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When easing risks become reality in Indonesia

WE see Bank Indonesia cutting the policy rate by 75 basis points in 3Q19 amid a weaker US dollar, a more dovish Fed, low domestic inflation, and a narrowing current account deficit in Indonesia.

Consensus, on the other hand, expects the policy rate to be flat to slightly up by the end of the year. There are a few reasons why our view is so different from the street's.

One of Bank Indonesia's policy mandates is currency stability, and the rupiah weakness we saw last year explains why it hiked aggressively - by 175 basis points - between May and November 2018.

Now, we think a weaker US dollar and a more dovish Fed set the stage for Bank Indonesia to unwind its previous rate hikes, if domestic macro conditions are right. Indeed, on the former, we expect the US dollar to be on the back foot, as we see US growth decelerating to a larger extent than in emerging markets, excluding China.

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On the Fed, Morgan Stanley's US economics team has pushed back their rate normalisation expectations amid a patient Fed, and they now expect the Fed to hike only once this year, in December. The Fed's latest forecasts and comments have also been more dovish than expected.

Domestic macro conditions are also getting supportive for Bank Indonesia to ease. Indonesia's inflation is currently surprising to the downside, and we expect it to moderate to 2.9 per cent this year, which is below consensus. This will further lift Indonesia's real rates and real rate differentials versus the US, buying protection against capital volatility and giving Bank Indonesia room to ease from current levels.

We believe Indonesia's lower inflation is partly driven by structural factors. Food inflation has come down as policymakers improve logistics and break up food cartels. Additionally, in previous cycles currency depreciation led to higher import prices. But this vicious loop is now breaking down, likely because the economy has de-dollarised and inflation expectations are better anchored.

We also expect Indonesia's current account deficit to narrow to a more manageable 2.6 per cent of gross domestic product this year, as the real effective exchange rate depreciation since 2017 helps improve the country's non-commodity competitiveness with a lag. A change in domestic demand mix from capex to consumption spending would also lower Indonesia's import intensity, while a turnaround in global growth, as envisaged by Morgan Stanley's global economics team, would support exports.

Compared to the 2013-2017 rate cycle, we believe policy easing could take place earlier in Indonesia this time. Back then, Bank Indonesia hiked the policy rate by 200 basis points during the 2013 taper tantrum. Policymakers eventually eased by 175 basis points, but they only embarked on rate cuts 31 months after rate hikes first began. This time, Indonesia's macro fundamentals are much better. Inflation is lower, real rate differentials are higher, and the balance-of-payments position is slightly better. As such, we expect easing to come earlier in this cycle, with three cuts of 25 basis points in July, August and September.

Currency stability, which is an important part of Bank Indonesia's mandate, is also supportive of easing. By the summer we think capital flows will have stabilised further, given our expectations of a 2Q19 recovery in global demand led by China and the US, as well as a supportive policy backdrop from the world's key central banks.

Over the longer term, Indonesia will need to reduce its dependence on external funding to decouple its policy rate cycle from external liquidity conditions. To do this, policymakers need to improve productivity and non-commodity export competitiveness in order to generate higher domestic savings.

To this point, we note that Bank Indonesia's policy mandate of currency stability is likely due to the notion that Indonesia is a highly dollarised economy and currency volatility would have negative implications. However, we believe the economy has de-dollarised, and allowing for a gradual pace of currency depreciation over the longer term would help the economy rebalance towards higher growth, a narrower current account deficit, and better liquidity.

So what will rate cuts mean for stocks? Morgan Stanley equity strategist Sean Gardiner believes they will be the next big catalyst for Indonesia's equity market. He sees banks as the biggest beneficiaries and is also positive on discretionary and real estate.

  • The writer is Asia Economist at Morgan Stanley