- Bank Indonesia surprises with a 25bp rate hike
- Move intended to anchor inflationary expectations and front run a potential cut in subsidies
- Price adjustments in subsidised fuel are in the offing. We explore few scenarios
- Implications for forecasts: Sticky inflation will convince BI to tighten policy further
Bank Indonesia kickstarts the rate hiking cycle
Decision: After sitting out of the hawkish camp for good part of the year, Bank Indonesia surprised with a 25bp rate hike on Tuesday, a first since 4Q18. This takes the benchmark 7-day reverse repo rate to 3.75%. The unexpected move was likely an attempt to front run a potential increase in subsidised fuel prices as well as to anchor inflationary expectations in midst of a persistent climb in core inflation. Growth resilience will help policymakers to keep their focus on inflation and financial market stability.
Economic assessment: Governor Warjiyo emphasised on pipeline inflationary risks, highlighting the significant gap between the headline and core readings, which was put to volatile and administered price indices. We also view this hike as a pre-emptive move ahead of an upcoming price adjustment in subsidised fuel products. The BI raised its 2022 CPI projection to “above 5%” and core CPI at 4.15%, whilst also signalling that inflation might be in breach of the 2-4% target in 2023 as well.
The view on growth was upbeat, with 3Q expected to head towards 5.5%, vs 5.4% in 2Q. 2022 projection was retained at 4.5-5.3%. Loan growth returned to double-digits in mid-2022, adding to the authorities’ confidence that liquidity normalisation moves had not had a detrimental impact on economic activity and banks’ liquidity position. The low loans-to-deposit ratio also backs this conviction.
Outlook: The central bank’s pre-emptive move has increased the likelihood that a price adjustment in fuel subsidies is on the cards (we elaborate in the next section and Indonesia: Fuel prices, subsidies, and inflation – balancing act). As the central bank sets the ball rolling, we retain our expectations of at least 50bp more hikes by end-2022. A sharp reduction in energy subsidies might necessitate larger and frontloaded moves. Separately, the BI plans to buy longer-tenor bonds, whilst selling short-term papers, in effect flattening the yield curve, and signaling a preference for defacto yield curve control.
On growth, we had drawn out our 2H growth outlook in Indonesia’s growth on cruise control, neutral on equities. Factoring in the resilience in the trade sector, stronger 2Q GDP growth number and firm consumption growth, we revise up our 2022 GDP growth forecast to 5.1%yoy (from 4.8%), also raising 2023 growth to 4.8% assuming the commodity, consumption and investment tailwinds extend into next year, besides higher public expenditure.
Subsidy decision will be key
In the past week there have been conflicting signals on the decision to adjust prices of subsidised fuel products. Apart from President Jokowi suggesting that high energy subsidies entail a heavy cost, Coordinating Minister of Investment and Maritime Affairs Luhut Panjaitan signalled that price increases were in the offing, as early as this week. This comes after indications that 2022 subsidies might exceed the revised IDR 502trn, which was already a ~50% increase from the Budget. Year-to-date consumption of subsidised Pertalite has reportedly surpassed 70% of the full year target of 23mn kilolitres.
While there is pressure to cut subsidies, the 2022 math has room to accommodate an increase in outlays. Jan-Jul22 outperformance in revenues, on the back of commodity windfall and VAT increase, increases the likelihood that budgeted revenue targets are likely to be overshot, providing some buffer for the fiscal math to financing subsidies this year. However, 2023 is perhaps a bigger sticking point for authorities, which might prompt their hand to bring forward the decision to hike subsidised fuel.
For 2023, based on an oil price assumption of US$90/bl, the draft state budget pegged total energy subsidies (including compensation to state owned energy companies) at IDR337trn, ~33% fall from 2022. Much of the difference falls on the smaller scale of compensation to Pertamina and PLN (from IDR 296trn to IDR 126trn in 2023) next year. There were also assurances that fuel and electricity tariffs will be held unchanged next year, to keep a lid on inflation. Coming back to potential subsidy price adjustments, we draw few scenarios
- Scenario 1 – Prevailing prices of gasoline and diesel, i.e., RON88, Pertalite, Pertamax and diesel are adjusted by 10% - could take inflation up ~40bp
- Scenario 2 – Prevailing prices of gasoline and diesel, i.e., RON88, Pertalite, Pertamax and diesel are adjusted by 20% - could take inflation up ~77bp
- Scenario 3 – Prevailing prices of gasoline and diesel, i.e., Pertalite, Pertamax and diesel are adjusted to fixed end-values i.e., IDR10000, IDR14500 and IDR8000 respectively, which implies 31%, 16% and 55% increase respectively - could take inflation up above 110bp and carry second round effects on food, transportation and logistics
Amongst these, the spillover impact from Scenario 3 will be most significant, necessitating a swift response from the central bank.
Market implications
Indonesia’s bonds and rupiah have benefited from the unwinding in aggressive Fed hike bets in recent weeks, with Bank Indonesia’s rate hike adding to the favourable mood. This was also accompanied by a resumption in foreign portfolio investors into debt, with inflows amounting to $1.3bn this month-to-date, first since Feb22, alongside a modest $370mn into equities. Despite the return in foreign interests, offshore positioning in debt is still modest at 15% of outstanding bonds. Bulk of the demand still comprises of domestic players – including banks, BI, retail investors, insurance companies etc., to tap into attractive bond yields compared to returns on domestic deposits. Meanwhile, spreads between IDR and UST 10Y yields are compressed levels of 410bp, vs 10Y average of 500-520bp. We are mindful of tail risks – from a more aggressive Fed, stickier inflation and market volatility could potentially weigh on the IDR bonds after the recent outperformance.
Renewed foreign inflows and US index pullback saw USDIDR ease towards 14600 but was swiftly bought up to back above 14900 as risk sentiments faltered. While BI’s rate hike provides near-term boost to the currency, the dollar index path will play a bigger hand in dictating the USDIDR path. Active intervention has prevented a break of 15000, but this resistance has not been without cost (foreign reserves fell by $4.2bn in Jul, part of which was due to external repayments). The 2H USDIDR trend is likely to be a function of broader dollar index moves, extent of correction in commodities prices which could narrow the year-to-date favourable trade surplus and broader risk-uptake. Barring a sharp on-sided fall in the currency, the central bank is likely to defend bouts of rupiah underperformance through intervention and market operations rather than put up a strong policy rate defence.
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