Soft commodity prices partly driving Indonesia to lower growth channel

Macro-rebalancing is not yet over.

Since 2013, soft commodity prices courtesy of China’s growth slowdown and expectations of rising global real rates as the US economy gets back on track have conspired to drive GDP growth in Indonesia from a peak of 6.5% YoY in 2011 to a 5.1% in 2Q14.

According to a research report from Morgan Stanley, this is as Indonesia’s uncomfortable external imbalances from weaker terms of trade meet with funding pressures in a rising rate environment. For 2015, similar factors are expected to be in play.

China’s GDP growth is expected to decelerate from 7.3% in 2014 to 7.1% in 2015. Commodity prices are likely to stay soft as a result, and Indonesia’ 2015 current account deficit will likely only see a mild improvement to -2.8% of GDP in 2015 (vs -3.2% in 2014).

Here’s more from Morgan Stanley:

This net savings deficit, coupled with rising LDR and prospective unwinding of extraordinarily loose global monetary policies, means that real interest rates are expected to stay elevated, a reversal from the structural decline in capital cost seen in the past 10 years.

Elevated real interest rate would constrain credit growth at lower levels and the incremental GDP growth extracted from the previous structural decline in capital cost would also reverse.

Indeed, with our base case assumption of a 15% retail fuel price hike early next year taking headline inflation to an average of 6% for 2015, we believe room for policy easing is limited.

We expect policy rates to be kept at 7.5%. In fact, market-oriented interest rates have already moved higher, and by more compared to policy rate.

Specifically, whilst policy rate has increased by 175bps to 7.5% since mid-2013, 3M JIBOR increased by 320bp to 8.1% in Aug-14 and 3M time deposit rate increased by 350bp to 9.2% in Jul-14.

Collectively, these factors would constrain GDP in a lower growth channel even as non-commodity exports drive a mild cyclical growth uptick. Our downward tweak of 2015 growth forecast reflects this view.

In our view, Indonesia’s macro rebalancing process is not yet over. Cyclical policy stances such as tight fiscal/monetary policy and currency depreciation would still need to be maintained to bring CAD to more sustainable levels.

As an aside, to the extent that actual real interest rates adjustment has been quite sizable and domestic demand growth has decelerated, we think the currency is likely to incrementally bear the greater burden of adjustment.

Meanwhile, we think structural reforms are required to improve the competitiveness of non-commodity segments to offset global headwinds from lower commodity prices and to lift potential GDP growth whilst ensuring external imbalances are kept under check in the medium term.

In fact, a faster pace of structural reforms that succeeds in attracting more longer-term capital such as FDI would buy more time for the CAD adjustment, support growth and lessen the urgency for cyclical measures such as tightening and currency depreciation to slow growth and narrow the CAD within a compressed time span.

We believe the cyclical policy adjustment that got off the ground last year, such as the weaker real effective exchange rate and higher real interest rates, together with the more favorable external funding environment seen this year, has mitigated the tail risks of a growth hard landing in Indonesia compared to a year ago and enabled Indonesia to be stabilizing in a lower growth channel for now.

This stabilizing growth and benign funding environment also provides a window of opportunity for the incoming administration to focus on implementing medium-term reforms instead of having to spend time on short-term “crisis-management” measures.

Whether policymakers maximize this window of opportunity for structural reforms will be key to watch and would be important in determining whether Indonesia can break out of this lower growth channel.