PART 3 COUNTRY STUDIES

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1 PART 3 COUNTRY STUDIES 281

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3 Chapter 8 POST-GLOBAL CRISIS CAPITAL INFLOWS TO INDONESIA: CHALLENGES AND POLICY RESPONSES By Darsono and Juda Agung 1 1. Introduction Indonesia has attracted large capital flows since the recovery of the global financial crisis. The push factors, such as the slow recovery in the advanced countries and abundant global excess liquidity, have led investors to search for better investment opportunities in the emerging countries with higher growth prospects and interest differentials. While the push factors have been apparently dominant, the pull factors, such as the prospective rating upgrades for Indonesia towards investment grade have also played an important role in making Indonesia an attractive investment destination. Like water, the foreign capital inflow is something that should be welcomed, but an excessive inflow can be destabilising, if it is not managed properly. Traditionally, the main concern over large capital inflows is that the foreign funds may be utilised to finance an unsustainable current account deficit that could pose the risk of abrupt reversals in capital inflows (de Gregorio, 2010). This scenario could lead to painful consequences as a large exchange rate correction would potentially create a mismatch and balance sheet problems, as we saw in the 1997/1998 Asian financial crisis. Fortunately today the scenario is somewhat different. Driven mostly by global excess liquidity, the emerging countries such as Indonesia are currently receiving large inflows during the episodes of current account surplus. Second, the characteristics of the inflows are different from those on the eve of the Asian crisis. Before the Asian crisis, they were dominated by the external debt of domestic firms in the form of direct lending, corporate bonds and commercial papers to finance domestic investments. The recent inflows are mostly invested in short-term portfolio instruments such as central bank bill 1. From the Directorate of Economic Research and Monetary Policy, Bank Indonesia, respectively. 283

4 and government bonds. Thus far, there is no indication that the inflows have been intermediated by banks to finance the real economic activities, so that the potential balance sheet problem in the event of a sudden stop would be very limited. The rapid capital inflows, nonetheless, pose some policy challenges. Capital inflows have created pressures on domestic currency appreciation, triggered asset price bubbles and intensified the risk of financial system instability. Speculative capital inflows could create economic vulnerabilities to changes in investor sentiment, primarily through changes in asset prices, the exchange rate, and maturity mismatches. The procyclical nature of capital flows has also created complexity in monetary and exchange rate policies in Indonesia. The capital flow cycle is naturally tied to the business cycle. Foreign capital tends to flow during an expansionary period; therefore, the subsequent liquidity created further accelerates the economy and on many occasions leads to asset bubbles. In contrast, portfolio capital typically flows out when the economic outlook deteriorates, which undermines the domestic economy. Consequently, the highly procyclical nature of capital flows can be problematic. Monetary policy to address inflationary pressures through higher interest rates could further attract capital inflows. The surge in inflows amidst inflationary pressures in 2010 clearly illustrates this dilemma. Conversely, monetary policy to boost economic slowdown is often constrained by exchange rate depreciation pressure as demonstrated in the second half of 2005 during the currency crisis after the oil price shocks. This paper aims to discuss the challenges posed by the large capital flows to Indonesia and their implications for monetary and exchange rate policies in managing the inflows. The following section presents the characteristics of inflows and challenges facing the central bank in managing the capital inflows in the aftermath of the global crisis. The third section elaborates the policy responses to date in Indonesia. The last section offers the conclusions. 2. The Recent Capital Inflows and Policy Challenges Like the other emerging countries in Asia, Indonesia has been a recipient of large capital inflows since the recovery of the global crisis. The recent pickup in private inflows to Indonesia is primarily in portfolio investments, reaching US$10.4 billion in the first half of 2011 (5.06 percent of GDP) from US$3.34 billion in the similar period of 2009 (Figure 1). FDI inflows increased dramatically as well, from US$3.35 billion in the first half of 2009 to US$11.05 billion in the 284

