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Capital Markets

Indonesia: full steam ahead to an overheated economy?

Credit Suisse reckons all of Indonesia's vital economic statistics point to overheating.

Indonesia’s economy is overheating. Well, it is according to a recent report published by Robert Prior-Wandesforde at Credit Suisse. The report argues that all key indicators including inflation expectations, wages, asset prices and the current account unfortunately all point to the same gloomy outcome. One factor inching Indonesia’s economy towards warmer climes is GDP growth which has been “pushed above the sustainable rate by a loose monetary stance,” and has subsequently led to an output gap:

“The key to our argument is the belief that 6½% GDP growth (let alone 7%) exceeds the economy’s trend rate of expansion, meaning that these kind of growth rates would create increasingly severe economic bottlenecks, eventually forcing the policy authorities to tighten more than they would otherwise have done. Such action would inevitably depress economic growth – the very thing the government and central bank was trying to boost in the first place – with the risk that bubbles then burst with very painful consequences”  

Sound familiar? As Prior-Wandesforde told Emerging Markets in January this year:

“Clearly, Indonesia’s public finances are extremely good – the fiscal deficit is just 1% of GDP and the private sector is underlevered. But what worries me is that Indonesia is effectively doing an India in the sense that monetary policy is being kept too loose, for too long.

Just like we saw in India, there is now an attempt to push growth to unsustainable rates via loose policy. Analysts’ trend estimates are too cyclical. The country is set to grow 6.5% this year but attempts to keep the economy growing at a 6.5%-7% will lead to overheating in a 2-year horizon."  

Not only does it echo an India of a couple of years back, but this was a situation Prior-Wandesforde predicted a while back too. The patterns keep pointing to his original hypothesis. With all indicators pointing to overheating, Prior-Wandesforde revises some of the forecasts for the Indonesian economy:

“Rather than 50bps, we are now looking for 125bps of policy rate hikes during 2013, with most of the action coming in the first half of the year if the rupiah tumbles...

...We are now expecting a current account deficit of USD23bn in 2012 and USD35bn (3.4% of GDP) in 2013. Both are way above the USD8.6bn and USD5.8bn consensus numbers, while next year’s forecast is bigger than the external deficit we expect in India as a share of GDP”  

Indonesia might still have an escape route thanks to a flexible exchange rate system. As Credit Suisse points out:

 “There is, however, plenty of precedent for the market to force quicker and more aggressive action on Bank Indonesia and modelling the likely development of the current account deficit we believe history may well repeat itself via a sharp depreciation of the rupiah. This could happen as early as the first half of 2013 and we have made a number of forecast changes to reflect this. The good news is that the earlier the necessary policy adjustments are made the more modest will be the eventual hit to economic activity.”
 
 Source: Credit Suisse

One point to add to Indonesia's structural vulnerabilities: the government has pursued an increasingly protectionist policy this year with respect to foreign investment in its banking industry, especially. This comes at an unfortunate time: as overheating and current account risks grow, the quality of foreign money into the country matters and foreign direct investment (FDI), rather than hot money, should be used to bridge the gap.  

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