An earlier than expected rate cut
On 17 February Bank Indonesia lowered both its benchmark policy rate and the overnight deposit facility rate by 25 bps each to 7.50% and 5.50%, respectively, while keeping the lending facility rate unchanged at 8%.This is the first time rates have been cut since 2012 and the consensus was not reckoning with until late in 2015 at the earliest.
Exhibit 1: Changes in Bank Indonesia’s benchmark policy rate since 2009
Source: Bloomberg, BNPP IP, 18th February 2015
Three months ago, Bank Indonesia raised its interest rate to its highest level in five years, to 7.75%, to contain inflation after the Indonesian government cut fuel subsidies. Recently, Bank Indonesia expressed its conviction that the rate of inflation will remain under control at the lower end of the inflation target range of 3%-5% in 2015 and 2016, thanks to the fall in global oil and food prices.
We believe that lower oil prices combined with the approval of the 2015 budget by the Parliament, which reinforces confidence in the retail fuel price trend, gave better visibility on inflation. We did not anticipate this rate cut to happen as early as now as we hold the view that a stabilisation of the current account deficit is needed. However, we recognised that the easing of inflationary pressures and the fact that the central bank had not cut rates since the 175bps of hikes following the fear of Fed tapering in May 2013 left room for easing.
Current Account Deficit (CAD) and inflation in focus
From our point of view, Bank Indonesia will remain cautious and is looking at how the pro-growth policies of the current government will impact the current account deficit. We see more coordination between Bank Indonesia and the government which makes us confident about the ability of this new government to implement reforms in a stable way.
We believe that no surplus is needed for Indonesia to keep growing in a healthy way, as Indonesia has sufficient foreign exchange reserves and FDI (Foreign Direct Investment) to finance a deficit of 2.50% of GDP. The current account deficit represents 2.9% (as of fourth quarter 2014). It improved last year as imports fell. We expect it to improve in 2015 following the fuel price subsidies reforms. Lower fuel subsidies enables; (1) the country to import less oil hence improving the trade balance, and; (2) to improve its budget. As a result, Bank Indonesia’s governor is forecasting the current account deficit to be below 3% of GDP in 2015. We expect it to improve to 2.8% for 2015.
In the upcoming months, we believe Bank Indonesia will remain cautious, keeping a close eye on inflation. To us, there is room to cut rates only if the inflation rate reaches the levels we saw prior to the fuel price hike of about 4%. Bank Indonesia will probably wait until third quarter 2015, when they will have better visibility on the execution of the reforms, and when inflation should have reached appropriate levels.
Last but not least, we acknowledge that the policy stance of the central bank is linked to the US Federal Reserve’s monetary policy. As we pointed out previously Bank Indonesia has already hiked rates by 175bps since May 2013. The Indonesian Rupiah is at its lowest level (12,922/USD) and as the current account deficit should now improve we expect Indonesia will not be as vulnerable as previously to a change in interest rate policy in the US. Bank Indonesia’s stance is definitely more toward easing than tightening for the rest of the year.