[Kabar-indonesia] Morgan Stanley Economists: Indonesia: Choosing Stability Over Growth

Thu Jun 29 07:05:18 MDT 2006

also: Asia/Pacific: Global Property Cycle Turns Down 

Morgan Stanley Economists 
June 29, 2006

Indonesia: Choosing Stability Over Growth

Stephen Jen ( Head of Global Currency Research), Sharon
Yeshaya (Asia Ex-Japan Currency Strategist), Deyi Tan
and I spent two days in Indonesia meeting with
policymakers. Below is a short summary of our findings
and thoughts:

Summary

A positive interest rate environment was one of the
key factors supporting growth revival in Indonesia in
2004 and the first half of 2005.  However, sharp rate
hikes of 4.25% to 12.75% in a span of five months in
2H06 by Bank Indonesia (BI) in response to inflation
concerns and volatility in rupiah affected the credit
cycle and growth environment.  Although inflation
concerns may be beginning to dissipate, we believe
that the rising US Fed rate and increasing financial
market uncertainties will continue to restrain BI from
resorting to major rate cuts in the second half of the
calendar year.  We now expect the benchmark 30-day
policy rate to decline only marginally to 11.5% (from
the current 12.5%) compared with our earlier estimate
of 10.5%.

Inflation concerns may be dissipating…

Although headline CPI still remains high, we believe
that BI is now less concerned on inflation.  CPI
inflation is expected to start decelerating from
August 2006 onwards, possibly heading as low as 6-7%
by the year-end. The deceleration is likely to be
supported by the base effects of higher oil prices
since last October. Obviously, the risk is that the
oil price rises above US$80 and/or the rupiah
depreciates sharply, bringing on the second round of
inflation pressures.  On balance, we believe that
domestic inflationary pressures will start dissipating
in the second half of the calendar year.

...and growth appears to be slowing...

On the growth front, several economic indicators are
showing a softening in momentum in the second quarter.
In particular, credit growth has been declining,
primarily as manufacturers and the services industry
slowed down on borrowing momentum. Loan growth in the
trade sector also decelerated in sync with the
weakening we saw in the export growth cycle.
Discretionary spending, in the form of automobile
purchases, which are typically the first to suffer
when consumer sentiments weakens, have also taken a
hit as fuel subsidy removals reduced purchasing power.
 Cement consumption, a proxy for fixed investment,
also does not provide cause for optimism in the
investment outlook.  Indeed, data in the first two
months of 2Q06 show a 2.4% contraction.

…..but exchange rate stability will remain the key
focus for now

We believe that BI is currently focused on financial
and exchange rate stability more than growth. In our
view, the past experience of instability has made BI
overly cautious on this aspect. It is concerned about
exchange rate expectations turning quickly into a
self-fulfilling vicious cycle of instability. We
believe that, in this context, the balance of payments
outlook and capital inflow trend will play a key role
in determining the interest rate outlook.

Balance of payments uncertainties likely to continue

While the current account being in surplus has helped,
volatility in the capital flow trend is causing
uncertainties. Non-FDI, including SBI, foreign
portfolio equity flows and government bonds, has been
relatively unstable. The government's 'go slow'
approach on structural reforms is not helping to
reduce reliance on these less stable inflows. We
believe that the central bank will stay cautious in
deciding on its interest outlook at a time when global
interest rates continue to firm up. We are therefore
revising our year-end forecast on the BI policy rate
to 11.5% compared with our earlier estimate of 10.5%.

Muddle-through approach on reforms implementation

On the political front, despite much excitement
following President Yudhoyono's victory and the
peaceful election, we have seen little follow-through.
 There have not been very many achievements in the
first year of the new government, in our view.  2005
proved to be a disappointment.  We believe that there
is a need for faster implementation of structural
reforms, such as increases in infrastructure
investments, labour law reforms, improving legal
certainty and improving tax administration.  Although
the government plans to take up some of these issues
over the next three months, we believe that the pace
might continue to be slow. The only area the
government may pursue some positive measures is, we
believe, in the banking sector.

Higher rates, financial market uncertainties and slow
reforms hurting investments

Investment growth remained weak during the past three
quarters. With machinery and equipment spending
declining, the overall investment growth trend has
only remained positive due to building spend
continuing to grow at a strong rate.  In such an
environment, growth is likely to be dependent on
government and private consumption.   Private
consumption growth has also decelerated post the sharp
hike in interest rates and the rise in domestic oil
prices during the second half of last year. However,
we believe that moderate interest rate cuts and no
further major additional oil price hike should allow a
moderate improvement in private consumption during the
second half of the year.

Bottom line

We believe that BI is likely to play safe, initiating
gradual and smaller rate cuts in the second half of
the year than we had estimated earlier, due to the
continued reversal in global risk appetite and
attendant pressure on Indonesia's balance of payments.
With the business investment cycle continuing to
remain weak and support from the export market also
weakening, the growth outlook is largely dependent on
private consumption. We believe that while there is
likely to be a minor acceleration in private
consumption growth in 2H06, the overall growth trend
is likely to be relatively subdued at 5.1%.

