Keeping the rupiah strong
2573 words
22 April 2006
Business Times Singapore
English
(c) 2006 Singapore Press Holdings Limited
OVERVIEW
FUELLED by the flow of hot money into Indonesia's equity and bond markets, the rupiah has been the world's best performing currency this year, gaining nearly 10 per cent against the US dollar in the first three months of the year.
But concerns are growing over the sustainability of the rupiah's current strength and Indonesia's macroeconomic stability, particularly as high interest rates are choking the real sector.
What then is the outlook for the rupiah, inflation and interest rates in the country? Can the government balance the need to lower interest rates so as to lessen operating costs for industry while keeping the rupiah at current levels? The Business Times assembled a panel of experts to tackle these questions.
PARTICIPANTS
in the roundtable:
Moderator: Shoeb Kagda, BT's Indonesia correspondent
Panelists:
Fauzi Ichsan, Indonesian economist, Standard Chartered Bank
Roosniati Salihin, deputy president, Bank Panin
David Chang, director of research, UOB Securities
Shoeb Kagda: Let's start with the rupiah. It is the best performing currency in the world this year. But can it sustain its momentum or are we looking at another up and down scenario?
Fauzi Ichsan: I think most analysts agree that the strengthening of the rupiah over the past four, five months has been due to the inflow of hot money into the equity and bond markets so there is a concern that such a rapid appreciation is not going to be sustainable in the long run.
However, there is also an argument that the strengthening of the rupiah has been created by a fundamental factor, which is the government's decision to raise domestic fuel prices by 126 per cent last October.
In doing so, Indonesia's fuel imports collapsed by about 25 per cent which increased the trade surplus dramatically. On top of that, because domestic fuel prices are closer to international prices, smuggling has also been curbed.
In that sense, while the rupiah's appreciation was created by the inflow of hot money, it is also supported by fundamental factors.
Roosniati Salihin: We follow closely what Bank Indonesia (BI) does and we are a bit surprised by the rupiah's strengthening. From a banker's perspective it's both good and bad in the sense that fewer people are interested in holding US dollars from our side, but the country's exports will be affected and I think we are still dependent on exports to strengthen our economy.
But mostly I think the credibility of the government's current economic team has helped a lot in terms of strengthening the economy. Indonesia's economy has always been quite deep but the credibility has been a positive factor. Whether this is sustainable or not will depend on where SBI (Bank Indonesia depository notes) rates will be in the second half of this year. We expect both interest rates and inflation to fall and only after this can the real sector start to expand again.
David Chang: In some ways the rupiah's strength has been fuelled by the stock market which has been quite strong this year. And stocks have done well because the equity market is driven by future expectations. Although the outlook for the first six months of this year is pessimistic, most investors are expecting a turnaround in the second half. That is still three months from now but the indications we get from the market are that most investors are confident of the Indonesian story and believe the economy will pick up.
So, yes, I am confident that the current rupiah level is sustainable. We are a long way away from the 2,500 level before the crisis and the 17,000 level at the worst, but I think the rupiah can continue to appreciate to below the 9,000 level against the US dollar. The key is how well the government continues to push for structural reforms and improve the investment climate.
Shoeb: In terms of where the rupiah is today and given that it has moved within a certain band since 2000, is this its real value?
Fauzi: We have always been bullish on the rupiah. Even when it was trading near 12,000 five to six months ago, we believed that it could strengthen back towards 9,500. Subsequently, we revised down our forecast to 9,000 and we've revised our forecast again to 8,500 by the end of 2006, basically on the back of capital inflows. And we believe the hot money inflow will continue because there is so much liquidity in the global financial markets.
Secondly, foreign direct investments are likely to rise for two reasons: Indonesia is the biggest market in Asean and it has abundant natural resources. And we haven't even taken into account the government's efforts to improve the investment climate. Now, if the government can pull it off and implement the investment package, then we can expect foreign direct investments to accelerate in the second half of the year. So there are several factors that have forced us to revise our rupiah forecast for this year.
At the moment we believe that the risk is mainly political because there is a widening gap between market expectation and reality on the ground. Markets were happy about the government's decision to raise fuel prices and President (Bambang) Yudhoyono's decision to reshuffle his Cabinet in December. However, the real economy is suffering, especially from higher inflation and high interest rates. Whether you like it or not, the economy operates on reality and not on market expectations so the challenge for the government is to narrow this widening gap. We do think that given the credibility of the current economic team, the government will manage to do this.
Roosniati: Many of our clients, especially the small and medium businesses, would like to see a more stable rupiah, instead of these ups and downs, because it makes it harder for them to calculate their costs and manage expectations. However, having said that, if the central bank continues with its strict money policies, and they seem to be doing a good job so far, I think the rupiah's current level is sustainable. For market players, the most important factor is sustainability and the government's seriousness in cutting the high cost economy, especially the unaccounted costs.
If this problem is not tackled, people will continue to prefer leaving their money in deposit accounts because of the high interest rates instead of using their funds to expand their business.
David: For the rupiah to continue to strengthen from this level, it will depend on how the government is able to implement changes in the investment programme. At the moment, the kind of investments we see coming in are in the areas of mining, plantations and agriculture. These are relatively simple capital-intensive investments that do not require a lot of workers.
