On again, off again: The central bank responds to challenging inflationary conditions

In an uncertain global economic environment, emerging markets like Indonesia have faced volatile inflationary pressures. While local monetary authorities have had to quickly adapt to a shifting balance between inflation and economic growth, the government continues to keep the prices of necessities down through a mix of price controls and imports.

While inflation re-emerged as a key downside risk in early 2011, it cooled markedly as the year drew on. Despite favouring cyclically exposed economies such as Indonesia and Korea, investors watched inflationary pressures closely as the year began – overall consumer price inflation had risen from 4.8% year-on-year in 2009 to 5.1% in 2010. Disruptions in food supply due to poor weather in 2010 were compounded by enduring weaknesses in the country’s infrastructure to cause an uptick in inflation, rising from 2.8% month-on-month at the close of 2009 to 7% in December 2010. Inflation eased considerably to 4.61% annualised following the end of Ramadan in September, down from 5.15% in August, and in comparison to other key emerging markets of similarly significant size, such as India and China, Indonesia has succeeded in taming excessive inflation.

A NUANCED APPROACH: Bank Indonesia (BI) runs a flexible inflation-targeting policy, within a 1% margin of an inflation target set by the Ministry of Finance – the target is 5% for 2011 and 4.5% in 2012. BI seeks to manage capital flows and thus the volatility of the currency through sterilised interventions, which carry a high cost for its balance sheet. It also plays a supervisory role for banks and financial institutions and seeks to lower the commercial lending rate to boost lending. BI targeted inflation in the range of 4% to 6% for financial year 2011 while the government forecast 5.65%.

Facing volatile global conditions and shying away from any moves that might dent resilient domestic growth, BI’s monetary policy committee remained hesitant to change interest rates following its 300-basis point cut during the 2008-09 crisis. The fine balance to strike was that between exacerbating interest rate spreads with other central banks, which could cause significant currency inflows, and containing inflation partly caused by seasonal price fluctuations.

The central bank only raised its reference rate once between August 2009 and October 2011, from 6.5% to 6.75% in February 2011, before bringing it back down to 6.5% in October 2011 and lowering it again by half a percentage point to 6% in November 2011.

Other than policy rate adjustments, the central bank has other tools at its disposal to boost or slow the economy, such as changing the reserve requirement.

For example, in September 2010 the central bank announced that it was raising the rupiah primary reserve requirement from 5% to 8%, effective November 2010, citing concern about rising inflationary pressures.

As Fauzi Ichsan, senior economist and head of government relations at Standard Chartered Bank, told OBG, “Acting on reserve requirements presents a cheaper tool of monetary policy for BI, since raising interest rates increases its cost of issuing central bank certificates (SBIs) as well as its cost of offering deposits to private banks. As such I don’t foresee any cut in reserve ratios for the foreseeable future.”

In September 2010 the bank also announced regulations regarding the loan-to-deposit ratio (LDR), in an apparent effort to boost lending, which might seem at odds with the increase in reserve requirements. The new rule, which went into effect in March 2011, requires banks to maintain an LDR of 78-100%, mandating higher reserve requirements for banks on either side of this target range. Many banks, such as Mandiri and Bank Central Asia, have opted to pay the penalty rather than extend more loans (see Banking chapter).

FOOD PRICE INFLATION: Although seen as too early a move, the central bank’s interest rate rise February 2011 showed eagerness to stop food and energy price inflation working through to higher expectations. Agricultural commodity prices were a key driver of the spike in inflation at the turn of 2011, with food price inflation reaching 16% a year at the close of 2010 and 18.25% in January 2011. The government has moved to tame food inflation by resuming imports of basic staples such as rice, while fuel subsidies continued to shield consumer demand from energy price increases. Rice prices typically rise in the last two months of the year and start to subside (albeit at a higher base level than the year before) from March onwards as harvests are sold on the market.

PRICE CONTROL MEASURES: Price controls on fuel and imports of basic food items including rice are a key component of Indonesia’s budgeted expenditures. Although they are a drain on budgetary resources and have been criticised by the Bretton Woods institutions, they have worked to tame inflation.

