Main story: Bank Indonesia (BI) has surprised on the upside for a second consecutive policy meeting, raising rates by a bigger-than-expected 50 bps as it seeks to shore up the rupiah, mitigate inflationary pressures, and stem outflows of foreign portfolio capital

Vox: local banks will be keeping an eye on margins and risk management, but don’t expect a severe impact

Outlook data: London-based research  provider Capital Economics says further aggressive rate hikes are unlikely, tipping two further 25bp increases to take the rate to 7% by the end of the year

Bank Indonesia (BI) has surprised on the upside with rates for a second consecutive monthly policy meeting, indicating the central bank is serious about frontloading rate increases that are sorely needed to shore up the rupiah and head off the inflation passthrough from last month’s increase in subsidized fuel prices.

BI Thursday raised the policy rate by 50bps 6.50%, the second increase as the monetary authority seeks to boost credibility and support the rupiah against a backdrop of fund outflows from emerging market assets.

Most analysts forecast an increase, but expected a smaller, 25 bps hike.

BI also raised the Fasbi deposit facility rate by 50 basis points rate to 4.75%, effectively drawing out liquidity from the money market.

The inflationary impact of the fuel price hike “will reach its peak in July," Bank Indonesia Governor Agus Martowardojo says, following his remarks last week that on-month inflation in July could accelerate to 2.38% from June’s 1.03% increase.

The government raised the price of widely used low-octane gasoline by 44% and the price of diesel by 22%.

Analysts say rising demand for basic goods during the Muslim holy month of Ramadan, which started Wednesday, will add to inflationary pressures. Inflation this year may range from 7.2% to 7.8%, according to BI estimates, well above BI’s initial target for the year of 3.5%-5.5%. 

"Market confidence will be bolstered by today's BI rate hike," Perry Warjiyo said. Investors and analysts also welcomed last month’s 25-bps hike as an encouraging sign that BI is tough enough to take on the short-term economic pain to ensure a smooth inflation passthrough and stem foreign outflows.

Offshore investors pulled out $4.1 billion from local stocks and bonds in June due to worries that a winding down of the U.S. Federal Reserve's quantitative-easing bond purchase program will hurt emerging markets.

Martowardojo says economic growth was likely around 5.9% in the second quarter, a tad lower than 6.0% in the first three months of the year.

BI is closely monitoring heat in the housing market and will tighten regulations related to property downpayments, Mr. Martowardojo said, but didn’t elaborate. 

BI last week lowered its economic growth estimate to 5.8%-6.2% from May's forecast of 6.2%-6.6%, in parallel with the World Bank which recently cut its own outlook to 5.9% from 6.2%. Both are forecasting lower economic growth than the government's official assumption of 6.3% growth.

Vox:  officials at several leading commercial banks spoke to The Insider Stories about the rate move.

Bank Mandiri CEO Budi G. Sadikin:

It will certainly compress margins. Mandiri has already anticipated this by submitting a Banking Business Plan (RBB) to BI that alters our margin compression [forecasts]. Deposit rates will rise following [the move by] BI. When the BI rate rises by 50 basis points, we will raise [deposit rates] by 50 basis points.

We will maintain lending volumes. As of June, withdrawals had been relatively high, and this may will slow towards the end of the year, but we are sticking to our target. Credit growth up to June was 19%-20% year-on-year.

Bank Rakyat Indonesia CEO Sofyan Basyir:

There will undoubtedly be an impact, but the extent depends on the individual bank, if it will raise money market or lending rates. BRI will not increase [rates] today, we will assess the conditions in 2-3 months. This is to avoid impacting our customers. We will seek to create internal efficiencies [that can absorb the rate increase without raising rates for clients.]

On the lending side, there is no problem, in fact this will lead to strong growth.

Bank Jabar CEO Bien Subiantoro:

It seems that deposit rates will rise by around 50 basis points while lending rates will stay unchanged. We have not had any difficulties so far in disbursing credit. We have only slowed commercial credit, from IDR8.5 trillion to IDR7 trillion, due to high risk. In other sectors, [credit] demand has remained high.

My view is that in these conditions, banks must maintain strong risk management.

Outlook data: Capital Economics: Further aggressive rate hikes in Indonesia unlikely 

• Bank Indonesia (BI) today hiked both its main policy rate and the Fasbi rate by 50bp amid concerns about the currency and the outlook for inflation. Consumer price inflation is likely to rise as high as 8% y/y in the coming months after the government pushed ahead with plans to scale back its fuel subsidy regime. However, the inflation spike should prove temporary and so does not justify an aggressive tightening cycle.  

• After unexpectedly hiking its main policy rate last  month, the vast majority  of analysts (including ourselves) expected interest rates to be hiked by  25bp today. Only 3 out of 19 analysts polled by Bloomberg correctly forecast the policy rate would be hiked by 50bp to 6.5%. The central bank also raised the Fasbi rate (the rate BI pays lenders on overnight deposits) by 50bp to 4.75%. 

• As BI makes clear in the accompanying statement, the priority over the coming months will be controlling inflation. The headline rate has been around the top-end of BI’s 3.5-5.5% inflation target in recent months (see Chart 1), and could rise as high as 8% in the coming months after the government in June agreed a deal to reform the country’s fuel subsidy regime. The new measures will see the price of petrol and diesel increased by 44% and 22% respectively. 

• Although fuel price hikes will push inflation higher in the near-term, they are essential in putting the economy on a more sustainable footing. Higher fuel prices will give domestic consumers an incentive to consume less fuel, which in turn will help to lower Indonesia’s import bill. This should lead to an improvement in the current account, which has been in deficit for the past six quarters. Moreover, by reducing spending on fuel subsidies, the government should have more resources to spend on badlyneeded infrastructure upgrades and better education.

• The coming spike in inflation should be short-lived. Indeed, on the two previous occasions when fuel prices were hiked, inflation was lower a year later than immediately before the decision.

• With core inflation currently falling and economic growth likely to weaken slightly this year, we suspect the same will be true this time. As a result, a series of aggressive rate hikes by BI is unlikely.

• Another factor behind BI’s decision to hike rates was to provide some support to the rupiah, which has been one of the worst performing currencies in Emerging Asia over the past 12 months. BI has been intervening heavily in currency markets over the past year to support the rupiah, which remains just above the psychologically-important 10,000 level.

• To sum up,  although today’s increase in interest rates was bigger than expected, we believe any further tightening is likely to be relatively gradual. Although inflation is likely to rise quite sharply in the coming months, the increase should prove temporary. With core inflation low and falling, we expect just two further 25bp increases in the main policy rate this year. This would take the BI rate to 7.0% at end-2013, compared with our previous forecast of 6.5%.