Nanang Hendarsah. Directorate of Economic Research and Monetary Policy BANK INDONESIA. November 2010

Transcription

1 Challenges and Policy Options in Managing Portfolio Investment Flows: Bank Indonesia s Recent Experiences Nanang Hendarsah Directorate of Economic Research and Monetary Policy BANK INDONESIA November 21 1

2 Challenges and Policy Options in Managing Portfolio Investment Flows: Bank Indonesia s Recent Experiences Nanang Hendarsah* Abstract Recent surges of capital inflows to Indonesia help deliver the economic benefits of increased domestic financial market integration with global market. Notwithstanding their beneficial effects, surges of capital inflow also pose challenges to the management of macroeconomic and prudential policies. In managing volatile capital flows, in the first place, Bank Indonesia prefer to exercise more prudence in maintaining macroeconomic stability and a robust financial system with good supervision. But, at the strategic and tactical level, Bank Indonesia s policy responses are blended in a broad and comprehensive policy mix, consisting of (i) accommodating exchange rate flexibility, (ii) conducting foreign exchange intervention, (iii) accumulating international reserve, (iii) enhancing liquidity management strategy, and (vi) imposing targeted macro-prudential regulation. In actual fact, exchange rate flexibility has served Indonesia well in absorbing external shocks during the 28/9 global financial crisis, and should remain a significant part of the policy response to volatile capital flows. And, among Asian economies, Indonesia could be seen as having the highest tolerance for FX appreciation during However, given the detrimental impact of exchange rate volatility to macroeconomic and financial system stability, efforts to smoothening exchange rate volatility were justified. In economic terms, Bank Indonesia is stretching its maneuvers to walk vigilantly on the three sides of the impossible trinity, but prefer to take a more flexible solution rather than a corner solution. A more flexible solution allows Bank Indonesia to keep its monetary policy independence while at the same time introduce targeted prudential measures in managing short term capital flows to help smoothening the exchange rate movements (not fully flexible). Targeted prudential measures such as the regulation of the One-Month Holding Period (OMHP) on SBI are found as a useful part of the policy toolkit for Bank Indonesia, particularly when a purely macroeconomic policy response were not adequate or conventional policy measures such as forex intervention lead to a complication in monetary management. Since the announcement of the OMHP measures in June 21 it is difficult to detect a significant deterrent to foreign investor inflows into SBIs. NDF market pricing also does not indicate the measures have created a bigger wedge between onshore versus offshore interest rates. But, should another crisis hit, they will not be able to liquidate their SBI holdings as rapidly as was seen in prior bouts of contagion. It is possible that this type of flow volatility could appear in another segment of Indonesia asset markets, such as government notes (SBN), depending on the extent of interplay between these markets and the severity of the situation. The challenges are fixed income investments everywhere have more leverage embedded in them than a typical equity market investment. This imply these flows could also be perceived as short term and subject to risks of abrupt reversal. Important lesson we could draw at times we issued the OMHP measure in June 21 that (i) the measures have been targeted at specific types of flows and markets (SBI), so as not to impede all capital inflows, and (ii) the measures have been well communicated and articulated so that it could be accepted by the market when markets appeared to fear stronger controls on flows. In short, more elaborate communication, articulating the objectives and motivation help limit fears of wider limits on flows. Hitherto, prudent macroeconomic policies supplemented with the existing targeted prudential measures have been providing a strong footing for Bank Indonesia in mitigating the risk of short term capital flows. Even so, given more challenges ahead, any additional targeted macroprudential policy should be left open. *Senior Economist, Bank Indonesia 2

3 Contents Pages 1. Trend of Portfolio Investment Flows 4 2. Causes and Consequences of Portfolio Investment Flows 4 3. Policy Responses (Policy Mix) to the Portfolio Investment Flows 7 - Exchange rate flexibility 7 - Foreign Exchange Intervention 8 - International Reserve Accumulation. 9 - Liquidity Management Strategy 11 - Targeted Macroprudential Tool Monetary/Fiscal Policy and Short Term Capital Inflows Implications of capital flows on conduct of monetary policy Can capital control help? 2 7. How to take as much benefit from the capital inflows? 21 Box - Box 1 : SBI Secondary Marker as a Vulnerable Market Segment 15 - Box 2 : Reactions to the OMHP measures 16 - Box 3 : Capital Control Versus Macropudential Regulation 21 Table : List of Bank Indonesia Regulation Related to Capital Inflows 23 3

