Just in time! Slow-growing taxes and exports, compared to GDP, have been chinks in an otherwise improving Indonesian sovereign credit story. Both plunged early in the pandemic, and many feared a slow recovery. Instead, they have rebounded in the past two years to reach record levels.

The turnarounds in the fiscal and external revenue trend could lend more stability to the sovereign ratings if they continue. These swift recoveries already helped return the outlook on the long-term sovereign ratings on Indonesia to stable, from negative, in 2022. We believe these trends could continue.

Low Fiscal And Export Revenue Ratios Are Sovereign Credit Weaknesses

Indonesia's weak fiscal and external revenue profiles are sovereign credit constraints. Its fiscal revenue and export earnings ratios are among the lowest of rated sovereigns. Both general government revenue and current account receipts, expressed as shares of GDP, rank in the bottom decile of sovereigns that reported these statistics in 2019. Moreover, both ratios declined during the years to 2020 (see chart 1). These trends weakened the fiscal and external resilience of the Indonesian economy.

Chart 1

The falling ratios reflected slow-growing shipments of key Indonesian export commodities, including coal and palm oil. Indonesia's manufacturing industry pales against those in neighbors Thailand and Vietnam. Between 2019-2023, both neighboring economies had gained significant market shares in U.S. imports as U.S.-China tensions curbed the growth of Chinese products entering the U.S. (see chart 2). Indonesia's share of total U.S. imports, however, saw little change because the country lacked the capacity to increase production.

Chart 2

The global commodity cycle greatly affects Indonesian sovereign credit metrics, as a result. Commodity exporters are big corporate taxpayers in the country. When exports slide, so too typically does tax income growth.

Consequently, weaker commodity exports hurt both fiscal and export revenues. We revised the outlook on the sovereign ratings on Indonesia to negative, from stable, in 2020 partly because we expected Indonesian exports and fiscal revenue to weaken in the pandemic. We also anticipated the recoveries for these ratios would be weak, owing to the impact of the pandemic on the global economy.

Indonesia has been trying to upgrade its export structure for more than a decade. The government has been urging mining companies to build mineral-processing facilities in the country. It offers incentives to export processed metals, rather than metal ores, to benefit export value and economic development.

The government also banned ore exports to increase the pressure on miners to invest in such facilities. Until recently, however, few such facilities were completed. Instead, the bans on ore exports weighed on the country's current account receipts.

Ferronickel Exports Have Helped To Lift Ratios

Things have changed since 2021, when the operation of new smelters helped fuel a sharp rebound in Indonesian exports (see chart 3). The surge in exported nickel pig-iron has bolstered the country's goods exports. The new smelters produce nickel pig-iron, which is also known as ferronickel alloy, an input for stainless steel production.

Chart 3

Last year, as war broke out in Ukraine, strong coal and palm oil shipments also reinforced exports. Metal exporters contributed little to direct income tax revenue because they enjoy tax holidays. However, their fast-growing activities generated much revenue for the government indirectly. This includes income taxes paid by the miners that supply them.

Indonesia Focuses On EV Batteries To Further Improvements

Indonesia wants to grow its exports further, but it is shifting focus. It aims to grow electric vehicle (EV) battery manufacturing into a major export industry. Thanks to the country's large reserves of nickel, a key material needed to make EV batteries, Indonesia is well placed to attract investments from battery makers.

The government is also trying to increase Indonesia's attraction as an investment destination by encouraging the adoption of EVs in the country. In April 2023, the government lowered the value-added tax on electric vehicles to 1% from 11%. A little earlier, in March, the government also passed an updated version of the Job Creation Law, which liberalizes the labor market and streamlines investment licensing and land acquisition. Alongside a reduction in the corporate tax rate for some firms, Indonesia's policy landscape is now more favorable for foreign investors.

The government is also guiding investments toward pure nickel production. One measure is to cease tax incentives for new nickel pig-iron facilities. These facilities compete with pure nickel smelters for nickel ore. While Indonesia's nickel reserves are large, they are finite. And the government prefers more to go to making higher-value EV batteries rather than nickel pig-iron.

Indonesia's efforts seem to be paying off. Several nickel smelters are being completed or are under construction in the country (see chart 4). Once smelters begin operation, nickel exports should pick up further. A few companies have also agreed to manufacture EV batteries in the country, including LG Energy Solution Ltd. (from Korea) and Contemporary Amperex Technology Co. Ltd. (CATL; from China). Hyundai Motor Co. and China-based Wuling Motors have reportedly agreed to assemble EVs in Indonesia.

Chart 4

This year, however, Indonesian exports are fragile. A slowdown in major advanced economies has dampened demand. And the supply disruptions that bolstered coal and palm oil prices last year have eased. Nickel prices have also fallen from levels early in the year, as supply outpaced global demand.

Longer term, Indonesia's EV battery ambitions may face another roadblock in the form of the U.S. Inflation Reduction Act (IRA). EV battery producers in Indonesia may not enjoy tax credits offered under the U.S. IRA offers to some others. In part, it's because Indonesia has not signed a free trade agreement with the U.S.

Another complication is that Chinese companies are investors in many nickel producers in Indonesia. The U.S. government may consider such producers as "foreign entities of concern"--a status that may also prevent them from enjoying tax credits.

The investments already put into Indonesia mean it will emerge as a node in the global EV supply chain, even if it doesn't get around the IRA obstacles. Over the next five years, the country should prevent a repeat of the sustained drop in exports relative to GDP. This should also benefit the tax ratio. Any such gains will become more apparent once the tax breaks for smelter and factory investors end.

These expected trends should help to augment credit support for the government. The wheels are turning.

Editor: Lex Hall

Related Research

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• Asia-Pacific Sovereign Rating Trends Midyear 2023: Sturdier Times, July 6, 2023
• Global Sovereign Rating Trends Midyear 2023: Fragile Stability, July 6, 2023
• Indonesia Ratings Affirmed At 'BBB/A-2'; Outlook Stable, July 4, 2023
• Economic Outlook Asia-Pacific Q3 2023: Domestic Demand, Inflation Relief Support Asia's Outlook, June 26, 2023
• 2022 Annual Global Sovereign Default And Rating Transition Study, April 28, 2023