Tamara Henderson Economist, Bloomberg Economics
The Indonesian rupiah and Philippine peso – Southeast Asia’s biggest underperformers in recent years – have scope to outperform in 2019. These currencies have two things going for them: market positioning is more in their favor and key downside risks are abating. Even so, the rupiah may have more of an edge.
Peso, rupiah gained ground against peers in Q1
Indonesian rupiah
The rupiah found itself in the cross-hairs of an emerging market sell-off last year, despite Indonesia’s relatively strong growth prospects, benign inflation and low external debt. As risk appetite soured, the market focused on Indonesia’s fast-paced widening in the current account deficit – which more than doubled to 3.6% of GDP in Q4 2018 from 1.7% in mid-2017 – and the risks posed by a relatively large share (37%) of foreigners holding Indonesian government bonds.
What’s more, a combination of aggressive easing by Bank Indonesia in 2016 and 2017 and steady tightening by the Federal Reserve since December 2015 reduced Indonesia’s yield advantage to a point that offshore investors were not nearly as well-compensated for the risks of ownership. The real yield differential on 10-year rupiah denominated government debt fell to about 240 bps in January 2018 from 450 bps at the end of 2016.
Rate hike restore yield appeal of Indonesian bonds
As the rupiah came under heightened pressure in 2018, Bank Indonesia responded with aggressive rate hikes. The central bank raised rates by 175 bps between May and November 2018. This is not quite as much as the Fed’s 225 bps of hikes since December 2015 or its own cumulative cuts of 200 bps in 2016 and 2017. Even so, the 10-year real yield differential recovered to about 480 bps in August 2018 and was about 460 bps at the end of March.
In addition to Indonesia’s better return prospects from government yields, key risks are abating. The current account deficit is poised to narrow from Q1. The trade balance swung into surplus in February and March as a slew of government measures to narrow the shortfall finally started to bear fruit.
What’s more, the apparent re-election of President Joko Widodo will avoid the uncertainty of a leadership transition. Jokowi, as the president is known, has a strong track record of accomplishments which should finally start to move the dial on growth during his second five-year term. If global risk appetite recovers sufficiently to ensure rupiah stability in 2H, Bank Indonesia may start to lower interest rates. The prospect of capital gains from rate cuts would add to the appeal of holding Indonesian government bonds. This would attract capital inflows and further boost the rupiah.
Philippine peso
A perception that the Philippine central bank was too relaxed about second-order price pressures put added weight on the Philippine peso in 2018. But the tide started to turn with the central bank’s shift to a more proactive monetary policy stance and subsequent return of inflation to the target range. Another advantage for the peso: after three consecutive years of underperformance within the region, a lot of bad news was already in the price.
Bangko Sentral ng Pilipinas aggressively raised interest rates by 175 bps in 2018. And, since the peak at 6.7% in September and October, inflation has progressively slowed. Inflation returned to the 2-4% target range in February and March, as beneficial base effects offset the impact of higher oil prices. The swift and sharp retreat in inflation has restored competitiveness to Philippine real yields – a positive for the peso.
Lower inflation extends the rebound in Philippine real yield
A negative, though, is the progressively higher cost of oil imports. This, as well as supply chain disruptions from the U.S.-China trade war, widened the Philippines’ current account deficit from a negligible 0.6% of GDP in Q1 2018 to 2.4% of GDP in 4Q 2018.
Supply constraints may continue to underpin, if not lift further, the cost of fuel this year. If so, further peso resilience may hinge on BSP continuing to anchor price expectations. Given its patchy track record on inflation, though, the central bank may need to resist the temptation of loosening monetary policy too soon. Meanwhile, BSP Governor Benjamin Diokno sounds eager to cut both the policy rate and reserve ratio.
