Will Economic Fundamentals Support Further Stock Gains?

9 10 2007

The Jakarta Composite Index rose sharply in late September and early October. But is the recent stock market rally supported by strong economic fundamentals? And, looking forward, what are the prospects for the Indonesian economy?

Well firstly it should be remembered that the state of the Indonesian economy is very important in determining the sustainability of a stock market rally. This is because a strong economy will boost corporate profitability, thus increasing the value of those companies and therefore, in turn, leading to higher stock prices. Market speculation and trading based on rumors will, in contrast, only affect share price movements in the short to medium term.

To ascertain the overall current economic conditions, Danareksa Research Institute has developed a Coincident Economic Index (CEI) for Indonesia. The CEI is constructed using data on cement consumption, car sales, imports, real money supply, and retail sales. An increase in this index suggests improving economic conditions, and vice versa.

In the first two months of 2007 the CEI fell. This indicated that the economy was slowing. Yet since March 2007 the CEI has headed higher. Indeed, in the five months up to July 2007 the CEI has risen every time, suggesting that the economy is on a sound footing. Improving purchasing power has been one of the pillars underpinning brisker economic activity. Inflation, which had dented consumer purchasing power at the beginning of the year, started to come under control in the second quarter of 2007. More specifically, the price of rice – a staple foodstuff in Indonesia – has fallen steadily since March 2007. And by July/August, rice prices were at their lowest levels in 8 months, or significantly lower than in the first quarter of 2007. Note that rice prices have a significant impact on the people’s purchasing power since this foodstuff has a large weighting in consumers’ expenditures.

And looking ahead, inflation is likely to remain benign. Nonetheless, there will be some short-lasting pressures on inflation during the fasting month and also over Lebaran due to seasonality factors. Hence, the year-on-year inflation rate is expected to hover around 6.9 percent from September to November. Importantly, however, the long-term trend for Indonesian inflation is not likely to be altered. And the impact of Ramadan and Lebaran on inflation is likely to be completely gone by the end of December when inflation is expected to fall to 6.26 percent.

One of the main reasons for the expected fall in December’s inflation rate is that rice prices are not likely to increase as much as they did in December 2006. This year the government has imported rice of various qualities (including prime quality rice) in a bid to prevent a significant increase in rice prices at the end of the year.

Thus, with the prospect of relatively low inflationary pressures, consumer purchasing power shall not be eroded further. Moreover, the relatively low inflation shall also give room to the Indonesian central bank to cut its benchmark rate further in the near term. Nevertheless, the likelihood of the central bank cutting interest rates in the period October-December is rather slim, we feel, given that inflation is likely to stay relatively high at around 6.9 percent during this period.

In January 2008, however, the central bank may opt to cut its benchmark rate again since inflation shall fall to around 6.26 percent in December (the data is released in early January 2008). For the year of 2008, inflation is expected to remain benign and even fall to around 5.3 percent by year-end. Thus, we believe the Indonesian central bank shall cut its benchmark rate to as low as 7 percent by the end of that year.

As such, the people’s purchasing power is likely to remain strong in the near term. And the government’s plan to hike civil servant salaries by around 20% next year will – to some extent at least – increase household purchasing power further. Note that since household spending accounts for around three quarters of Indonesian GDP, the greater purchasing power should be able to drive brisker economic growth going forward.

The brisker economic activities and the brighter economic prospects are also revealed by our business sentiment survey. Every other month we survey around 700 CEOs of companies operating in Indonesia. From the survey’s findings, we construct a Business Sentiment Index (BSI). The reading of the index is quite simple: a reading above 100 indicates that the CEOs are optimistic (which often means that economic conditions are improving), while a reading below 100 indicates that CEOs are pessimistic (usually a reflection of deteriorating economic and business conditions). Based on our surveys, the BSI has increased consistently since January 2007, thereby indicating that the CEOs’ businesses are doing better. From a reading of 115.0 in January the BSI rose to 123.5 in July 2007; this improving trend suggesting that the economy is picking up its growth pace.

In addition to the improving domestic factors, external factors are also proving to be favorable for the Indonesian economy. Since despite the sub-prime lending debacle in the US, Indonesian exports to the global market have remained strong in 2007. In August, for example, exports reached US$ 9.61 bn. And in the first eight months of 2007 exports reached US$ 73.75 bn, or up by 13.4 percent from the same period in the previous year. This shows that global demand for Indonesian products remains strong.

