Indonesia: On India's Trail
April 29, 2010
By Deyi Tan, Chetan Ahya & Shweta Singh l Singapore|
Raising Our 2010 and 2011 GDP Outlook
We are maintaining our bullish call on Indonesia. Indeed, like other ASEAN economies, the cyclical turnaround had begun in Indonesia with 4Q09 GDP registering 5.4%Y (versus the trough of 4.1%Y in 2Q09). High-frequency domestic demand indicators - such as motor vehicle sales, cement sales and imports of capital & consumer goods - are pointing towards growth acceleration. Meanwhile, external demand is also lifting Indonesia's exports to 55.5%Y, 3MMA in February 2010. As part of the ASEAN GDP review which we are currently undertaking, we are lifting our GDP forecast to 6.0% from 5.5% in 2010 and to 6.5% from 6.3% in 2011 to mark to market recent macro developments. The revisions today will bring Indonesia earlier towards achieving what we see as its potential growth level of 6-7%Y.
Indeed, we had been bullish on Indonesia; back in 2Q09, we argued that it could potentially add another ‘I' to the ‘BRICs' story (see Indonesia: Adding Another ‘I' to the BRIC Story, June 12, 2009). It had become clear that political stability was likely to continue with President SBY winning his second presidential mandate, with a bigger parliamentary seat share. To be sure, Indonesia's story was not without risks. The risks we saw for Indonesia were via the currency conduit. Despite the reduction in external debt over the years, the composition of external debt within its macro balance sheet was still higher than in other ASEAN economies, leaving Indonesia relatively more vulnerable to capital flows volatility and the spillover impact of that onto the currency, inflation and monetary policy. However, the reduction of the tail risks of the global economic crisis and the return of risk appetite, coupled with the ongoing macro balance sheet improvement, helped Indonesia avoid such disruptive macro instability at the trough of the global recession.
How Are We Different from Consensus?
Our new GDP forecasts are higher than consensus forecasts of 5.8%Y for 2010 and 6.0%Y for 2011. Benign demographics, elevated commodity prices and political stability are positive factors driving Indonesia. Yet, in our view, the most important of all lies in what we see as the structural decline in cost of capital for Indonesia.
Indonesia on India's Trails
Indeed, as we had been reiterating, we see Indonesia likely to emerge as a story more similar to India rather than China (see Indonesia on India's Trail: Structural Cost of Capital Decline Story Is Intact, April 20, 2010). In the past, a weak political environment, high ratios of public and external debt to GDP and poor corporate balance sheets have caused Indonesia's exchange rate to remain highly volatile since the 1997 crisis. This in turn resulted in higher inflation and higher policy rates. Moreover, unlike India and China, Indonesia has a relatively open capital account for its resident population. When an external event caused some exchange rate volatility, residents have only added to that volatility by moving their rupiah bank deposits into dollar deposits. Exchange rate volatility and frequent macro shocks meant higher credit costs for the banking system. Banks have been persistently maintaining high net interest margins, partly to cover for high credit costs and uncertainty in the interest rate environment.
Now, the improved political environment, along with steady repair and restructuring of the government, banking sector and corporate sector balance sheets are helping to reduce the exchange rate volatility and cost of capital on a structural basis. This should further lead to a virtuous cycle of confidence among international investors and non-resident Indonesians. Capital inflows and remittances are likely to continue to improve, which would help to reduce cost of capital further. Indeed, India has shown a similar economic evolution, in which structural reforms following the 1991 balance-of-payments crisis led to a clean-up of the macro balance sheet. The cost of capital fell. Banks' lending rates followed, opening up a big gap between corporate sector ROE and cost of capital. The upshot is a boost in corporate profits, more investments and a higher potential GDP growth trend. This is what we believe is currently underway in Indonesia.