4 Challenges and Policy Options in Managing Portfolio Investment Flows: Bank Indonesia s Recent Experiences Nanang Hendarsah The trend of Portfolio Investment Flows Since early 29, the global portfolio inflows to Indonesia have regained strong momentum from their short-lived slump in the last part of 28. Portfolio investment flows that are intermediated mainly outside the banking system comprise a much larger share of aggregate flows to Indonesia. In the meantime, banking flows have suffered as a result of the crisis and the slow recovery of banks together with the prospect of more stringent regulation and higher capital requirements. During 21 foreign portfolio investment continued at a strong pace, charting a surplus of US$ 7.25 billion during the first half of 21 and expected to rise to US$11.32 billion in the second half of the year (Graph 1). A significant proportion is being invested in public fixed income government bond/note namely Government Bonds (SUN) and Central Bank Bill (SBI), and Equity (Graph 2) $ billion FDI, net FPI, net USD Billion Equity Government Bond Central Bank Bill IDR/USD IDR/USD 8,9 9,4 9, Lehman Brothers Collapse, 28 Greek Crisis, May Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Greek Crisis, May 21 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 1,4 1,9 11,4 11,9 Graph 1. Capital Flows in Indonesia Graph 2. Portfolio Flows in Indonesia The Causes and the Consequences of Portfolio Investment Flows Higher growth compared to advanced countries as well as wide interest rate differentials create attractive investment opportunities in Indonesia (pull factors). Meanwhile, structural factors namely unusually low policy rates and long term yields in the advanced countries and a substantially weaker growth outlook suggest that a larger allocation to emerging assets including to Indonesia could persist over the medium term (push factors). 4

5 Capital inflows to Indonesia, if sustainable, may help deliver the economic benefits of increased domestic financial market integration with global market. Capital inflows can spur financial market development which in turn can potentially foster economic growth either by financing projects in underdeveloped sectors through a lower cost of capital or by stimulating consumption or raise the economy s growth potential via a more efficient allocation of capital (Diagram 1). Notwithstanding their beneficial effects, recent surge capital inflow also pose challenges as they might run counter to the objectives of domestic macroeconomic policies because their potential to generate overheating, loss of competitiveness, and increase sterilization costs. Particularly, these inflows, on top of already excess liquidity in domestic banking system, create major difficulties for Bank Indonesia in monetary policy formulation provided that potential future inflation pressures are substantial. Meanwhile, rising policy rate to keep future inflation in check raise concerns over further widening of interest rate differentials which would lead to even greater capital inflows. Diagram 1 : the Cause and Consequences of Portfolio Investment Inflows GLOBAL : PUSH FACTORS EMERGING MARKET (EM) : PULL FACTORS THE BENEFIT & THE PROBLEM Global Liquidity Expansion (Post -Crisis) Advanced Economy Low Interest Rate Unsustainable Debt Tightening Lending Standard Stronger Growth Outlook Rising Asset Valuation Return Higher Interest Rate Expected Currency Appreciation Currency Appreciation & Helps Inflation Sources of Financing Lower bond Yield & High Share Price Deepen Financial System More Complex Macroeconomic Management Risk of Sudden Reversal Risk of Asset Bubble Vulnerable Financial System Based on the observation of the linkage between capital inflows and the real economy and financial system, at least there are three key stylized facts of three episode of capital inflows namely before, during, and after. First, portfolio inflows tend to be pro-cyclical, that is inflows increases in good times and falls in bad times. Second, as the consequence of pro-cyclicality, the real appreciation adds pressure to the current account balance which requires further adjustment in the nominal exchange rate in the latter period (Graph 3 and 4) 5

6 REER Appreciation (%yoy) Before During After CA (%GDP) Before During After Graph 3 : REER Appreciation (%) Graph 4 : Current Account Balance (% of GDP) Real GDP (%yoy) Before During After Inflation (%yoy) Before During After Graph 5: Real Economic Growth (%) Graph 6 : Inflation (%) As the expectation of depreciation builds up, the reversal of portfolio inflows is somehow certain. In this case, exchange rate must be flexible to absorb the shock. Third, foreign portfolio inflows induce an increase in assets prices and an appreciation of nominal and real exchange rates. The transmission could run not only from higher demand for assets, but also from the increase in domestic liquidity, which in turn will further boost assets prices. Another problems arise as part of them are volatile in nature while the flows are largely in excess of the economy s absorptive capacity, and the Indonesia s thin market is too fragile to face a huge and uncertain global financial market. They could endanger financial stability, especially when they lead to sharp asset price movements, highly volatile, and concentrated in short maturity instruments hence could engender vulnerability to crisis. As mentioned above, the surge portfolio investment flows to Indonesia take a large share in fixed income bond/note/bill which have more leverage embedded in them than a typical equity market investment. This is one reason why policy makers everywhere sometimes implicitly 6

7 think of these flows as short term and subject to risks of abrupt reversal. And, at the same time are less concerned with flows to equity markets. In particular, SBIs, which have been a convenient vehicle for offshore investors to engage in carry trades and also to arbitrage onshore versus offshore interest rates, have historically been the most sensitive to shifts in global risk appetite. Shifts in these positions contribute to severe bouts of spot (FX) market volatility when risk appetite wanes, with October 28 and May 21 being a dramatic example (Graph 2) The challenge for Government and Bank Indonesia are now how to draw maximum benefit from these surge portfolio investment while managing the contemporaneous risks, and attract more long-term capital inflows directed to productive sectors. The Policy Responses to the Portfolio Investment Flows In managing large volatility in capital flows, in the first place, Bank Indonesia prefer to exercise more prudence in maintaining macroeconomic stability and a robust financial system with good supervision. Obviously, sound macroeconomic and financial policies at national level is the first line of defense. This would enhance policy credibility and create conducive environment for investment in any type. Diagram 2 : The Policy Respond on Portfolio Investment Inflows : The Available Tool Kit Policy Mix The First Line of Defense The Second Line of Defense The Third Line of Defense Prudent and Consistent Macroeconomic Policy Conventional Policies» Exchange Rate Flexibility» Foreign Exchange Intervention» International Reserve Accumulation» Foreign and Domestic Currency Liquidity Management Macroprudential Policies However, at the strategic and operational level, in trying to modulate the volume of net capital inflows Bank Indonesia s policy responses are blended in a broad and comprehensive policy mix, consisting of (i) accommodating exchange rate flexibility, (ii) conducting foreign exchange intervention, (iii) accumulating international reserve, (iii) enhancing liquidity management strategy, and (vi) imposing targeted macro-prudential regulation (Diagram 2). 7

