(MENAFN- Gulf Times) Bank Indonesia unexpectedly cut its policy rate by 25 basis points to 7.5% last week, which, according to QNB, is a reversal of BI's policy direction mainly as it expects inflation to fall.
BI was expected to tighten as inflation is above target, but also in order to counteract Federal Reserve (Fed) hikes in US interest rates, currently expected to start in mid-2015.
"However, looser monetary policy may be negative for growth owing to the risk of capital flight and a potentially weaker exchange rate. High external debt in Indonesia means that a weaker exchange rate increases the debt servicing burden and could be a drag on growth," QNB said.
The BI gave two main reasons for the rate cut. First, the BI stated that it now expects inflation to fall to the lower end of its target range of 3% to 5% in 2015-16. Inflation slowed from a peak of 8.4% in December 2014 to 7.0% in January 2015.
The recent fall in oil prices more than offset the removal (in November and January) of large subsidies on petrol as well as cutting diesel subsidies to a small fixed amount (about $0.08/litre).
Second, BI cited its efforts to reduce the current account deficit (currently 3% of GDP). Lower interest rates should weaken the exchange rate, boosting exports and making imports more expensive, helping to lower the current account deficit.
This suggests that BI has shifted its stance in favour of a weaker exchange rate. From June 2013 to December 2014, BI raised interest rates and intervened in foreign exchange markets to support the exchange rate and curtail capital outflows. Now it is cutting interest rates with the explicit intention of reducing the current account deficit through a weaker exchange rate.
There are two main reasons behind lower perceived risks of capital flight. First, investor sentiment towards Indonesia has become more positive - the main Jakarta stock index is up 6.6% since rates were last raised in November, and sovereign 10-year bond yields have fallen 71 basis points. The new administration (inaugurated in October) has pressed ahead with important reforms that should strengthen the economy and the fiscal position.
Subsidy cuts freed up fiscal space, which allowed for an increased allocation to infrastructure investment ($4.6bn) in the revised 2015 budget, announced in January, as well as for some fiscal consolidation - the expected 2015 deficit has been revised down from 2.2% to 1.9% of GDP.
Investment in infrastructure was central to the new administration's manifesto and should reduce supply bottlenecks in the economy, unleashing private sector growth. The improved investor sentiment and new opportunities for foreign investors may have alleviated BI concerns about capital flight.
Second, recent easing by central banks around the world may have offset concerns related to Fed tightening. BI stated in its press release that it expects QE by the ECB to increase portfolio flows to EMs, including Indonesia. Ongoing aggressive monetary easing and asset purchases by the BoJ may also be expected to support capital flows.
Meanwhile, falling global interest rates mean BI is also able to lower rates without creating large destabilising changes to interest rate differentials. In fact, with looser monetary policy across Asia (Australia, China, India and Singapore have all eased and Malaysia is expected to be next), the BI rate cut may be necessary to maintain export price competitiveness within Asian competitors.
Nonetheless, BI's new policy direction is not without risks.
First, despite improving sentiment, there remains a risk that capital inflows could be reversed as the Fed tightens, or as currency instability discourages investment. In this respect, capital inflows, as measured by the financial account surplus of the balance of payments, almost halved in Q4 to $7.8bn (3.6% of Q4, GDP).
Second, Indonesia has relatively high external debt ($294bn, 34% of GDP), over two thirds of it in dollars. Therefore, the recent appreciation of USD against IDR significantly increases the debt servicing burden and concerns about the ability of Indonesian corporates to repay.
Third, the weaker exchange rate could increase imported inflation, leading to BI missing its target band and forcing another policy reversal.
In line with QNB forecasts, the country's real GDP growth slowed to 5% in 2014 from 5.6% in 2013.
"We expect growth to continue slowing during 2015 as the USD debt overhang and the stronger dollar drags on growth and make the investment programme harder to implement. The weaker exchange rate may keep inflation above the BI target band, leading to persistently tight monetary policy. Therefore, we keep our forecasts for growth unchanged at 4.5% in 2015, but expect a recovery in 2016 to around 5.2% as the investment programme begins to kick in."
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