[Kabar-indonesia] Morgan Stanley: Indonesia: Normalization of Interest Rates Underway

[Joyo at aol.com]

Morgan Stanley Economists 
Wednesday, August 9, 2006

Indonesia: Normalization of Interest Rates Underway

Deyi Tan (Singapore)

Bank Indonesia cuts policy rate by 50bp to 11.75%

The policy statement indicated that “this decision was
adopted in light of the continued macroeconomic
stability in Indonesia, reduced risks from external
factors, findings from various surveys and the
economic and monetary outlook”.  The central bank’s
move is largely in line with the recent market
expectations; however, it is higher than the hesitant
reduction over the last three months.  The bond market
had begun to price in the probability of a 50bp cut
since the press statement by the Deputy Governor,
Miranda S Goeltom, on July 27, which indicated that
there is greater room for rate cuts in the coming
months.

Three key macro trends supporting aggressive cut in
rates

While there is no surprise in the moderating inflation
trend, we believe that BI has probably accelerated the
pace of rate cuts on account of the continued
deceleration in growth trends and the relatively
comfortable external environment supporting a stable
exchange rate. There are three key macro trends at
work:

(1) Moderation of inflation in line with expectations.
We expect CPI inflation to head below 15% from August
2006 onwards, possibly to as low as 6-7% by the
year-end.  The deceleration is likely to be supported
by the base effects of higher oil prices from October
onwards.  Obviously, the risk is that the oil price
rises above US$85 and/or the rupiah depreciates
sharply, bringing about a second round of inflationary
pressure.  On balance, we believe that domestic
inflationary pressure will start dissipating in the
second half of the calendar year.

(2) Persistent weakness in domestic demand. Most of
the cyclical growth indicators show that growth had
continued to slow until recently.  Consumption
indicators, such as car and two-wheeler sales, and
consumption credit indicate continued deceleration
through to June 2006.  Similarly, capex trends as
reflected in the capital goods imports, commercial
vehicle sales and cement sales also indicate no
recovery so far.  Broader measures of growth such as
electricity consumption and total bank credit also
indicate a similar trend.  The only area that
indicates a marginal improvement in growth trend is
goods exports.

(3) Stable exchange rate and external environment.
After witnessing volatility in the May, the IDR has
been relatively stable over the past month or so.

This favourable trend has been supported by: (a)
improving macro stability (the fiscal impact of oil is
now positive unlike in 2005); (b) improved trend in
capital inflows, particularly foreign portfolio
inflows; and (c) the recent change in market
expectations for US interest rates, as reflected in
Fed futures, which are now pricing in a peak rate of
5.38% compared with 5.58% priced in at end-June.

Changing our rate outlook for end-2006

While we were expecting the normalization of interest
rates, our forecasts were building in slower rate cuts
in the near term and aggressive rate cuts in 2007. 
However, with a more supportive external environment
and persistent weakness in domestic demand, BI now
appears to be opting for a faster rate cut in the near
term.  We are therefore now expecting the policy rate
to be at 10.5% by the year-end, compared with the
11.5% expected earlier.  However, we maintain our 2007
year-end estimate at 9.25%.

Maintaining growth recovery outlook for the second
half

Although growth has remained subdued in the second
quarter of 2006, we believe that lower interest rates
will support a recovery in domestic demand — both
consumption and fixed investments — in 2H06.  We
therefore expect GDP growth to accelerate to 5.5% YoY
in the second half compared with 4.7% estimated in the
first half of the 2006.  Our growth forecast assumes
no major support from the potential acceleration in
structural reforms by the government, particularly on
infrastructure investment.

Potential reversal in global risk appetite — a key
risk factor

We believe that Indonesia is highly vulnerable to a
potential reversal in global risk appetite trends. 
Global risk appetite-dependent portfolio flows,
including equity and short-term debt securities, are
by a large margin the most positive component in the
balance of payments (BOP) financial account.

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Joyo Indonesia News Service
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