Citigroup Indonesia Macro View - Outlook in 2011 – Volatility and Opportunity

 We expect Indonesia will grow 6.3%-6.5% in 2011-12; Investment key —

Private consumption and investment should be the main driver, and unlike in 2010, domestic demand growth should exceed overall GDP growth. Investment will likely be supported by accommodative domestic global and liquidity conditions; an encouraging trend is the sizeable pick-up in FDI we saw in 2010.

 BI “diluted” its inflation targeting framework; we upgrade inflation forecasts

— We upgrade our inflation forecast to 6.5% from 6.0% in 2011F, with signs of rising core (in fact, our estimate of core on QoQ sa already show annualized rate of 5.1% in Dec). BI risks hurting its credibility by shifting its monetary policy framework to targeting core inflation instead of headline inflation – we maintain our rate hike forecast of 75bps in 2011 starting in March with possible delay to April.

 Budget deficit in 2011F likely to remain below target at 1.2% of GDP — We expect to see more concerted efforts to speed up spending in 2011 vs. 2010 (deficit of only 0.6% of GDP) but still likely to fall below target. Higher oil prices and interest rates would have a small negative impact.

 Bond supply target could be cut in 2011F; Global bonds to increase —

The original gross bond issuance for 2011F is targeted to increase 30% YoY, but with surplus funds (of about Rp47trillion) in 2010, we expect bond issuance could be cut by at least Rp30 trillion. Government is targeting 16%-25% of gross bond issuance (equivalent to $3.6bn-$5.7bn) in global bonds (including sukuk), much higher than the $2.7bn issuance in 2010.

 External liquidity position has improved; provides buffer for intervention

— FX reserves rose 46% in 2010, the fastest pace in Asia – FX reserves can cover over 2x ST debt by remaining maturity (ex-standstill) vs. 1.5-1.6x pre- Lehman. Coverage still looks “decent” at 1.25x after factoring in potential “mobile” portfolio flows. We expect FX reserves will rise gradually to $115bn in 2011F – CA surplus and portfolio flows to shrink but FDI to rise.

 Market Outlook: IDR weakness temporary; IDR curves to bear flatten —

While IDR may remain under pressure in the near term, we think this will eventually reverse: 1) BI’s dovish stance should eventually shift in the coming months; 2) BI’s war chest of $96bn of FX reserves will be used to mitigate FX volatility, while IDR’s high carry will be tempting; 3) Fundamentals remain solid – rating upgrade path intact; and, 4) inflows into EM debt and equities should persist and Indonesia should benefit. We expect curve flattening in local bonds

– 5yr IDR bonds should back up to 100bps gap as rate hiking starts while long end would need to re-price with 10yr likely settling at 8.75%-9% by year-end.