Indonesia
Indonesia: EU Concerns, China Tightening and Inflation
June 07, 2010

By Deyi Tan, Chetan Ahya & Shweta Singh | Singapore

A Wall of Worries?

We remain most bullish on Indonesia within ASEAN from a medium-term structural perspective. Yet, EU sovereign debt concerns and Chinese tightening introduce some risks to the growth equation. As we had outlined in earlier research (see Implications of EU Debt Concerns for AXJ, Chetan Ahya and Sumeet Kariwala, May 10, 2010), Indonesia is one of the trio (India, Indonesia and Korea) which is most vulnerable to EU sovereign debt concerns on account of its balance sheet linkages - i.e., relatively higher dependence on external financing. In a period of risk-aversion when markets focus precisely on such linkages, it is not surprising that Indonesia's equity market (in USD terms) saw one of the worst corrections in AXJ in the period from the end of April to the recent low on May 25.

Still Exposed but Less Vulnerable than Before

To a certain extent, this cycle is not different from 2008 in that those in AXJ which were more vulnerable back then are also the ones which saw a comparatively bigger impact in equity markets in the recent low. Yet, we argue that Indonesia is less vulnerable now compared to how it was in 2008.

For starters, we think external conditions are less treacherous compared to the 2008 financial crisis.  Libor-OIS spreads have inched upwards to 31bp from 13bp as of end-April. However, as our head of global rates strategy, Jim Caron, points out, while USD funding costs have gone higher as a reflection of the new paradigm of risks, credit is not inaccessible, as it was in 2008 when Libor-OIS spreads blew out at 366bp in October. Moreover, the 2008 crisis involved subprime mortgages and a sizeable derivatives market which were bought by leveraged institutions, magnifying the destructive power when the US housing market turned. Unlike then, though, we understand from our credit colleagues that this is less the case with European sovereign bonds.

Second, domestic macro fundamentals are in better shape compared to mid-2008 before the Lehman event hit. Back then, Indonesia was on a liquidity high. We had highlighted then that Indonesia could be overheating and the central bank was behind the curve in terms of policy tightening. The current account balance had dipped into negative territory by 2Q08. As a sign of tightening domestic liquidity, a divergence between 3M JIBOR and the policy rate was already opening up in mid-2008. Running high growth via strong credit expansion alongside a current account deficit is a potentially destabilizing concoction, leaving the economy vulnerable to sudden stops in capital flows. Add to that the fact that a high percentage of central bank bills are held by foreigners which are prone to flow reversal and capital account convertibility in Indonesia is high. When risk-aversion arises and flows dwindle, credit-fuelled macro momentum invariably slows.

That was then and, under those conditions, one has to agree that Indonesia had still withstood the 2008 financial crisis fairly well, thanks to its long-standing improvement in macro fundamentals. If so, this time is likely to be better, as the first ingredient of strong credit expansion is absent. Macro momentum is less dependent on credit with loan growth standing at 17.6%Y in May 2010 (versus a peak of 39.3%Y in October 2008). Policymakers' ability to manage the currency and domestic liquidity conditions is also better, with the second ingredient of external balance position getting more comfortable. Foreign reserve cover for short-term external debt stands at a fairly similar level of 2.7x, but the foreign reserve level in terms of import months has risen from 5.6 in August 2008 to 9.0 in April 2010, given the historically high foreign reserve level of US$78.6 billion in April 2010 before EU concerns intensified. Foreign holdings of SBI in April 2010 stands at 24% of total compared to ~35% in July 2008. The current account balance is also in surplus territory at 1.1% of GDP in 1Q10, implying a fatter basic balance to buffer against capital outflows.

Correspondingly, these factors have given the central bank more wherewithal to intervene to defend the currency in May. Indeed, not only has the rupiah kept within what we see as the 9,000-9,500 BI comfort zone, the fact that the rupiah depreciation has been relatively resilient relative to other AXJ currencies bears testimony to this.

