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Analysis: Capital inflows and fiscal policy risk
In line with our expectations, capital inflows have continued into the Indonesian market, especially through government bonds as the yield of the 10-year rupiah bond fell to 7
Change Size
In line with our expectations, capital inflows have continued into the Indonesian market, especially through government bonds as the yield of the 10-year rupiah bond fell to 7.78 percent from last week's 7.92 percent.
Since the beginning of the month, fund inflows to the stock market and bond market reached US$149 million and $683 million (see graphic 1), respectively, supported by rupiah appreciation of around 0.5 percent during that week.
Our view on higher support coming from local investors materialized when domestic ownership in government bonds rose to Rp 949 trillion last month despite the lack of support from banks (see graphic 2). Lenders cut government bond portfolios by Rp 46 trillion after reaching an all-time high of Rp 486 trillion on March 3.
Looking ahead, the European Central Bank (ECB) will continue its quantitative easing and we expect capital inflows into Indonesian government bonds to persist, allowing for the 10-year rupiah bond yield to fall to 7 percent by the end of the year.
Supported by capital flows, higher loan disbursements and rupiah appreciation, February's foreign reserves reached $104.5 billion, which we believe was a part of the central bank's strategy to strengthen its war chest.
Going forward, we note that seasonally low government debt repayments will begin in April (see graphic 3), paving the way for higher foreign reserves ahead. However, recent oil price increases remain a risk.
Additional market risk could stem from steep appreciation of the rupiah, a concern that was also voiced by Bank Indonesia (BI)'s research department in a recent meeting with us. Looking at the trend of the rupiah since October 2015, our local currency has already appreciated quickly.
In our view, possible profit-taking and market repositioning ahead of the Federal Open Market Committee (FOMC) meeting on March 17 could limit the upside of the rupiah in the short-term. We expect the rupiah to trade at around 13,000-13,300 against the US dollar through next week.
Our realistic approach toward government spending and fiscal deficit expectation is also in line with the government's recent report on the low realization of February's tax revenues at Rp 122.1 trillion (-6.4 percent year-on-year), with spending coming in at Rp 251.5 trillion (+25.4 percent yoy).
Looking at the trend in the last two years, domestic tax collection, without significant improvement, could be below Rp 1,000 trillion this year, forcing the government to cut spending by up to Rp 500 trillion, assuming a 2.7 percent fiscal deficit. The government has three possible moves to tackle its lowered revenues. First, it could cut spending. Second, the government could issue more government bonds and third, the government could pursue a tax amnesty policy.
On the tax front, there are plans to accelerate and intensify individual income tax collection by training around 4,000 tax office personnel. Note that 2015 data indicated that the individual income tax share constituted around 22 percent of total tax revenues.
On the government's bond issuance, we remain confident that foreign capital inflows will support government bonds and provide additional liquidity to the financial system, particularly given dovish policies from major central banks to allow for a low global yield environment. Note that the 2016's capital inflow already lowered the JIBOR overnight rate to 5.13 percent from last year's 7.59 percent.
With oil up 8.37 percent on intentionally lowered production, commodity prices in the past week continued their uptrend with crude palm oil up 4.45 percent and coal rising 4.36 percent. In the current market cycle, we believe the dovish tendencies of global central banks since 2015 and expansionary fiscal policies implemented by many Asian countries are the factors behind the rally. At this stage, we prefer to wait for further economic data prior to deciding whether or not the recent moves are justified.
Finally, we believe BI is likely to maintain its benchmark rate at 7 percent as they need to assess the impact of the FOMC meeting and the recent steep appreciation of the rupiah to the overall economy while maintaining its dovish policy stance.
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The writer is an economist at Bahana Securities.