8 1) Exchange rate flexibility Exchange rate flexibility has served Indonesia well in absorbing external shocks during the 28/9 global financial crisis, and should remain a significant part of the policy response to volatile capital flows. Allowing the exchange rate to adjust can mitigate the transmission of global liquidity and capital inflows attracted by appreciation expectations. Among Asian economies, Indonesia is seen as having the highest tolerance for FX appreciation. The Indonesian rupiah (IDR) appreciated nearly 34 percent from the trough in March 29 through April 21, undoing the depreciation during the crisis (28/29), before stabilizing during April October 21 (Table 1) March 29 April 21 and April 21 Oct 21 (poin to point) Currencies Apreciate (+) Depreciate ( ) Apreciate (+) Depreciate ( ) Mar 9 Apr 1 (%) Apr 9 Oct 1 (%) IDR 11,993. 9, ,72. 8, JPY KRW 1, , ,124. 1, SGD THB PHP MYR Table 1 : Asian Currencies 2) Foreign Exchange Intervention Intervention in the foreign exchange market is a key policy decision for Bank Indonesia Indonesia facing large capital inflows. Massive and rapid capital inflows frequently induce steep exchange rate appreciation in a short period of time creating uncertainty in business sectors. Under this circumstance, intervention has been pursued to smoothing the excessive fluctuation of exchange rate or managing undesirable FX fluctuations (Graph 7). The sustained and sharp appreciation of IDR may also have significant repercussions on the economy mainly could damage the competitiveness of export sectors and potentially reducing economic growth. Minimizing the sharp appreciation of IDR to preserve macroeconomic stability will also be very important providing that the large share of capital inflows are in the form of portfolio investment. Particularly, if exchange rate movements are driven by speculative 8

9 capital flows, a sudden reversal could put both the financial system and real economy at risk. This due to the fact that portfolio investment are very susceptible to the surplus current account reversal as the appreciation of the rupiah would also facilitate more imports hence narrowing current account. Indonesian experience during 24 and 28 shown how the reversal of current account from surplus to deficit triggered the withdrawal of foreign funds from domestic financial markets (Graph 8). Likewise, if net capital inflows occur in the context of a current account deficit, the real appreciation could exacerbate the external imbalance, heightening vulnerability to a sharp reversal of capital inflows % IDR JPY KRW THB PHP MYR 7, 7,5 8, 8,5 9, 9,5 1, Rp/$ Current Account rhs IDR 9,12 1,13 9,221 5 US$ million 4 3 8, ,5 11, 1 Jan 8 Mar 8 May 8 Jul 8 Sep 8 Nov 8 Jan 9 Mar 9 May 9 Jul 9 Sep 9 Nov 9 Jan 1 Mar 1 May 1 Jul 1 Sep 1 11,5 12, 11, Mar 4 Jun 4 Sep 4 Dec 4 Mar 5 Jun 5 Sep 5 Dec 5 Mar 6 Jun 6 Sep 6 Dec 6 Mar 7 Jun 7 Sep 7 Dec 7 Mar 8 Jun 8 Sep 8 Dec 8 Mar 9 Jun 9 Sep 9 Dec 9 Mar 1 Jun 1 Sep 1 Dec 1 Graph 7 : Asia Exchange Rate Volatility Graph 8 : Current Account and IDR Therefore, in light of such above consideration, intervention is rigorously conducted and take into account the development of a comprehensive set of policies including inflation target, a need to maintain adequate international reserve, and the sterilization cost. Bank Indonesia perform macro-simulation regularly to ensure whether the level of the exchange rate in line with macro objectives in the perspective to achieve the optimal trade-off between internal balance and external of the economy. In short, intervention is not an independent policy tool. It cannot generate permanent changes in exchange rate when intervention objectives are inconsistent with macroeconomic policies. Bank Indonesia prefer gradual and predictable changes whose impact we can anticipate. 3) International Reserve Accumulation. If the intervention to be fundamentally justified to achieve the optimal trade-off between internal (growth v.s. inflation) and external (current account) balance of the economy, 9

