 19). As mentioned earlier, FX reserves fell as well. Indeed, Indonesia’s exports have remained sensitive to commodity price movements.
Furthermore, in two separate occasions when the USD strengthened, BI raised rates to stabilise the currency (October 2023 and April 2024). With its real rates among the highest in the region, it is no surprise that Indonesia’s growth dynamics did not improve further over the last year.
We believe our comparative assessment of India’s and Indonesia’s performances over the past year underscores the importance of robust external accounts at a time the global backdrop has become rather volatile.
Our assessment highlights both the importance of moving up the value chain of production (given commodity prices can be rather volatile) and having a diversified export mix (to better withstand protectionism).
It also highlights the importance of continually innovating. While India has fallen into a sweet spot of higher services exports, that too might fall into periods of weakness (for instance, net services exports fell to a nine-month low in April), or disruption (for instance, if artificial intelligence hurts India’s service export prospects).
And for Indonesia, while it has moved from exporting ores to exporting metals, it may be important to move higher up the value chain and have a more varied export basket to secure external stability.
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