Summary view – The economy continues to demonstrate domestic demand resilience in the 2Q09, and exports are slightly rebounding. We upgrade our current account surplus forecast as trade surplus continues to surprise on the upside, which should help buffer renewed volatility in portfolio flows. Credit profile continues to improve as debt remains low and FX reserves continue to improve — we expect an upgrade next year to mid double-B.
Things to watch – Sharp run-up in oil prices will likely renew concerns on the fuel subsidies, and risk to inflationary expectations going into next year. BI should cut another 25bps in July, but the dovish rhetoric could now dissipate. Two other key drivers to watch are the upcoming Samurai bond issuance (we expect around $1bn) and the July 8 presidential polls, where President Yudhoyono could be re-elected after just one round.
Strategy – The some pull-back on risk, and de facto IDR, was something we had been expecting as positioning has grown crowded. We would see this as an opportunity to re-enter into long IDR and IDR bond positions, especially if the 5yr yields pierce the 10.5% range. We expect Indonesia 5yr CDS spread premium with Philippines to be range-bound from here.
Growth looks relatively resilient in the 2Q09Indicators for domestic demand look resilient in 2Q09, paving the way for growth close to the 4% range this year. After a better than expected 1Q09 growth of 4.4%m Finance Minister Sri Mulyani had said that investment is due to recover this quarter and next following the QoQ decline in the 1Q09. Domestic demand indicators are slightly mixed – motor vehicle sales are slightly weaker in April, but retail sales have held up well, consumer confidence continues to rise to an over four-year high and cement consumption has picked up. Exports have rebounded in March to April, and
the rise in commodity prices and signs of stabilization in US and Japan, and stepped up economic activity in China provide further upside. However, credit growth has remained weak, down 1% year-to-date. Despite cumulative rate cuts of 250bps, lending rates have only rallied about a quarter of that, and banks continue to remain cautious in extending credit. Post-election foreign investment flows could provide a buffer to growth in the 2H10F.
BI should continue to ease though language could shiftWith inflation being consistently below expectations, real rates still high and the base effect favorable, we expect BI will continue to ease two more times to 6.5%. Indonesia posted a lower than expected inflation for three consecutive months, and we now expect inflation this year will only average 5.2% (from 5.4%), with inflation expected to average significantly below 5% by year-end. Along with benign inflation, we think BI could cut policy rates fall to 6.5% for two reasons: first, lending rates have significantly lagged policy rates, real rates are still high and credit growth has actually contracted year-to-date; second, Indonesia’s credit risk premium has fallen, and with global policy rates being very low, covered interest rate differential still remains above 2yr average, we think BI has leeway to cut rates without sparking significant IDR volatility.
However, there is growing risk they pause at 6.75%. The further rise in inflation expectations associated with oil prices and growth recovery would play a role in next year’s inflation trajectory. Regardless of a fuel price adjustment, we think BI is concerned that next year’s inflation will be in the high end of their 4%-6% range, which could play a role in whether the next rate cut (to 6.75%) is accompanied with a more “neutral” policy statement. Acting BI Governor has noted that, while there is still room to ease monetary policy there is “not much anymore.” However, we don’t expect BI cutting short of 25bps will have significant impact on growth and overall appetite for IDR bonds.
Credit re-rating — External position improvesMoody’s positive outlook revision is consistent with Indonesia’s credit re-pricing since late 2008. We think the improving credit story is underpinned by a favorable political backdrop which could set the stage for more investmentinducing reforms, resilient domestic demand growth, improving external liquidity and very low and declining government and external debt both close to 30% of GDP on the back of prudent (too prudent, in our opinion) fiscal policy.
We expect an upgrade to Ba2, at par with Fitch’s rating, will eventually happen next year. Moody’s rating action did not result in much price action on Indonesia bonds, FX and CDS – we think market (and ourselves) have already been very bullish Indonesia and positioned as such. While fiscal prudence has been a structural feature for awhile, one factor which was a source of concern last year but continues to improve is Indonesia’s external liquidity position. FX reserve rose to $57.9bn in end of May, helped by continued portfolio inflows (about US$1.1bn in foreign inflows in IDR bonds and bills in May). However, as worries on crowded positioning grow on top of oil price concerns, we have seen some renewed outflows, leading IDR to
underperform this month. Offsetting concerns on portfolio flows, the trade and current account is improving. We’ve revised our current account surplus forecast higher this year to US$4.4bn (1% of GDP) from $1.9bn (0.4% of GDP) previously. We expect FX reserves will end largely stable at current levels, which covers about 1.9x short-term debt by remaining maturity and around 2.2x total external financing requirements.
We think concern about the oil price run-up adversely impacting Indonesian assets, particularly FX and bonds, look overdone. First, the government is significantly under-spending and we are well within the government's provisioned crude trading range of $50-$60/barrel this year (official forecast is $45/barrel). Second, although Indonesia is a net oil importer, it is a net gas exporter, and thus, net oil and gas trade deficit remains small at -0.1% of GDP, which is by far not the largest in the region. Third, government has announced it has no plans to raise fuel prices in 2010F though this is hardly a guarantee. We estimate subsidized fuel prices are about 30-40% below market.
Presidential elections could be resolved by JulyAccording to the polls, President Yudhoyono’s re-election chances look strong and could be done by July. Last month, we raised concerns that with a threeway race, it’s still unclear if Yudhoyono-Boediono can win an outright majority by the first round on July 8. Results of recent polls vary and there are some signs Yudhoyono’s lead may be falling, but one recent poll still shows a 52% support, and the last LSI poll (though conducted in early June; we consider LSI to be one of the more reputable pollster) has it at 63%. While Yudhoyono winning should not be a huge surprise for the market, a quick July outcome should spark a relief rally.
Good day to you.