10 then the next question is whether Bank Indonesia require accumulate international reserve? or has a relatively low level of foreign exchange reserves, for example from a precautionary perspective?. If so, then rapid capital inflows can be a good opportunity for the central banks to increase international reserves (Graph 9) US$ Miliar Rasio Cadev/Portfolio Portfolio: Posisi SBI, SUN plus flow saham sejak Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Jan 6 Apr 6 Jul 6 Oct 6 Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul 1 Oct 1 Graph 9. Indonesia International Reserve Graph 1 : Ratio of Reserve to Portfolio Investment In addition, providing that with the level of reserve at $93.4billion (as of 23 November October 21) is thus far adequate to meet more than 7 months of imports and government debt services payment, further modest strengthening of reserve buffers may be justified for Indonesia. This because Indonesia is relatively exposed to global risk aversion. Hence, an adequate ratio of international reserves to foreign portfolio positions is required to play role a self insurance when a capital reversal occur (Graph 1). For example, international reserve accumulation has been relatively modest about US$15 billion in 29 and US$ 25.7 billion through October 21. Some of these gains were partially reversed in May as the currency modestly depreciated due to the impact of the European crisis. Reserves dropped by about US$4 billion to US$74.6 billion in May, but recovered by nearly US$ 17.1 billion in June until October 21. From a macroeconomic stabilization perspective, however, the accumulation of foreign reserves required to keep the exchange rate from appreciating may lead to excessively loose monetary conditions and creating the potential for financial system vulnerabilities. In this case, the resulting increase in the money supply should be sterilized through open-market operations. But mounting sterilization costs, however, are also a concern. The difference between the interest paid by Bank Indonesia to commercial banks for draining liquidity and the 1

11 interest received on official reserves brought implication to central bank balance sheet, as experienced by most Emerging Economies (Graph 11). 4) Liquidity Management Strategy Bank Indonesia is also exploring options to prevent the unwanted impact of short term capital inflows by introducing intrusive methods to control the money supply or liquidity in the financial system stemming from capital inflows such as by introducing reserve requirement. (%) Korea India Philipina Thailand Brasil Turki China Malaysia Singapura Indonesia Graph 11 : Interest Rate Differential EM - US 45, 4, 35, 3, 25, 2, 15, 1, FASBI Term Deposit SBI (Total) Jan 8 Mar 8 May 8 Jul 8 Sep 8 Nov 8 Jan 9 Mar 9 May 9 Jul 9 Sep 9 Nov 9 Jan 1 Mar 1 May 1 Jul 1 Sep 1 Nov 1 Graph 12. SBI, Term Deposit, FASBI (Stock) In this context, Bank Indonesia introduced two policy measures to absorb unnecessary liquidity by: (i) Raising the Primary Statutory Reserve Requirement from 5% to 8% of bank's third party rupiah deposits. The additional 3% held in Primary Statutory Reserves will be remunerated at 2.5% p.a., and (ii) Imposing a statutory reserve requirement based on the LDR as a means of ensuring credit growth firmly based on prudential banking principles As part of the strategy to enhance liquidity management on June 16, 21 Bank Indonesia also introduced a term deposit instruments without an underlying debt security. This instrument is non-transferable -hence tapering chance for foreigners to accumulate SBI. Should the domestic banks need temporary liquidity it can be redeemed prior to maturity (early redemption) with subject to certain requirements (Graph 12 ). In addition, Bank Indonesia also introduce nine month SBIs, in a move to shift a greater portion of its liquidity draining operations to longer tenors. Previous to the announcement Bank Indonesia had already moved away from weekly SBI auctions to 11

12 monthly SBI auctions and shifted issuance away from one month tenors to mostly three, but also six month tenors. These shifts in monetary management serve to decrease the availability of instruments most attractive for facilitating carry trade and arbitrage plays. 5) Targeted Macroprudential Tool. In some circumstances a purely macroeconomic policy response and conventional policy measures such as sterilized intervention were not adequate. To this end, targeted prudential measures to limit a short term and volatile capital inflows are justified and found as a useful part of the policy toolkit so as to allow Indonesia to pursue macro-economic stability and safeguarding the integrity and the stability of financial system. The Regulation on Non-Internationalization of Indonesia Rupiah (January 21) On 15 January 21 Bank Indonesia introduced regulation No. 3/3/PBI/21, which imposed restrictions on rupiah transactions and foreign-currency credit offered by banks. The regulation banned rupiah transfers to offshore accounts in a bid to stem a large swing in the value of IDR against the USD. This restriction stopped non-residents from borrowing in rupiah, switching it into US dollars, to profit when the rupiah weakened. Bank Indonesia also imposed a USD3 million limit on forward rupiah transactions, effective 12 January, down from USD 5 million previously. The regulation has been through some major revisions in 25 known as Bank Indonesia Regulation Nr.7/14/PBI/25 The limitation on rupiah transaction and foreign exchange credit by banks. There are two main objectives of this regulation: (1) to curb the speculative transaction undertaken by Foreign Parties through rupiah transaction and/or derivative transaction which could lead to rupiah instability; and (2) as an instrument for policy of noninternationalization of Rupiah. Subsequently, improvement on operational issues has been taken accordingly to ensure the effectiveness of the measure. The regulation effectively limited the offshore deliverability of the rupiah and dried up trading in deliverable rupiah forwards. To meet the offshore hedging and/or speculative demand, an offshore market in rupiah non-deliverable forwards (NDFs) gradually developed. 12