To go beyond that, Indonesia has to compete with its neighbours for capital. When we go into the manufacturing and consumer sectors, I think the government has a very challenging task of changing the investment climate and one of the key aspects is the current labour law which the government is having difficulty submitting to Parliament. That would determine whether the rupiah stays at this level or strengthens.
Shoeb: The government has in the past used interest rates to manage the rupiah. How sensitive is the rupiah to current interest rate levels? And if interest rates do fall, what happens to the rupiah?
Roosniati: The government will be very careful in lowering interest rates and I think from the current signals, Bank Indonesia is not going to push down interest rates as fast as they raised them, and will take its time doing so. I think if interest rates are clearly going down in line with US interest rates, it should be manageable.
Fauzi: It depends on two things. First, on how much interest rates pick up, and we believe Bank Indonesia is unlikely to cut before the second half. We believe that at 12.75 per cent, the BI rate is at the peak of its cycle and it will be cut gradually to 11.25 per cent by the end of this year.
Secondly, assuming US Fed rates go up by another 25 basis points, that would still leave enough margin differential of 6-6.5 per cent which is fine as long as the investment climate is attractive enough to attract portfolio flows.
We believe that the government will improve the investment climate over the next nine months, maybe not as fast as investors might wish but they are moving in the right direction. That would be sufficient to convince investors that there is a long term story in Indonesia and that it's worth investing for the long run.
David: I am rather optimistic about the interest rate situation. Inflation rose quite sharply at the end of last year but by the second half of this year, inflation is expected to come down quite sharply. So assuming that real interest rates are kept constant until 2007, I expect SBI rates to be in single digits by the end of next year. This will be driven by improved foreign investments and continued gross domestic expansion.
Shoeb: Fauzi and Roosniati, do you share the same optimism?
Roosniati: The only downside we have to consider is security because portfolio money is very mobile and that needs to be taken into consideration. The only factor that can secure macroeconomic stability is FDI and longer term investments in infrastructure. I would worry if the money coming in is targeted only at equities or fixed income funds.
David: I think that FDIs for 2006 will definitely exceed last year's and the outlook for increased foreign direct investments is good. You look at just one deal - the sale of Bumi Resources was US$3.2 billion - and I understand there are other bigger investments in the oil and gas sector. But what I hope to see is more broad-based investment in other sectors.
Fauzi: We think that inflation will fall to 8 per cent this year and fall further to 5-6 per cent by the end of next year which would allow BI to cut one-month SBI rates to around 8 per cent by the end of next year.
David: We are not very far off from single digit one-month SBI rates so I think it is very achievable and it will be a significant decrease from current levels. That's why we are not being unrealistic to expect the equity market to continue to gain for the rest of this year.
Shoeb: Things look rosy on the macroeconomic front. What do you see as the major risks to Indonesia's continuing macroeconomic growth and stability? Another bomb perhaps?
Fauzi: I don't see terrorism as the biggest threat. I think the biggest threat will come from the government's inability to implement its policies and meet its promises to introduce structural reforms, the infrastructure package, the investment package. If it can't do that, investor optimism would slowly evaporate and as real investments might not rise fast enough to ensure that the 2.5 million new entrants to the labour force find full employment. If under-employment continues to rise to exceed 50 per cent of the labour force, that would create the potential for social and political instability.
Then the market optimism which we have seen building up to maximum level could certainly collapse. Of course, the possibility is small but we have to take it into consideration.
Roosniati: On top of that, the expectations on President Yudhoyono's government are quite high and if they are not met fast enough, confidence will fall. Furthermore, there is the competition from China, India and Vietnam which are all moving very fast and are FDI-friendly. We continue to promise that we are also pro-business and pro-foreign investors but we still have a lot of regulations and red tape.
David: If the government is not able to ensure labour reforms, I think that will be a major setback for investment potential in Indonesia and it will be less competitive than other countries in the region and Indonesia will continue to lose out. Furthermore, Indonesian companies will continue to lose their competitive advantage as well as worsen the unemployment problem.
Shoeb: Is 2006 a make or break year for Indonesia? How much of a window does the country have to put its house in order before investors lose patience?
David: Looking at it from the equities side, we always say that Indonesia has one chance to make it. This is that one chance. If we make it we will grow from here, if we don't we will have serious problems. Again using the stock market as an indicator, investors are willing to give Indonesia the benefit of the doubt and they are investing in the country. We should be able to see by the end of the year whether the government will keep its promise in the future years. So, yes, I think this is a crucial year and I think a lot of the investment positions will be decided this year.
Roosniati: Unlike western countries, we do not look at situations as make or break. Indonesians are a very patient people and not confrontational. I would prefer to call 2006 a transformation year for Indonesia as we have seen a lot of things happen which we have not seen before in our lifetime such as combating corruption. Changing the mindset of the people is not easy. I think we should give credit to the government and as Indonesians, we have to support this government and this president.
Fauzi: The government is certainly moving in the right direction and we have witnessed many things we have not witnessed ever before which is quite revolutionary. Also, the eagerness of the current economic team to introduce structural reforms on a timetable is unprecedented. The government knows where it has to go and it has given itself a strict timetable and it seems to be moving in the right direction.
It is willing to confront labour which many governments avoided doing in the past. It was willing to cut fuel subsidies sharply even though it is politically one of the most unpopular measures for any Indonesian government to implement and one which has brought down governments in the past. The markets and investors are now willing to give Indonesia the benefit of the doubt because the potential is there.