150622 indonesia watch by ABN AMRO

Group Economics Emerging Markets

Indonesia Watch

Arjen van Dijkhuizen, +31 20 628 8052

External deficits have fallen, but risks remain 22 June 2015      

Indonesia’s growth rate dropped to a post-financial-crisis-low in Q1, driven down by both domestic and external demand We expect annual growth at 5% in 2015 and 5.5% in 2016, helped by rising infrastructure spending and external demand President Jokowi made a strong first impression, but it remains to be seen if he can keep the reform momentum alive Bank Indonesia will likely remain cautious with rate cuts, but will keep easing macroprudential requirements instead The current account and FX reserves have improved since the tapering tantrum in 2013 Indonesia remains vulnerable to capital outflows (due to e.g. rising bond yields, Fed lift-off) and further rupiah weakening

Economic growth in Q1 fell to post-financial-crisis low … After dipping to a still relatively high 4.7% in 2009 during the global crisis, growth accelerated to 6.4% in 2010. Since then, growth has gradually fallen, dropping to 4.7% yoy in Q1-2015 (the lowest level since Q3-2009). Private consumption slowed to 4.7% yoy, as the November 2014 fuel subsidy cuts caused uncertainty, while high interest rates, rising inflation and currency weakness also did not help. Investment slowed as well, as business sentiment was hit by tight monetary policy and lower commodity prices. Public investment disappointed too, as the reallocation of savings from the fuel subsidy cuts towards infrastructure spending was delayed. Finally, exports suffered from weaker external demand and falling commodity prices, with commodities still accounting for 40% of exports.

Economic growth slows further in Q1 % yoy

level

40 08

Economic growth (lhs)

We expect growth at 5% in 2015 and 5.5% in 2016 We expect economic growth to pick-up a bit in the course of this year, with annual growth remaining at 5%. We assume domestic demand to receive a boost from higher infrastructure spending and external demand to be supported by economic stabilisation in China and a pick-up of growth in advanced economies. All this will have positive feedback effects on private investment and consumption. We expect economic growth to accelerate further next year, reaching 5.5%. Will Jokowi succeed in keeping reform momentum? President Joko Widodo (“Jokowi”) made a strong first impression by lowering politically sensitive fuel subsidies. He subsequently raised the infrastructure budget by more than 50%. Earlier this year, he announced to expand powergenerating capacity through public-private partnerships. The government also introduced a “one-shop system” in January 2015, which should make it easier for (foreign) investors to obtain business permits. Still, Jokowi has no strong powerbase in parliament, meaning he has to continuously convince other parties to support his policy agenda. Moreover, his popularity has started to fall somewhat recently. All in all, although some more progress on structural reforms can be expected, it remains to be seen whether Jokowi can deliver the strong breaktrough that is hoped for by foreign investors.

Inflation bounces back on rupiah weakness

HSBC Manufacturing PMI (rhs)

% yoy / %

Sources: Bloomberg, Thomson Reuters Datastream

… and manufacturing PMI still in contraction mode High frequency data do not bode well either. While the Manufacturing PMI has recovered from March’s historic low of 46.4, the index remains far below the neutral 50 mark (May: 47.1). Vehicle sales also continued their downward slide. Car sales dropped to a five-month low in May (-18% yoy), while motorcycle sales dropped to the lowest level since August 2012 (-37% yoy). By contrast, one positive note came from consumer confidence, as the index bounced back a bit in May after having dropped sharply in March/April.

6 4 2 09

Headline inflation

Core inflation

Source: Thomson Reuters Datastream

Policy rate

Indonesia Wa atch, External deficits d have fa allen, but risks remain – 22 June 2015

Rupiah weaknes ss triggers a re enewed rise in n inflation … The e fuel subsidy ccuts drove infla ation to a five-y year high of 8.4 4% yoy y in Decemberr. After normaliising in early 2015, 2 higher fo ood pric ces and rupiah h weakness havve driven inflattion higher aga ain. The e rupiah dropp ped by 7.5% versus v the US SD in 2015 alo one ms and d by 35% since e 1 June 2013.. This weaknes ss not only stem from m USD streng gth, but also from f Indonesia a-specific facto ors pril (falling growth, high inflation, po olitical turmoil such as the Ap ble exe ecution of fore eigners). Core inflation has remained stab since late 2014 ((around 5%). While W fading effects e of the fu fuel bsidy cuts cou uld bring some relief in late e 2015, ongoiing sub rup piah weakness (we expect the IDR to depre eciate versus tthe US SD to 13700 and 14100 per end-2015 and d end-2016) a and pottential effects frrom El Niño po ose upward inflation risks. k Indonesia (B BI) to remain cautious … causing Bank s moneta ary policy, BI focuses f on infflation (target 4 4% In setting +/- 1% for 2015/16) and the current accountt deficit (targett: 5-3% of GDP).. Last Novemb ber, BI immed diately reacted to 2.5 the e inflation spike e by raising the e policy rate by y 25 bp to 7.75 5%. Witth inflation and d the current account deficit improving, BI ccut the e policy rate ba ack to 7.5% in February. BI has h been on ho old since, including at its latest meeting on June 18. Goiing ward, should in nflation fall with hin the target zone z in late 201 forw 15, tha at would creatte some room m for easing. However, givven inflation risks ste emming from rupiah r weakne ess and El Niñ ño, d given potential contagion frrom rising ‘risk--free’ bond yie lds and or the Fed lift-offf, we expect BI B to remain cautious with ra ate g on easing macropruden tial cutts. Instead, BI will likely go me easures (e.g. do ownpayment re equirements fo or housing loan ns). ports and imp ports are contrracting Exp ast Indonesia’s trade e data show a steep contraction in the pa qua arters. In January-May 2015, exports we ere down by an ave erage 12% yo oy, with oil and gas exports s even falling by alm most 40% yoy. Lower commo odity prices ex xplain part of tthis dec cline, but the decline in exxport volumes by 9% (desp pite rup piah depreciatio on) shows thatt weak demand d from China a and adv vanced econom mies plays a clear role as well. Meanwh ile, imp ports have falle en by almost 20% 2 yoy in 201 15 so far. Nextt to low wer fuel importss and lower imp port prices, falling capital goo ods imp ports are refleccting the slowdo own in manufacturing.