13 The regulation also effectively limited non-residents transaction in IDR without economic underlying transaction such as swap overnight-related short term inflows (Graph 13). 2,5 2, 1,5 1, 5 US$ Million Regulation on Non Internationalization of IDR Dec 1 May 2 Oct 2 Mar 3 Aug 3 Jan 4 Jun 4 Nov 4 Apr 5 Sep 5 Feb 6 Jul 6 Dec 6 May 7 Oct 7 Mar 8 Aug 8 Jan 9 Jun 9 Nov 9 Apr 1 Sep 1 USD Mn Rp/$ 1, 8, Central Bank Bills 9, 8,5 Exchange Rate 8, 9, 7, 9,5 6, 5, 1, 4, 1,5 3, 11, 2, 11,5 1, 12, Jan 5 May 5 Sep 5 Jan 6 May 6 Sep 6 Jan 7 May 7 Sep 7 Jan 8 May 8 Sep 8 Jan 9 May 9 Sep 9 Jan 1 May 1 Graph 13 : Swap Overnight FX Inflows Graph 14 : SBI as Foreign Investment Underlying A large and persistent onshore-offshore yield gap indicates that foreign exchange restrictions are working and helping to segregate the onshore and offshore markets. The development of a robust NDF market is also testimony to the fact that the restriction imposed were effective. But, while the restriction (non-internationalization of IDR) prevent speculative flows into the spot market or swap related short term inflows, foreign players regain exposure to the currency by investing in Bank Indonesia s Central Bank Bill or SBIs (Graph 14). SBIs, which have been a convenient vehicle for offshore investors to engage in carry trades and also to arbitrage onshore versus offshore interest rates, have historically been the most sensitive to shifts in global risk appetite. Shifts in these positions contribute to severe bouts of spot (FX) market volatility (Box : SBI Secondary Market as a Vulnerable Market Segment) The Regulation on One-Month Minimum Holding Period (16 June 21) Rather than prevent the overall capital inflows, Bank Indonesia policy respond to surges of portfolio capital inflows has been targeted to certain segment perceived to be volatile flows. For that reason, the policy of the One-Month Holding Period (OMHP) issued in 16 June 21 has been targeted only on capital flows to the SBI, with the main purpose 13

14 of preventing a sudden reversal of capital in large scale which in the past frequently cause exchange rate volatility. The regulation oblige any buyer of SBI to hold a minimum holding period of 1 month (28 days) for both primary and secondary market purchases for all tenors, applicable to both residents and nonresidents, effective 7 July 21. In short, regulation of The 1- month holding period in SBIs locks in foreign investments in SBIs for at least a month. Given the lock up period, the measures do not appear to have significantly deterred foreign inflows, but could dampen the volatility of outflows. Foreign ownership in SBIs was not reduced after the implementation of the measures, but capital inflows have been filtered, to more long-term tenor of at least one month, no longer effectively only overnight placements that can be withdrawn at any time. (Box : Reactions to the measures and the implications.) Monetary/Fiscal Policy and Short Term Capital Inflows Complexities faced in conducting monetary management either by reducing capital inflows through sterilized intervention and let the IDR to strengthen further may open policy option for Bank Indonesia to use monetary policy to reduce inflows. Monetary easing can narrow the interest rate differential between foreign and domestic interest rates and, thereby, theoretically reduce the incentives for carry trade, in which investors borrow in low-yielding currencies and invest in high-yielding ones. Meanwhile, fiscal tightening can support monetary policy by reducing the budget s financing needs and thus allowing for lower interest rates. Fiscal austerity could also mitigate asset bubbles directly by lowering aggregate demand growth and supporting a capital account adjustment, thereby cushioning the cost of a sudden reversal in inflows % BI Rate CPI rhs % % Jan 6 Apr 6 Jul 6 Oct 6 Jan 7 Apr 7 Jul 7 Oct 7 Jan 8 Apr 8 Jul 8 Oct 8 Jan 9 Apr 9 Jul 9 Oct 9 Jan 1 Apr 1 Jul Graph 14: BI Rate and CPI Inflation Graph 15: Fiscal Deficit 14

15 However, lowering interest rates to respond to capital inflows may be at credibility risk at the time of future inflation pressures expected to rise (Graph 14), providing that our latest reading of economic conditions showed increasingly strong domestic demand. Whereas, interest rate setting should be as respond function towards achieving the medium term inflation target. Box 1 : SBI Secondary Market as a Vulnerable Market Segment In the midst of the low U.S. dollar interest rates, the abundance of global liquidity, the rising expectations of weakening U.S. dollar, and the increased risk appetite, offshore carry traders engage in NDF transaction with offshore bank to take profit of FX trade by taking a long position of the rupiah. In such circumstances, the interest rate of rupiah in the NDF market will be depressed down far exceeds the domestic interest rates. Diagram 1 : FX Carry Trader Arbitrager Trader (bank) USD Short IDR Long NDF Rate USD Long IDR Short NDF Market Bank USD Sibor USD Borrow Money Market OFFSHORE NDF Implied Rate ONSHORE SBI Arbitrage SBI Rate USD Short IDR Long Spot Market Thus, the offshore bank has a short position of the rupiah in the NDF market. In order to cover the short position and also make a profit, the offshore banks also must take a long position of the rupiah in the onshore market or engage in interest rate carry trade if the offshore rupiah NDF rate is lower than onshore rupiah rate. Thus, the offshore bank can play the role as arbitrager trader. 15

