Fragile financial market

The Jakarta Post ,  Jakarta   |  Thu, 05/18/2006 1:11 PM  |  Opinion

The sudden drop in the rupiah exchange rate and the Jakarta Stock Exchange (JSX) Composite Index early this week is simply further evidence of how fragile our macroeconomic stability is, and how vulnerable the local currency is to speculative attacks.

True, since the rupiah floats, the currency is supposed to move up and down, reflecting investors' and speculators' perceptions of the economic outlook. But the drop of 5 percent in the rupiah rate from Rp 8,735 to Rp 9,160 against the dollar in just one trading day on Monday was not a normal market development. Nor was the 6.3 percent drop in the share price index on the same day, to 1,429.50 from 1,539.40 last Friday, a normal market correction of the steady, steep rise in local share prices over the last few weeks. It's true that negative regional sentiment precipitated the fall, but the drop in other Asian markets was much smaller than the dramatic tumble in Jakarta.

The rupiah continued to fall to as low as Rp 9,470 on Tuesday before closing at Rp 9,220, while the JSX index remained rather flat with a slight decline of 0.12 percent.

This simply indicates how dominant hot, short-term funds and speculators have been in portfolio capital inflows over the past year. In a stable economy with strong fundamentals, speculators have a role to play in the financial market. It is speculators who add to market liquidity and depth because they frequently turn over (change) their portfolios. In contrast to investors who focus on good returns on a consistent basis for a relatively long period, speculators are interested mostly in very high returns as quickly as possible.

But too much of a speculative element in a fragile market economy such as Indonesia's could do severe damage. And it is mostly speculative sentiment, supported by short-term funds, rather than an improvement in economic fundamentals, that has caused the JSX share index to gain almost 30 percent and strengthened the rupiah by 13 percent in the last five months. Those figures have made the rupiah's performance the second-best in Asia.

The central bank has often boasted of the robust increase in its international reserves to over $43 billion, from as low as $30 billion late last year. It has even hinted at the possibility of spending a portion of the reserves on advance repayment of the country's $7.8 billion debt to the International Monetary Fund. But this advantage has left our financial market broadly exposed to instability due to speculative attacks.

It was mostly foreign portfolio investors and speculators who benefited from the bullish sentiment in the financial market. They enjoyed handsome profits from both the rupiah's gains and the marked rise in JSX share index. Even with the significant drop in both the rupiah and share price index early this week, the investors and speculators who unloaded a good portion of their portfolio still ended up with a big profit.

As long as capital inflows remain dominated by short-term, portfolio capital, and are not based on foreign direct investment and export earnings, our financial market will constantly see bouts of boom and bust as it is widely exposed to great risks of waves of attacks by foreign speculators bent on making a killing. And a highly volatile market is not conducive to business. With almost 75 percent of domestic private savings at banks consisting of deposits of only one to three months, one can see how vulnerable our financial market is.

The high pace of portfolio capital inflows often creates a misguided sense of confidence among central bank and finance officials. This leads to misdirected monetary policies. The high inflow of ""hot money"" also often drives up the rupiah to artificial heights that cannot be sustained by economic fundamentals.

Given the disadvantages of short-term funds, and in view of our entirely free capital account, it is worthwhile to revisit the idea of managing portfolio capital inflows by taxing funds that remain in the country less than one year. Chile once did this to help stabilize its foreign exchange market.

The market also eagerly awaits the comprehensive package of financial reforms the government promised a few months ago. This will be the third reform package this year, after the ones dealing with infrastructure development in February and investment in March.

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