Inflation - A Beneficiary of Improved Macro and Lower Exchange Rate Volatility
On the inflation front, the medium-term trend of core inflation has been steadily declining with lower troughs and peaks. The recent positive surprises on the inflation front allude to the continuation of the structural story we have highlighted above. Core inflation has again decelerated to 3.6%Y in March 2010 (versus 4.4%Y a couple of months ago and a recent high of 7.4%Y in February 2009) amid the lower exchange rate volatility, the impact of currency appreciation and the pass-through of that to headline CPI. To be sure, Indonesia's inflation outlook is an interplay of cyclical demand-pull pressures and the erosion of base effects on one hand and the benign impact of stable currency trends on the other. We still think that cyclical inflationary pressures will take hold and be on the rise as the economy remains on a path of expansion. Increases in WPI will likely be passed through to the consumer level. Yet, this cyclical rise in inflation should be seen in the broader context of a structural decline in inflation trend over the medium term.
The upside risk lies in whether there could be an unforeseen bout of currency volatility if another round of global risk-aversion were to materialize. Yet, this is not our base case. Commodity prices are another risk factor but, at US$84/bbl, we think that oil prices remain in a sweet spot: elevated and improving the terms of trade for net commodity exporters, but not high enough to compound overheating risks and debilitate the current account balance as domestic demand accelerates, thereby putting pressure on the currency.
As such, we trim our inflation forecast to 5.0% from 6.0% for 2010 and to 5.7% from 6.5% for 2011. Meanwhile, given the monetary tightening from currency appreciation, the benign impact of that tightening on import-led inflation, and the dovish tone in the monetary policy statement so far, we are pushing back our expectations of the first rate hike from July to September. We expect the policy rate to go from the current 6.5% to 7.5% by year-end instead of the original 8%.
What Are the Risks to Our Outlook for Indonesia?
They are likely to stem from three sources:
• Commodity prices: As we highlighted above, this a double-edged sword for Indonesia: prices that are neither too low (negative terms of trade) nor too high (overheating risks) would be benign for Indonesia.
• Central bank monetary policy management: Subdued inflation pressures together with tightening via the currency tool are allowing the central bank to delay policy rate hikes. With a typically dovish stance, risks could also stem from the central bank overstaying its presence with policy rates that are too accommodative.
• The political environment: In particular, watch with regard to the Bank Century bailout incident, the implications of that on related key decision-makers, and the dynamics between President SBY and the various coalition parties in the government.
April 29, 2010
By Deyi Tan, Chetan Ahya & Shweta Singh l Singapore|
Raising Our 2010 and 2011 GDP Outlook
We are maintaining our bullish call on Indonesia. Indeed, like other ASEAN economies, the cyclical turnaround had begun in Indonesia with 4Q09 GDP registering 5.4%Y (versus the trough of 4.1%Y in 2Q09). High-frequency domestic demand indicators - such as motor vehicle sales, cement sales and imports of capital & consumer goods - are pointing towards growth acceleration. Meanwhile, external demand is also lifting Indonesia's exports to 55.5%Y, 3MMA in February 2010. As part of the ASEAN GDP review which we are currently undertaking, we are lifting our GDP forecast to 6.0% from 5.5% in 2010 and to 6.5% from 6.3% in 2011 to mark to market recent macro developments. The revisions today will bring Indonesia earlier towards achieving what we see as its potential growth level of 6-7%Y.
Indeed, we had been bullish on Indonesia; back in 2Q09, we argued that it could potentially add another ‘I' to the ‘BRICs' story (see Indonesia: Adding Another ‘I' to the BRIC Story, June 12, 2009). It had become clear that political stability was likely to continue with President SBY winning his second presidential mandate, with a bigger parliamentary seat share. To be sure, Indonesia's story was not without risks. The risks we saw for Indonesia were via the currency conduit. Despite the reduction in external debt over the years, the composition of external debt within its macro balance sheet was still higher than in other ASEAN economies, leaving Indonesia relatively more vulnerable to capital flows volatility and the spillover impact of that onto the currency, inflation and monetary policy. However, the reduction of the tail risks of the global economic crisis and the return of risk appetite, coupled with the ongoing macro balance sheet improvement, helped Indonesia avoid such disruptive macro instability at the trough of the global recession.
How Are We Different from Consensus?
Our new GDP forecasts are higher than consensus forecasts of 5.8%Y for 2010 and 6.0%Y for 2011. Benign demographics, elevated commodity prices and political stability are positive factors driving Indonesia. Yet, in our view, the most important of all lies in what we see as the structural decline in cost of capital for Indonesia.
