In principle, a negative current account should not be a problem for Indonesia given the economy’s strong demographic profile, but the slump in external demand will expose the strong credit growth in the domestic economy. A deteriorating current account deficit coupled with higher inflation, a tighter labour market and ongoing strong domestic credit growth will inevitably fuel fears of overheating. Our leading indicator points to some relief ahead, but the upturn is weak.
As we have argued, it is unlikely that the central bank will lower interest rates; and indeed, should the currency start to weaken materially and further fan inflation, the bias could shift quickly towards tightening. This would likely put a strong brake on the domestic economy.
Foreign investors have poured into Indonesia’s government bond market in the past 3 years, but the upside for gains in the next 6m is limited in our view as the risk of rate hikes has increased (see chart above of a rising interest rate implied by a Taylor Rule)