Chinese Tightening Is Not a Disparate Event from EU Sovereign Debt Concerns

Clients have also asked us whether EU sovereign debt concerns or Chinese tightening is more material for Indonesia - the latter due to the commodity trade linkages and China's effect on commodity prices. Indeed, slightly more than half of Indonesia's exports are commodity-related. However, we think that China's impact on Indonesia is likely to be limited. For one, Indonesia is not an export-oriented economy. Exports stand at only 21.4% of GDP. In terms of the various commodity segments, China's demand accounts for only 16.3% of Indonesia's edible oils (CPO) exports, 12-14% of its mineral fuel and oil/gas exports and 10.4% of the base metals & articles exports. Its trade balance with China for these products is also very small, at 1.0% of GDP (12M trailing sum) for mineral products, 0.3% of GDP for edible oils and -0.1% for base metals and articles.

Moreover, commodity linkages notwithstanding, we do not see EU sovereign debt concerns and China policy tightening as two disparate but rather two endogenous events. The former lowers the probability of the latter. Indeed, our China economist, Qing Wang, believes that the Greek debt crisis means Chinese policymakers would be more cautious in initiating major policy shifts (i.e., tightening) (see China Economics: Can Recent Policy Campaign Against Property Speculation Cause a Hard Landing?, May 24, 2010). Recent comments by policymakers also allude to that and suggest a period of policy pause in the coming months.

Does Inflation Remain the Fear?

If a repeat of 2008 is unlikely and markets are going to eventually brush aside current concerns, inflation of the sort led by currency depreciation is unlikely to happen. However, when growth momentum accelerates, the question then becomes - how strongly could inflation of the demand-pull sort materialize in Indonesia? After all, the second-order derivative in currency appreciation is likely to peter out and we do not think the central bank will let the currency appreciate significantly and quickly below the 9,000 threshold level, given the decreasing global share of its manufactured exports. Moreover, Indonesia's geographical idiosyncrasies and long-standing infrastructure bottlenecks would also tend to accentuate demand-pull inflationary pressures when they arise.

To be sure, we are under no illusion that the recent 2-4% inflation rate marks a new inflation paradigm but is just a function of base effects. We believe that cyclical inflation will rise as growth gathers pace. May inflation at 4.2%Y is already showing that and inflation will accelerate towards a more normalized run-rate of 5-6% in 2H10, in our view. Yet, given the improvement in macro stability and currency management, we think that the peak in inflation is unlikely to be as high as in previous cycles. Currency appreciation may see limited delta going forward, but we argue that currency stability alone is equally important, if not more, in anchoring inflation through expectations. Indonesia's own experience reflects just that.

Comparing point to point, the Indonesia rupiah has stayed in the vicinity of around 9,000 against the USD in early 1998 versus now. Yet, the sporadic bouts of currency volatility in this period mean that inflation has averaged 13.6%. In comparison, in 1985-1996 when the currency weakened steadily at 6.8% CAGR, inflation has averaged a lower 7.9%. Import-led inflation via currency depreciation/appreciation is one transmission channel to higher/lower inflation. However, inflation expectations and whether they are anchored by some form of currency predictability (steady depreciation at the very least) seem to be the other more critical factor. This is why we think improved currency stability for Indonesia means that not only would we see reduced volatility and lower peaks in inflation, but the inflation mean on which lower volatility is centred would also inevitably trend lower.

Oil Prices and Monetary Policy Management Are the Wild Cards

What could go wrong in Indonesia then? In our view, oil prices are a wild card and a double-edged sword for Indonesia. Low prices are not good for Indonesia as they imply negative terms of trade. However, oil prices reaching US$100/bbl and above are not unequivocally positive either for a few reasons. For one, Indonesia overheats more easily than other ASEAN economies due to infrastructure constraints. Second, it increases the probability of an inflation shock. Retail fuel prices are still subsidized in Indonesia. Though the government collects commodity revenue, which mitigates the fuel subsidy outlays, we believe that the impact on the fiscal balance gets non-linearly more negative with higher oil prices. The price disparity with neighbouring countries is likely to open the opportunity for arbitrage.

