Bank Indonesia (BI) lowered the policy interest rate by 25 basis points to 7.25% on Thursday (14 January) as previous efforts at fiscal stimulus and other macroeconomic policy moves do not appear to have succeeded in boosting the economy.
IHS perspective | |
Significance | This was the first reduction in the BI rate in 11 months as elevated inflation, poor investor sentiment towards emerging markets in the second half of 2015, and the resulting bouts of significant currency depreciation made even hinting at easing monetary policy a risky proposition. |
Implications | IHS has felt for several months that with inflation easing following the removal of fuel subsidies, and weak global demand, that BI should reduce the policy interest rate in order to bolster a domestic economy that is struggling to gain momentum. |
Outlook | It will be critical over the next few days and weeks to see how investors react to the BI's shift towards an easing bias for monetary policy as well as all incoming economic news. However, IHS has long believed that investors would respond positively to monetary easing as it would be addressing the economy's core domestic demand issues which are easier to deal with than weak external demand. IHS is not currently expecting BI to carry out additional easing, but the bank's shift in tone opens the door for it. |
Bank Indonesia makes its move to stimulate the economy after months of signalling
After indicating since October 2015 that there is increasingly room for monetary easing in Indonesia, BI's board of governors finally acted by reducing the BI rate to 7.25% at its first meeting of 2016. The bank indicates that fourth quarter growth for 2015 did not "improve significantly" despite continued ramping up of government spending and some moves by the central bank to create looser liquidity conditions without lowering the BI rate. This is one of the major reasons for the reduction of the BI rate, with falling inflation and stability in the rupiah following the first increase in the US federal funds rate also being supportive of the rate cut. According to BI, during the fourth quarter exports continued to struggle from weak demand and prices, while domestic demand was led almost entirely by government spending with private investment remaining weak and private consumption holding steady. More encouraging was the USD5.6 billion increase in international reserves during December, which was the first month-on-month (m/m) increase since February 2015 and the largest increase since April 2012, putting reserves at USD105.9 billion at the end of the month.
The bank's post-decision press release also indicated that further monetary easing "will take place after rigorous assessments of the domestic and global economy". This hints at the bank being open to the idea of further easing, but not unless the incoming economic data indicates that this is a prudent move. BI indicates that one favourable development was that the US Federal Reserve Bank (the Fed)'s move to raise interest rates in December did not cause market turmoil, and this is certainly one area that BI will be monitoring closely as the Fed is expected to gradually raise interest rates further over the near and medium term. Additionally BI indicated that it will be closely monitoring conditions in China and movements in commodities prices as both will be critical to foreign exchange earnings and the government's 2016 budget revenues and spending plans.
Growth outlook remains uninspiring, but inflation should remain low
Based on the press release from BI, economic conditions in Indonesia were more or less unchanged from the third quarter, where GDP growth was driven primarily by the government succeeding in ramping up budget implementation/spending (see Indonesia: 6 November 2015: Indonesia economy strengthens marginally in Q3, will struggle to meet government's growth targets). Domestic demand was otherwise limited with BI indicating private fixed investment remained fragile due to the persistent weakness in commodity prices and profitability as well as excess capacity due to weak domestic demand. Interestingly, the bank indicates that private consumption held steady. The weakness in domestic demand is evident in the weak credit demand figures with the country's broad money supply measure (M2) expanding just 9.2% year on year (y/y) in November 2015, the weakest November result in 11 years. Additionally, nominal US dollar import data continue to show imports of capital and consumption goods contracting in excess of 20% y/y as of November. It is unclear if the reduction in interest rates will bolster private sector demand, but when combined with weaker inflation it should, at a minimum, bolster sentiment. Currently IHS expects the economy to expand 4.4% for 2016, after expanding an estimated 4.7% in 2015 with any improvements in domestic demand being met by imports while export performance remains weak.
Inflation sunk towards the bottom band of BI's 3–5% inflation target by December 2015 because the inflationary impact of the reduction and subsequent full removal of petrol subsidies starting from November 2014 have largely worked their way through the economy (see Indonesia: 5 January 2016: Indonesian inflation hits six-year low in December but may not fall much further). More favourable base effects as well as continued weakness in commodities prices, and limited growth in domestic demand, will support low near-term inflation. IHS's January forecast calls for annual average inflation of 3.7% for 2016, with prices slowly drifting upwards as the year progresses in part due to expected drought conditions caused by the El Niño weather pattern boosting food prices. Thankfully the drought conditions have not yet had a significant impact on food prices, but as drought conditions persist agricultural production will suffer. Additional upside risk to inflation stems from the potential for another sharp depreciation of the rupiah as global economic conditions remains soft and potentially because of BI's move towards an easing bias for monetary policy.
Outlook and implications
BI has opened the door wide to an easing bias for monetary policy. However, further easing by the central bank may not arise if the recent developments in the Chinese economy result in weaker export revenues and resurgent negative investor sentiment towards the rupiah. Thankfully inflation should remain on the lower end of the bank's 3–5% 2016 inflation target for the next few months before rising slowly. If external demand and foreign investment conditions remain stable and inflation low, BI should have the space to lower interest rates further to support domestic demand. Otherwise BI may need to undertake some other macroprudential regulations to simultaneously boost economic activity while limiting the impact of liquidity boosting measures on the rupiah and inflation. IHS does not currently expect the central bank to lower interest rates further, but like BI we will be closely reviewing data releases from both Indonesia and other major trading partner economies ahead of Indonesia's fourth quarter GDP release and our February forecast round looking for the potential for additional rate reductions.