At the central bank’s board of governors meeting on July 20-21, Bank Indonesia (BI) maintained its benchmark rate at 6.5 percent, against the consensus forecast, shared by Bahana Securities, of a cut to 6.25 percent, and a seven-day reverse repo rate of 5.25 percent, compared with the Bahana and consensus forecast of 5.5 percent — all against market expectations.

At this stage of the market cycle, BI apparently believes that the implementation of monetary easing coupled with fiscal spending has already strengthened Indonesia’s economic growth momentum.

Moreover, BI sees a stable economy, supported by manageable inflation, improved current account deficit and expects a stable rupiah exchange rate against the US dollar to support further recovery.

On the tax amnesty front, BI supports the implementation, which could increase liquidity and infrastructure funding. Finally, BI reiterated its migration rate plan to the seven-day reverse repo rate, which will be implemented on Aug. 19.

At this point, BI maintains its 2016 economic growth forecast ranging from 5 percent to 5.4 percent, compared with Bahana’s 5.1 percent forecast. In the second quarter, the central bank is looking at GDP growth of 4.94 percent, versus 4.92 percent in first quarter and Bahana’s forecast of 5 percent, helped by improved household spending that supported higher retail sales as a result of the Idul Fitri festivities and higher government expenditure. Furthermore, recent increased commodity prices have led to a better-than-expected second quarter trade balance surplus of US$1.9 billion, from $1.7 billion in the first quarter.

External factors such as Brexit failed to curb fund inflows, which amounted to $482 million in government bonds and $676.6 million into the stock market, benefiting from positive tax amnesty
sentiment.

This has allowed for an improvement in the rupiah’s exchange rate, with July’s appreciation at 1.2 percent, from 2.5 percent in June.

On the Fed rate, BI predicts one rate hike to come by 2016 year-end while our analysis indicates that Brexit is triggering steep drops in global yields worldwide (figure 1), but with a limited impact on Indonesia given only 1.1 percent direct export exposure or 4 percent total exposure to the UK.

On the domestic side, the recent implementation of the tax amnesty has provided positive sentiment to markets. Looking ahead, as we expect global bond yields to continue to remain low, we revise our rupiah exchange rate expectations to Rp 13,500 against the US dollar by 2016 year-end, from Rp 14,000 previously, and Rp 13,000 by 2017 year-end, from Rp 13,500 in previous forecast.

Going forward, we still project BI to lower its benchmark rate (Figure 2) on continued low global yields, subdued global growth and weak inflation expectations. As a consequence, we have already revised down our BI rate projection to 5.75 percent, from 6.25 percent previously, by the end of 2016, as well as for 4.5 percent for the seven-day reverse repo rate, compared with 5 percent in our previous estimate. This is expected to translate into a lower 10-year government bond yield at 6.5 percent, versus 7 percent previously.

At the moment, we retain our view of a lower interest environment and we expect BI to deliver its next rate cut in August.

Looking at the previous cycle of 2010-2012 economic boom and massive capital inflows, BI was reluctant to have a relatively strong rupiah and is likely to cut interest rates significantly during the period of huge capital inflows.

That said, we conclude that for the financial markets, another delay in firm monetary loosening by the central bank should be perceived as negative, resulting in lower growth expectations and an inflation figure at the lower end of BI’s target range of 4 percent, plus-or-minus 1 percentage point.

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The writer is an economist at Bahana Securities.

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