Lastly, with Bank Indonesia typically operating a dovish stance, there is also the macro risk that policy rates could be kept too accommodative for too long, turning a benign cycle into an overheated one. These are the wildcards we would watch out for in Indonesia, though the recent pullback in commodity prices means that these stay only as risks for now.

EMEA
CEEMEA FX: On the Implications of a Stronger USD
June 07, 2010

By Pasquale Diana, Tevfik Aksoy, Oliver Weeks, Alina Slyusarchuk, Michael Kafe, Andrea Masia & James Lord | London

Following our Global Currency Research team's new EURUSD forecasts (see FX Pulse, May 27, 2010), we have revised our FX forecasts across CEEMEA. Our new forecasts are predicated on continued weakness in risk appetite in the near term and an improvement in the risk environment later in the year. In this piece, we look at our macro rationale in each region and conclude with some strategy ideas.

Central Europe: Paring down gains versus EUR, still favour PLN: More near-term volatility points to weaker CEE crosses, not only against USD, but also against EUR, especially in the coming three months as the risk environment is weak. In terms of broad EUR outlook versus EUR/CEE crosses, the relationship is far from straightforward. True, over recent years strong EUR periods coincided with strong CEE currencies versus EUR. However, this is far from a stable relationship, and ought not to be followed slavishly. For instance, this relationship held up well in 2H07/1H08 (and even then not uniformly across CEE). This was a time when inflows into CEE were at the highest and EUR was very strong against the USD.

Since then, we had two periods of broad EUR weakness. The first one coincided with the massive sell-off in risky assets in late 2008 and a ‘flight-to-quality': unsurprisingly, over that period CEE currencies weakened sharply versus USD but also EUR. In the current period of EUR weakness, which started in October 2009, we initially had a period of favourable risk appetite and good inflows into the region, which saw CEE FX appreciate versus EUR, despite broad EUR weakness. Only over the last month, when the risk environment became more jittery, has this pattern reversed. Overall, the simplistic equation (EUR weakness = CEE FX weakness versus EUR) does not always hold in practice, and a more careful assessment of the risk environment is needed. Our forecast is predicated on continued weakness in risk appetite in the near term (and therefore weaker CEE FX versus EUR), but a gradual improvement in the latter part of the year. This could bring us back to a situation where the EUR adjustment takes place in an orderly fashion and in a risk-supportive environment. At that stage, we could once again see CEE FX appreciate vis-à-vis EUR. Indeed, this was the trading environment that prevailed in 4Q09-1Q10.

In Central Europe, we take stock of the weaker starting point for FX and revise currencies weaker throughout the horizon. As well as a weaker starting point, we also take stock of the fact that some central banks (most notably the NBP) have appeared less inclined to let their currencies appreciate ahead of what they perceive fundamentals would justify. Even so, we continue to favour the PLN among regional currencies, mostly due to more favourable growth dynamics, as well as the fact that the NBP will likely begin its tightening cycle ahead of other regional central banks. The CZK appears fairly solid, though we note that, given the muted inflation outlook and the Czech Republic's extreme reliance on exports, the CNB will likely be reluctant to allow CZK to firm more than a few percentage points per year (around 3% is seen as trend appreciation versus EUR). The HUF could benefit from better risk appetite, but Hungary is also the country where the risk from negative fiscal surprises is the highest, in our view. This could continue to put pressure on the HUF. Finally, we highlight how the RON has remained relatively stable recently, courtesy of an interventionist central bank which sees no reasons for it appreciate or depreciate too fast. Given thin liquidity and a successful history of intervention, the NBR tends to achieve quite a great deal with relatively little ammunition in the FX market. Paradoxically, therefore, even though Romania looks fairly vulnerable to us, the RON may be reasonably well protected if the sell-off were to intensify in the coming weeks and months.