Furthermore, Indonesia has been able to diversify its export destination markets. In 1996, for example, Japan accounted for 25.9 percent of Indonesia’s total exports. Yet by 2007, Japan’s share had fallen to 20.8 percent. Meanwhile, Indonesia’s exports to the US declined from 13.6 percent of the total in 1996 to around 10.4 percent in 2007. In contrast, however, China’s share of Indonesian exports rose from 4.1 percent in 1996 to 8.4 percent in 2007. This suggests that Indonesia has been able to diversify its export destination markets; a positive development considering that Indonesia’s exports will be less affected overall by any instability in one of the countries.

Against this backdrop, we believe that the current economic recovery is sustainable. Hence, the Indonesian economy is likely to continue picking up its growth pace going forward. Indeed, the Indonesian economy is expected to grow by 6.2 percent in 2007 and by 6.3 percent in 2008.

As such, the current rally in the stock market is likely to be sustainable, we believe, given that it is supported by good economic fundamentals.

Demystifying the Macro-Real Sector Missing Link

5 06 2007

The Indonesian macroeconomic condition has been improving. Some economists, however, have claimed that the Indonesian real sector has not improved. Is there any missing link between the macroeconomic condition and the real sector?

Latest GDP data show that the Indonesian economy is still expanding. The Indonesian economy grew by 6.0 percent year on year in the first quarter of 2007, slightly slower than 6.1 percent year on year in the fourth quarter of 2006. In the first quarter of 2007, household consumption posted strong growth of 4.5% year-on-year (YoY). Exports grew by 8.9% YoY, and investments grew by 7.5% YoY. Meanwhile, government spending grew by 4.3% YoY.

The main driver of the relatively firm economic growth is lower interest rates. Lower interest rates mean a lower opportunity cost of money. In this regard, consumers and firms are more willing to borrow from banks since the cost of borrowing is not as high as before. At the same time, those who have excess savings (both households and consumers) have more incentive to spend their money (on consumption goods or by making investments) since the interest earned from putting their money in the bank would not be as much as before.

That is, lower interest rate is likely to push investment activities up. And with the prospects of benign inflation (Danareksa Research Institute expects around 5.8 percent by the end of the year) and lower interest rate (Danareksa Research Institute expects around 7.5 percent by year end), investments are expected to increase further in the near future. This will make the engines of economic growth for 2007 more balanced, thus meaning the current economic expansion is more sustainable.

Nevertheless, some economists and analysts are still skeptical about the recent (macro economic) development. They have claimed that the Indonesian real sector is still on the doldrums. Some have even suggested that the real sector has not grown at all. These, according to them, have resulted in increasing unemployment and poverty rates. The improvements, they further have pointed out, have only occurred at the macro level in the form of booming stock market, strengthening rupiah, low inflation rate, and improving GDP growth number. In short, there is a missing link between macro economic condition and the real sector condition.

The statement that Indonesian real sector has not moved despite the improving macro economic condition, however, is rather misleading. First of all, the macro economic condition is the aggregation of the micro economic condition (including the condition in the real sector). As such, it is very unlikely that there exists a situation where the macro economic condition is good, but at the same time the general condition at the micro level is bad.

Furthermore, the statement that real sector has not grown is not entirely true. On the contrary, almost all sectors in the economy grew significantly since the third quarter of 2006. The manufacturing sector, for example, grew by 5.9 percent YoY in the fourth quarter of 2006 and by 5.4 percent YoY in the first quarter of 2007. The construction sector grew by 10.4 percent YoY in the fourth quarter 2006 and by 9.3 percent YoY in the first quarter 2007. Meanwhile, the Trade Hotel & Restaurant sector grew by 7.0 percent YoY in the fourth quarter of 2006 and by 8.5 percent YoY in the first quarter of 2007.

If we assume that the definition of the real sector is all sectors excluding financial (grew by 7.1 percent YoY in the first quarter of 2007) and services (grew by 7.0 percent in the first quarter of 2007), then the aforementioned paragraph clearly provides compelling evidence that activities in the real sector have picked up.

If the Indonesian economy is expanding, why then the unemployment rate has not fallen significantly and why some economic pundits still believe that the real sector has not moved?

The main reason is that because the economy has not grown fast enough. According to our calculation, the Indonesian economy needs to grow by at least 6.7 percent just to absorb new workers that enter the labor force. As such, as long as the economic growth rate is below that level, it is very likely that unemployment rate to stay at its currently high level. The unemployment rate even tends to increase. And under this condition, it is difficult to see a significant reduction in poverty rate.

