BMI View: Despite the fact that Bank Indonesia (BI) has gone to lengths to maintain its record low benchmark interest rate in the face of overheating fears, we believe that the window for the central bank's easy monetary policy is fast closing in the face of the government's impending fuel price hikes. As a result, we now believe that BI will hike its benchmark interest rate by at least 25 basis points (bps) by the end of 2013 (versus our previous forecast for the rate to remain unchanged) ahead of another 50 bps in hikes in 2014.
As we have written previously ( see 'BI Stands Firm As Fuel Price Hike Looms,' May 15), Bank Indonesia (BI) has thus far been reluctant to tighten monetary policy despite a spike in inflationary expectations. In fact, the central bank has even refrained from raising its deposit facility (FASBI) rate, a move that would constitute somewhat of a half-measure as compared to a benchmark interest rate hike. Much of BI's reluctance can likely be chalked up to the economy's moderating growth performance; real GDP growth has slowly yet consistently trended downwards over the past nine quarters, arriving at just 6.0% year-on-year (y-o-y) in Q113 versus a rate of 7.0% in Q410. With gross fixed capital formation growth slowing considerably to 5.9% y-o-y in Q113 from 7.3% in Q412, BI will also be hesitant to raise borrowing costs, thereby effecting additional drag on investment. Furthermore, regional central banks continue to ease policy, with South Korea, Thailand, Vietnam, Sri Lanka, and India all cutting their benchmark interest rates in May.
Fundamental Pressures In Check…
BI looked to tackle slowing growth with aggressive rate cuts beginning in Q311, eventually bringing its benchmark rate to an all-time low of 5.75% amid an environment of moderate inflation. Since then, headline inflation has generally remained well within the central bank's target range of 3.5%-5.5%, with core inflationary pressures remaining mild. Despite fears of overheating, lending growth has also stayed within reasonable bounds, peaking at a cycle-high of 26.1% and coming in at 22.3% in March, and broad money supply growth (M2) topped out at a manageable 20.9% y-o-y in June 2012 (14.0% in March).
|Fundamentals Relatively Dovish|
|Indonesia - Total Outstanding Loans & M2, % chg y-o-y (LHS) & Headline & Core CPI, % chg y-o-y|
The lack of fundamental inflationary pressures has allowed BI to sit tight with its interest rate policy in the face of a host of concerning economic developments. Since the beginning of 2012, Indonesia's external balance has weakened significantly, largely as a result of the deterioration in the country's terms of trade due to a significant decline across its main commodity export groups. At the same time, domestic demand has remained buoyant, leading the country to post its first current account deficit since the Asian Financial Crisis in 2012.
…But Extenuating Circumstances Loom Large
Although much of the deficit has been a result of a confluence of factors that have not been within the purview of policy-makers, the government's cumbersome and inefficient fuel subsidy policy has stoked the flames of the imbalance, artificially pumping up domestic demand for crude oil (of which Indonesia is a net importer). At long last, however, the government has found the will to act on the issue, with the price of subsidised fuel set to rise by 44.4% (from IDR4,500/litre to IDR6,500) potentially before the end of June. By the central bank's calculations, the fuel price hike could take headline inflation as high as 7.7%, which would be well outside of its target range and would likely necessitate action. In view of the government's new fuel policy, we have upgraded our own end-year inflation forecast from 5.0% y-o-y to 6.5%.
Forced To Act
With the fuel price hikes now all but certain, we believe that BI will be forced to act by hiking its benchmark rate by at least 25 basis points (bps) by the end of the year. Language from the central bank has been increasingly hawkish over the last few months, and Deputy Governor Halim Alamsyah on June 3 stated that an adjustment in the benchmark rate would be more effective than a hike to the FASBI rate in managing inflationary forces.
|Indonesia - Exchange Rate, IDR/US$|
Indeed, a benchmark interest rate hike could also help to stabilise the ailing rupiah, which has entered yet another period of increased volatility and has sold off by 1.8% since the beginning of May. In April, Indonesia posted a US$1.6bn trade deficit, placing additional downside pressure on the currency, and the central bank is likely to be extremely wary of allowing the unit to breach the IDR10,000/US$ mark, at which point confidence in the rupiah has quickly unwound in the past. While BI is unlikely to move pre-emptively by hiking its benchmark rate at its June 13th policy meeting, we believe that a hike could arrive as early as Q313. As such, we also note that risks to our 2013 real GDP growth forecast of 6.1% are to the downside, with rising borrowing costs likely to hit investment activity.