State Street Cautious on Indonesia Price Dilemma: Southeast Asia

Indonesia’s combination of accelerating inflation and record-low bond yields is prompting State Street Global Advisors and Schroder Investment Management Ltd. to cut holdings.

The average yield on Indonesian sovereign debt has risen 16 basis points since reaching an 11-month low of 5.8 percent on Jan. 7, within 22 basis points of the 5.58 percent record on Feb. 10, 2012. Local-currency notes have declined in 2013 after generating a return of 13 percent last year, the best performance among 10 Asian local-debt markets compiled by HSBC Holdings Plc. Consumer prices rose 4.57 percent last month, the most since October, official data show.

Indonesian President Susilo Bambang Yudhoyono is under growing pressure to raise the price of subsidized fuel to curb the current-account deficit as his window to act narrows ahead of elections in 2014. A 44 percent increase in the minimum wage in Jakarta, along with similar gains elsewhere in the archipelago, and a 15 percent rise in electricity prices this year, are also adding to the inflationary pressure.

“In the case of Indonesia we ought to be a bit more cautious at this level where the yields are trading,” Ng Kheng Siang, head of Asia-Pacific fixed income at State Street Global Advisors in Singapore, said in a Jan. 29 interview. “Some of the measures that potentially will be rolled out would further impact on inflation.”

Fuel Bill

The government spent 211.9 trillion rupiah ($22 billion) on subsidizing fuel last year, compared with a target of 137.4 trillion rupiah, Finance Minister Agus Martowardojo said on Jan. 7. As well as being a drain on the state budget, the rising bill has contributed to the current account swinging to a deficit of $16.2 billion in the three quarters through September 2012 from a surplus of $4 billion a year earlier.

That has put pressure on the rupiah, which has fallen 0.1 percent this year to 9,643 per dollar as of 11:35 a.m. in Jakarta, following a 5.9 percent decline in 2012 that was largest among Asia’s 10 most-traded currencies excluding the yen.

Brent crude traded in London, a benchmark for more than half the world’s oil, has risen 7 percent this year and 22 percent since the end of June, according to data compiled by Bloomberg.

Bank Indonesia expects consumer-price gains to remain in a range of 3.5 percent to 5.5 percent in 2013. The upper limit could easily be breached if subsidized fuel prices increase by 10 percent or more, according to estimates from PT Bank Danamon Indonesia and PT Mandiri Sekuritas, a unit of the nation’s largest lender by assets.

Defensive Stance

“Next year will be an election year and any decision will have to be taken fairly soon,” said Rajeev De Mello, who manages $7 billion of debt as the Singapore-based head of Asian fixed-income assets at Schroder. “Indonesian bonds had offered relatively high yields but now they’ve come down. I’m defensive on Indonesia now,” he said, adding that he moved his exposure to Indonesia to underweight in late 2012, meaning he holds less than the benchmark index he follows.

Foreign ownership of Indonesian government bonds has dropped by 1.1 trillion rupiah since reaching a record 274 trillion rupiah on Dec. 6, 2012, official figures show.

Bank Indonesia will keep its reference rate at a record-low 5.75 percent for a 12th month tomorrow, according to all 17 analysts surveyed by Bloomberg. The benchmark rate will probably be raised by at least 25 basis points by year-end, according to 12 of 21 economists in a separate survey.

Rupiah Volatility

The central bank signaled the need to boost short-term borrowing costs to lure capital inflows when it raised the rate it pays lenders on overnight deposits, known as the Fasbi, in August to 4 percent from 3.75 percent. Policy makers may need to boost the Fasbi rate gradually as the rupiah declines, while keeping the benchmark rate unchanged, Deputy Governor Hartadi Sarwono said in November.

The rupiah’s one-month implied volatility, which measures expected exchange-rate swings used to price options, has increased 80 basis points this year to 6.5 percent. That compares with 5.45 percent for Thailand’s baht and 4.25 percent for the Philippine peso.

“The central bank may need to step in and raise interest rates,” said Ng at the asset management unit of State Street Corp., which has $24.4 trillion in assets under custody. “That’s going to be helpful to reduce the volatility in the rupiah.” Ng said he has an underweight position on Indonesia.

Indonesia’s 10-year bond yield of 5.25 percent compares with 3.79 percent for the Philippines, 3.55 percent for Thailand and 3.48 percent for Malaysia. The 10-year yield may climb to 5.97 percent by end-2013, according to the average forecast of six analysts in a Bloomberg News survey.

Domestic Demand

The gross domestic product of Southeast Asia’s largest economy increased 6.2 percent last year, the third year in a row that it has exceeded 6 percent. Domestic consumption accounted for 64 percent of the expansion.

“Indonesia is a domestic demand-led economy and is not influenced much by external conditions,” Kenichiro Ikezawa, a Tokyo-based fund manager at Daiwa SB Investments Ltd., which oversees about $54 billion, said in a Feb. 5 interview. “We can take advantage of its growth potential. Yields have been dropping, but they are still higher than many Asian nations.”

Yudhoyono, who can’t run for president next year after serving two terms, struggled to win support from within his own coalition for a proposed fuel-price increase last year.

Loose Policies

“Electricity tariffs and raised minimum wages will drive inflation expectations higher in 2013, even without an increase in fuel prices,” Handy Yunianto, head of fixed-income research at Mandiri Sekuritas in Jakarta, said in a Feb. 5 interview. Inflation may accelerate to 7.5 percent, the fastest pace since March 2009, should there be a 30 percent increase in subsidized fuel prices, he said.

The cost of protecting Indonesia’s five-year debt against non-payment has risen nine basis points this year and reached a four-month high of 152 basis points on Feb. 4, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market. It was 145 basis points on Feb. 8.

Standard & Poor’s said in April last year it has refrained from joining Fitch Ratings and Moody’s Investors Service in awarding Indonesia investment-grade status as the country’s push to lure investment is at risk from “policy slippages” such as the failure to cut fuel subsidies.

“The place where we’re more conservative is Indonesia,” Adam McCabe, deputy head of Asian fixed income at Aberdeen Asset Management Plc in Singapore, said in an interview on Jan. 24. “The policies are too loose. If they were to do nothing and the market feels they are losing credibility then the country risk premium increases.”

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