UPDATE 1-Indonesia narrows c/a deficit, but may not easily deflect outflows
(Adds analysts comments, details)
* Q3 c/a deficit at 3.8 pct versus 4.4 deficit in Q2
* Q3 balance of payments at $2.6 bln deficit
By Rieka Rahadiana and Jonathan Thatcher
JAKARTA, Nov 13 (Reuters) - Indonesia's large current account deficit narrowed in the third quarter, but less than expected and not enough to end concerns about the vulnerability of the Southeast Asian economy to more capital outflows when the U.S. Federal Reserve tapers its asset-buying stimulus.
Worries over the size of the deficit, which has been gnawing at investor confidence for months, were underscored on Tuesday when Bank Indonesia announced a surprise 25-basis-point increase in its interest rates, saying it did so to manage the current account.
The balance of payments numbers highlight Indonesia's struggle to curb import growth, especially for fuel, in the face of weaker global demand for its exports and despite efforts to slow domestic consumption.
"The improvement in the current account deficit was mainly bolstered by a higher oil and gas trade surplus, in line with sharper decline in non- oil and gas imports compared with non- oil and gas exports, as well as a narrower deficit in services and income trade," the central bank said in a statement.
The deficit in the current account was 3.8 percent of GDP in the third quarter compared with 4.4 percent in the second, and the equivalent of $8.4 billion.
That was worse than the government's 3.3-3.5 percent prediction and a median 3.7 percent in a Reuters poll of economists. The overall balance of payments deficit rose to $2.6 billion from $2.5 billion in the previous quarter.
Graphic for current account: link.reuters.com/xan64v
Finance Minister Chatib Basri said last week that improving the current account was his priority even if it did mean forcing down growth in Southeast Asia's biggest economy.
"The risk is that the CAD (current account deficit) will remain large over the next few quarters, leaving the rupiah vulnerable to potential swings in global capital flows," Goldman Sachs said in a research note.
"There is also a risk that capital inflows could be less than normal even if we do get to a sustainable CAD level. Renewed concerns over the impact of Fed tapering on large CAD countries could also add to (rupiah) depreciation pressures."
It forecast the rupiah would fall to 12,000 to the dollar in three months, a level not seen since March 2009.
The rupiah was trading at 11,600 per dollar before the announcement which came after the local market had closed. That is a 4-1/2-year low and some 17 percent down since the start of the year, the steepest decline of any Asian currency. Weakening all year, it took a heavy hit after news in August that the second-quarter deficit in the current account had ballooned.
Much of the concern with the current account has focused on rising fuel demand by the former OPEC member, which has seen a steady decline in oil production.
"A sustained deficit in the oil trade balance is the main factor behind the wider current account deficit since 2Q 2012. Daily production of crude oil has been on a gradual decline and net imports of refined oil have continued to grow as the consumer base expands," said Singapore-based DBS economist Gundy Cahyadi.
"This is unlikely to change in the near term ... Furthermore, it is unlikely that there will be another adjustment in the subsidised fuel price in the near term." He expected the current account deficit to ease slightly to 2.5 percent of GDP in 2014 from about 3-3.2 percent this year.
The central bank statement underlined its concerns, saying measures were needed to control fuel consumption.
Bank Indonesia has now increased its main interest rates by 175 basis points since June. It said earlier this month it was comfortable with the current exchange rate and, with the end of massive intervention, has been rebuilding its foreign exchange reserves.
A number of economists expect more rate rises next year and a subsequent trimming back in bank credit growth.
Economists have warned that with elections next year - for parliament in April and the presidency in July - that several members of the cabinet are already more focused on votes than policy.
"The problem is in implementation of policy," said David Sumual, economist at PT Bank Central Asia in Jakarta.
The government unveiled a fiscal package in August, including measures to draw more foreign investment, but has still not spelled out the details. It is planning another package soon aimed at improving business conditions in a country listed by the World Bank as one of the most difficult to operate in.
But economists said Indonesia's position appears stronger than a few months ago and the central bank was praised for what one economist called a "brave" decision to raise rates.
"Indonesia is coming to the party in the sense that its policies are looking more credible. It is getting interesting, we are getting down to levels that balances some of the risks on account of the tapering in the U.S.," said Gary Dugan, Singapore-based CIO at Coutts, who currently prefers fixed income exposure through dollar bonds.
"On credits, we are looking to buy quite soon and on equities we are underweight. The safe bet for bonds is go through the dollar route initially and local bonds will look attractive if the currency can hold on to these levels."
"The equity market is not that expensive. It's a good long-term story, but we need to see the end to bad news before we start buying."
Foreign holdings of Indonesian local currency government bonds dropped from 302.94 trillion rupiah ($26.13 billion) in May to 284.01 trillion in August over worries about tapering of bond purchases by the Federal Reserve.
But after the Fed surprised markets in September by postponing the start of the wind down of purchases, risk appetite has improved propelling inflows back into Indonesian local debt. Foreign holdings have since grown to 319.46 trillion rupiah as of Nov. 11.
"(The buying of Indonesian dollar bonds) shows people want the country exposure but not the currency exposure," said Denmark-based Saxo Bank CIO Steen Jakobsen.
($1 = 11,592.5000 Indonesian rupiah) (Additional reporting by Umesh Desai in Hong Kong; Editing by Jacqueline Wong)
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