5 similar period of 2011, with accelerated domestic demand for investments (Figure 1). The composition of portfolio investments has been skewed towards portfolio debt assets. In the post-crisis period, the inflows towards local currency debt market, particularly government bonds have been very dominant (Figure 2). Portfolio debt flows to corporate sector have been very limited due to underdeveloped corporate debt markets in Indonesia. Foreign holding on government bonds stood at US$23.9 billion (as of Sept. 2011), or around 32.5 percent of outstanding bonds. Meanwhile, foreign ownership of central bank bills decelerated to US$4.7 billion following the measures taken by BI to discourage inflow to the short-term central bank bills. The large capital inflows into Indonesia are driven by both pull and push factors. The pull factors, i.e., strong economic fundamentals and attractive yield, have led foreign investors to look for more prospective investment in the emerging market. Indonesia has stronger growth prospects in 2011 (6.5 percent) and 2012 (6.37 percent), while inflation is predicted to be maintained at a relatively low level in 2011 (4 percent) and 2012 (4.5 percent). Its fiscal deficit is projected at a more sustainable level, around 1.5 percent of GDP. In terms of yield, the return on Indonesian asset is still much higher than that of the advanced countries and quite competitive as compared to other neighbouring countries (Figure 4). Another pull factor that renders Indonesia attractive as an investment destination is the prospective rating upgrades to investment grade (Figure 3). From the external side (push factors), capital inflows are boosted by global excess liquidity, low interest rate, slow recovery, and unsustainable debt in the advanced countries. 285

6 The large inflows confer benefits to the economy. The inflows have helped to reduce the cost of capital. Given limited market liquidity, the strong inflows have reduced the yield of government bonds substantially to 7.16 percent at the end of 2010 from around 20 percent during the Lehman crisis, implying cheaper budget financing (Figure 5). Rupiah appreciation, following the capital inflows, has a positive impact in curbing imported inflation. It is one of significant factors behind the relatively low CPI inflation in 2011 (Figure 6). In addition, the appreciation of the rupiah also facilitates the effort in enlarging economic capacity through a cheaper raw material and capital goods import that are required to enhance investment. 286

7 However, the large capital inflows have posed a number of policy challenges. Firstly, the inflows have created upward pressures on the rupiah, which have led to concerns about the declining export competitiveness. The capital inflows, in general, have driven nominal rupiah appreciation since 2009 (Figure 8). The risk of the exchange rate overshooting has been mitigated by Bank Indonesia through foreign exchange market intervention. In real terms, the value of the rupiah has also appreciated since 2009, despite remaining relatively competitive as compared to a number of other countries in Asia (Figure 9). Figure 7 Capital Flows to EM and Major Challenges 287

8 Secondly, the capital flows potentially create vulnerabilities in the macrofinancial system. The dominant inflows to the portfolio investments especially to government bonds and central bank bills are more vulnerable to a change in market sentiment and, thus, risk of a sudden reversal. By the end of June 2011, the shares of foreign holding in Central Bank Bills (SBI) and Indonesia s government bonds still reached 33 percent of total SBI and around 33 percent of total government bonds (Figures 10 and 11). These figures are the highest among the countries in the region. Thus, there is potential risk of sudden capital reversal, which in turn could trigger destabilisation of the financial market. The large inflows also potentially create asset bubbles. The recent inflows have boosted stock and bond prices in Indonesia. The stock market index in Indonesia has now reached its highest levels, having risen in 2010 by about 46 percent, although the clear signs of stock price bubble are not evident at this stage (Figure 12). 288

9 Figure 12 Inflows to Stock and Stock Market Index In addition to the Greek crisis in mid-2010, the sudden capital reversal in the Indonesian financial market also occurred in September 2011 due to the spill-over effect of the Euro crisis and US debt problem. The yield of the Indonesian government bond increased mostly due to non-resident investors net sales. Yield of Indonesian government bond (10 year) increased on month-todate basis (mtd) (Figure 14) in line with the movement of yields of other regional countries government bonds. However, on year-to-date (ytd) basis, the yield of Indonesian government bonds still recorded a decline (Figure 13). Non-resident investors net sale resulted in a decrease in the share of non-residents holding of Indonesian government bonds from 32.6 percent (26/8/2011) to 29.4 percent (29/9/2011). However, further increase in Indonesian government bond s yield is, partly, restrained by government buy-back, Bank Indonesia purchase, and solid macroeconomic fundamentals. In addition to Bank Indonesia and government, banks are other main buyers of Indonesian government bonds in the secondary market (Figure 15). 289

