| Source: Bank Indonesia

Due to massive floods that have plagued several parts of Indonesia (amid the rainy season's peak) distribution channels have been damaged, thus causing inflationary pressures. The central bank expects the country's January inflation rate to range between 0.85 percent and 1 percent (month to month). Compared to the same month in previous years, this is a positive outcome but compared to the last five months it is rather high. High inflation has a negative impact on bonds thus resulting in Indonesia's 10-year yield rising the most in three weeks on today's trading day.

The Federal Reserve's tapering issue has been - and will remain to be - influential. Although tapering has been announced in December 2013 (The Fed will reduce its bond-buying program by USD $10 billion per month to a monthly USD $75 billion), implementation and the market's reaction remain unknown. Moreover, the Fed will probably cut its stimulus program by another USD $10 billion at the FOMC meeting scheduled for 28-29 January 2014, according to various analysts.

Better Performance in Second Half of 2014?

Economist at Bank Standard Chartered Indonesia Eric Sugandi predicts in Indonesian newspaper Kompas that the rupiah exchange rate will have appreciated to IDR 11,400 per US dollar by the end of 2014. But several challenges still need to be addressed, particularly the country's wide current account deficit (CAD). Indonesia's CAD stood at a record high of USD $9.9 billion in the second quarter of 2013 (equivalent to 4.4 percent of GDP) but is expected to have eased to around 3.5 percent of GDP at the end of 2013 amid government fiscal policy programs, slightly improved commodity prices, continued inflow of direct investments and a sharply depreciating rupiah (which limits imports as these became expensive). However, the CAD is still at an unsustainable level and therefore Sugandi believes that Indonesia's central bank (Bank Indonesia) will raise the country's benchmark interest rate (BI rate) again. Bank Indonesia has raised its BI rate gradually from 5.75 percent in June 2013 to 7.50 percent in November 2013 in order to combat high inflation (8.38 percent yoy at end-2013) and support the rupiah. An increase of 50 basis points to 8 percent would not be a surprise move according to Sugandi. In the second half of 2014, the CAD is expected to have reached a sustainable level of below 3 percent of GDP. This then has a positive impact on the rupiah.

Another factor that may pressure the rupiah in the first half of 2014 are the legislative and presidential elections. Bank Danamon Chief Economist Anton Gunawan in Indonesian newspaper Jakarta Globe said that the rupiah will remain volatile before the elections but start to strengthen in the second half of 2014 (after the elections) as a new leader is expected to bring back investors' confidence in the capital markets. However, this outlook includes the provision that incumbent Jakarta Governor Joko Widodo will be selected as the PDI-P's presidential candidate.

Gunawan would not support a very aggressively interest rate hike in 2014 as he is concerned about banks’ liquidity, particularly the small banks.”