W

hile capital market investors had plenty to smile about in 2010 given a 46 percent increase in the Jakarta Composite Index, the best performing in the region, and a 12 percent return from the IDMA government bonds index on foreign capital inflows, 2011 may prove to be a much more difficult year to make money in our view.

The first threat to spoil the capital market party this year will be inflationary pressure. It is possible that the smiles we have been seeing could disappear as macroeconomic indicators start destabilizing.

December’s inflation rate already climbed to a 20-month high of 6.96 percent year-on-year (y-y), higher than our estimate of 6.67 percent y-y and market consensus of 6.71 percent.

On a month-on-month (m-m) basis, December’s 0.92 percent inflation was more than double the 0.4 percent average December inflation in the past several years. This brought 2010 year-to-date inflation to 6.76 percent, or two times higher than 2009’s level of 2.76 percent.

Quite similar to the previous month, December’s inflation rate was mainly contributed by raw foods and clothing of 2.81 percent and 1.08 percent m-m respectively on holiday seasonality. It is worth highlighting that raw foods like chilies surged some 40 percent from early December on the back of bad weather disrupting supplies.

World Meteorological Organization (WMO) said moderate to strong La Niña is expected to continue at least trough the first quarter of this year in the central and eastern tropical Pacific. This would continue to bring wetter than normal conditions in several pacific areas including Indonesia.

Heavy rainfalls caused by the La Niña may not just disrupt Indonesia’s rice production, but also other big rice producers such as Thailand and Vietnam. Although those countries are estimated to remain in surplus this year, they are likely to be reluctant to export in a big way given the need to secure their own domestic requirements. This would result in global rice prices to jump as speculation broadens in our view.

Given subsidized oil limitation program starting in March and expected supply shortages of rice and other food materials, we revise our inflation target from 6.7 percent to 7.5 percent at end 2011.

This means higher core inflation which should hit 5 percent by May on rapid acceleration of raw materials prices.

Thus, we believe that the central bank will be forced to raise its benchmark rates gradually by 100 basis points (bps) in aggregate to 7.50 percent by the end of this year, or 50 bps higher than our previous target of 7.00 percent. We see that central bank will lift the BI rate starting in May as core inflation reaches 5 percent. With higher inflationary pressure from Lebaran’s seasonal effect, BI will have to raise its benchmark rate more aggressively in August-October 2011 in our view.

In the past the central bank has been reluctant in raising rates due to continued foreign inflows. As a result, Bank Indonesia has recently announced a measure to help stabilize the rupiah by reducing its sterilization cost trough limiting short-term foreign borrowings up to 30 percent maximum of banks’ total capital. In addition, Bank Indonesia is also tightening through raising foreign exchange reserve requirement ratio to 8 percent by June 2011.

In conclusion, we suggest investors to tighten their seatbelts amid upward pressure on inflation, which would necessitate interest rate hikes by the central bank.