Friday, April 12, 2013

BI rate flat all eyes on government fuel policy

As expected, Bank Indonesia left its BI and FASBI rates unchanged at 5.75% and 4.00%, respectively in today’s governor board meeting. The central bank is confident that the rates remain consistent with this and next year inflation targets of 4.5% ± 1%.

More on liquidity absorption, rather than interest rate hike to fight inflation.  The first paragraph of central bank’s press release tells its main focus going forward: inflation. It assesses that inflationary pressure in the early months was not a monetary phenomenon and was due to volatile foods. Thus, BI prefers to absorb excess liquidity to manage the short term shock of inflation. Meanwhile, BI will maintain the rupiah's level at its fundamental in which we see a wider toleration of its depreciation.

On the other hand, Bank Indonesia tones down its growth forecast. It remains firm on the domestic economic condition although rising downside risks, especially from the sub-optimum global economic recovery, are highlighted. It expects growth to hover between 6.2% - 6.6% and 6.6% - 7.0% in 2013 and 2014, respectively, a downward revision from the previous 6.3% - 6.8% and 6.7% - 7.2%.

The central bank expects balance of payment deficit to ease in 2Q13 owing to higher surplus in the capital account. This is considering that it will receive fresh flows from government’s recent global bond issuance amounting to US$3bn. Nevertheless, Bank Indonesia anticipates the deficit in current account to linger as the imports of oil products remain high due to rising subsidized fuel consumption.

Wider toleration for the rupiah's depreciation yet volatility remains stable. As of Mar13, international reserve declined by US$0.4bn to US$104.8bn (equivalent to 5.7 times of import and government’s debt service payment), lower than Feb13 reserve reduction of US$3.6bn. In our view it was because Bank Indonesia tolerated further rupiah weakening due to inflationary and trade deficit risks. The rupiah depreciated by 0.57% mom, reaching Rp9,720/US$ in Mar13. Nevertheless, we think Bank Indonesia had intervened the market to smoothen volatility. It was in a downward trend as shown from the rupiah’s volatility index which fell from 15.5 in Feb13 to 15.0 in Mar13.

Until this moment, we remain comfortable with our BI rate forecast of 5.75% until YE13. Despite Mar13 on-year inflation reaching 5.9% and surpassing BI’s upper limit inflation target of 5.5%, the noise has somewhat been over sounded. Rising headline inflation in early months was due to acceleration of few food prices which is mostly a temporary supply side matter and is related with the government’s agriculture import regulation. Meanwhile, the demand-side inflation, the so-called core inflation, remains relatively steady even if we exclude gold price deflation.

We still expect, however, BI’s lower bound rate (FASBI rate) of the money market to be raised by at least 25bps to 4.25% this year. We think the hike is necessary to support the currency that remains under pressure as a consequence of the current account deficit. We suspect FASBI rate will be hiked in Jun13 the soonest as the central bank is expected to be in an autopilot mode until the next governor is officially appointed.

All eyes on government’s fuel subsidy policy. We believe any monetary policy response will be formulated based on the upcoming policy in curbing fuel subsidy. There are several options being discussed but they mainly fall into two categories: price and volume measures. Price hike option will have larger impact on inflation, by around 2.4ppt vs. the latter which is 0.6ppt. Accordingly it can save more government spending by 0.8% of GDP compared to 0.3% of GDP in fuel consumption rationing policy. Without any firm fuel subsidy policy budget deficit could reach close to 3% of GDP assuming no budget cut and higher education spending to maintain the required 20% of total spending threshold.

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