Trade T contrac cts, but curre nt account has improved USD U bn

% yoy

8 80

6 60 0 4 40 -4

2 20 0

-8 -2 20 -12

-4 40 10

Current accoount balance (lhs)

Exports (rhss)

Imports (rrhs)

So ource: Thomson Reuters R Datastream m

wly Risk profile is improving slow wly improving, as a external defficits Indonesia’s risk profile is slow F reserves hhave risen while fiscal indica ators arre falling and FX re emain quite so ound. This is also reflected d in S&P’s reccent ra ating outlook ch hange to Posittive. S&P still rates Indonesiia in (th he highest) spe eculative gradee, while Fitch and a Moody’s have h already granted d the country (the lowest) investment grrade ome years ago o. Indonesia’s CDS premium m has fallen since so late 2013, althou ugh edged up a bit in recent weeks reflectin ng a eneral rise in risk aversion. ge

Rupiah R weake ens, CDS prem mium stable ID DR per USD

So overeign 5y, USD, bp

14000

1400

13000

1200 1000

12000

8 800

11000

6 600

10000

4 400

9000

2 200

8000

0 06

Excchange rate (lhs)

CDS preemium (rhs)

So ources: Bloomberg g, Thomson Reuteers Datastream

d a bit since tapering tantru um Current accountt has improved ernal financess have impro oved since tthe Indonesia’s exte tap pering tantrum in 2013, when n it was classifiied as one of tthe frag gile five partlyy due to its external defic cits. The curre ent acc count deficit iss expected to fall to 2.5% of o GDP this ye ear (witthin the govern nment’s target)), from 3.2% in 2013. Moreovver, afte er falling by ove er 10% in 2013 3, FX reserves have risen aga ain and d now cover sixx months of im mports and two times short-te erm external debt. Still, while extern nal debt ratios are manageab ble, deb bt service is e expected to rise to 25% of exports e this ye ear. This reflects the rrelatively large share of USD denominated deb bt, making Indo onesia sensitive to (further) ru upiah weaknesss.

he outlook Main risks to th ems from the ra apid In our view, the main risk to thhe outlook ste se in bond yields in advanced ed economies and a a (faster-th hanris ex xpected) monetary tighteningg in the US, wh hich could trigger a ne ew round of capital outfllows from em merging markkets. Allthough the extternal position has improved since the tape ering tantrum, the elev vated share of USD denomin nated external debt d an nd high debt service ratio leaves Indone esia vulnerable e to further rupiah weakness. w Otther downside e risks stem from f disappointing grrowth in key trrade partners and from political omplications ob bstructing Jokoowi’s reform effforts. co

Indonesia Wa atch, External deficits d have fa allen, but risks remain – 22 June 2015

K forecasts forr the economy of Key o Indonesia 2 2012

2013

2 2014

2015e

20 016e

GDP (% yoy)

6.0

5.6

5.0

5.5

CPI inflation (% yoyy)

4.0

6.4

6.5

5.0

-2.0

Bu udget balance (% GDP)

-1.8

-2.2

-2.0

Government debt (% % GDP)

% GDP) Current account (%

-2.7

-3.2

-3.0

-2.5

-2.0

ment (% GDP) Gross fixed investm

32.7

32.1

32.6

33.0

33.5

Gross national savvings (% GDP)

32.4

30.9

31.7

31.6

32.4

USD/IDR (eop)

9 9670

12189

12 2440

13700

14 4100

EUR/IDR (eop)

12 2553

16796

15 5052

13700

16 6215

udget b alance, cu urrent acc. for 2015 and 2016 are ro ounded figures Bu

Source: EIU, ABN N AMRO Group Economics E

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