Strong domestic demand may buoy Indonesia’s GDP to 6.3% in 2011

The economic outlook for Indonesia remains healthy in 2011 and 2012, underpinned by robust domestic demand. We expect consumption spending to remain relatively stable at 4.8% in 2011 and 2012, and investment spending to rise 8.7% in 2011 and by 8.1% in 2012.

Private consumption and investment, which together make up nearly 90% of GDP, should contribute strongly to economic growth. Consumption is expected to add 2.7 % points to real GDP growth in both 2011 and 2012, while investment spending should contribute around 2.0 % points in each year.

Nevertheless, downside risks exist given the current global economic and financial headwinds. Consumer spending could moderate as a result of easing commodity prices and equity market weakness (via lower incomes), while exports could face downward pressure from weaker global demand.

We still expect decent economic growth ahead but lower than BI’s optimistic forecast of 6.6% and 6.5% for 2011 and 2012 respectively. Our forecast is for real GDP to grow by 6.3% in 2011 before moderating to 6.1% in 2012.

Inflation has been surprisingly tame recently with housing and transportation cost having a moderating influence. Food price growth has also slowed after the Ramadan period. As a result, Sep’s headline inflation eased to 4.6% yoy from 5.5% in Aug.

Core inflation rose a more modest 4.9% yoy in Sep from 5.2% in Aug, but this was still high when compared to the 12-month average of 4.5%.

Nevertheless, we believe that headline inflation could remain high on average in 2011 on the back of demand-pull factors resulting from the strong economic growth to date.

In 2012, healthy economic growth and structural inflation should keep inflation elevated. Moreover, tweaks to official electricity billing rates and possible adjustments to fuel subsidies in 2012 could push inflation higher. In addition, imported rice prices could also increase as a result of the floods in Thailand.

Thus headline (as well as core) inflation could remain elevated in 2012, hovering around 6.0%, up slightly from 5.8% in 2011.

The surprise 25 bps rate cut to 6.50% by BI on 11 Oct was premised on supporting economic growth of at least 6.5% in 2011 and 2012, and on inflation easing from 4-6% in 2011 to 3.5-5.5% in 2012.

We believe the rate cut was premature. First, despite the global economic uncertainties,  Indonesia is still very much a domestically-driven economy. Second, we think that inflation is likely to remain elevated for the foreseeable future. We observed that whenever the BI inflation-adjusted policy rate dips into negative territory, it typically induces a rate hike. The failure to tighten rates appropriately could allow inflation expectations to unhinge.

The recent BI rate cut could also result in further rupiah weakness. With core inflation already at elevated levels, a weaker rupiah could keep inflationary pressures up. BI’s credibility could be hurt if inflation surprises significantly on the upside. Hence, we believe that BI will probably have to reverse policy and raise rates in 2H12 (possibly in 3Q12).