Bank Indonesia on Hold as Rupiah Solid Ahead of April Elections

Bank Indonesia meets Thursday and is expected to keep rates steady at 6.0%. If the rupiah remains relatively firm, then BI is likely to remain on hold for the time being. Elections in April are unlikely to have much impact as Jokowi is widely expected to win a second term.

POLITICAL OUTLOOK

President Joko Widodo (Jokowi) is finishing up his 5-year term. He remains highly popular, regularly leading all polls ahead of the next elections. The economy has fallen short of his pledge of 7% growth, but Jokowi’s popularity has not suffered much, it seems. He cut costly fuel subsidies and opened the country to foreign investment.

Elections will be held in April 2019. The presidential and parliamentary vote will be held simultaneously for the first time ever. Recent polls suggest Jokowi will come out on top again to serve a second and final 5-year term, and this is our base case. The latest reading shows Jokowi ahead 55-35%, with 10% undecided or not voting.

Former General Prabowo Subianto will stage a rematch with Jokowi. He is backed by the Great Indonesia Movement Party (Gerindra). In the 2014 election, Jokowi beat Prabowo 53-47%. Recall that Prabowo disputed the 2014 election and withdrew before the count was completed. Before the 2014 election, Prabowo ran and lost in 2009 as the running mate of Megawati Sukarnoputri.

Corruption remains one of the country’s biggest challenges. Indonesia scores relatively low in the World Bank’s Ease of Doing Business rankings (73 out of 190 and down from 72 the previous year). The worst components are starting a business and enforcing contracts, while the best are getting electricity and resolving insolvency. It does slightly worse in Transparency International’s Corruption Perceptions Index (96 out of 180 and tied with Brazil, Colombia, Panama, Peru, Thailand, and Zambia).

 

A BRIEF HISTORY LESSON

After its loss in World War II ended Japan’s occupation of Indonesia, nationalists immediately declared independence from the Dutch. Returning Dutch forces, aided by the UK, clashed with these nationalists, who were led by Sukarno and many others. After several years of fighting, the Netherlands formally recognized independence for Indonesia in 1949, with Sukarno becoming the first president. Sukarno was later named president-for-life in 1963.

After overthrowing Sukarno in 1967, Suharto ruled Indonesia from 1968-1998. Having been appointed president initially, Suharto was not aligned with any political party. In order to stand in the next elections, Suharto took control of an existing military federation called Golkar (roughly translated as “Working Group”) and turned it into his own party. During this period, the president was appointed by parliament. Given Golkar’s dominance given one-party rule, this all but cemented Suharto’s role as a potential president-for-life.

The deepening Asian crisis led to violent riots in May 1998, caused by food shortages and rising unemployment. Ultimately, the economic crisis cost President Suharto his job as he lost the support of the populace and the armed forces. He was forced to resign in May 1998 and was replaced by his Vice President Habibie, who served as interim President until the 1999 elections.

The fall of Suharto saw the creation of several political parties to challenge Golkar. In the 1999 parliamentary elections, Megawati Sukarnoputri’s Indonesian Democratic Party-Struggle (PDI-P) won the most seats with 33% of the vote. Megawati (Sukarno’s daughter) was denied the presidency by Abdurrahman Wahid (also known as Gus Dur). Gus Dur was able to win the presidency when his National Awakening Party (PKB) allied with other Muslim parties to form the so-called Central Axis.

Gus Dur’s term was plagued by economic and political instability, leading him to become increasingly erratic. Coupled with some corruption scandals, this eventually led parliament to formally impeach him in July 2001. He was replaced by runner-up Megawati. That year, parliament declared that starting in 2004, the president would be elected by the popular vote. In the 2004 election, Susilo Bambang Yudhoyono became the nation’s first directly elected president by beating incumbent Megawati Sukarnoputri in the runoff election.

Yudhoyono won a second term in 2009, beating former President Megawati with a commanding 60.8% of the vote in the first round. In 2014, Yudhoyono completed his second five-year term and could not seek re-election. Current President Joko Widodo (PDI-P) won over Prabowo Subianto (Gerindra) with 53% of the vote in the first round.

