2014 Outlook Slashed As Headwinds Mount

BMI View: Indonesian assets have been hit hard by the confluence of a global flight to the US dollar as well as a record current account deficit and high domestic inflation. Although both the government and central bank have made efforts to stem high levels of volatility, we note that the measures introduced thus far are unlikely to be sufficient, and that tighter monetary policy may still be needed to avert a crisis of confidence. As a result of the hit that rising borrowing costs and inflation will take on investment and private consumption, we have downgraded our 2014 real GDP growth forecast materially to 5.4% from 6.0% previously.

Indonesian asset markets have been roiled recently following the release of worse-than-expected Q213 current account data, which reflected a record US$9.8bn deficit against a previous central bank estimate of US$9bn. The deficit, which was equivalent to 4.4% of GDP (harkening back to blow-out deficits in the mid-1990s), proved to be the catalyst for a substantial sell-off in Indonesian assets. Equities and the rupiah were particularly hard-hit, shedding 9.9% and 5.0%, respectively, over the past week.

BI, Government Measures Still Insufficient

Under Pressure
Indonesia - Exchange Rate, IDR/US$

2014 Outlook Slashed As Headwinds Mount

BMI View: Indonesian assets have been hit hard by the confluence of a global flight to the US dollar as well as a record current account deficit and high domestic inflation. Although both the government and central bank have made efforts to stem high levels of volatility, we note that the measures introduced thus far are unlikely to be sufficient, and that tighter monetary policy may still be needed to avert a crisis of confidence. As a result of the hit that rising borrowing costs and inflation will take on investment and private consumption, we have downgraded our 2014 real GDP growth forecast materially to 5.4% from 6.0% previously.

Indonesian asset markets have been roiled recently following the release of worse-than-expected Q213 current account data, which reflected a record US$9.8bn deficit against a previous central bank estimate of US$9bn. The deficit, which was equivalent to 4.4% of GDP (harkening back to blow-out deficits in the mid-1990s), proved to be the catalyst for a substantial sell-off in Indonesian assets. Equities and the rupiah were particularly hard-hit, shedding 9.9% and 5.0%, respectively, over the past week.

BI, Government Measures Still Insufficient

In an attempt to calm markets, Bank Indonesia (BI) has been actively intervening by purchasing both government bonds and the rupiah. However, as we wrote recently ( see 'BI Remains Under Pressure As Reserves Plummet', August 15 th 2013), BI's intervention has failed to stem the tide of selling that has been working against Indonesian assets throughout 2013, and with the central bank's reserves having already fallen by 17.8% since the beginning of the year (total foreign currency reserves now stand at a relatively inadequate 10.5% of GDP), we note that BI will be hard pressed to continue its pace of support for the rupiah should the currency continue to sell off.

Under Pressure
Indonesia - Exchange Rate, IDR/US$

Indeed, the rapid erosion of confidence in Indonesian assets is a signal that proactive measures taken by both the government and BI over the past few months meant to curb the economy's external imbalances remain insufficient. Complicating matters for policy-makers is slowing economic growth, largely as a result of a lull in investment activity, as well as soaring inflation, which hit 8.6% year-on-year (y-o-y) in July.

BI To Remain Vigilant

Although we continue to expect the country's high inflation levels to retreat in 2014 (largely due to its policy-driven nature following fuel price hikes in June), both the government and the central bank will be forced to continue to address price growth before they can shift their attention to supporting economic activity. Despite the fact that BI has already hiked its benchmark interest rate by 125 basis points (bps) since June (including 50 basis points of hikes at an emergency meeting held on August 29), real rates are still solidly negative, and with imported cost pressures set to build following the rupiah's sell-off, further hikes are not out of the question. While we are currently projecting for BI to hold its benchmark rate at 7.00% until the end of the year, we note that price action on the rupiah continues to signal significant selling pressure. Should this continue, the central bank may find it necessary to pursue further rate hikes. On the part of the government, the Yudhoyono administration has announced a stimulus package that seeks to avoid inflationary direct transfers in favour of pro-investment policies.

Into Negative Territory
Indonesia -BI Benchmark Interest Rate, % & Headline CPI*, % chg y-o-y & Government 10-Year Bond, % yield

The package, introduced on August 23, has three main thrusts. The first, aimed at shoring up the rupiah and cutting the current account deficit, includes such measures as tax cuts for labour intensive, export-oriented industries, as well as a relaxation of quotas for mineral exports. The second, which is meant to address export weakness, will provide further tax incentives for labour intensive industries, while also applying new taxes on imports of such goods as luxury vehicles. The third raft of policies, which should be the most effective, will apply a raft of tax holidays and other incentives towards the investment in and export of key commodities such as palm oil, nickel, copper, and bauxite.

Stimulus Unlikely To Prevent Growth Slowdown

While the introduction of such a package indicates proactive policy-making on the part of the government, we nevertheless note that the intended measures will do little to shore up economic activity in the near term, and markets appear to agree with us given the Jakarta Composite Index (JCI)'s reaction to the news. Additionally, the introduction of tax holidays and other incentives in the commodities space may not be enough to entice investors, who will still face longer-term (and anti-business environment) initiatives in Indonesia aimed at curbing the export of unprocessed commodities. That said, the assistance for labour intensive industries will be well-received, as this year's minimum wage hikes (in some areas as high as 50%) have already forced a spate of affected firms to implement large-scale lay-offs.

Not Impressed
Indonesia - Jakarta Composite Index

Facing the dual headwinds of acute financial market volatility as well as higher domestic borrowing costs amid a heavily inflationary environment, we believe that both investment activity and private consumption are set to take a hit as we move into 2014. As such, we have materially downgraded our 2014 real GDP growth forecast from 6.0% to 5.4%, and we note that we will be looking to downgrade our rupiah forecast for both 2013 and 2014 over the coming days. Likewise, as the growth slowdown becomes more acute in H114, we believe that BI will be likely to shift towards a more growth supportive bias, with potential interest rate cuts coming into play.

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