Interest rate to hit 14% in 2006: Economists

Urip Hudiono, The Jakarta Post, Jakarta

Indonesia's economy may have to brace for interest rates of 14 percent in the first half of 2006 as the central bank continues its monetary policies designed to tame inflation and support the rupiah, analysts say.

Standard Chartered Bank's (StanChart) chief economist for Indonesia, Fauzi Ichsan, expects Bank Indonesia (BI) to continue raising its benchmark interest rate until the second half of next year, before finally lowering it as inflation in the country; forecast to subside to 8 percent from over 15 percent for the next few months.

"We expect the BI rate to rise by 75 basis points (bps) in the first quarter of next year, and another 25 bps to 13.75 percent in the second quarter, before falling to around 12.0 percent by the year's end," Fauzi said in the London-based bank's latest economic update.

This is, however, lower than StanChart's previous forecast of a 150 bps rate hike in total, reaching 14.25 percent, throughout next year.

Fauzi based his estimates on indications that BI appears to be softening its monetary tightening measures and may trim future rate hikes, as it sees core inflation -- which excludes volatile components such as food and energy -- remaining largely lower than headline inflation, thus implying an already positive real interest rate.

BI also considers the recent surge in headline inflation as a one-off phenomenon rather than the result of a lax monetary policy, expecting core inflation to be at 9.5 percent and headline inflation at 17.4 percent in 2005.

The central bank raised its BI key rate by 50 bps to 12.75 percent on Dec. 6, as November's on-year inflation rose to 18.38 percent, shortly after the Oct. 1 fuel price hikes. The rate hike was lower than analysts expectation of 13 percent, indicating that BI intends to maintain a balance between tightening monetary policy without hurting consumption too much.

The BI rate influences the interest rate of the central bank's one-month SBI promissory notes, which it uses to absorb excess liquidity from the market, as well as loans and time deposit accounts that banks offer. Higher rates make it costlier for businesses to obtain loans for expansion plans, as lenders try to maintain a profitable interest margin between their debts and time deposit accounts, thus slowing economic growth.

Christa Janjic, senior economist of Switzerland-based investment bank UBS, also estimated that rates would continue to rise, likely peaking at 14 percent by February or March next year, as inflation stays above 15 percent until the third quarter, before easing down to between 6 percent and 7 percent by the year's end.

She expects the first rate cuts to happen in the third quarter, wrapping up 2006 at about 10 percent.

With this meant for the markets, Janjic added, was that the rally for the rupiah and for bonds can probably continue a bit longer, but economic growth would slow down to 4.3 percent next year.

Economist Faisal Basri of the University of Indonesia said recently that BI would still have to raise its rates to contain inflation and support the rupiah, which, aside from a market euphoria from the recent Cabinet appointments, still lacks underlying transactions such as export proceeds.

"The BI rate must continue to be raised for at least the next three months, reaching 13.5 percent," he said, expecting the level be the highest, so as not to hurt the economy.

"BI should then gradually lower it, perhaps by 5 bps each step, to avoid sudden shocks to the rupiah."

Following the Cabinet reshuffle, the rupiah rallied from Rp 10,050 to Rp 9,650 against the U.S. dollar, before stabilizing to Rp 9,890 during last week's profit-taking.