Indonesia on India's Trails
Indeed, as we had been reiterating, we see Indonesia likely to emerge as a story more similar to India rather than China (see Indonesia on India's Trail: Structural Cost of Capital Decline Story Is Intact, April 20, 2010). In the past, a weak political environment, high ratios of public and external debt to GDP and poor corporate balance sheets have caused Indonesia's exchange rate to remain highly volatile since the 1997 crisis. This in turn resulted in higher inflation and higher policy rates. Moreover, unlike India and China, Indonesia has a relatively open capital account for its resident population. When an external event caused some exchange rate volatility, residents have only added to that volatility by moving their rupiah bank deposits into dollar deposits. Exchange rate volatility and frequent macro shocks meant higher credit costs for the banking system. Banks have been persistently maintaining high net interest margins, partly to cover for high credit costs and uncertainty in the interest rate environment.
Now, the improved political environment, along with steady repair and restructuring of the government, banking sector and corporate sector balance sheets are helping to reduce the exchange rate volatility and cost of capital on a structural basis. This should further lead to a virtuous cycle of confidence among international investors and non-resident Indonesians. Capital inflows and remittances are likely to continue to improve, which would help to reduce cost of capital further. Indeed, India has shown a similar economic evolution, in which structural reforms following the 1991 balance-of-payments crisis led to a clean-up of the macro balance sheet. The cost of capital fell. Banks' lending rates followed, opening up a big gap between corporate sector ROE and cost of capital. The upshot is a boost in corporate profits, more investments and a higher potential GDP growth trend. This is what we believe is currently underway in Indonesia.
Inflation - A Beneficiary of Improved Macro and Lower Exchange Rate Volatility
On the inflation front, the medium-term trend of core inflation has been steadily declining with lower troughs and peaks. The recent positive surprises on the inflation front allude to the continuation of the structural story we have highlighted above. Core inflation has again decelerated to 3.6%Y in March 2010 (versus 4.4%Y a couple of months ago and a recent high of 7.4%Y in February 2009) amid the lower exchange rate volatility, the impact of currency appreciation and the pass-through of that to headline CPI. To be sure, Indonesia's inflation outlook is an interplay of cyclical demand-pull pressures and the erosion of base effects on one hand and the benign impact of stable currency trends on the other. We still think that cyclical inflationary pressures will take hold and be on the rise as the economy remains on a path of expansion. Increases in WPI will likely be passed through to the consumer level. Yet, this cyclical rise in inflation should be seen in the broader context of a structural decline in inflation trend over the medium term.
The upside risk lies in whether there could be an unforeseen bout of currency volatility if another round of global risk-aversion were to materialize. Yet, this is not our base case. Commodity prices are another risk factor but, at US$84/bbl, we think that oil prices remain in a sweet spot: elevated and improving the terms of trade for net commodity exporters, but not high enough to compound overheating risks and debilitate the current account balance as domestic demand accelerates, thereby putting pressure on the currency.
As such, we trim our inflation forecast to 5.0% from 6.0% for 2010 and to 5.7% from 6.5% for 2011. Meanwhile, given the monetary tightening from currency appreciation, the benign impact of that tightening on import-led inflation, and the dovish tone in the monetary policy statement so far, we are pushing back our expectations of the first rate hike from July to September. We expect the policy rate to go from the current 6.5% to 7.5% by year-end instead of the original 8%.
What Are the Risks to Our Outlook for Indonesia?
They are likely to stem from three sources:
• Commodity prices: As we highlighted above, this a double-edged sword for Indonesia: prices that are neither too low (negative terms of trade) nor too high (overheating risks) would be benign for Indonesia.
• Central bank monetary policy management: Subdued inflation pressures together with tightening via the currency tool are allowing the central bank to delay policy rate hikes. With a typically dovish stance, risks could also stem from the central bank overstaying its presence with policy rates that are too accommodative.
• The political environment: In particular, watch with regard to the Bank Century bailout incident, the implications of that on related key decision-makers, and the dynamics between President SBY and the various coalition parties in the government.