We have recently returned from Jakarta where we met with clients, policymakers and local analysts. Our thoughts and notes from the trip follow below. The interactions did not alter our macro views — 2010 growth of 5.5%, rate hikes from 3Q10, low risk of a budget blowout but uncertainty from politics.

In fact, most interactions confirmed our line of thought. Nevertheless the exchanges provided additional insight to issues ranging from inflation, monetary policy, the exchange rate, foreign trade (in particular that with China) and fiscal policy.

Inflation, monetary policy and the exchange rate
Bank Indonesia (BI) officials were upbeat about the 2010 growth outlook and relaxed, if not downright dovish, on inflation.

BI expects growth of 5%-5.5%, driven by strong consumer spending, exports and investment. It believes that on the supply side, this should translate into robust gains in the manufacturing, trade and transport and communication sectors.

It expects year-end consumer price inflation to fall between its 4%-6% target. Officials sounded relaxed on the outlook for food and energy prices.

Despite the Agricultural Ministry projecting lower domestic rice output this year (due to weather effects), BI officials expect the country’s rice output to remain more than sufficient in meeting domestic consumption needs, with enough left over for Indonesia to continue exports of the grain.

Meanwhile, the fuel price hike that was much talked about last year now appears to be off the agenda, owing to the current political environment. Finance ministry officials were also of the same view.

Given that inflation has been generally benign, we were then curious to know why inflation expectations have been on the rise.

Officials attributed this to rising global oil prices, which have spurred rumours of a hike in (subsidised) fuel prices. Adding to the dovish tone, officials were also of the view that the economy was still operating someway below long-term potential (or a negative output gap, in short).

Consequently, BI officials were surprised that we had pencilled in policy rate hikes from July, and even more surprised to hear that we expect the overnight reference rate to be lifted to what they deemed as a “very high” 8% by the year-end, from 6.5% currently.

Our take is that a policy rate of 8% is not high, considering that prior to the downturn it had been as high as 9.5%. Furthermore, given our expectations that CPI inflation will reach 6% year-on-year (y-o-y) by the year-end, an 8% nominal  policy rate translates into 2% in inflation-adjusted terms — in line with historical averages.

In essence, while we are relaxed about inflationary pressure in 1H10, pressures should grow in 2H10.

We also see the output gap differently than BI. Official data indicates that capacity utilisation has been trending higher and is now running at around 75%, a reading that jives with Indonesia’s surprisingly good economic performance over the crisis period.

Meanwhile, our estimates suggest that only a small output gap exists at present, and that this should turn positive in 2H10. As excess capacity fades, inflation risks grow.

On the exchange rate front, we expect the Indonesian rupiah (IDR) to rise to 8,700 per US dollar (USD) by year-end, as capital inflows return. BI officials — and most others we met — concurred that the rupiah was set to strengthen this year. However, most were sceptical that USD/IDR would fall below the 9,000-9,100 level, taking the view that the authorities would not allow the exchange rate to hurt exports.

Our view is that, on a trade-weighted basis, the IDR will not be appreciating as much as against USD, as was the case last year (Chart 1). This suggests to us that the authorities could be more tolerant of IDR appreciation than market participants expect.

With inflation not yet a policy concern, BI will continue to focus on lifting bank lending. It is targeting loan growth of 10%-15% this year, from sub-6% as of November 2009. Encouragingly, data from 2H09 show bank lending has finally picked up after near zero growth between mid-2008 and mid-2009 (Chart 2).

But if this nascent improvement is to be sustained, BI will have to go beyond moral suasion. To that end, policymakers are mulling over whether to inversely link banks’ reserve requirement ratios (RRR) to loan-to-deposit ratios, as was the case before October 2008.

Such would incentivise banks to up their loan-to-deposit ratios. The RRR is currently a flat 7.5% of a bank’s total rupiah deposits. Prior to the crisis, the RRR had ranged from 5% to 13%, depending on the size of banks’ third party funds and their loan-to-deposit ratios.

Trade, China and the FTA
One of the most striking take-aways from our trip was the intense level of interest among policymakers and clients regarding the impact of the Asean China Free Trade Agreement (ACFTA) on the Indonesian economy.

Everyone wanted to know if, and how, Indonesia benefited or lost out from the agreement, particularly with reference to China.

The level of interest surprised us, considering that under the agreement, import tariffs on 90% of the goods traded among China and the Asean 6 countries have been gradually scaled back since 2005, to 0% as of January 2010.

The Indonesian response was also a stark contrast to Singapore, where the 0% tariff target this year has drawn comparatively less attention.

