16 August 2018
Indonesia: Central bank raises rates in quest to stabilise currency

Bank Indonesia (BI) surprised investors with a 25 basis point policy rate hike. BI has resumed tightening to stabilise the rupiah, which had fallen to its weakest level since October 2015

BI seeks to stabilise IDR

The Indonesian rupiah (IDR) traded as weak as IDR14680 earlier this week from Friday’s IDR14400. The weakness came amid a worsening in the current account deficit, which was announced last Friday to have widened to -$8 billion or to -3% of GDP in 2Q from -$5.5 billion or -2.2% of GDP in 1Q, and from -$4.8 billion or -1.9% of GDP in 2Q 2017. The currency was also hit by expectations of a steady policy rate decision at today’s meeting as well as the contagion effect of the slide in the Turkish Lira (TRY). Today’s July trade deficit of $2 billion, the highest in five years, indicated that the current account in 3Q could widen further as imports accelerated to satisfy strong domestic demand.

All of this argued for BI’s resumption of its tightening cycle and today's surprise 25 basis point rate hike after a pause in July. This brings BI’s tightening to 125 basis points so far this year. We believe that BI could continue with its tightening cycle until some stability is achieved. Higher interest rates will eventually moderate domestic demand and imports. Import substitution efforts by the government such as using a higher palm oil–diesel blend and redirecting oil exports to the local market, and keeping the fiscal deficit at around -2% of GDP may help moderate growth and stabilise the IDR.

This combination of monetary tightening and government measures could eventually address a couple of the drivers of IDR weakness – the weak external payments condition and strong domestic demand. But these measures will take time to work through the economy, which brings the burden of short-term stabilisation onto the central bank.

India: No respite for the rupee

As if the global market turmoil isn’t enough, domestic economic developments have been turning sour for the Indian rupee. This provides little hope for a break in the trend of the currency testing new lows against the US dollar. Prepare for more aggressive central bank policy tightening ahead

The Indian rupee (INR) exchange rate per US dollar surged to a record high of 70 when the Turkish financial crisis hit emerging market currencies hard earlier this week. As if the external drags on the INR aren’t enough, the domestic economic data -- a multi-year high trade deficit, elevated inflation, and signs of slowing GDP growth -- haven’t been any friendlier.

With an apparently shallow central bank (RBI) tightening cycle ahead, the current INR depreciation trend looks to be a prolonged one. The next challenge will be a string of state elections in the remainder of this year and general elections in 2019, which should see investors starting to add a political risk premium into local financial assets. As such, we don't rule out an aggressive central bank (RBI) policy tightening at the October meeting. Yet we see no threat to our 71.5 forecast for the USD/INR by end-2018.

Indonesia: Trade deficit widens to five-year high

The trade balance fell back into deficit in July, posting the widest gap in five years. This together with the weakness of the current account and Indonesian rupiah could argue for a non-consensus rate hike today

IDR fundamentals not as strong as trade deficit widens

Import growth rebounded in July with a 32% increase after moderating in June due to the effect of Ramadan. June’s imports increased by a moderate 12.7%. The recovery in imports, powered by strong domestic demand, handily beat expectations of 14% and resumes the robust pace of import demand seen in April and May.  

  • Non-oil imports accelerated by 29.3% in July from June’s modest 8.8% increase.
  • Energy imports surged 47% from the previous month’s 34% annual growth. Higher energy prices, as well as stronger demand due to higher energy subsidies, account for this vigorous import growth.

Exports in July rebounded, with a 19% gain year-on-year, which also beat the consensus forecast of 11.6%. But imports outpaced exports. As a result, the trade balance reverted to the recent trend of deficits. Catch-up from the holiday-related moderation in imports in June may partly explain the rebound. But strong domestic demand also underpinned the strength in imports while the challenging trade situation also played a role.

What it means for the central bank

The reversion to a trade deficit in July does not bode well for the current account in 3Q. The current account deficit in 2Q widened to -3% of GDP or to -$8 billion from a 2Q 2017 deficit of -1% of GDP or almost -$5 billion. Strong domestic demand could continue in the second half of the year and contribute to a further widening in the trade and current account deficits. We expect the current account deficit of -2.6% of GDP or a deficit of $28 billion in 2018 from 2017’s -1.4% of GDP or -$14.5 billion. We believe that the underperformance of the Indonesian rupiah in the past week is as much related to the slide in the Turkish Lira as to the widening current account deficit. These developments could argue for a non-consensus Bank Indonesia policy rate hike at this afternoon’s meeting.

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