Spending on subsidies has typically overshot budgeted amounts, as in 2010 when it reached a total of Rp214.1trn ($25.7bn), 6.4% over allocations. A large part of the budget overshoot in 2010 was caused by an expansion of a programme by the state procurement agency, Bulog, to distribute 15 kg of rice monthly to 17.5m poor, as well as higher electricity subsidies.

Imports typically start towards year-end to counteract the price cycle, yet procurement orders were only placed in February 2011, exacerbating food price inflation in the early part of the year. In light of seasonal fluctuations in commodity prices including food and government rice imports, inflation fell back as the second quarter wore on, dropping to 4.79% by September 2011. Analysts expect the annualised rate to remain roughly at or below 5% for the full year.

SUBSIDY REFORM: Fuel subsidies are by far the biggest drain on state resources, although rice imports have proved politically important in the authorities’ fiscal response to inflation. Energy subsidies (both fuel and power) in the 2011 budget total Rp195.5trn ($23.5bn) out of a subsidy bill of Rp237.2trn ($28.3bn), with total subsidies accounting for 17.96% of the budget. While official rhetoric has touched upon the politically sensitive issue of subsidies, little concrete reform is expected to take place before the 2014 electoral cycle.

Energy subsidies account for 14.79% of the 2011 budget. Although President Susilo Bambang Yudhoyono’s administration cut fuel subsidies in 2005 and in 2008, momentum on reform has stalled somewhat despite pressure from the IMF – the government has repeatedly delayed plans to end subsidises on fuel sales for transport in Java in recent years. The focus has shifted in the shorter term towards reducing usage volumes rather than the subsidised fuel price by limiting consumption rather than promoting greater fuel efficiency. Given the dip in the government’s popularity in various 2011 polls, it seems unlikely that it will move ahead with cuts in subsidies, particularly as the country moves into an election cycle by 2014.

The revised May 2011 budget assumes average oil prices of $80 a barrel, when prices at the time stood at around $113. Yet subdued pressure on oil prices in the second half of 2011 and high prices for Indonesia’s commodity exports mitigated the fiscal impact of subsidies and budgetary pressure for reform. “The overshoot on energy subsidies will not be excessive in 2011 given the strengthening rupiah and the relatively subdued international oil prices,” Fauzi told OBG. “Also, any increase in subsidies is likely to be offset by higher tax revenues from coal and crude palm oil exports.”

The main revision since 2008 has come in the form of a plan to shift from the use of kerosene to liquefied petroleum gas, a cheaper source of energy that carries a lighter fiscal burden in the form of subsidies. The government hopes to cut the fuel subsidy bill from Rp129.7trn ($15.6bn) budgeted for 2011 to Rp123.6trn ($14.8bn) in 2012 through the fuel rationing pilot project in Jakarta. It is still unclear how the government plans to limit consumption – it has only said it wishes to cap consumption at 40m KL in 2012, down from an expected 41m KL in 2011.

The government has also announced plans to shift from subsidies on goods to subsidies targeted to people by 2014, which would double domestic prices, although concrete plans have yet to be issued by the Ministry of Energy as to how this would happen. While the details of such a system have yet to be announced, the state would either give cash handouts or discount cards to the lowest income-earners.

Analysts agree that the impact would be minimal if enacted gradually, but it seemed clear in late 2011 that no move on subsidies would take place until later in 2012 at the earliest. Following the drop in inflation after Ramadan, BI cut its reference interest rate by 25 basis points to 6.5% in October 2011 and then again to 6% in November 2011.

Although seen as too early by surprised analysts, the move did follow similar cuts by central banks in other major emerging economies such as Brazil and Turkey. With the expectation of cooling commodity and energy prices given anaemic growth in developed markets, inflation forecasts for 2012 remain in line with or slightly below authorities’ targets, between 3.5% and 5.5%. But downward pressure on the rupiah in late 2011 may yet bring inflationary pressures to bear, testing authorities’ abilities to respond to changing conditions.