Economy No rate change is expected at the BI meeting this Thursday - DBS Vickers

No rate change is expected at the BI meeting this Thursday. The consumption-led expansion in aggregate demand and the surge in capital inflows indicate that inflation risks may increase in 2H

The market widely expects Bank Indonesia will leave the overnight reference rate unchanged at 6.75% when they meet this Thursday to review monetary policy. CPI inflation recently slowed further to 6.2% YoY in April from 6.7% in March helped by two consecutive months of declines in food prices, taking the inflation-adjusted real rate back into positive territory. Despite the widespread expectations of no rate move, BI’s policy statement this week is still likely to signal vigilance on inflation. This is because the drop in food prices based on local harvest is only seasonal, and demand-driven price pressures have been increasing. Core inflation excluding food and fuels has accelerated further to 4.6% YoY in April, the highest over 19 months and closer to the middle point of BI’s target range of 4-6%.

Indeed, the growth in aggregate demand has remained strong and importantly, the recent economic expansion is led by growth in private consumption demand. The first quarter real GDP registered 6.5% YoY, the second highest over 14 quarters, albeit slightly below our forecast of 6.7%. Private consumption expenditures bounced back to 4.5% from 4.4% in the preceding quarter, contributing about 2.6ppt to the headline GDP growth in 1Q. Exports of goods and services have also maintained double-digit growth rate of 12.3%, although net exports contribution to GDP was reduced to near zero because of faster-than-expected expansion in imports. On the other hand, gross fixed capital formation failed to show upside surprises in 1Q (7.3%, vs. 8.7% in 4Q10; GDP contribution: 1.7ppt), suggesting that it remains premature to expect a substantial removal of the supply side constraints in the economy that helps contain inflation.

Moreover, capital inflows have resurged and exerted upward pressures on liquidity supply and hence price pressures. Foreign reserves jumped USD 8.1bn in April after rising USD 6.1bn in March, reaching a new record high of USD 113.8bn. Portfolio capital inflows have returned to Indonesia thanks to the stabilization in headline inflation numbers, which tempered market expectations of BI rate hikes. Net foreign investment in bond and equity assets increased by about USD 1.4bn and USD 2.1bn respectively last month. Despite BI’s tolerance of rupiah appreciation and stricter regulations on capital inflows into SBI (the holding period requirement was tightened in April), rising inflows have still translated into expansion in domestic liquidity supply. Note that M2 growth of 16.9% in 1Q has already exceeded nominal GDP growth of 15.4%. The consumption-led economic growth expansion, resurge in capital inflows and acceleration in liquidity supply lead us to believe that the risks to inflation are still towards the upside.