Indonesia: Bent on growing at all cost?
Indonesia will continue to enjoy relatively high growth in 2011 and 2012 despite the global economic uncertainties and feeble financial markets. Being a domestically-driven economy should shield Indonesia from any external headwinds and as such, a medium-term real GDP growth of above 6% is not entirely unthinkable.
In 2011, real GDP is expected to come in at 6.5% while inflation is likely to average 5.5% on the back of lower food and commodity prices. On the monetary policy front, there were a few surprises throughout the year. Bank Indonesia (BI) surprised the market in early 2011 with a 25bpts rate hike, taking the benchmark rate to 6.75%, and then gave an even bigger surprise when it completely reversed its policy of the preceding two quarters by cutting the rate by 75bpts to 6.00% in 4Q.
In addition, the central bank also moved to ensure sufficient liquidity in the banking system by cutting the FASBI rate – the rate which banks receive for depositing funds with the central bank – by 50bpts to 5.25% in April 2011.
We expect the economy to expand by 6.1% in 2012, not significantly different from BI’s downward revised estimate of 6.3%. Still, the healthy private consumption (of 5.2%) and investment expenditure (of 8.2%) should underpin the 6.1% real GDP growth. Despite the stronger contributions from private consumption and investment expenditure, real GDP growth should come in lower than in 2011, owing to slower net exports growth (exports minus imports).
Net exports’ contribution to 2012 real GDP growth is expected to be half that of 2011 at just 0.9 percentage point. However, we do not share BI”s optimism that inflation is on the downtrend going into 2012. BI is targeting an inflation rate of 3.5–5.5% for 2012, underpinned by weak global commodity prices and slower global growth. Instead, we think that headline inflation could well remain elevated in 2012, given that the economy will grow robustly in 2011 and 2012. Therefore, we expect inflation average around 6.0% in 2012.
The wild card for Indonesia is inflation, which could prove to be the BI’s undoing, especially if it does not come in as expected. Unlike BI, we believe that there are both demand pull and cost push factors that could keep inflation relatively elevated in 2012. On the demand side, the healthy private consumption spending to date, spurred by a loose monetary policy, is likely to put upward pressure on prices.
In addition, the weakness in the rupiah could raise prices of imported goods, hence supporting inflation in 2012. Moreover, tweaks to official electricity billing rates and possible adjustments to fuel subsidies in 2012 could stoke inflation. The floods in neighbouring countries like Thailand and Malaysia could push up the prices of commodities, especially for food stuff such as rice.
On the supply side, inadequate infrastructure (electricity generators, roads, port, etc.) has kept prices of domestically-produced commodities and food stuff high in the form of high transportation and production cost. Moreover, the inflexible labour laws did not help at all.
After the 75bpts cut in the BI reference rate, some market participants had expected the central bank to embark on even more cuts amid easing inflation as well as growing global and financial uncertainties. However, we have doubts about the rate cuts and do not agree that easing policy now or in the near future is appropriate, especially given that the economy is on a strong growth trajectory, and that inflation could remain elevated.
The concern is that loosening rates too quickly and aggressively, the government has actually raised the risk of inflation rising. This, if accompanied by further rupiah weakness, could lead to intensifying inflationary pressure. More importantly, BI’s credibility could be at stake if inflation surprises significantly on the upside, which may mean BI would have to reverse its policy and raise rates even more aggressively once more.
Despite being a domestically-driven, the vagaries of the global economies and financial straits have spared the rupiah. In Sept 2011, BI intervened to smoothen out the volatility in the currency. From available data, BI used nearly USD10.7bn of its foreign exchange reserves of USD114 bn from Sept-Oct to defend the rupiah.
The currency has depreciated nearly 6.5% to around the 9,000 level since September, giving up all of the 5.3% gains it made since the beginning of the year. Anecdotally, BI has not intervened as aggressively since September as it appeared that foreign selling has eased. Nevertheless, we do not expect the rupiah to return to its pre-September level (at 8,600 on average) anytime soon.
The volatile external environment, together with the aggressive policy rate cuts to date, could see the rupiah settling at 8,800, in line with the government’s 2012 budget assumption for the USD-IDR.