Government Stance on Indonesian Economy and Investors' Reaction

| Source: Bank Indonesia

Foreign investors, who continued their net selling of Indonesian assets in August, seemed to be content with the recent policy changes of the central bank as, at the end of last week, they recorded a net purchase of IDR 357.26 billion (USD $32.5 million) at the Indonesia Stock Exchange (IDX). However, considering the full week, foreigners still sold more Indonesian stocks than the bought (about USD $127 million).

In the month of August, foreign investors sold IDR 5.97 trillion (USD $542.7 million) worth of Indonesian stocks, which caused the IHSG to drop 9 percent. The IHSG has now been corrected for three consecutive months since June, or a total of 17 percent. Main reasons for eroded foreign confidence are the weakening rupiah and Indonesia's widening current account deficit. The rupiah has been on a weakening trend as global funds are pulled out from emerging markets, including Indonesia. This situation is aggravated by domestic inflationary pressures (since prices of subsidized fuels were raised in late-June) and higher interest rates (bringing down prospects for economic expansion of Indonesia in 2013).

A few days ago, I attended a meeting with Finance minister Chatib Basri, head of the Fiscal Policy Agency Bambang Brodjonegoro, chairman of the board of commissioners of the OJK Muliaman D Haddad, OJK commissioner Nurhadia and chief of the Indonesia Stock Exchange Ito Warsito. In this meeting Chatib Basri explained his view on some of the issues that have emerged in the Indonesian market. Firstly, about how the weakening rupiah is not a problem confined to Indonesia alone, but occurs in almost all regions. And about the current account deficit figure of 4.4 percent of GDP (which usually is about 3 percent of the country's GDP). Although the overall balance deficit in the second quarter amounted to USD $2.5 billion, and thus is lower than the USD $6.6 billion deficit of the first quarter, the market is still concerned about the current account deficit. Therefore, the government is taking efforts to reduce the current account deficit in the third quarter.

Secondly, Basri spoke about the capital outflow from the Indonesian capital markets as mentioned above. However, he detects an increase in demand for Indonesian sovereign bonds.

Thirdly, the government has taken measures to stabilize the deficit: it will spur exports (through fiscal incentives) and is committed not to block imports in the non oil & gas sector to support economic growth. However, in order to reduce imports of oil, the government is planning to increase the use of biodiesel (produced from domestic palm oil). It is also important to note that after prices of subsidized fuels were raised in June, domestic consumption of fuels eased about 4 percent.

In order to tackle high inflation, the government will replace import regulations from a quota control system to a price control system. Importers are allowed to import food products if the price on the Indonesian market is higher than the price determined by the government. The policy program that is launched by the Finance ministry is supported by the central bank's decision to raise interest rates by 50 basis points to 7.0 percent.

There are a few things I noticed. First of all, plans to control food prices by increasing imports will not necessarily be effective. This is due to the fact that high rupiah volatility makes importers think carefully before doing any importing. Secondly, the higher BI rate indeed narrows the spread between inflation and interest rates, but inflation in August is still expected to be high at 1.3 percent. Moreover, higher interest rates will limit economic expansion. As such, the government has some homework to do to stabilize the rupiah and curb inflation. Meanwhile, the Federal Reserve will be more inclined to end its quantitative easing program as the economy of the United states has grown 2.5 percent in the second quarter of 2013. This implies the end of cheap US dollars entering emerging markets such as Indonesia. In fact, it will cause an outflow.

I expect the IHSG to remain volatile in the first week of September. Investors will be very interested in the release of US jobs data as it influences the Fed's decision concerning QE3. On the domestic side, market risks are currently relatively high with the central bank's decision to raise interest rates at the expense of economic growth. This week, profit taking may occur after the three-day 'winning streak' at the end of last week. Therefore, I recommend investors to wait and see before (re)entering the Indonesian stock market.

David Sutyanto is a research analyst at Jakarta-based First Asia Capital

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