Turkey: Improved fundamentals to lead to an eventual strengthening in the currency: Fundamentals have improved significantly, with real GDP growth picking up speed and the fiscal position improving noticeably. We recently raised our 2010 real GDP growth forecast to 5%Y, which is likely to help improve the fiscal results via higher tax revenues. The government has so far been careful in limiting non-interest expenditures, and we think that the anticipated introduction of a fiscal rule should keep concerns regarding debt sustainability and sovereign risks at bay. Inflation is still high and likely to remain elevated until early 2011, which calls for a need to tighten monetary policy. Our expectation of monetary tightening in 4Q10, which might be as much as 150bp, suggests that TRY should remain relatively strong, with real interest rates heading into positive territory.

Moreover, the local retail investors are still quite long in FX against TRY and they had been taking every opportunity of currency weakness to sell USD deposits, which essentially helped dampen volatility. Turkish sovereign ratings improved significantly in late 2009 and 2010 and the outlook seems positive to us - especially following the passage of the fiscal rule, and later on a successful implementation could lead to further rating upgrades and pose an upside risk to the TRY.

Israel: Tug of war between solid fundamentals and BoI interventions: A fast recovery story with a robust growth outlook fortified with a good fiscal policy, i.e., a good macro story. A surplus in the current account and sound fundamentals suggest noticeable strengthening in ILS, especially in the presence of record-high FX reserves. However, the BoI's determination to support exports and hence growth amid a tame inflation outlook leaves the upside capped, i.e., ILS might not appreciate in line with the fundamentals. Recent escalation in geopolitical noise and diplomatic risks might also cap ILS appreciation.

Stronger USD, weaker oil prompt slight RUB downgrade: Our RUBUSD forecast is driven by two changes in the assumptions.  The weaker EUR against the USD leads to a weaker RUB against the USD, given the RUB's management against the EURUSD basket. Second, given our new weaker oil assumptions, the forecast against the basket changes slightly. We now see the RUB basket at 31.5 for end-2010 and 32.5 for end-2011 (31.0 and 31.5 previously).  Volatility and risk-aversion also suggest near-term RUB weakness. 

We understand that CBR policy is currently aiming effectively to remove what it sees as ‘excess' oil revenue inflows from the market.  In practice, there are now sub-intervals within the 3 RUB corridor so CBR purchases rise to US$450-500 million a day when the RUB is close to the strong edge of the corridor, and slow to around US$150 million further from the edge. These sizes of intra-band intervention depend on oil prices: the CBR sets an undisclosed ‘fair' oil price and aims to neutralise oil revenue above that level.  As before, the CBR will buy US$700 million at the edge before moving the corridor 5 kopecks, but plans to cut this ratio gradually.  The corridors are ‘imperfectly' symmetric, i.e., the CBR will support the RUB in roughly equal amounts on the weak side. With oil at US$70, we think this model looks manageable - we estimate that the current account surplus in the rest of this year would be around US$20 billion, though we do still expect net capital inflows on top of this.  Monetary sterilisation through OBR issuance is currently effective but can become expensive and difficult once banks become more active, as they are starting to.  At higher oil prices, this model of neutralising oil revenue is only likely to work with fiscal support, i.e., when the Reserve Fund mechanism is working.  The oil funds are still being spent down, and rebuilding them looks a distant prospect as it would require very sharp spending cuts.  If oil recovers, we still think both higher inflation and a stronger RUB will eventually be the result.

Reining in ZAR forecasts: On account of our theme of higher near-term volatility and bias toward EMFX weakness, we have brought forward our call for ZAR weakness in 2H10, and now expect USDZAR to reach our previous year-end target of 8.00 as early as June/July.  Thereafter, however, we expect a subsequent improvement in risk appetite over the remainder of the year to be positive for the ZAR. We think that this will be further supported by a smaller current account deficit than we had earlier anticipated (3.9% of GDP versus 4.3% previously), thanks largely to a favourable combination of lower oil price assumptions (US$75/bbl versus US$82 previously) and higher platinum price forecasts (US$1,665/oz versus US$1,569 previously).