16 In other words, an arbitrage opportunity for offshore bank arises when the NDF-implied IDR interest rate falls below the onshore IDR interest rate, such three month SBI rate (Graph A). The Bank will borrow U.S. dollars in offshore money market at low interest rates, and sell the U.S. dollar in onshore spot market. The rupiah will be used to buy SBI at a higher interest rate than the implied NDF rate. Thus, the bank will obtain profits from the difference in interest rates, while its exchange rate risk remain protected through their transactions in the NDF market. These trades effectively transmit appreciation pressures from speculative trades in the offshore market to the onshore market % Foreign Holding of SBI - RHS SBI 3 mo rate triliun Rp 1 per. Mov. Avg. (IMPLIED RATE NDF) May 9 Aug 9 Nov 9 Feb 1 May 1 Aug 1 Nov 1 Graph A : NDF Interest Rate (Implied) and SBI Rate These positions, as well as open carry trades, can be subject to abrupt reversals when risk appetite wanes (with 28 being a dramatic example). To take a more recent example, during May of this year, many investors reduced their risk positions. Offshore FX carry traders exited their NDF positions (causing NDF implied IDR offshore interest rates to rise) and many arbitrage traders exited their positions that took advantage of low IDR interest rates offshore versus higher IDR interest onshore. In exiting, arbitrage traders sold SBIs and also sold rupiah for dollars. In addition, arbitrager carry traders also liquidated SBI holdings and sold rupiah for dollars. As a result, onshore-offshore interest rate differentials reversed, and the Indonesia rupiah in the spot market depressed and become very volatile. Bank Indonesia s weekly draining auctions of primarily one-month SBIs added to the attractiveness of carry trades and onshore/offshore arbitrage, because 1) the one-month tenor of SBI s matched the most commonly traded tenor of NDF contracts, and 2) weekly auctions facilitated price discovery and SBI market liquidity, furthering their facility for short-term trading. Box 2 : Reactions to the OMHP Measure The announcement of the holding period (OMHP) was made immediately following a large liquidation of foreign holdings in May. The OMHP was well-received by market participants because the targeted nature of the measures and their application to both domestic and foreign institutions. At first, the measure effectively trim down the transaction volume of SBI trade in the secondary market (Graph B) and encouraged foreigners to switch portfolio to long dated tenor (government bond). 16

17 However, two months since the announcement, foreign holdings of SBIs as a percent of the outstanding stock have returned to over 2 percent, again nearing historic highs during October 21, and foreign inflows into SBIs have nearly kept pace with those into government securities. NDF market pricing also does not indicate the measures have created a bigger wedge between onshore versus offshore interest rates, with this difference widening only marginally since the announcement and near the historical average for this differential prior to the announcement of the measures mos 6mos 3mos 2mos 1mo < 1mo Jan Apr Jul Okt Graph B. Daily Volume of SBI Secondary Market It is difficult to detect a significant deterrent of the OMHP measures to foreign investor inflows into SBI and foreign investors appear nearly as willing to purchase SBIs with a one month holding period as previously. Foreign banks or hedge funds still could purchase seasoned SBIs (e.g., three-month bills with two months to maturity) in the secondary market as part of an on-/offshore arbitrage trade. But, with a one month lockup, should another crisis hit, they will not be able to liquidate their SBI holdings as rapidly as was seen in prior bouts of contagion. Indeed, the OMHP measure is not intended to reduce the total inflows, but more intended to prevent a sudden reversal of capital and a large scale. In addition, the measures aim beyond simply preventing sudden capital reversal but also increasing the central bank s liquidity management instruments and also promoting deeper local money markets. On the other hand, fiscal tightening is not necessary because the focus of the government s fiscal policy has been to promote fiscal consolidation, and gradually reduce government debt to achieve fiscal sustainability (Graph 15). The government has also focused fiscal policy on providing a modest degree of stimulus to the overall economy whilst maintaining fiscal prudence. In short, real government expenditures tend to decrease as capital inflows surge, suggesting that fiscal policy has generally been countercyclical. The Implications of capital flows on conduct of monetary policy In the midst of a rapid capital inflows, problems faced by the central bank of a small open economy becomes multifaceted when confronted with policy trilemma. This because the 17

18 central bank for example must achieve inflation target and require policy independence to achieve the target, and let the exchange rate move freely. This can be attributed to what is usually called the model of policy trilemma of international finance (Mundel-Fleming Model). The model states that countries cannot simultaneously fix their exchange rate, have an open capital account and pursue an independent monetary policy. Only two out of these objectives are mutually consistent. If a country wants to keep independent monetary policy, it has to do it either with free capital mobility, and let the exchange rate to move freely (point C on the diagram 1) or with fix exchange rate regime and close the capital account (point A on the diagram 1.). In order to achieve and maintain macroeconomic stability, Bank Indonesia which adopt inflation targeting framework must have independent monetary policy with interest rate (BI Rate) as the main policy tool. Under this framework, the exchange rate must be flexible supported by an open capital account. However, given the detrimental impact of exchange rate volatility to macroeconomic and financial system stability, efforts to smoothening exchange rate volatility might be justified for Bank Indonesia. In this regards, Bank Indonesia is at somewhat more flexible solution (point D on the diagram 1) rather than at the corner solution as implied strictly by the model of policy trilemma. A more flexible solution allows the country to keep its monetary policy independence while at the same time introduce certain measures to manage the exchange rate movements (not fully flexible) and to some extent restricting the movement of very short term capital flows. A D C Open capital account B 18