Meanwhile, there are some weaknesses in the economy that has started to occur since the last quarter of 2006 on the back of long dry season. The extended dry season has led to the delay in the rice (and other food crops) planting season, which to some extent explains the year-on-year contraction in the Agriculture sector by 0.5 percent in the first quarter of 2007. This has eroded income and purchasing power of farmers.

In addition, the delay in rice planting season has resulted in increases in rice prices starting in December, which apparently have a negative impact on overall consumer purchasing power. Under normal conditions, the impacts of rice price increases on purchasing power are not usually significant and only last for a month or two. This time around, however, the impact has been more severe than usual (the negative impact has lasted for at least five months).

The negative impact of the high rice prices on consumer purchasing power is clearly evident in Danareksa Consumer Confidence survey. Our survey shows that the Consumer Confidence Index (CCI) started to fall in December, and that it continued to decline in the following months. By April 2007, the CCI had fallen to 80.7 from 91.6 in November 2006 (down by 11.9%).

Against this backdrop, the economic activities in the first quarter of 2007 did not grow as fast as it should. And, accordingly, the number of new job creation was not as high as expected. These have led to the inaccurate impression of sluggish condition in the real sector.

In summary, there is no missing link between the macro economic condition and the real sector. In line with the positive development in macro condition, the real sector has also grown. However, the growth rate has not been fast enough to significantly reduce unemployment rate or poverty rate.

Is the Series of Interest Rate Cuts Over ?

27 04 2007

The Indonesian central bank stopped lowering interest rates in its monthly meeting in early April for a number of reasons: possible further price increases in the coming months; rising inflationary expectations; the fact that inflation has remained persistently high; and worries that adding a monetary stimulus to the economy would only have a limited impact on growth while, at the same time, triggering higher inflation.

Currently the Indonesian long-term inflation rate is around 6 percent. With the impact of the fuel price hikes removed from the inflation data, the current long-term inflation rate is stable at around 6 percent. As such, the perception that inflation is likely to stay at a relatively higher level in the near future is not accurate we believe.

Inflation expectations are abating. dRi’s consumer survey suggests that the increase in price pressures that started to occur in December pushed up consumers’ inflation expectations. But as the harvesting season got underway, however, consumer expectations on prices started to fall in February 2007.

Growth is still below its potential level. Our calculations suggest that the long-term potential growth rate for the Indonesian economy is around 6.7 percent. Job creation at this growth rate is just enough to absorb new job seekers. Thus, as long as the economy grows below 6.7 percent, it is very unlikely that we would see persistent price pressure from the demand side.

The economy still needs a stimulus. Some signs of weaknesses in the Indonesian economy have emerged since December 2006. The readings from the Consumer Confidence Index and the Coincident Economic Index suggest that the current economic conditions might not be as strong as the central bank had previously thought. As such, additional stimuli from the monetary side would not cause the economy to overheat we believe. Download the full report.

Slower-than-Expected Growth in 2007?

28 03 2007

Recent statements made by high-ranking Indonesian officials suggest that the Indonesian economy may not grow as briskly as earlier expected. A deeper analysis, however, suggests that the country’s growth momentum remains intact.

In its assessment of Indonesian economic conditions in 2006, the central bank has stated that the quality of the economic growth is deteriorating. This, according to Burhanudin Abdullah the governor of the central bank, can be seen in lower-than-expected economic growth, a rising unemployment rate, and an increase in the number of people who are classified as being “poor”. In 2006, the Indonesian economy grew by 5.5 percent, or lower than the government’s growth target, and even lower than the growth rate of 5.7 percent in 2005. Furthermore, the central bank has implied that economic conditions were not likely to improve in the near term.

Meanwhile, Sri Mulyani the finance minister has also expressed her doubts in regard to the nation’s economic growth prospects for 2007. The minister has even suggested that the Indonesian economy is likely to grow by only around 5.6 to 6.0 percent, or significantly lower than the government’s target of 6.3 percent growth for 2007. According to the minister, slow investment activities may limit the potential growth in 2007. The minister contended that it would not be easy for investment activities to see double digits growth in 2007. Indeed, investment has struggled in recent years. Despite growing by 14.2 percent in 2004, investment only grew by 10.8 percent in 2005 and by a paltry 2.9 percent in 2006. Read the rest of this entry »