"Unlike the run-up to the first round of the July 6 presidential elections, we believe that Bank Indonesia recognizes that the current climate to the second round on Sep. 20 is less friendly towards the rupiah," explains Philip Wee, economist at DBS Bank.
The first round showed that the lead between market favorite Susilo Bambang Yudhoyono and incumbent President Megawati Sukarnoputri was much narrower than expected.
"As witnessed from elections in Taiwan and India, one should not discount the unexpected," Wee said.
On the international front, the U.S. Federal Reserves has started hiking rates, while rising oil prices have made Indonesia, which recently became a net importer of oil, even more vulnerable to the global environment.
Importantly, the headline inflation has being converging uncomfortably close to the 1 month SBI, the benchmark interest rate is now at around 7.36 percent, off an historic low of 7.32 percent in May.
Consumer Price Index spiked to 7.2 percent year on year in July, up from 6.8 percent in June and looking ahead, the rising wholesale price index is heralding a further buildup in headline inflation.
The major source of inflation is emanating from food prices, which surged 10 percent year on year in July, the fastest since Oct 2002. Food prices account for 21.5 percent of CPI and inflation has now been rising for five consecutive months ever since the rate bottomed out at 4.6 percent in February.
A better measurement of underlying price pressures, CPI ex-food and fuel, grew at a slower 6.2 percent in July, compared with 6.1 percent in June.
Still the trend is up and many economists anticipate the headline figure to move even higher.
"Over the next couple of months, we expect the inflation rate to rise to 7.5 percent, and we think that will prompt a rate hike by Bank Indonesia,"said Michael Spencer, Asia Chief Economist for Deutsche Bank.
"Rising inflation and a depreciating currency mean, in our view that monetary policy will have to get tighter. We expect the intervention rate to rise 50-75bps by year-end," he added.
CSFB is also forecasting rates to rise to 8 percent by end year and to 8.5 percent by end 2005.
The central bank's official 2004 CPI forecast is 7.0-7.5 percent year on year and the authorities are slowly acknowledging that to meet this target, actions may be needed.
On Tuesday, Bank Indonesia Governor Burhanuddin Abdullah indicated that the central bank was considering two policy options to curb inflation: money market operations or raising interest rates. A decision is expected at next week's board of governors meeting.
Burhanuddin pointed that the central bank has already intensified its absorption of excessive liquidity through BI certificate auctions over the last two months, a move aimed at tightening liquidity.
Economists believe a key determinant in the central bank's decision to cut rates will be the rupiah's stability.
In recent weeks, the Indonesian currency has weakened and the central bank has already downgraded its end-year forecast for the rupiah from 8,600 against the U.S. dollar to 8,900 to the dollar.
On Monday, Bank Indonesia also tightened net open positions on the rupiah to discourage speculation.
Though the second round election is expected to be violence free, many currency traders believe there is further downside potential for the rupiah
"In all, 8,900 is now viewed as the support for currency, which is seen retesting at 9,600 as the elections draw nearer," Wee said.
In a recent research note, JP Morgan forecast the currency would progressively depreciate to 10,000 to the dollar by the end of the year.
Meanwhile, CSFB also said it believes that there is further downside potential for the rupiah, given its projection for external liquidity to
deteriorate. "The accelerating inflation is now eroding the spending power of consumers and also reducing the real interest rate differential attractiveness of the Indonesian money market. The trade surplus is likely to narrow as imports of refined fuel and petroleum products are expected to catch up with crude oil exports. We maintain our 3 month forecast of 9,200 and 12 month forecast of 9,360," the investment bank said.
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