10 Figure 15 SUN Holding by Ownership In the Central Bank Bill market, foreign holdings of SBI decreased from US$6,441.3 million (26 Aug. 2011) to US$4, million (28 Sept. 2011). In 2011, a sudden sell-off of SBI by non-residents was constrained by Bank Indonesia s policy of 6 month-holding period. In the stock market, in line with the movement of global stock exchanges, Indonesia s stock exchange index (JCI) suffered a significant decline. The drop in JCI was driven by foreign investors net sales (Figure 17). However, solid macro fundamentals and the relatively sound balance sheets meant that the system was able to withstand the further drop in stock market. 290

11 Non-resident investors net sales in the domestic financial market put pressures on rupiah exchange rate. The rupiah and most of the other Asian currencies fell against US dollar (Figure 19). The rupiah experienced 0.71 percent depreciation (ptp) (Figure 18). Bank Indonesia intervened in the domestic foreign exchange market to keep the stability of the rupiah in tact (Figure 20). Fortunately, with ample liquidity in the domestic money market, the 2011 shock in the global financial market has not impacted the domestic money market. In fact, the interbank O/N rate is on a declining trend (Figure 21). Rates on deposits and lending are also trending downward, although the spread between these two rates is still wide (Figure 22). Bank credits keep increasing supported by with the growth of working capital and investment credits. 291

12 Thirdly, a surge in foreign capital inflows compounds the complexity of the challenges faced in terms of domestic monetary management. Persistent foreign capital inflows can undermine the efficacy of monetary management considering the measures taken in managing liquidity in the economy by Bank Indonesia are ultimately offset by the sheer magnitude of the capital inflows. This reduces the degree of monetary policy independence to external forces (Juhro, 2010) and is reflected by the orientation of monetary policy, which not only strives to control inflation, but also mitigates (eventually) rupiah appreciation through intensive intervention. In other words, interest rate dynamics are not fully influenced by market forces, domestic monetary policy is the primary determinant. The challenges outlined represent a trilemma continuously faced by all open countries like Indonesia. Essentially, countries with open economies are constantly faced with a trilemma between free capital flows, exchange rate stability and independent monetary policy in the interest of the domestic economy. This trilemma triggers additional complications in the implementation of the ITF-based monetary policy in the context of an open economy because, on one hand, the role of the exchange rate as a shock absorber is not fulfilled and, on the other hand, there is a tendency to steer monetary policy, directly or indirectly, towards managing the exchange rate. Amid a deluge of foreign capital inflows, policy orientation towards managing external balances can become counterproductive to the management of internal balances. 292

13 3. Managing Capital Flows Greater domestic economic integration with the global economy, coupled with a deluge of foreign capital flows, have increased macroeconomic management complexity, in particular monetary and exchange rate policy. Accordingly, monetary policy is recurrently faced with a trilemma, e.g., the impossible trinity, between free capital flows, exchange rate stability and independent monetary policy in the pursuit of price stability. To confront this issue, the choice becomes how to transform the impossible trinity into a possible trinity. The concept of the possible trinity can be expressed as an intermediate solution that avoids volatile swings in the exchange rate, controls excessive short-term capital inflows and reinforces independent monetary policy (Palley, 2009). Therefore, a policy mix is required in order to strike an optimal balance between these three goals (Figure 23). In terms of the exchange rate, the rupiah should be managed and provided space for it to remain flexible and appreciate, but avoid being overvalued as this will endanger macroeconomic stability. Consequently, Bank Indonesia s presence is required in the foreign exchange market to ensure that the rupiah does not deviate with excessive volatility. Of course, this option is no longer available if the rupiah becomes overvalued. Simultaneously, efforts to accumulate foreign exchange reserves are vital as a form of self-insurance considering that shortterm capital flows are particularly vulnerable to the risk of sudden reversal. It is noteworthy that monetary policy strategy using the interest rate as a primary instrument must be buttressed by other policy strategies, for example through measured intervention in the foreign exchange market coupled with sterilised intervention. This can be accomplished by considering the relationships between the weak and inconclusive UIP (Uncovered Interest Parity) variables. A weak relationship would imply that a monetary policy strategy that relies solely on the interest rate as an operational target might not be optimal. Disyatat and Galati (2005) suggest that central bank intervention in the foreign exchange market can psychologically affect exchange rate fluctuations and is quite effective in directing the exchange rate in the short term, especially when compared to a response taken through the interest rate. The effects are more evident in a developing country along with the smaller market structure, armed with relatively comprehensive information available to the central bank compared to market players, and the coordinated intervention among central 293

