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Foreign Exchange

Indonesian rupiah appreciation may outperform, says fund manager

The Asian currency bloc is often touted as an attractive medium- to long-term appreciation trade, based on the emerging-markets growth story and spurred by the re-emergence of global growth.

That story has been somewhat muted across the emerging markets, largely because the global economy is entering a mid-cycle slowdown, according to Amit Tanna, a senior portfolio manager at JPMorgan Asset Management.

Yet not all emerging-market currencies are correlated to global growth in the same way, and the Indonesian rupiah (IDR) has in recent times exhibited a lower correlation than some of its regional peers (see chart).

 Asia's growth - correlation to US, EU and China growth

 Asia's growth - correlation to US, EU and China growth
Sources: Bloomberg and Citi Investment Research and Analysis estimates

Tanna says Indonesia’s stable fiscal picture, including its strong terms of trade in the export of bulk commodities such as thermal coal to China, is a major positive in its growth story. Moreover, domestic consumption has typically been a stronger growth driver than exports, as Indonesia benefits from a growing population and affluent middle class, Tanna adds. The low correlation between Indonesian growth and global economies can be contrasted with that of other emerging economies, such as Mexico, which have experienced a significant uptick in correlation with US growth in the past few years.

Correlation between US GDP Growth and Other Countries (10-year rolling window)

US growth correlation 
Spike in Mexico's correlation with US growth patterns circled

Source: St. Louis Federal Reserve

“[Indonesia is] very well placed from a cyclical point of view, as domestic demand is a key driver for growth there. This makes IDR well placed as we enter a mid-cycle slowdown globally,” Tanna argues.

So how can investors best position themselves to take advantage of this low correlation? Tanna says one-year vanilla call options on IDR are a good way to prepare for a steady rise in Indonesian growth over the next 12 months.

“IDR call spreads are relatively attractive as one can position for a medium-term appreciation of the rupiah in a risk-controlled way,” he says.

“With only the premium at risk, one can scalp away the tail risk of the investment opportunity while maintaining a relatively attractive profit potential.”

Giving further credence to the strategy, the Indonesian central bank has been praised for its steady monetary policy and its willingness to smooth rate fluctuations through market intervention. “The central bank understands that, if it needs to tighten, it can do it through the exchange rate. They’re active in the market,” says Tanna. “They’re comfortable letting the rupiah rise. The fact that they’re there to intervene when times are volatile gives the real-money guys confidence.”

Bank Indonesia has gradually been cutting its rates from a peak of near 17% in August 2008 down towards 14.82% as of last month (see chart). Having been less aggressive in cutting rates during the early phase of the crisis, the bank can afford to avoid raising them now, Tanna says.

Indonesia Base lending Rate, Dec-May

 Source: Bloomberg data

And the low-volatility climate has favoured real-money investment over leveraged funds, Tanna claims, with foreign direct investment from China particularly strong.

“There’s strong institutional interest in [Indonesia’s] bond market. And it’s not just from Asian reserve managers. We’ve seen big inflows into their local market. Nominal yields are high and the fiscal story is strong.”

A boost in the country’s sovereign rating may also favour capital inflows and rupiah appreciation. Standard&Poor’s rates the country BB+, with a positive outlook.

Asked about the inflation rate, printed at 5.98% for May 2011, Tanna says: “That’s perhaps one of the risks at the moment. If inflation were to move higher meaningfully, one would become concerned. But people are very cognizant of that already.”

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