Stephanie Phang – Capital inflows pose a bigger risk to Indonesia than inflation, and may prompt the central bank to introduce more measures to reduce short-term money even as it delays interest-rate increases, Morgan Stanley says.

"Inflation has been more benign than expected because of better currency stability," analysts Chetan Ahya, Deyi Tan and Shweta Singh said in a note on Wednesday. "Bank Indonesia instead appears more concerned about the potential large capital inflows, and how they might exit the country in a disorderly fashion."

Excess liquidity in the banking system as measured by the stock of open-market operation instruments stood at $31.4 billion as of May, or 14.7 percent of bank deposits, according to Morgan Stanley. Indonesia was likely to face a "maximum challenge" if capital inflows into the region continued to rise, it said.

The central bank unveiled measures last week to encourage investors to keep their money in Southeast Asia's largest economy and reduce volatility in capital flows and the currency.

The rupiah has risen 16 percent against the dollar in the past year, the biggest gainer in Asia. Investors have been attracted to a benchmark interest rate of 6.5 percent, compared with Japan's 0.1 percent.

"With local interest-rate levels being the highest in Indonesia, the negative carry is the largest in the region," the Morgan Stanley analysts said. "As foreign exchange reserves rise further, the central bank will likely continue to initiate more measures to discourage short-term debt inflows."

Foreign exchange reserves are forecast to rise to more than $80 billion this year. The reserves fell to $74.6 billion at the end May from $78.6 billion in April.

Bank Indonesia kept its policy rate at a record-low 6.5 percent for a 10th month in June, holding out as its Asia-Pacific peers Australia, India and Malaysia have tightened monetary policy.

Consumer prices in Indonesia rose 4.16 percent in May, and the central bank this month kept its 2010 and 2011 inflation estimate at 4 percent to 6 percent.

Indonesia does not expect to change its benchmark interest rate policy this year if inflation is 5.1 percent to 5.2 percent, acting central bank Governor Darmin Nasution has said.

"We think the risks are skewed toward a further delay, with regard to [expectations of] a first rate hike in September," Morgan Stanley said. "Improved macro stability, rising foreign exchange reserves and currency stability are driving a structurally lower inflation trend."