Indonesia: inflows drown fundamentals 8 October 2010

Interest rate strategy

Indonesia: inflows drown fundamentals

DBS Group Research 8 October 2010

Capital flows have been strong for the past four months and market performance has been impressive But asset prices are now overstating fundamentals. This is a problem Government bond yields mask inflation and rate hike risks and the equity market has outperformed regional peers by a wide margin Policy makers still think that the risk of being too early in interest rate policy tightening outweighs the risk of being too late, but given the strength of credit and domestic demand growth and inflationary pressure, policy makers cannot sit on the sidelines much longer Investors should prepare for a more decisive response from policy makers

Markets have delivered impressive returns

Capital flows have been strong for the past four months and market performance, in both the equity space and bond space, has been impressive. Despite the global financial crisis, broad-market equity total return benchmarks are up more than 30% since Dec-2007 and bond benchmarks trade more than 50% higher (see charts below). But too much of a good thing is not a good thing and asset prices now overstate fundamentals. Government bond yields have already fallen to levels that mask inflation and rate hike risks and the Jakarta Composite has outperformed regional peers by a wide margin (see chart on page 2). This is not all good. First, while attracted by positive long-term fundamentals, it is likely that some of the generally welcome foreign capital inflows during the next period of risk aversion in global markets turn into outflows. Second, local

Capital flows have been strong, but too much of a good thing is not a good thing

Foreign flows into Indonesian Stocks & Bonds

IDR trillion 25 20 15 10 5 0 -5 -10 Jun-09 Bonds Stocks

Comparative Returns
%, cumulative from 12/31/2007

80 60 40 20 0 -20 -40 -60

Bonds (iBoxx Total Return Index) Stocks (MSCI Total Return Index)

Dec-09

Jun-10

Dec-10

-80 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

Jens Lauschke (65) 6224 2574 jensjoerg@dbs.com

Indonesia: inflows drown fundamentals 8 October 2010

Comparative stock returns

%, cumulative from 12/29/2006, local-curreny terms

140 120 100 80 China (Shanghai Composite) Indonesia (Jakarta Composite) India Thailand Malaysia Korea

With commodity prices rising, the risk to the inflation outlook is now to the upside. Inflation is likely to average 6.5% in 2011

60 40 20 0 -20 -40 -60 Dec-06 Jun-07 Dec-07

Taiwan (TAIEX) Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

markets are small (the government bond market is about 15% of GDP and the corporate bond market about 1.6% of GDP, the equity market capitalization is about 50% of GDP) and large capital flows boosts domestic liquidity and makes the conduct of monetary policy more difficult. Third, the more markets move away from fundamentals, the more likely it is that the eventual correction has an impact on the real economy. Policy makers are reluctant to use interest rates to anchor inflation expectations ... Moreover, excess liquidity is considerable, credit growth is strong, and consumer prices are up 5.8% from a year ago. These trends are likely to continue and with commodity prices rising, the risk to the inflation outlook is now to the upside. It is quite plausible that annual inflation rises above 6% in 2011 (year-on-year changes in CPI inflation have averaged 8% over the past eight years).

Consumer Price Inflation

Index, 2007=100 Sep-10 CPI Food 123.2 142.5 130.9 122.2 106.4 118.8 117.2 115.3 CPI Food Prep Food Clothing Transport Housing Education Health MoM % changes Sep-10 0.44 0.4 0.5 1.1 0.6 0.3 0.3 0.2 6M Avg 0.70 1.6 0.5 0.6 0.4 0.4 0.4 0.2 12M Avg 0.47 0.9 0.6 0.4 0.2 0.3 0.3 0.2

... and asset markets are rising accordingly

Prep Food Clothing Transport Housing Education Health

Bank Indonesia needs to be more proactive

Judging from the inaction on policy interest rates, policy makers still think that the risk of being too early in policy rate tightening outweighs the risk of being too late. Governor Nasution said in early September that as long as we can still manage our monetary variables by other instruments, we will try to avoid changing the interest rate. Bottom line, policy makers are reluctant to use interest rates proactively to anchor inflation expectations and reduce the volatility in price trends. While they are becoming more concerned about the inflation outlook,

Indonesia: inflows drown fundamentals 8 October 2010

Foreign Holdings of Indonesian LC Govt Bonds

cumulative chg from Mar09, IDR trillion 120 100 80 60 40 20 0 Mar-09 Foreign Holdings Sep-09 Mar-10 Sep-10 Total Market

10Y IDgov = a * GDP + b * CPI + c * 3M Jibor + d

%pa 16 15 14 13 12 11 10 9 8 7 6 Dec-03
quarterly data

Model 10Y IDgov Yield

Dec-05

Dec-07

Dec-09

they continue to reiterate the importance of supporting credit expansion and overall economic growth. As long as this is the prevailing perception among market participants and risk appetite remains healthy, both the equity market and the bond market will do well. As foreign entities continue to absorb all of the net supply of bonds to the market, the rich trading levels of and low yields on Indonesian government bonds will continue to mask inflation and rate hike risks and trade well below fair value (see charts above). Eventually, the policy rate will have to be raised from the current record low level of 6.5% and that point is probably not as far away as investors hope. Given the strength of credit growth and domestic demand growth, inflationary pressures, capital inflows, market developments and international pressure, it is unlikely that the market will have policy makers on its side much longer. We think the first rate hike from Bank Indonesia could come as early as this quarter. The hike in the primary reserve requirement ratio in September already signals that policy makers feel the need to act. So far, they have merely restored banking system liquidity conditions to pre-crisis levels and more needs to be done to anchor inflation expectations and ensure healthy economic growth. Investors have to prepare themselves for a more decisive response from policy makers to current trends in the economy and markets.

Conclusion
As long as there is the perception that a) interest rate policy in Indonesia will be reactive rather than proactive with regard to inflation and b) policy remains focused

Headline CPI Inflation & 10Y Bond Yield

% 20 18 16 14 12 10 8 6 4 2 0 Jul-03

Comparative Stock Returns

%, cumulative from 12/31/1999, local-currency terms

500
10Y Yield (%pa)

400 300 200 100 China (Shanghai Composite) Indonesia (JCI)

CPI (%YoY)

0 -100 Jan-00 Jan-02 Jan-04

Jul-05

Jul-07

Jul-09

Jan-06 Jan-08 Jan-10

Indonesia: inflows drown fundamentals 8 October 2010

on supporting credit expansion and overall economic growth, the music is playing and the party goes on - both in the equity as well as in the bond market. But no party goes on forever. With inflation risks to the upside investors have to prepare themselves for policy makers removing the punch bowl. Bank Indonesia has already demonstrated that it is willing to act and interest rate hikes will soon be used to change market perceptions that monetary policy conditions will remain accommodative. Bond yields will rise when that happens.

Sources for all charts are Bloomberg and DBS Group Research.

Indonesia: inflows drown fundamentals 8 October 2010

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