(TIS) - Citigroup economist Helmi Arman says the weakening rupiah will negatively impact growth.

The following is an extract from an Indonesia Macro Flash report by Citi.

IDR depreciation: Adverse impact to growth

Weaker IDR may not necessarily lead to a shift in consumption from imports to locally produced goods. Finished consumer goods and capital goods only comprise about 25% of total imports. The bulk of imports (75%) are raw materials of which comprise of industrial raw materials and to a lesser extent fuels. The significant components of these industrial raw materials are items such as basic
metals and metal products (10 - 15% of raw materials), plastics (7%), chemicals (6%), cereals (3%), fertilizers (1%), etc.

Negative impact of IDR weakening will likely be accentuated by tighter credit availability — Loans growth has already decelerated following a contraction of the export sector in 2012. As inflation and loan to deposit ratios reach new highs and FX volatility escalates, bank lending appetite may be further trimmed. Corporate FX debt levels and cost mismatches will be in the spotlight, although by our analysis average debt ratios do not seem hazardous on a system-wide basis. Our baseline expects credit growth to slow towards 18% by YE13, from 21% as of May.

IDR depreciation will pressure margins in certain sectors more than others — Using BPS’ 2011 manufacturing industry statistics, we identify the relatively vulnerable sectors, i.e. those that have high import content but low percentage of exported sales. Several heavy industries fall into this category, e.g. vehicles, steel, chemicals and pharmaceuticals manufacturing. Yet there are also industries which have low import content but a high portion of exports that can benefit from the currency weakening,
such as palm oil, paper, furniture manufacturing.

Inflation impact of IDR/USD swings not negligible, but benign global commodity prices may provide cushion — Our estimates show that the elasticity of headline inflation to every 1ppt IDR/USD depreciation is about 0.1pps. However, the actual pass through was also found to depend on the direction of global commodity prices, which affects the price of imported foodstuff such as cereals and commodities, such as gold and cooking oil. Meanwhile core inflation appears to be influenced more by the tradeweighted
exchange rate instead of just IDR/USD.

Policy implications: Sectoral policies may remain an option to complement an interest rate hike — Demand for imported raw materials such as chemicals and plastics are indeed linked to growth in a wide range of sectors. But for materials such as metals (of which imports make up 10-15% of total raw material imports), demand can be traced back to growth in a select few industries related to building construction and also vehicle manufacturing. In the context of managing imports in the face of weak exports, sector-specific policies will likely remain an option going forward as a supplement to rate hikes. The aforementioned industries (i.e. construction and vehicle mfg.) may stay under the spotlight of policymakers if growth is deemed excessive, as seen in the recent tightening on housing loan-to-value ratio regulations.

These items are either imported due to insufficiencies in domestic production or lack of capacity in parts or of the production chain. If the IDR depreciates, there will thus be very little substitution effect for locally-produced raw materials. Import substitution can be achieved only if there is improvement in domestic capacity to produce the aforementioned raw materials. Following a huge stream of
investments into basic industries over the past couple of years, capacity improvements may eventually come, but likely after 2014 or even 2015.

The implication is that any reduction in imports will likely come at the expense of economic growth. In the presence of excess capacity in basic manufacturing industries, a rise in the cost of the imported raw materials may result in a shift towards locally-produced raw materials (thus will may have a positive effect to economic growth). However, without the capacity to manufacture locallyproduced
alternatives, rising raw material import costs will only pressure industry margins, push up selling prices, reduce demand and lower economic growth. Amid a weak export outlook, how strong a decline in economic growth will be needed to substantially reduce imports? There is no straightforward answer to this question because the elasticity of imports to different industries varies. However, we try to shed light by digging up data from Indonesia’s Input-Output table. It can be seen that output from industries such as chemicals and plastics (which are heavy users of imported raw materials) are used as inputs in a wide range of manufacturing industries (ranging from apparels, household appliances, electronics, batteries, etc.). But demand for certain raw materials can be linked to the growth in a select few industries. Demand for raw materials such as basic metals and non-ferrous metals can be pin-pointed to selected industries which are related to building construction and vehicle production. The elasticity of raw material imports to these two sectors should be relatively high. And as a result, growth in these sectors may remain in the watchful eye of policymakers from the viewpoint of managing the external imbalance, as evidenced by past regulations, e.g. minimum vehicle downpayments and tighter housing loan to value ratios.