Rupiah fate may hang on Indonesian inflation

Singapore (Antara News) - The rupiah was Asia's worst-performing currency in 2007 and may struggle again this year if a global slowdown cuts demand for Indonesia's exports, but a healthy economy and an end to official rate cuts may help.

Analysts say much may hinge on what the government decides to do about inflationary risks, with some betting that it will allow the currency to rise to combat imported inflation.

The rupiah fell 4.3 percent against the dollar last year as global credit market turmoil dented investors' appetite for risky emerging market assets and cuts in Indonesian interest rates ate into its yield advantage over Asian rivals.

Soaring global oil prices -- crude hit $100 a barrel this week -- have also raised concerns about the cost of government fuel subsidies, and how consumption might be hurt and inflation pushed up if those subsidies are cut.

Traders still remember vividly the 9 percent plunge in the rupiah in a single day in August 2005, when foreign investors dumped stocks and bonds, worried about the fiscal cost of subsidising energy as well as inflationary risks.

Subsidies were cut and interest rates forced higher to fight inflation, and consumption slumped.

"Prospects of fuel subsidy cuts and higher rates are raising the spectre of another stampede exit by foreigners from their substantial holdings in the local bond market," said Mirza Baig, a currency strategist at Deutsche Bank in Singapore.

"In short, unless oil prices retreat significantly, or large FDI inflows materialise, the rupiah's woes could well worsen," he said in a research note.

Foreign direct investment (FDI) was fairly strong in 2007, rising to $10.2 billion in the year to Dec. 15, compared with $5.97 billion for all of 2006, official data shows.

The rupiah was quoted at 9,410 per dollar on Thursday.

Analysts at Credit Suisse predicted it would stick around 9,400 over the next three months.

But they warned: "We are neutral on the rupiah, but think risk is tilted towards rupiah weakness."


Peso contrast

Some analysts draw a contrast between the rupiah and the Philippine peso , which was Asia's top performer in 2007 with a gain of 19 percent versus the dollar.

Both have relatively high yields.

Bank Indonesia has cut interest rates by a whopping 475 basis points since early 2006 but its main rate is still 8 percent. The Philippines' benchmark rate is 5.25 percent.

The peso made most of its gains -- rising almost 12 percent -- after the Federal Reserve started to cut interest rates in September in a bid to contain the impact of the U.S. housing market and credit problems.

The rupiah failed to made any headway. What made the difference, analysts say, were the record remittances sent home regularly by millions of Filipinos working abroad.

"The peso is still underpinned by the remittance story, but the rupiah has seen capital flow in and out quite rapidly," said Enrico Tanuwidjaja, a currency strategist at OCBC Bank.

In particular, Indonesian assets have suffered from an unwinding of "carry trades". These involve investors borrowing low-yielding currencies to fund investments in assets with higher, if riskier, returns. Such assets are often quickly sold when financial risks are perceived to be on the rise.


The bright side

There are some rupiah bulls out there.

They point to the health of the economy, not so much as a supporting factor in itself, but because it underpins the risk of inflation pushing higher, which could prompt the government to tolerate a stronger currency.

Economists polled by Reuters last month forecast the economy would grow 6.4 percent this year, after a forecast 6.3 percent in 2007, which would be the highest rate in 11 years.

Most analysts believe Bank Indonesia's rate-cutting is over for now, as stronger domestic demand and fiscal spending support economic growth and inflationary pressures gradually
pick up.

But, at the same time, some analysts caution that any rush to tighten policy to fight inflation could deal a blow to local financial markets, which the authorities would want to avoid.

"Gross domestic product growth is on a firm recovery path which could further add demand-driven price pressures," Euben Paracuelles, a Royal Bank of Scotland economist, said in a note.

"Bank Indonesia may, as a result, increasingly seek a stronger rupiah to ward off rising imported inflation," he said.

Inflation eased slightly to 6.6 percent in December from 6.7 percent in November, but analysts believe it will pick up steam due to high food and oil prices. (*)
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