Decision: Bank Indonesia acknowledged the risk of inflation breaching the 2-4% target in second half the year and pressure on the currency from global cues but did not exhibit any urgency to normalise policy. Policymakers held the policy rate unchanged at 3.5%, steady since February 2021. Withdrawal of excess liquidity remains the preferred route as the gradual increase in the reserve requirement rate announced in May runs its course. Year-to-date, RRR hikes have reportedly absorbed IDR 119trn worth liquidity without causing material disruption to banks’ financing/ credit activity.

Economic assessment: The central bank’s take on the global and domestic projections were little changed from the last rate review. The view on US Fed rate matched market expectations, with end-2022 rate at 3.5% and end-2023 at 4.0%. Global growth faced downside risks, with average oil price seen at $103bbl, higher end of the government’s budgeted range. Domestic growth forecast remained at 4.5-5.3%, with inflation expected to test past the 2-4% target in second half of the year, before returning to the band in 2023. A manageable core inflation path and limited second round effects were seen as positives. Credit growth is expected to top the official forecast of 7-9% underscoring easy financial conditions. Rupiah movements are likely to be monitored and strengthened through the rupiah exchange rate stabilisation policy through triple intervention framework.

Policy dashboard: Even as Bank Indonesia flagged the uncertain global backdrop and an aggressive US Fed, signs of an impending shift in policy direction were largely absent. In our view, the central bank’s decision to sit out the hawkish camp is premised on: 

• BI pre-empted the June inflation report, where headline inflation is expected to breach the upper band of the 4% target range (DBSf: 4.1% yoy). This rise is, however, seen as being supply-driven, with second round effects still muted with core readings below the 3% mark

• Higher subsidy budget has helped contain inflation pressures, thereby providing more headroom to BI to remain in sync with a growth-supportive fiscal policy

• Terms-of-trade benefits will counter risks of any deterioration in the external balance (we see the likelihood of a small current account surplus this year)

• US-Indonesia rate differentials have narrowed but the share of rate sensitive flows in the bond market has fallen vs the last tightening cycle (17% vs 38% before the pandemic)

• Despite rupiah’s recent depreciation, on year-to-date basis the currency is amongst the regional outperformers owing to the commodity windfall. Add to this, our DBS Equilibrium Exchange Rate (DEER model) projects the rupiah to be slightly overvalued in our latest update, questioning the need for tightening rates

 

Factoring in the above arguments and absence of any material change in the central bank’s guidance, we delay our rate hike call to August (from July currently), whilst maintaining the total quantum of hikes for the year at 75bp.

Risks to policymakers’ dovish bias stem from any correction in commodity prices on global recessionary fears in 2H as well a sharp rally in the US$ due to broader risk aversion, which could add depreciation pressure on the rupiah. We continue to monitor BI’s commentary in the run-up to the July policy review.

Oil prices and its fiscal impact still under watch

As we discussed in High subsidy budget leaves Bank Indonesia with more headroom, extension of subsidies helped to keep a lid on price pressures, thereby allowing the authorities more headroom to keep rates on hold.

Two developments, however, suggest fiscal burden could rise if prices of commonly used fuel variants are to be kept unchanged. Firstly, Brent price has averaged $104/bbl year-to-date in 2022, at the upper end of the government’s revised budgeted oil price adjusted to $95-$105/bbl. Supply concerns have, however, lifted prices in June, where month-to-date average is $118/bbl, 13% above official assumption. If such levels prevail in 2H, the subsidy bill could rise further. Secondly, significant widening in oil market crack spreads points to a potential increase in fiscal costs, as prices of more expensive retail fuel prices i.e., refined products need to be kept unchanged whilst revenue gains from natural resources (O&G) moderates. This is likely to carry implications for the economy’s trade (current account) and fiscal math.

Fiscal consolidation needed in 2023

Between Jan-Apr22, total revenues rose by a sharp 46% yoy, boosted by across-the-board pickup in tax (see chart), customs & excise and non-tax receipts, benefiting from price boost in commodity prices, strong trade, and reopening lift. Expenditure rose at a slower clip of 4%, driven in part by higher subsidies, interest payments and social assistance. 



We peg our 2022 fiscal deficit forecast at -4.5% of GDP. Banking on terms-of-trade benefits from higher commodity prices, and post pandemic boost, the 2023 fiscal deficit path is geared to return to sub-3% of GDP path. The mandate of Law No. 2/2020 on state fiscal policy and system stability was to provide the government the temporary provision of exceeding the budget deficit cap of -3.0% of GDP for a maximum of three years, due to the pandemic. In line with this provision, 2023 deficit has been pegged at -2.81-2.95% of GDP vs -4.85% in 2022. The underlying math assumes: 

• 2023 deficit at IDR 562.6trn (-30% yoy)
• State revenues IDR 2255trn to 2383trn (11.3% to 11.8% of GDP)
• State spending IDR 2818trn to 2979trn
• Around IDR 27trn to 30trn is likely to be allocated towards the new capital

Notably, there will be few savings as pandemic-led stimulus measures are wound down next year and new taxes are considered. Key amongst this will be a) exemptions on income taxes, for instance for companies from sale of imported goods, lower tax rates for priority business sectors etc.; b) VAT exemptions to health sector players i.e., hospitals, agencies contribute to medicines, vaccines, as well as real estate purchases etc.; c) luxury VAT on cars exemptions will end and rates on purchases from 3Q will start and be gradually restored by 4Q.  Concurrently, just as the VAT rate increase by 1% went into effect from April 2022, the government started i) taxing crypto transactions and assets; b) coal royalty rate was raised on new contracts on 14-28% if prices reach $100/ton from the current 13.5%. Notably, producers who fulfil DMOs (effectively cap prices at $70-$90, will be subject to 14%).

Encouraged by favourable momentum in the fiscal math, trade as well as on-course recovery led the S&P Global Ratings to dial up Indonesia’s rating outlook to ‘stable’ from ‘negative’ earlier in the year.



Besides the math outlined, the prospect of a higher subsidy bill (if oil stays above the assumed range), higher transfers to state owned oil companies, correction in non-O&G commodities and slow growth/ recession prospects in major economies are risks on the horizon, which might jeopardise revenue assumptions, in turn necessitating a sharper pull back in spending plans to keep within targets next year. 

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