Indonesia Macro View - Trip Notes: IDR Appreciation as BI’s Disinflationary Tool - Citigroup

 Indonesia’s growth story, underpinned by domestic demand, look solid.
Growth pinned at 6.5% in 2011 remains well anchored by domestic demand and positive income effects from commodity prices. The ability of growth to reach a 7% trajectory depends on how the government effectively deals with infrastructure development, but so far, the near-term prognosis on this looks uninspiring.

 Concerns on inflation center on core and fuel price pressures. We believe strong growth and accommodative monetary conditions raise upward risk to core inflation momentum, though BI downplays some of the core inflation as distorted by gold prices. While domestic prices of subsidized fuel are unlikely to be adjusted this year, a sharply widening gap between subsidized and non-subsidized fuel could result in fuel switching which could prematurely exhaust the allocated quota for subsidized fuel, and translate to inflationary pressures.

 We think BI’s policy bias is to use IDR appreciation as a disinflationary tool.
While BI uses a mix of policy tools – an interest rate hike in Feb, monetary and macro-prudential measures to manage domestic liquidity and capital flows, and FX appreciation – the message we got from our meetings with BI is that its policy bias is towards using more FX appreciation to curb inflation.

 There is higher risk BI may only hike once more rather than twice this year.
Our meetings in Jakarta suggest the political/policy resistance to raising rates to curb inflation is much higher than we earlier thought, and we think there is greater risk we see fewer rate hikes than our base case this year. The resistance to rate hikes seem to stem from both concern that rising interest rates differential exacerbates capital inflows and from BI’s balance sheet considerations (though BI has downplayed the role of the latter).

 Fiscal and financing outlook is not a concern despite rising energy subsidies.
The government is highly liquid from cumulative years of under-shooting its deficit targets, and the fiscal outturn in 1Q 2011 indicates not much has changed in its chronic fiscal prudence.

 Market outlook: Turning more bullish IDR; IDR bonds could still bull flatten.
We are more bullish on the medium term prospects for IDR appreciation, and could see USD-IDR head to the 8,300-8,500 range later this year – we think it makes sense to gradually scale-in – possible IDR weakness on foreign outflows from maturing SBIs on 9th of June could provide entry opportunities. We think IDR bond yields can still bull-flatten further on offshore flows, solid country fundamentals and manageable near-term inflation outlook.