14 banks in the region. Other advantages can also be acquired from intervention strategy in the foreign exchange market, where intervention coupled with sterilisation policy can partially control the quantity of liquidity permanently. The use of intervention to affect money quantity can also support sub-optimal and asymmetric interest rate elasticity against liquidity control in the economy. The role of intervention in the foreign exchange market was seen to increase during the financial crisis period, particularly in countries with fundamentally sound domestic economy. This policy was taken in order to respond to capital flight that occurred in a number of developing countries as a result of flight-toquality to instruments deemed more financially sound, such as US T-Bonds, which has intensified depreciation pressure. Hence, to withstand excessive, spiralling depreciation-inflation expectations and to direct the exchange rate according to fundamental growth, many central banks intervened in the foreign exchange market. Regarding capital flows, adhering to a free foreign exchange regime, macro prudential measures consist of policy options designed to reduce excessive shortterm capital flows. Such measures have been introduced by Bank Indonesia through regulations that oblige investors to hold SBIs for a minimum period of one month. This policy has helped diversify foreign portfolio capital flows and extend the duration of SBIs. Monetary policy complexity stemming from the interest rate can partially be resolved by quantitatively applying tighter monetary policy by raising the reserve requirement. In addition, macro prudential policy is aimed to avoid asset bubbles and excessive credit growth, which can trigger potential financial system instability. This type of macro prudential policy is effective if banks can intermediate the capital flows. Nevertheless, if the capital flows emanate directly from unregulated sectors, like direct loans from the private sector, measures to control capital inflows are another option, for example by limiting private loans. 294

15 Figure 23 Managing Trilemma The coordinated implementation of a policy instrument mix is ultimately part of an important strategy of employing an optimal possible trinity in the current climate blighted by widespread uncertainty. Coordination is critical, not only to address the two sources of imbalances (external and internal imbalances), but also to optimally manage the impact of monetary policy, while avoiding overkill and mutual exclusivity. To this end, policy coordination should be based upon a wider implementation framework as formulated in the crisis management protocol (CMP) scheme, which incorporates prevention, management and resolution. In this context, measured management of the dynamics of foreign capital flows is required. As a first line of defence, Bank Indonesia and the government will apply prudent and consistent macro prudential policy in order to maintain positive perceptions of the domestic economy in general. More specifically, these measures include the possibility of permitting exchange rate appreciation, the accumulation of foreign exchange reserves and other monetary and fiscal policies. In this regard, Bank Indonesia continuously assesses prudential and structural policies to manage capital inflows, for instance by applying a minimum holding period for domestic portfolio, and limits on the Net Open Position (NOP) of foreign exchange and the account balance in rupiah for foreign banks, as well as applying a foreign exchange reserve requirement as outlined in Figure