The contrasting responses can perhaps be explained by Indonesia’s relatively lower level of trade openness, and how certain industries there such as textiles and apparel manufacturing have historically enjoyed high levels of trade protection.

Under ACFTA, industries such as these will no doubt have to undergo a period of sometimes painful adjustment as they go head to head with more competitive imports. Indeed, some industries may no longer even prove viable. But what this means is that over time, Indonesia will start to play to its comparative advantage — allocating economic resources better, so that opportunity costs from inefficient activities will be reduced.

Yet, even as these positive structural changes take place, we think Indonesia could continue running a trade deficit with the other 10 signatories of ACFTA (these are Brunei, Myanmar, Cambodia, Laos, Malaysia, the Philippines, Singapore, Thailand, Vietnam and China).

In the year to November 2009, Indonesia’s deficit with this group of economies totalled US$1.8 billion (RM6.1 billion). Half of this was accounted for by the deficit with China (Chart 3).

While this trade deficit with the ACFTA is still small, at under 1% of total nominal GDP, the gap could persist, or even widen, in the coming years. Doubtless, there will be industries adroit enough to capitalise on the greater market access provided by ACFTA.

However, as a whole Indonesia’s export sector will, on a relative basis, remain less competitive than many of the agreement’s other signatories for some time yet. Further pressure on the deficit could come from faster relative appreciation of the rupiah, especially if other Asian countries keep a tight grip on their currencies.

The Indonesian economy is also very much driven by domestic rather than external demand; in such an environment, the increase in import demand arising from lower tariff barriers could more than offset the increase in export activity.

Fiscal policy
As has been flagged, the Ministry of Finance will be revising the macroeconomic assumptions it made under the 2010 budget, probably around April. Two of its assumptions — the price of crude oil and the rupiah’s rate of exchange against the USD — stand out as being too low.

The government currently assumes that crude oil will average US$65/barrel this year, compared to a year-to-date average of US$75/bbl, and a full-year consensus of US$78/bbl. Meanwhile, the rupiah is assumed at a low 10,000 against the USD, against a year-to-date average of around 9,300.

Lifting the oil price assumption will necessarily imply a wider budget deficit projection (even as the rupiah is assumed to be stronger), since higher crude prices mean a larger fuel subsidy burden for the government.

Policy officials have indicated that the crude oil assumption will be revised up to US$70-US$80/bbl, while the overall budget deficit will be revised to a larger 2%-2.3% of GDP. This compares to a current projection of 1.6%, the same as 2009.

At this rate, we see very low risks of a budget blow-out. In fact, if anything the government’s assumptions could prove too conservative. According to our estimates (which take into account both the expenditure and revenue side of the budget), a crude oil price of US$80/bbl and USD/IDR rate of 9,400 for the year would still only imply an overall budget deficit of 1.5% of GDP (Table 1).

In short, even following macroeconomic conditions later this year, there will still be ample room in the budget for oil prices to rise and/or the rupiah to weaken some ways before we have to start fretting over budget risks.

To an extent this could explain why officials do not expect the revisions to the budget assumptions to affect the IDR 175 trillion in 2010 gross debt issuance the government had flagged earlier.

Investors can take further comfort in the fact that there are also IDR 38 trillion in funds left over from last year that can be tapped. To that end, demand for Indonesian debt has remained strong.

In the year to-date, the government has already managed to raise IDR 44.73 trillion, or nearly a third of its financing needs. Foreigners also continue to take an active interest, with net foreign inflows into the bond market recorded every month since September 2009.

As of Jan10, non-resident holdings of government bonds stood at 115 trillion rupiah (RM41.86 billion), or 19.5% of total government bonds outstanding.

Politics
Our conversations with analysts and officials suggest that there is still a risk of Sri Mulyani stepping down as finance minister in the next month or two, owing to the Bank Century case.

Pansus, the special House of Representatives committee set up to investigate the Bank Century bailout, is scheduled to make its final recommendations on March 4.

In the event that Sri Mulyani does step down, Anggito Abimanyu, currently the head of the Fiscal Policy Agency (which comes under the MOF), is the forerunner for the post.

Abimanyu, who is trained in economics, has a blend of experience in academia and policy, and should he take over of the reins, it would not likely herald any shift in longer-term fiscal policy. Nonetheless a Sri Mulyani resignation could still have a negative impact on investor sentiment.

Feedback from our Indonesia equity research team indicates that many foreign investors are not yet aware of the Bank Century case. Furthermore, while Abimanyu is not totally unknown to foreign investors, Sri Mulyani does enjoy a much higher profile and has come to be identified with policy reform. — Feb 25, 2010

This article appeared in The Edge Financial Daily, March 1, 2010.