19 Diagram 1. Policy Trilemma However, Bank Indonesia is facing not only the trilemma at the strategic level, but also trilemma at the tactical level. In the one hand, reserve accumulation and sterilization intervention are required for preventing undesirable nominal and real exchange rate appreciation and at the same time avoid unnecessary domestic liquidity expansion (point A on the diagram 2). However, these policy choice will also impair the central bank balance sheet.. B A Managing liquidity Diagram 2. Tactical Trilemma C On the other hand, reserve accumulation will be balance sheet-friendly if Bank Indonesia conduct unsterilized intervention, let the domestic liquidity increase which means tolerate the possibility of higher inflation and real appreciation (point B on the diagram 2). In dealing with this tactical trilemma, the corner solution such as point A may be the first best option. Nevertheless, binding to the central bank act which stated that central bank has to maintain certain minimum of capital, again, somewhat more flexible solution could be the second best option, in a sense that Bank Indonesia move inside the triangle and strike the optimal balance among three corner solution all the time. In this context, Indonesia experience shows that macroprudential measures has been very useful as the financial system becoming more complex and interwoven across borders. Macroprudential measures to manage capital flows and domestic liquidity plays an important role because it reduces the necessity to intervene in an effort to dampen appreciation pressure, which in turn also reduces the pressure on the central balance sheet. 19

20 Can capital controls help? Another interesting development is the public acknowledgement by some authorities, including the IMF, of the need to use capital controls to enhance financial stability. Rather than rejecting capital controls outright, more authorities are now interested in studying how to design and apply specific control measures. In international discussions level, the capital control may be justified if all conventional macro policy options that are available can no longer be considered adequate to mitigate the adverse effects of the extreme capital mobility. Capital controls have a strong grounds to be part of policy tools to manage the capital inflows for several reasons, namely if the inflationary pressures intensify, if reserves accumulation is far more than optimal, if the value of domestic currency has been overvalued, and if the majority of capital inflows are transitory.. Some very important points to consider when applying capital control and to make these measures effective, it is necessary to differentiate between different sources and types of flows, to consider the choice of channels and instruments, and to pay attention to communication and enforcement capacity, as well as the design of entry/exit and adjustment mechanisms. Last but not least is the need to consider the specific environments and regulatory regimes under which controls will be introduced. In general, measures that require minimal changes to existing rules will be easier to communicate, implement, adjust and exit from. Those that require fundamental changes to the current system may have a larger psychological impact but may also carry a higher risk of failure. The evidence on the effectiveness of capital controls is thus far mixed. Emerging countries experiences have shown some have and have not been successful in the past. How about Indonesia? Hitherto, prudent macroeconomic policies supplemented with some prudential measures provide a strong footing for Bank Indonesia in mitigating the risk of short term capital flows. Even so, there will always be room for additional policy options, and capital controls are a double-edged sword best saved for emergencies. Important lesson we could draw at times we issued the OMHP measures last June 21 that the policy has been well communicated and articulated so that it can be accepted by the market when markets appeared to fear stronger controls on flows. More elaborate communication, articulating the objectives and motivation will help limit fears of wider limits on 2

21 flows. In addition, any potential measure has to be assessed in a country specific and market specific context to examine the incentives and the ability of investors to circumvent, and beyond this narrow criteria, whether they are effective in achieving their objectives. Box 3 : Capital Control Versus Macropudential Regulation The delineation of prudential measures and capital controls is often difficult, and the terms have often been used interchangeably and in partially inconsistent ways. Policy measures could be considered as capital controls if they discriminate between residents and nonresidents. For example, if residents may buy domestic assets, such as securities, while nonresidents may not, the measure is considered a capital control. Also in our case, we impose regulation of the One-Month Holding Period of SBI. We consider this regulation not as capital control because it does not discriminate between resident and non-resident. Capital controls can affect capital flows by imposing limitations on a type of capital account transaction or on a payment and transfer related to these transactions. Therefore, a prohibition of residents purchase of foreign assets, and a prohibition of making a payment for the acquired asset are both capital controls. Capital controls have often been used to achieve prudential goals in the absence of a developed regulatory framework or adequate risk management practices in the financial sector. Prudential measures regulate risks taken by financial institutions, including risks related to cross-border financial transactions to ensure the soundness of the financial sector. They can focus on individual institutions or on the financial system as a whole and can take the form of quantitative and qualitative standards on capital adequacy, risk management, asset concentration, and liquidity, among others. In some cases, they discriminate between international and domestic capital transactions and, as such, may be economically equivalent to capital controls. For example, a higher reserve requirement on nonresident deposits than on resident deposits contains an element of capital control and needs to be considered as such. Measures that differentiate between the use of domestic currency and foreign exchange, such as limits on banks net open foreign exchange position, are internationally accepted as prudential measures. However, asymmetric open position limits, which introduce different limits on short and long positions, can discourage the respective flows (for example, a lower short position can limit capital inflows). How to take as much benefit from the capital inflows? Maintaining prudent macroeconomic policies and selective prudential measures is necessary to take full advantage of short-term inflows and to mitigate the risk of capital reversal. However, at present the big challenge for Indonesia is how to improve the composition of capital inflows to a longer term productive use so as to support sustainable economic growth. In particular, Indonesia needs capital inflows aimed to increase investment into productive sectors which can expand the capacity of the economy. Without increasing in productive 21