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Morgan Stanley Economists 
June 28, 2006

Asia/Pacific: Global Property Cycle Turns Down 

Andy Xie (Hong Kong)

Summary and conclusions

The most important force in the global economy in the
past five years has been the synchronized property
boom.  The demand spillover from the property boom has
supported corporate earnings and, hence, equity
markets through its effects on consumption and
investment.  The commodity boom also depends on its
demand spillover.

It appears that all major property markets have peaked
(Japan is the notable exception but may not be far
behind).   Inflation is picking up simultaneously
around the world.  As long as inflation remains a
concern, major central banks are likely to raise
rather than cut interest rates over the next 12
months.  Overvaluation is already weighing down the
global property cycle.  Rising interest rates put it
on a downward trend.

Even if there is a soft landing, the global economy is
likely to surprise on the downside in 2007. 
Considering how fast and high the property cycle has
risen, a burst is possible, which could cause a global
recession in 2007.

Global financial markets have not woken up to the
fragility of global demand that supports corporate
earnings and demand for commodities.  As global
property turns down, commodity demand and corporate
earnings are likely to surprise on the downside in
2007.

The global property cycle

The world has experienced a synchronized property
cycle.  Los Angeles, London, Mumbai, New York,
Shanghai and Sydney have all seen property prices
surge.  Of course, not every city has joined the boom.
 We can call it a global cycle as major cities around
the world that determine their national economic
strengths have experienced the boom at the same time.

A property boom is usually a local phenomenon.  A
national bubble, let along a global one, is rare.  Why
has it happened?  Is it just a coincidence that all
the major cities have had a property boom at the same
time?

Three factors have led to the global property bubble. 
First, property financing has become part of the
global financial system.  As part of globalization,
mortgage products are being sold around the world,
which has increased the correlation of property
markets around the world.

Second, deflation shocks have allowed major central
banks to sustain super-loose monetary policy.  The
resulting excess liquidity has surged into mortgage
products and decreased property financing cost at the
same time around the world.

Third, institutional property investors have become a
significant portion of the global financial system. 
They have been able to shift capital into different
cities according to relative valuation.  Their
behavior has increased the correlation of property
markets around the world.

In short, the changes or innovations in the global
financial system have led to a rising correlation of
property markets to each other and to central bank
policies.  It has essentially turned deflation shocks
of the past decade into a global property bubble.

Property downturn means global economic downturn
The mechanism for monetary stimulus to turn into
demand in this cycle has been through property. 
Rising property construction is an important source of
job creation.  The wealth effect on consumption has
also been very important in many economies (e.g.,
Australia, India and the US).  Property could explain
most of the above-trend growth in the global economy
in this cycle, I believe.

As the global cycle turns down, the global economy
could experience a period of below-trend growth
symmetric to the above-trend growth in the past.  My
guesstimate is that the property bubble exaggerated
the global growth rate by one percentage point in 2004
and 2005.  The global economy could experience a 3%
growth rate in 2007-08 on average.

Significant risk of global property hard landing

Property bubbles rarely have soft landings.  The
market consensus for a soft landing is expecting the
exceptional.  The market confidence for a soft landing
stems from its enormous confidence in major central
banks to fix problems.

Global property value has inflated enormously since
2000.  US housing value rose to 173% of GDP in 2005
from 135% in 2000, Australia's rose to 347% from 271%.
 If data could be collected for China and India,
similar trends could be observed.

If the ratios between property value and GDP should go
back to the 2000 level or even the 1997 level, it
would involve significant price declines.  If the
market were rational, there would be a rush for the
exit and steep price declines, causing a hard landing
for property.
The seemingly soft landing in Australia and the UK in
the past two years has lulled investors into believing
that other markets will follow the same pattern.  The
difference is that these markets began to soften in a
strong global economy.  In my view, the global economy
has peaked out and could provide little support for
growth engines like China and the US when their
property markets turn down.

If the global economy does experience a property hard
landing, the global economy could experience a
recession in the next two years, while average growth
could still be 3%.

The cyclical bear market is here

The bear market for global property is at the heart of
the bear market for other asset classes.  The global
property bubble has been a major factor in strong
corporate earnings.   For example, it has supported
western consumers to spend without wage growth.  As a
result, the share of corporate earnings in GDP has
risen across the world.  When the ratios of property
to GDP normalize, the ratios for corporate earnings to
GDP should also normalize.

I believe that earnings expectation will be revised
down substantially in the next six months.  The most
vulnerable sectors are financial and material sectors.
 The former has benefited from high credit growth due
to the property and liquidity boom, the latter from
commodity inflation.

Bonds are the first asset class to turn down in this
cycle and remain a sell, in my view.  Bonds were
mispriced in the past five years, mistaking super-low
inflation as permanent.  The yield on G7 bonds could
rise by another one percentage point.

Emerging market currencies have also entered a bear
market.  Ex-China and oil exporters, emerging
economies have net foreign liability of $2.3 trillion.
 Much of the liability is liquid in stocks and bonds. 
As the risk reduction trade continues, part of the
foreign money will be pulled back into the G7
economies.

Turkey appears to be the first emerging economy in a
liquidity crisis.  Several more could follow.  The
easy liquidity lulled a number of emerging economies
into depending on portfolio inflows to fund their
consumption through consumer credit.  As the inflow
stops, these economies will have to raise interest
rates substantially to curtail their consumption.

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