Tuesday, March 8, 2011

Morgan Stanley: Indonesia Macro Trip Takeaways

By Deyi Tan, Hozefa Topiwalla & Shweta Singh | Singapore

What's new?
We hosted a macro trip to Jakarta, meeting with policy-makers, such as BKPM, BAPPENAS, MOF and Bank Indonesia, and independent macro observers, such as the World Bank. We highlight the key trip takeaways below:

1) Cyclical Downside Risks to Growth; Cyclical Upside Risks to Inflation

Downside risks to growth and upside risks to inflation were highlighted. With inflation remaining above target due to supply shocks from food and oil, the need to manage inflation expectations from cost-push inflation spillover remains. Regional currencies appear to be riding on a wave of appreciation, and so is the rupiah. A combination of different policy response mix (i.e., currency, interest rate, liquidity and macro prudential measures) is likely to be undertaken to reinforce policy effectiveness.

In Indonesia, the currency and the interest rate were de-coupled in 2010, courtesy of QE2, strong capital inflows into this part of the world and the ‘trilemma' pressures that central banks were facing. However, with inflation being a concern, Bank Indonesia not having been ahead of the curve in managing inflation and capital flow volatility, we think the currency and interest rate policy will likely be coupled again in 2011. We believe that currency appreciation will reinforce the effectiveness of the monetary policy response, but it is unlikely to replace the interest rate tool as the key tool.

2) The FX War Chest Is Growing; Structural Story Remains Alive

A current account surplus is expected for 2011, although this is likely to narrow and possibly give way to a current account deficit in 2012 as imports expand. The financial account is expected to improve, with FDI taking up a more significant share compared to portfolio flows. On the back of balance-of-payments flow, the foreign reserve level continues to rise and has now reached the US$100 billion mark (see ASEAN MacroScope Indonesia: The US$100bn War Chest, February 14, 2011).

We think that reaching the US$100 billion mark is an important milestone. We have been highlighting the bullish story of structural decline in the cost of capital since 2009 (see Indonesia Economics: Adding Another ‘I' to the B-R-I-C Story? June 12, 2009) and FX reserves are an important part of this. External funding linkages and their collateral impact on IDR during risk-aversion periods have been Indonesia's Achilles' heel. A sturdy war chest of foreign reserves should help break the vicious loop that tends to go from capital flight to liquidity dry-up to currency depreciation to import-led inflation and then to forced policy tightening. Macro volatility is reduced, driving lower lows and lower highs in capital cost, which in turn will help incentivise investment and engineer higher potential growth. With the higher foreign reserve levels, policy-makers also appear to be more comfortable in managing liquidity risks this time round. Indeed, in this context and despite cyclical inflation issues, the structural story of decline in the cost of capital in Indonesia remains very much alive.

3) Private Investment Story Underway; Infrastructure Investment Likely to Follow

Private investment momentum remains healthy, and momentum is expected to pick up further this year. This underpins our story on how the medium-term structural decline in capital cost will help incentivise further private investment growth. On the other hand, however, infrastructure bottlenecks continue to be bugbears. Recent stories of congestion and stranded trucks in Port Merak are a case in point. The latest fiscal budget appears to have planned for an increase in infrastructure expenditure. However, execution of infrastructure investment remains a focal point.

On the infrastructure front, we believe that reforms are gaining pace, which will ultimately help to support infrastructure spending. Indeed, while President Susilo Bambang Yudhoyono first held the Infrastructure Summit in 2005, we think 2005 should not be seen as the inflexion point in infrastructure spending, but rather the start of the infrastructure reform momentum. The message we got this time appears to be consistent with what we have heard previously (see Indonesia Strategy: Key Takeaways from Our Jakarta Trip, January 10, 2011). Several important regulatory changes have been made, and others are underway. For example, the Indonesia Infrastructure Guarantee Fund, which has been set up, will help to provide government guarantees to improve the bankability of PPP projects. PT SMI and PT IIF will help provide long-term financing for PPP projects. The Project Development Facility, on the other hand, will help to improve project preparation. Meanwhile, policy-makers are also proposing to make the tendering process more flexible to remove the minimum requirement for number of bidders. The new land acquisition bill is also expected to be passed in the first semester this year, which would help to reduce both the cost and time uncertainty in acquiring land. The 2010-14 PPP Book outlines 100 projects worth US$47 billion. However, policy-makers intend to prioritise five key projects, namely: 1) Central Java Power Plant; 2) Bali cruise terminal; 3) Jakarta Airport rail connection; 4) East Java Water Supply; and 5) Medan airport toll road, to inspire confidence in Indonesia's ability to execute on PPP projects. Tender for most of these projects will be done in 2011.


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