In 2011, we expect currency weakness to set in for three reasons. First, the current account deficit is likely to widen further in 2011. Although we see domestic growth accelerating only modestly from 3.3% in 2010 to 3.7% in 2011, we look for disproportionately higher growth in gross domestic capital formation, which we expect to rise to 5%Y from a relatively low base of 1.4%Y in 2010.  Higher capital spend would no doubt necessitate higher imports of machinery and intermediate inputs - which account for as much as two-fifths of South Africa's import bill.

Second, although we maintain that capital flows into emerging markets will be abundant in 2011, we expect the momentum to slow somewhat, particularly once the major central banks begin to normalise policy rates (we expect US and UK policy normalisation to begin in 1Q11, followed by the ECB and Japan in 3Q11).  During this period (1Q-3Q11), we expect the combination of a wide current account and a slower pace of capital inflows to rein in what we continue to believe is an excess liquidity-driven appreciation of the ZAR. In fact, our fair value model suggests that, at a spot rate of circa 7.60, USDZAR is 9.5% overvalued. Contrary to many other emerging markets where foreign direct investment is a significant component of total inward capital flows, South Africa's heavy reliance on fickle portfolio capital suggests that, even though capital flows are fungible, its currency is more susceptible to the vagaries of global risk-love than its EM peers (for example, South Africa relied entirely on portfolio inflows to fund its current account deficit in 4Q09).

Third, some of the important drivers of our fair value model which have hitherto lent relative fundamental support to the ZAR (e.g., interest rates and inflation differentials) should start to swing back in favour of the US dollar. 

Finally, it is important to note that although we expect the ZAR to weaken in 2011, we have revised our end-2011 target from 8.50 to 8.20, thanks again to a lower oil price profile: In line with the oil futures curve, we now expect oil prices to average some US$76/bbl in 2011 - much lower than our previous estimate of US$83/bbl. This, together with an upward revision in platinum prices (from US$1,637/oz to US$1,802/oz), should help cap the 2011 current account deficit at no more than 4.3% of GDP (4.9% previously).  Our current account deficit forecasts are lower than the Reuters consensus estimates of 4.5% and 5.0% of GDP, respectively, and partly explain the more orderly depreciation that we expect to unfold over 2011.

Strategy: TRY/CEE and ILS/CEE to Rise by End-10 

As our economists explained in the previous section, the projected profile for CEEMEA currencies has in general been revised to reflect a weaker path. The main reason for the change is the adjustments made to our USD assumptions, which we expect to show broad-based strength for the rest of 2010 and much of 2011.

We expect the CEE currencies of CZK, HUF, RON and, to a lesser extent, PLN to remain weaker for longer and to underperform the rest of the region during the remainder of 2010 as concerns over the euro area linger. The likes of TRY, ILS, RUB and ZAR should outperform the CEE until the end of the year.

Into 2011 though, the profile shifts, with CEE currencies beginning to stage a more concerted recovery against the USD, while the pace of appreciation in TRY and ILS should moderate. ZAR and RUB are even expected to depreciate against USD.

Against the EUR, we expect continued appreciation in TRY and ILS until the end of the year. CEE currencies should also start recovering against the EUR from 3Q onwards, but should not perform as strongly as those elsewhere in the CEEMEA region. This is partly because of the macro challenges that these countries face, but also due to the higher correlation with the EUR. With the EUR expected to weaken further against USD in the coming quarters, we think that CEE will underperform. Accordingly, TRY/CEE and ILS/CEE crosses could perform well for the next six months or so at least. 

Long EM/JPY Offers Significant Medium-Term Value

We are forecasting significant appreciation of a number of EM currencies versus JPY by end-2011. We are particularly bullish on the TRY, ILS and PLN versus JPY.

As we have explained in prior publications, we remain bullish on EM currencies for the next 12-18 months, despite our near-term caution. Part of our bullish call is our expectation for a significant amount of capital to flow into EM over 2010 and 2011. With growth likely to remain robust in EM, and G10 policy rates expected to remain very low for a long time, we expect capital to flow to EM seeking higher returns against a backdrop of generally weaker economies in the developed world.