 

ECONOMIC OUTLOOK

Jokowi is benefitting from a fairly robust economy. The IMF expects GDP growth of 5.1% in 2019 and 5.6% in 2020 vs. an estimated 5.1% in 2018. GDP rose 5.2% y/y in Q3, but data in Q4 suggest some deceleration as we move into 2019. As such, we see some downside risks to these growth forecasts.

Price pressures remain low. CPI rose 3.1% y/y in December, near the bottom of the 3-5% target range. Pipeline price pressures are still easing. WPI rose 3.7% y/y in November, the lowest since June and the fourth straight month decelerating. These readings suggest potential for further deceleration in consumer inflation.

The central bank has paused for now. It started the tightening cycle back in May 2018 and hiked a total of 175 bp over the course of the year, largely in response to the plunging rupiah. Bank Indonesia was able to stand pat in December due to the firmer rupiah. The next policy meeting is Thursday and no change is expected. As long as the rupiah remains strong or stable, there will be no urgency to resume the tightening cycle.

The fiscal accounts remain in solid shape. The OECD sees the budget deficit narrowing to -2.0% in 2019 and -1.8% in 2020 from an estimated -2.3% in 2018 and -2.9% actual in 2017. We may see some deterioration in H1 2019 in the runup to the elections, but the medium-term trajectory remains favorable as Jokowi has been able to substantially shave subsidy costs during his first term.

The external accounts are likely to deteriorate modestly. Export growth has slowed recently, pushing the 12-month total trade balance into deficit beginning in August. That deficit has grown to the highest level since September 2013. The OECD sees the current account deficit widening to -2.6% of GDP this year and -2.5% in 2020 from an estimated -1.8% in 2018. However, we see upside risks to these deficit forecasts given the deterioration in the trade balance.

Foreign reserves have edged higher recently. Reserves troughed near $115 bln in September but have risen to $120.7 bln in December. This is the highest since May and covers 6 months of imports and are equivalent to more than twice the stock of short-term external debt. Lastly, Indonesia’s Net International Investment Position has fallen to only -29% of GDP, the lowest on record.

Foreign ownership of Indonesian government bonds peaked at 41% in January before falling steadily over the course of the year a still-high 38% in December. As such, Indonesia still remains vulnerable to shifts in hot money flows from abroad.

 

INVESTMENT OUTLOOK

The rupiah is outperforming after underperforming last year. In 2018, IDR fell-6% and was only slightly better than the worst performers ARS (-50.5%), TRY (-28%), RUB (-17.5%), BRL (-14.5%), and ZAR (-14%). So far in 2019, IDR is amongst the best EM performers at +2%, trailing only BRL (+4%), RUB (+4%), ZAR (+4%), COP (+3.5%), MXN (+3), and CLP (+3%). Our EM FX model shows the rupiah to have NEUTRAL fundamentals, and so we expect this outperformance to ebb a bit.

USD/IDR is trading at its lowest levels since last June just above 14000. The pair is on track to test the June 2018 low near 13839. However, a clean break below the 14035 area would set up a test of the January 2018 low near 13263.   Much will depend on the external environment.

Indonesian equities are underperforming after outperforming last year. In 2018, MSCI Indonesia fell -5% and compares to -17.5% for MSCI EM. So far in 2019, MSCI Indonesia is up 4.0% vs. a 5.5% gain for MSCI EM. This is underperformance is expected to continue, as Indonesia has an UNDERWEIGHT in our EM Equity Allocation model.

Indonesian bonds are underperforming. The yield on 10-year local currency government bonds is +4 bp YTD and is behind only the worst EM performers Colombia (+23 bp) and Singapore (+9 bp). With inflation likely to remain low and the central bank on hold for now, we think Indonesian bonds will start to outperform.

Our own sovereign ratings model showed Indonesia’s implied rating was steady at BBB+/Baa1/BBB+. Actual ratings of BBB-/Baa2/BBB are still enjoying some upgrade potential.