JAKARTA – Indonesia has one of strongest fundamentals in the region. Public debt is below 30% of GDP, one of the lowest among emerging market economies. Inflation has been moderate at around 4% in recent years. Governance is stable and political risk is low.
Yet, afflicted by the hangover from the 2014/15 commodity crash and a still-challenging investment environment, economic growth has been stuck at 5%, well below Indonesia’s potential, in our view.
With policy-making becoming more challenging and the 2019 Presidential election looming, Indonesia would need a major pull from the external environment to move to a higher gear. GDP growth may still pick up slightly to 5.3% and 5.4% in 2018 and 2019, respectively, up from our forecast of 5.1% for 2017. Stronger commodity prices will translate into higher contribution of net exports to overall GDP growth. Investment growth will continue its gradual recovery. Meanwhile, consumption growth remains relatively stable at 5%.
Even as the government maintains an accommodative fiscal policy stance, there is not much room for stimulus, given the 3% fiscal-deficit rule. We expect the budget deficit to hit 2.6% of GDP in 2018, similar to our forecast of 2.7% for 2017. While our forecast is higher than the government’s official deficit target of 2.2% of GDP for 2018, it is driven mostly by a potential shortfall in revenues rather than an increase in spending.
Higher crude oil price is positive for the government’s budget. Combined, income tax and non-tax revenues from the oil & gas sector (IDR113tn) stand at about 10% higher than energy subsidies in the 2018 budget (IDR103.4tn). We estimate that every 10% rise in crude oil prices (from the baseline assumption of US$48/barrel in the 2018 budget) will provide an additional IDR6.7tn in net spending, or about 0.05% of GDP. If crude oil prices were to average US$65/barrel next year, we are then likely to see a 0.2%-pt swing in the budget deficit (budget deficit may be potentially lower at 2.0% of GDP).
We forecast CPI inflation to hit 4.0% and 4.5% in 2018 and 2019, respectively, up from our forecast of 3.9% for 2017. CPI inflation has averaged 3.8% so far in H2, lower than the 4.3% average in Q2. Food inflation has continued to weaken during the year. Inflation in the volatile food component of the CPI (18.9% weighting) came in a record-low 0.8% in October. This has pulled down the overall CPI, despite inflation staying circa 5% in both transport/communications and housing/utilities components of the CPI.
We expect BI to start hiking rates again in Q4 2018, bringing the policy rate back to 5% by mid-2019. Not only do we expect inflation to tick up, but anticipation of a stronger broad USD may also mean that higher domestic interest rates are necessary.
The IDR is expected to shift from its stable 13,000-13,600 range of the past two years to a modest depreciation path to 14,200 in the next two years. Unlike 2017, the USD will not be dragged down by lower US bond yields. The US 10-year Treasury yield is set to keep rising towards 3% into 2019 on US Fed rate hikes, an incremental unwinding of the Fed’s balance sheet, more balanced financial regulation, and the possible implementation of Trump tax cuts next year.
Despite rising US interest rates, Indonesia government (IDgov) bonds are still likely to do well from a total-return perspective. The combination of below-trend growth, still-low inflation, and a dovish central bank (50bps of rate cuts in 2017) has been a boon for government bonds, with the IBoxx ABF Indonesia government total return index up 14.0% since the beginning of the year.
With higher coupons, duration risks for IDgov bonds are less than that for comparable USTs. If UST yields head moderately higher, IDgov bond prices should be less sensitive to the downside. In any case, Indonesia’s low inflation and improving external funding dynamics should provide support for IDgov bonds. Externally-driven selloffs, much like what happened in mid-2013 and late-2016, should fade. From this perspective, IDgov bonds appear expensive, but may not be as expensive as they look.
We believe the current rich valuation in Indonesia’s equites is sustainable. This is mainly supported by a positive outlook on the global economic landscape, the moderate pace of interest rate hikes, USD strength, and supportive risk appetite for emerging markets. Domestically, the “Jokowi put” applies as the 2019 elections will prompt the government to “make no mistakes” on policies.
We are positive on Indonesian equities. We believe returns could be front-loaded as investors position for pre-election volatility in the second half of the year. Investors can look for sectors and themes such as digital banking, infrastructure, resilient consumer staples, services, as well as export sectors including tourism, agriculture, fishery, and media, which are likely to outperform in an economy undergoing transformation.