Indonesia: Falling behind the Curve

(from my colleagues Dr. Win Thin and Ilan Solot)

Bank Indonesia has fallen far behind the curve in its currency management tactics. After fairly steady intervention kept USD/IDR trading near the 10,000 area from May through early August, the authorities have been allowing the pair to move sharply higher since mid-August. 

We believe part of this shift is due to concerns about the pace of reserve loss, as foreign reserves fell from $107 bln in April to $92.7 bln in July, a drop of nearly 15%. August numbers will be released sometime over the next week, and is likely to show another sizable drop.

At $92.7 bln, Indonesia’s foreign reserves are nearly five months of imports. However, a better metric for EM vulnerability during this current period of capital outflows from EM is the current account deficit and short-term debt relative to foreign reserves. For Indonesia, this ratio stands near 85% and is the second-highest in Asia behind India’s 97%.
 

Indeed, these ratios are quite high across all the major EM countries, not just Asia, as these two are eclipsed by only South Africa, Turkey, Hungary, and Ukraine. The FX swap lines set up in Asia by the Chiang Mai Initiative, can help, but will not materially change the country’s predicament since that is borrowed money that must eventually be repaid.

Foreign investors that wish to exit their Indonesian positions have experienced sporadic difficulties in recent weeks, especially in the fixed income markets. There have been some days where dollar demand has not been fully met, and other days when it has been fully met. The unpredictable nature of BI’s dollar supply has frustrated global investors, and is unlikely to improve until the central bank communicates its willingness to fully accommodate any dollar demand.

Along with better communication and predictability, we believe Bank Indonesia may have to rely more on an interest rate defense of the rupiah in lieu of aggressive FX intervention. BI delivered hawkish surprises at its June (25 bp hike) and July (50 bp hike) meetings, but then did not hike rates at its August meeting. It was then forced to hike 50 bp at an extraordinary (unscheduled) meeting August 29. The next scheduled meeting is September 12, and we think BI may be forced to deliver another 50 bp hike then if it wants to shore up sentiment.

While growth is slowing, price pressures remain high and will be aggravated by inflation pass-through, so another rate hike is not completely out of order. CPI accelerated to 8.8% y/y in August from 8.6% y/y in July, and remains well above the 3.5-5.5% target range. Pass-through from the weaker rupiah warns of upside risks to inflation ahead. With the policy rate at 7%, real interest rates remain deeply negative and so we believe there is scope for further tightening by BI.

Foreign investors have been net sellers of Indonesian equities since May. YTD outflows of $876 mln make up about half of 2012’s inflows of $1.7 bln, according to Bloomberg data.  Foreign investors have also been divesting from Indonesia bonds too during this period, which has led BI to provide liquidity in the bond market. 

Recent comments by BI Deputy Governor Warjiyo suggest the central bank has bought north of IDR31 trln of bonds in the secondary market. The sales of local bonds by foreign investors seem to have stabilized for now (see graph), but rates continue to be very elevated – just below 9.0% for the 10-year sector.

USD/IDR is creeping towards the March 2009 high near 12015 and then the November 2008 high near 13000. While Bloomberg screen prices put the cycle high near 11500, spot IDR has traded as high as 11850 recently. After those levels, one needs to go back to the 1997-1998 Asian Crisis, when the pair spiked as high as 16950. 

We cannot say with any certain how weak the rupiah will get, but we believe EM overall will remain under pressure well into Q4 due to ongoing tapering uncertainty. Given its vulnerable position with weak fundamentals, IDR is likely to continue underperforming within EM. YTD, IDR is the third worst vs. USD at -14%, behind only INR (-18%) and ZAR (-17%). TRL is next at -13% YTD.