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Sidelined

Decision and economic assessment

Bank Indonesia reiterated its expectation that the US rates were poised to head lower in 2H24 in its monthly policy review on Wednesday. A dovish pivot from the US Fed is a necessary precursor for the BI to open the door for rate cuts, in our view.

Moreover, the domestic is benign, limiting the need for policy easing at this juncture. Growth is expected to stay supportive in the 4.7-5.5% range (DBSf: 5%). Loan growth rose 11.8% yoy in January, strongest pace since 4Q22, suggesting limited transmission of policy rate hikes to the real economy.

On the inflation front, Feb24 headline inflation ticked up to 2.8% yoy in Feb from 2.6% the month before, driven by a sharp 8.5% increase in the volatile gauge (supply-driven). Sequential pressures have risen on higher rice prices, risks to domestic production from El Nino, and stronger demand amid religious festivities. Mar-Apr readings are also expected to be firm, albeit within the 1.5-3.5% BI target. The rupiah has been trading on a weak note on a year-to-date basis, down 2% against the USD YTD, even if faring better than regional counterparts like the Malaysian Ringgit and Thai Baht, which face adverse rate differentials vs the US.

Policy outlook

There is considerable uncertainty in the pipeline regarding the direction of global interest rates, particularly for the US Fed, as markets continue to delay expectations of a start to the rate easing cycle. All eyes are trained on this week’s FOMC meeting and the accompanying dot-plot. The resultant volatility in the US dollar and rates is likely to swing the Indonesian markets, necessitating the central bank to maintain a favourable differential with the UST for the time being. 

We continue to expect an extended pause by the central bank. While our end-year forecast for the BI rate remains at 5.75% (down from 6% currently), the start of the easing cycle is likely to be in late 3Q24 rather than mid-year.

A modestly wider current account deficit

Indonesia’s current account deficit (CAD) narrowed to -0.1% of GDP in 2023, returning to red after two successive years of surplus. The magnitude was, however, muted compared to the over -3% of GDP gap during 2013-2014.

Under the hood, much of the CAD widening was due to a 26% yoy drop in the merchandise trade surplus in 2023 vs the year before, outpacing the 10% reduction in the services deficit, while primary and secondary income were largely stable. Under the financial account, direct investments continued to fare better than the portfolio flows (net inflows), leaving the overall balance of payments in surplus to the tune of $6.3bn vs $4bn in 2022. As the chart below highlights, foreign direct investment flows have consistently supported the overall balance of payments, offsetting the swings in portfolio flows. Encouragingly, our preferred measure, the basic balance of payments (CAD + net FDI), still amounted to a surplus of 0.9% of GDP last year, albeit down from +2.4% in 2022.

We expect a modest widening in the current account deficit in 2024.

January-February 2024 trade surplus declined by nearly 70% yoy to $2.9bn vs $9.2bn in the comparable period a year ago. This is backed by a ~9% drop in exports whilst imports were up 7.5% in the same period. Frontloading in investments ahead of the political transition, pre-festive demand (consumption goods and oil), and higher food (rice) purchases lifted total imports. Exports, on the other hand, continue to be bogged down by negative price effects, led by lower coal, palm oil, and iron ore shipments, besides a few distortions amongst trading partners during the Lunar New Year closures. This is likely to see the current account swing from a modest -0.1% of GDP in 2023 to -1.5% in 2024.

Final election result and fiscal dynamics

The final election result is likely to stay close to the early count. The quick count had put incumbent Defence Minister Prabowo Subianto and his vice-presidential candidate Gibran Rakabuming Raka (ex-mayor and son of outgoing President Jokowi) in a comfortable lead in the mid-February elections (Indonesia elections: Exit polls produce a clear winner).

The transition period until the official inauguration in October 2024 will see the incoming administration gain a majority in the House of Representatives.

On the fiscal front, cash handouts, fertiliser support, and the extension of a few existing welfare spending commitments in 1Q24 are likely to increase overall spending this year. Add to this, no further fuel or energy price adjustments are likely, signaling higher disbursements towards energy subsidies. This led the government to flag the risk of a wider fiscal deficit of -2.8% of GDP this year from the earlier held 2.3% and compares to -1.7% in 2023. 

The Value Added Tax (VAT) is due to be raised by 1% to 12% in January 2025 (~0.3-0.4pp benefits to revenues), as part of the Tax Harmonisation Law, which was passed in October 2021. Local press suggests that the planned increase faces considerable opposition from lawmakers, as we write. The proposed increase in the tax rate comes at a time when the incoming administration is seeking a larger revenue pool to fund new welfare spending programs while non-tax revenues moderate. Overall revenues rose 5.3% yoy in 2023 due to a mix of higher natural resource-based revenues, dividends from state-owned names as well as a lagged impact of the rollout of tax reforms, including the VAT increase undertaken since 2022.

The broader need for Indonesia to raise its tax-to-GDP ratio remains a priority. The general government revenue/GDP ratio is set to moderate to 14.6% in 2024 from 15.0% in 2023, the lowest in the 'BBB' category and well below the median of 21.3%, according to the base metrics used by Fitch Ratings.

Markets have also been focused on the new government’s plans to increase social spending and subsidies. This follows campaign promises of free lunches and milk for students across the nation, besides support to other groups, which is expected to add an estimated IDR100-120trn (~0.4-0.5% of GDP) in the first year of implementation and IDR460trn annually when it achieves scale. This is behind the deficit forecast set at -2.45-2.8% of GDP projection for 2025, despite a strong 5.3-5.5% growth forecast. 

We revise our projections for this year to -2.2% of GDP (vs -1.8% currently) and -2.5% (-2%) for 2025. A prolonged negative reaction in the markets is unlikely as the overall deficit is kept within the -3% of GDP threshold, while resultant bond issuances are likely to prevent pullback in 10Y yields towards 6.0-6.2%.


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