Following a decision by the Indonesian government to raise fuel prices, the Bank of Indonesia raised its benchmark rate to help stem inflation.
In mid-November, the Bank of Indonesia decided to raise its benchmark interest rate to 7.75% at an emergency meeting. This followed only five days after a previously scheduled meeting where the central bank decided to hold rates steady at 7.5%.
In the interim, newly-elected President Joko Widodo had removed some government fuel subsidies, lifting the price of fuel by 2,000 rupiah (around a 30% increase). While expected, the decision highlighted some of the economic challenges facing the Bank of Indonesia.
In a statement, the Bank said the move was “to ensure that inflationary pressures remain under control and temporary.” Inflation had previously been expected to come in near the Bank’s target of 4.5 ± 1.0% at year’s end. With the increase in the fuel price – which often passes through to shipping and food costs – the central bank now expects inflation to reach 8% before receding.
Preparation for a world without the Fed’s QE
The central bank currently maintains a high borrowing rate to help reduce Indonesia’s current account deficit, a measure of a country’s balance of payments including trade. A high current account deficit and a weak currency could leave Indonesia vulnerable to shifting capital flows. By raising rates, the Bank accomplishes two goals: it demonstrates it is ahead of the curve vis-à-vis inflation and it helps check the current account deficit from growing.
Over the past six months, Indonesia’s currency, the rupiah, fell by six percent as investors began eyeing a shake-up in the global interest rate landscape. With weakening demand abroad for Indonesian currency, higher domestic inflation could weaken the rupiah further. Raising interest rates will hopefully help to stabilize the currency.
On top of currency concerns, Indonesia has run a current account deficit since 2012. In Q3, that deficit dropped from over 4% of GDP to just about 3% on the back of a more favorable trade balance. This is a positive development for Indonesia. Lower deficits means less reliance on foreign short-term funding. The central bank forecasts further improvement in Q4.
Looking ahead, Indonesia will face an unbalanced global interest rate environment as the Fed likely will begin raising rates in mid 2015. While the Indonesia central bank expects capital inflows to Indonesia to continue, it has emphasized it will remain “vigilant” against external volatility.
Flagging growth?
The central bank’s focus on inflation and the current account certainly seem to indicate that it is wiling to tolerate somewhat slower growth in order to strengthen economic stability. In 2012, Indonesia had been growing at 6.5% annually, but now is managing just under 5.2%. While this is a sharp drop-off, a recent address by the central bank Governor, Agus Martowardojo, pointed to macro stability as a foundation for structural reforms to unlock higher potential growth. Keeping the lid on inflation does just that by giving the government room to work.
Confidence Measures
The increase in fuel prices will also help the central bank accomplish its mission in two ways. First, increasing the price of fuel should lead to reduced demand. Currently, oil and fuel imports make up a large part of the imbalance in Indonesia’s current account. Reduced energy imports will help alleviate that. This should help in the event of volatility stemming from US monetary policy normalization.
Secondly, the fuel subsidy program was previously estimated to consume close to 10% of the total government budget next year, roughly $11 billion. With that bill now reduced, the government should be able to allocate more funds for infrastructure and social welfare programs. In a statement, the Bank of Indonesia hoped that the policy “will boost the government’s fiscal capacity in terms of nurturing stronger and more sustainable economic growth.”
Investors should take confidence from the determination of Widodo’s government to push through the price hike (higher fuel prices are never popular) and from the central bank’s proactive measures. Indonesia seems to be moderately well positioned for potential future volatility. Its capital surplus in Q3 could fully finance its current account deficit, and its forex reserves have increased to over 6 months worth of imports and debt servicing.
Risks do remain, however. Higher domestic prices and borrowing costs could hurt growth more than the central bank imagines. An external shock could put pressure on the rupiah, which would lead to higher bills for energy imports. But, so far, it looks like the new government and the central bank are alert to preventing problems from arising.