With risk appetite set to rebound, we have assessed the correlation of several EM/JPY crosses (over the past three years) with both the S&P 500 and MSCI EM, to judge how these crosses are likely to perform in the bullish environment we expect for next year.

TRY/JPY, PLN/JPY and ILS/JPY have all been highly correlated with developed and EM stock markets, with TRY/JPY actually having the highest co-movement, with an R-squared of just over 0.6. This high correlation is not surprising, since JPY has often been used as a funding currency to invest in EM assets.

While we expect the use of JPY as a funding currency to be a factor behind the yen's weakness, there are other reasons to be bearish on JPY, as was outlined in last week's FX Pulse. Indeed, given the recent TWI strengthening of the JPY, we think that the MoF will be keen to prevent currency strength, particularly because some competitor countries in Asia have experienced currency weakness of late. This could put more pressure on the BoJ to ease further and could result in an inflation target being imposed on the MoF, which would weaken the JPY, in our view, given the risk of a step-up in an aggressive QE programme.

PLN/CZK to Resume Uptrend

One of the trades we recommended late last year and into 2010 was long PLN/CZK. We continue to think that long PLN/CZK positions will do well over the next 12-18 months. Our near-term views on the market suggest that some caution is warranted on this trade, and that a better entry point may well present itself over the next month or so. On the back of any move toward 6.20, we would recommend entering long positions. Given the low policy rates in the Czech Republic, the CZK is often used as a funding currency. PLN/CZK is thus a directionally bullish trade, appreciating as risk appetite recovers. Accordingly, for those that believe that the external risk environment is likely to recover from here, present levels are attractive. 

As our economists highlight in the previous section, Poland's growth outlook suggests that it is likely to be an outperformer of the CEE currencies. As one of the weakest currencies in the region during the 2008-early 2009 sell-off, we think that the PLN was over-punished during the last downturn, since it was one of the only countries in the region to have experienced positive growth last year. Accordingly, we think that there is still some catch-up to be done relative to other CEE currencies.

Moderating Near-Term Outlook for Latin American Currencies

Though fundamentals in Latin America remain relatively robust, the region is unlikely to be immune from ongoing global market stresses should they reappear. The recent confluence of market weakness as a result of European sovereign concerns and heavy positioning in EM assets has led to a material repricing of risk. Weaker EMFX and our G10 FX team's lower forecasts for EUR/USD have prompted us to review our near-term forecasts for Latin American currencies, especially for 2Q and 3Q10.

The rationale affecting Latin America FX is based primarily on the region's links with the rest of the world. But in the immediate term, our more bearish view of the EUR could again lead to a general environment of decreased risk appetite globally. Despite strong fundamentals, Latin American currencies are still risky assets and should therefore feel the brunt of any ongoing global market volatility and/or weakness. More structurally, a weaker EUR is likely to be reflective of slower growth in the eurozone, which may act as a drag on marginal export growth in Latin American countries more significantly exposed to Europe. As our Latin American economics team has also pointed out, Europe represents a large share of FDI for countries like Brazil and could be a potential drag on currency strength if these FDI flows were to dry up in the near term as Europe adapts to its new constraints.

In addition, a weaker EUR (stronger USD) is unlikely to be supportive of commodity prices at the margin. Given the reliance of many Latin American economies on commodities (BRL, PEN, COP, CLP), lower commodity prices may also act as a drag on the pace of appreciation at present, especially as this could potentially lead to a deterioration in the terms of trade.

Finally, though not our base case, a weaker EUR could potentially mitigate the extent to which China feels compelled to revalue the CNY. The link here, again, is twofold, with commodity price strength failing to materialise as much as expected under a more pronounced appreciation of the CNY and as central banks in Latin America may be less inclined to allow for significant appreciation of their own currencies without China's ‘lead' due to the fears of a loss of competitiveness.