16 Figure 24 Bank Indonesia s Policy Mix 296

17 Meanwhile, in line with such measures to manage foreign capital inflows, exchange rate management in harmony with fundamental conditions is conducted through symmetrical foreign exchange market intervention, which provides space for rupiah appreciation in the event of an influx of foreign capital flows. Accordingly, the amount of rupiah appreciation permitted must remain congruous with the degree of exchange rate appreciation in neighbouring countries. Therefore, in addition to helping ease inflationary pressures, exchange rate management is not expected to undermine the competitiveness of the domestic economy. When the economy is beset by more arduous challenges consisting of a further deluge of foreign capital inflows, and amid domestic inflationary pressures, Bank Indonesia will consider the application of follow-up policies, including Capital Flow Management (CFM). 2 It should be emphasised that the sequence of policy measures to manage foreign capital inflows is critical, particularly for an economy like Indonesia that departed from open conditions in line with the application of a free foreign exchange regime at the beginning of the 1980s. In this context and with due regard to the policies practiced in several other countries, the various stages of policy commence with measures adhering to a free foreign exchange system and then subsequently become more managed. 4. Concluding Remarks Indonesia has attracted large capital inflows since the recovery of the global financial crisis. The push and pull factors have led investors to search for better opportunities for investments in the emerging countries with strong economic fundamentals and interest rate differentials. The large inflows have benefited the economy, reducing the cost of capital, curbing imported inflation due to rupiah appreciation following capital inflows, and facilitating the effort in enlarging economic capacity through cheaper raw material and capital goods import that are required to enhance investment. Despite the benefits, large capital inflows have posed a number of policy challenges. Firstly, the inflows have created upward pressures on the rupiah, which have led to concerns about the declining export competitiveness. Secondly, 2. According to IMF guidelines (2011), CFM is best applied when an economy meets the following three conditions: (i) The exchange rate is not undervalued multilaterally; (ii) Foreign exchange reserves are excessive and, thus, incur additional costs; (iii) The economy is overheating, the inflation outlook is rising and there is risk of a credit boom or asset price boom. 297

18 capital flows potentially create vulnerabilities in the macro-financial system. The dominant inflows to the portfolio investments are more vulnerable to a change in market sentiment and thus risk of a sudden reversal. Thirdly, a surge in foreign capital inflows compounds the complexity of the challenges faced in terms of domestic monetary management. The post-crisis challenges have revealed some valuable lessons for monetary policy and exchange rates. First, in a small open economy, like Indonesia, the multiple challenges facing monetary policy as a result of capital inflows imply that the monetary authorities should employ multiple instruments. In the face of capital flows, while the exchange rate should remain flexible, it should be maintained in such a way that the exchange rate is not misaligned from its fundamentals. Concomitantly, measures are required to accumulate foreign exchange reserves as self-insurance given that short-term capital flows are particularly vulnerable to a sudden stop. In terms of capital flow management, a variety of policy options are available to deal with the excessive procyclicality of capital flows, especially short-term and volatile capital. On monetary management, the dilemma facing monetary authorities have been partially resolved by applying quantitative-based monetary policy to support the standard interest rate policy instrument. In addition, macro prudential policies aimed at maintaining financial system stability should also be adopted to mitigate the risk of asset bubbles in the economy. Second, exchange rate policy should play an important role in inflation targeting in a small open economy. According to standard ITF, central banks should be not attempt to manage the exchange rate. This conventional view argues that the exchange rate system should be allowed to float freely, thus acting as a shock absorber for the economy. However, in a small open economy with open capital movement, exchange rate dynamics are largely influenced by investor risk perception, which trigger capital movements. In this environment, there is a case for managing the exchange rate in order to avoid excess volatility that could push the exchange rate beyond its inflation target band 298

19 References Bank Indonesia, (1998), Annual Report 1997/98, Jakarta. Bank Indonesia, (2002), Annual Report 2001, Jakarta. Bank Indonesia, (2011), Monetary Policy Report 2011, Various Editions, Jakarta. Bank Indonesia, (2011), Monetary Policy Review 2011, Various Editions, Jakarta. De Gregorio, José, (2010), Monetary Policy and Financial Stability: An Emerging Markets Perspective, International Finance, 13:1, April. Disyatat, P. and G. Galati, (2005), The Effectiveness of Foreign Exchange Intervention in Emerging Market Countries, BIS Working Paper, 172. International Monetary Fund, (2011), Recent Experiences in Managing Capital Inflows Cross-Cutting Themes and Possible Policy Framework, Prepared by Strategy, Policy, and Review Department IMF. Juhro, Solikin M., (2010), The Vicious Circle of Rising Capital Inflows and Effectiveness of Monetary Control in Indonesia, Research Note, Directorate of Economic Research and Monetary Policy, Bank Indonesia. Palley, Thomas I., (2009), Rethinking the Economics of Capital Mobility and Capital Controls, Brazilian Journal of Political Economy, Vol. 29, July- September. 299

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