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Upside with Rupiah Bonds

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James Bladen
James Bladen
James Bladen joined Alpha Southeast Asia in 2015. He has written on a wide range of issues covering capital markets, Islamic finance and M&A. He worked as a consultant in Indonesia (2013-2017) and moved to New York in 2020 where he continues to cover Southeast Asia. Disclosure: I have no direct investment holding in any stocks or bonds in Indonesia , and no plans to initiate any positions within the next 96 hours. The opinion expressed in this article is my own. I have no commercial relationship with any company cited on this website nor am I receiving any compensation from anyone except from Alpha Southeast Asia, controlling shareholder of www.www.whatinvestorswant.com

There are two reasons investors love Indonesian local currency bonds: yields are amongst the highest in Asia, and the government is doing its best to support the asset class. Bank Indonesia (BI) already slashed policy rate by 50bp to 7% and reduced the reserve requirement (GWM) by 100bp to 6.5% so far this year. But the government is still not satisfied: it wants to push lending rates to single digits by year-end. The question for this Thursday is whether: a) BI will cave in to government pressure and slash rates further; and b) if it matters given that OJK is bypassing BI through deposit rate caps (not yet implemented).

While we think it shouldn’t, BI will likely yield to political pressures despite of higher February inflation. And more fundamentally, we think does not matter so much now that the government is having more interventionist measures. It is planning on implementing caps on deposit rates, essentially bypassing BI to force banks to lower lending and deposit rates. This limits the necessary price signals for the financial sector and the economy, raising financial stability risks. We believe while this is positive in the short term for bond investors, it is negative for Indonesia’s economic future.


The call for this Thursday’s meeting is rather mixed. On the one hand, inflation is high – February CPI rose to 4.4% YoY and BI’s target range is 3-5% – necessitating BI to pause to monitor its recent aggressive rate cuts. On the other, political pressures to slash rates are rising. Both President Jokowi and Vice President Yusuf are calling for lower interest rates to support growth. While we do not think BI should, it will likely cave in to political pressures and slash rates by 25bp on 17 March 2016. The cut, while good in the short-term for bond investors, is rather bad news for the sustainability of the economy and especially the financial system.

BI cuts have not translated into equivalent reductions of deposit and lending rates are due to tight liquidity conditions. M2 – a measure of deposits – slowed to 7.7% YoY in January from 8.9% in December. Banks have reported that while cost of funds have declined, they are unwilling to raise loan growth target given the slowing domestic growth environment. Credit growth slowed to 9.3% YoY in January from 10.1% in December. The loan-to- deposit (LDR) remained elevated even with slower credit growth at to 93.5% (Chart 1), highlighting still tight liquidity conditions due to limited credit growth. The central bank targets 12-14% credit growth and it is unlikely that this will be reached.

But the government is impatient. To lower lending rates, the government capped the interest rates for savings and time deposits owned by state-owned companies, the government and local administrations at 5%. Additionally, the Financial Services Authority (OJK) plans to set a maximum limit at 100bp of the BI benchmark rate for lenders with core capital between IDR5trn and 30trn, known as BUKU III lenders. The limit for BUKU IV with core capital above IDR30trn will be set at 75bp. This is expected to be implemented early April, according to reporting by the Jakarta Post.

High deposit and lending rates reflect market conditions and risk premium – a price signal that will be lost should OJK gets what it wants. OJK’s interventionist measures are worrying for several reasons. One this could cause a shortage of deposits, causing M2 to slow further from its already meagre growth rates. This means that banks could have funding issues. Second, should banks lower interest rates in response to government pressures, then banks’ asset quality may deteriorate due to lending to economic segments that are may not be able to pay for the true costs of funding. Third, this could cause misallocation of resources and lead to inefficiency in the economy.


We believe that after the euphoria comes the sobering realization that Indonesia still has a very wide funding gap (See The hole in the fiscal-led story). Private sector lending will likely be subdued this year, requiring fiscal expenditure to make up the gap. However, it is limited in scope from a funding point of view due to declining revenue. Finance Minister Brodjonegoro stated recently that Indonesia’s fiscal space is limited. Parliament already delayed passing the amnesty tax bill, a measure that we thought would not make a material impact on the revenue ratio. Regardless, this means that fiscal expenditure will need to be slashed. And even so, Brodjonegoro stated that he is considering a wider fiscal gap than expected.

This is one of the reasons for the government to cap deposit rates and to pressure BI to slash policy rates further. The government understands that the 5.3% GDP target will be difficult to reach due to low private sector investment and weaker revenue sources (our 2016 GDP estimate is 4.9%). Thus, to achieve its public-investment led growth strategy, it needs to increase its investor base to finance its widening budget. And the government is pushing for this by capping the interest deposit rates, making bond investments more attractive to both domestic and foreign investors.

We worry that BI is not saving enough ammunition for surprise external shocks from a more-than-expected hawkish Fed and China’s sharp decelerating growth. By moving to loose and too fast, Indonesia is putting short-term gains at the expense of its financial stability. And most importantly, the government is not using this importunity to address fundamental weakness of its revenue ratio, which will bite back when the global hunt for yield subsides.

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