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Jakarta/Singapore. Indonesia just recorded its strongest annual growth rate in 15 years and shows no sign of a significant 2012 slowdown, yet its central bank is Asia’s most dovish.

Investors appear to have no concerns about that disconnect, judging from demand for Indonesia’s debt at an auction this week that was so strong the offering was expanded by 50 percent.

But inflation looks set to rise in the next couple of months, spurred by strong domestic demand, a spike in food prices from harvest-impeding rains, and the government’s plan to boost fuel and power prices.

That could force Bank Indonesia into a policy U-turn that undermines its credibility.

“We think they’ll ultimately have to change tack,” said Leif Eskesen, an economist with HSBC in Singapore who has been critical of BI’s unexpected interest rate cuts in October and November.

“Too much insurance has basically been taken out against a slowdown in growth.”

The central bank holds its next policy-setting meeting on Thursday, and economists in a Reuters poll widely expected it to hold rates steady. In fact, a growing number now think rates will be on hold all year, a sharp change from mid-January when the consensus call was for at least one more cut.      

In Asia, Indonesia’s economic growth rate trailed only China and India in 2011, and it weathered a global slowdown in the second half far better than its larger Asian peers. 

It has recorded five consecutive quarters of year-on-year growth above 6 percent, and 2011’s pace of 6.5 percent was the strongest since 1996, just before the Asian financial crisis left Indonesia limping to the International Monetary Fund for a bailout. Economists are looking for 2012 growth of 6.1 percent, a milder slowdown than they have predicted for China, where growth is forecast to dip to 8.4 percent from 2011’s 9.2 percent.
 
Despite the string of steady growth, BI has delivered rate cuts and imposed other measures that economists estimate add up to 175 basis points worth of effective easing since October.

Compare that with Thailand, where flooding ravaged the economy, yet the central bank has lowered interest rates by a relatively modest 50 basis points. 

Luring Investors

The rationale behind BI’s rate cuts was that the euro zone debt crisis could spiral out of control, sparking a global recession that would crush growth and scare away foreign investors who usually hold one-third of Indonesia’s debt.

Indonesia got an unpleasant taste of capital flight in September, when worries about Europe shook global markets and pushed investors toward the perceived safety of the US dollar.

Foreign holdings of Indonesian debt slipped to 31 percent in September from 35 percent in August. The country exhausted 8 percent of its foreign exchange reserves defending the rupiah, which tumbled almost 7 percent in the first half of September.

BI sprung the first of its two surprise 2011 rate cuts on Oct. 11, when the memory of September’s selloff was fresh. Its policy statement made clear that the motivating factors were Europe’s debt troubles and the risk of capital reversal.

But global meltdown fears have abated. The euro zone still appears to be slipping into a recession, but it looks less likely to drag down the rest of the world, particularly when the US economy seems to be picking up speed.

Indonesia’s economy is far more domestically focused than most of its export-sensitive Asian peers, so a mild slowdown in global demand would do little harm. Growth at home looks strong.

Assuming China’s economy cools without collapsing, Indonesia will have a voracious buyer for its commodities.

Rising incomes have lifted buying power for the Southeast Asian country’s rapidly growing middle class. Inflation has receded over the past year, coming in at 3.65 percent year-on-year in January. 

If price pressures stay subdued, BI may still have more easing to do, said Eric Sugandi, an economist with Standard Chartered in Jakarta, who expects another rate cut in March.

“They won’t hike — not this year,” Sugandi said, pointing out that the US Federal Reserve looks likely to leave interest rates near zero until late 2014, which would make it hard for BI to tighten without attracting a destabilizing wave of capital.

“They need to cut more,” he added. “The problem is the timing.”  

Sugandi said the central bank may rely more heavily on open market operations or adjustments to banks’ reserve requirements in order to fine-tune monetary policy. 

Pressure Building

Underneath the benign headline inflation figure, price pressures are building. January’s inflation picked up month-on-month, and core prices remained elevated.

The government now sees output of rice, the country’s staple grain, falling well below a targeted 72 million metric tons in 2012 because of wet weather and crop disease, an admission that is likely to lead to further rice imports and higher prices.

Add in higher electricity tariffs, expected in April, and inflation could pick up to 5.5 percent, said David Sumual, an economist with Bank Central Asia, Indonesia’s largest consumer bank.

If the government also raises fuel prices or cuts subsidies — something the IMF has long advocated to ease budgetary strain and reduce economic distortions — inflation could spike above 6 percent.

“In this case there could be a hike later this year,” Sumual said.

Indonesia’s inflation-fighting efforts were “helped last year by lower commodity prices in the third and fourth quarter — external factors, not BI’s control of the money supply. That helped keep inflation low.”

With Brent crude oil trading at $116 per barrel despite a sluggish global economic outlook, BI probably can’t count on falling commodity prices for help this time.

HSBC’s Eskesen thinks BI will stick with its dovish tone at Thursday’s meeting, focusing on downside risk to the economy rather than the threat of rising inflation. 

Part of the reason for that view is BI’s belief that the economy can safely grow at a rate well above 6 percent a year without overheating and generating too much inflation. 

Eskesen thinks potential growth is only slightly above 6 percent because Indonesia is still plagued by poor infrastructure and other bottlenecks that make it difficult to do business there. 

He expects another 50 basis points in rate cuts in the first half of the year, but thinks this would be a policy mistake that only stokes inflation in the second half of the year.

“They should not have cut in the first place,” he said.

Reuters