22 capacity (supply side), the rapid growth of consumption will always be accompanied by inflationary pressures. Related to this, the important steps urgently needed to be taken include :» First, by directing the capital flows to finance business sectors. The government can provide stimulus in the equity market, for example, in the process of initial/secondary public offering and also corporate bond issuance. High appetite of foreign investor to Indonesia's financial markets can also be directed to support stocks and bonds issuance by the state owned enterprises.» Secondly, the government should be able to speed up the infrastructure development. Various policy initiatives in the infrastructure plan has been issued and announced, but the most important thing is now how to strongly and consistently implement this initiatives.» Third, the government could take advantage of the strong interest of foreign investor to invest in Indonesian financial markets to deepen the domestic financial market. The availability of market instruments should be expanded to accommodate a variety of foreign interests in accordance with their risk and return profile. Nevertheless, opening domestic market and developing variety of market instruments need to be supplemented with a clear and transparent regulations and strictly implemented so as to create a regulated financial market. With a deep and liquid markets as well as strong regulation, will bring Indonesia financial market to become a resilient market against each occurrence of shock. 22

23 List of Bank Indonesia Regulation as respond to capital inflows: No. BI Regulation Policy Measures The Purpose of Regulation 1 No. 3/3/PBI/21, Restriction on Rupiah Transactions and Foreign to curb the speculative transaction revised with Currency Lending by Banks undertaken by Foreign Parties No. 7/14/PBI/25 through rupiah transaction and/or PROHIBITIONS derivative transaction which could Banks are prohibited from conducting certain lead to rupiah instability. transactions with Foreign Parties as follows : 1. Provision of Credit in rupiahs and/or foreign As an instrument for policy of noninternationalization of Rupiah currencies 2. Placement in Rupiahs ; 3. Purchase of Rupiah-denominated securities issued by foreign Parties Inter-office account in Rupiahs ; 4. Inter-office Account in foreign currency for provision of credit outside Indonesia ; 5. Equity participation in rupiahs ; 6. Rupiah Transfer to an account held by Foreign Parties and/or joint account held by a Foreign Party and non-foreign Party at domestic Bank ; 7. Rupiah Transfer to an account held by Foreign Parties and/or joint account 8. held by a Foreign Party and non-foreign Party at overseas Bank RESTRICTIONS Banks are restricted in conducting selling and/or buying Derivative Transaction with Foreign Parties with nominal amount exceeding USD 1 million without underlying investment in Indonesia EXCEPTIONS 1. The prohibition of Credit are not applied to Syndicated Loan led by Prime Bank ; to Credit card ; to consumption credit used in Indonesia ; to intraday rupiah and foreign currency overdrafts supported by authenticated document indicating confirmation of fund credited to the account on the same day ; to overdraft for administration charges. 2. The prohibition of Rupiah Transfer to Foreign Parties are not applied if conducted with regard to economic activities in Indonesia ; or between rupiah account held by the same Foreign Parties. 23

24 No. BI Regulation Policy Measures The Purpose of Regulation 2 No. 7/1/PBI/25 Limitation on Bank s Short Term External Debt. As prudential measures Banks are required to limit the daily balance of Short Term Foreign Borrowings to no more than 3% (thirty percent) of Bank Capital. The limit was abolished in October 28 as respond to the global crisis (BI Regulation No. 1/2/PBI/28), but currently under reviews to to be reapplied as prudential measures 3 No. 5/13/PBI/23 Revised with No. 12/1/PBI/21 Bank Net Open Position Bank are required to maintain a net open position at the end of each working day a maximum of 2% of bank capital, apply to ON and OVERALL (ON and OFF) balance sheet during the day (real time compliance) On 16 June 21, the On Balance Sheet NOP limit of maximum 2% of capital is abolished, however, the Overall NOP is still maintained at 2% of capital. The existing real-time compliance on NOP limit is further relaxed into 3 minutes window time. 4 No. 12/11/PBI/21 The minimum one month holding period of Bank Indonesia Certificate (SBI) This policy requires central bank bill (SBI) owners in the primary and secondary market to retain a minimum one month (28 days) holding period. During that period, the owner of SBI is prohibited to transfer the SBI ownership either by way of an outright or repo to other party, except repo to Bank Indonesia. This policy is imposed to both resident and nonresident investors and is intended to lengthen the ownership and the transaction period of SBI in the secondary market. This policy is effective as of the next monthly SBI auction on 7 July 21 As prudential measures To limit bank engage in speculative transaction Revision on 16 June 21 was intended to buttress the deepening of the domestic foreign exchange market while keeping in consideration bank prudential aspects To prevent any sudden and large short term capital inflows and outflow 24