Kahlil Rowter, Jakarta
In the last few months Indonesian foreign reserves have risen steadily at the same time that the rupiah has strengthened. The two are certainly related. So closely in fact that we need to look elsewhere for the real reason. Foreign inflows into the financial market are one leading candidate. But will it be permanent? And if it isn't, why?
Since the economic crisis in the late 1990s, the exchange rate has been the most watched economic indicator. Besides its psychological impact, it is also intimately interwoven into the fabric of the economy. Many commodities and services are quoted in U.S. dollars, even those produced and consumed onshore. Hence many prices move not because of changes in supply or demand, but due to the volatility of the exchange rate.
Since Bank Indonesia gave up the intervention band in 1997, this volatility has reverberated throughout the economy, often causing decision-making jitters. Not being able to pin down prices, both output and input, has discouraged investment which at its core is risk taking. Hence, currency stability is paramount.
Fast-forward to 2006. We should be pleased that our foreign reserves have risen from an average of US$35 billion last year to the current position of a little over $42 billion, or about $39 billion after paying our debt to the International Monetary Fund. Part of this increase is due to export growth thanks to favorable commodity prices. At the same time imports are still soft owing to the slowdown in the domestic economy. However, the trade balance is in risk of tapering off as the global economy cools down and our own imports start to rise on the back of domestic economic growth.
The other major factor driving reserve accumulation is the inflow of foreign currency. Its role can be roughly estimated by looking at net inflows as a portion of reserve change. Foreign ownership of government bonds rose from $3.2 billion in December 2005 to $6 billion in September 2006. While foreign net purchases in the equity market now total approximately $1.3 billion. These two sums add up to about 51 percent of the net addition in reserves for this period. It is therefore safe to say that foreign inflows have played a very significant role in the rise of foreign reserves and consequently the rupiah.
It should be noted that foreign equity net purchases may not represent what actually took place. The weakness of this statistic is that equity brokers are no longer required to state where their orders originate from. This means foreign equity buyers can be understated. On the other hand, foreign participation is mostly indicated by orders from foreign equity brokers, which could overstate foreign ownership. We can only hope that capital market supervisors will someday publish regular equity ownership by institutions, similar to government bond ownership.
A large share of foreign ownership in a country's foreign reserves may be necessary and, therefore, an insufficient cause for concern. But let us examine more closely two recent periods where it might. The first was May 2006. The rupiah strengthened from Rp 9,830 per US dollar at the end of 2005 to Rp 8,775 at the end of April 2006, but then fell back to Rp 9,220 by the end of May 2006. Why?
Foreign ownership in government bonds in May 2006 dropped about $133 million, but foreign equity net purchases slowed down considerably from $340 million to $78 million in April. What really took place in May were foreign sales of $160 million and purchases of $238 million. But the sales triggered a price drop in many shares resulting in a retraction of the index from 1,464 at the end of April to 1,329 at the end of May. Meanwhile reserves still rose in May by about $161 million.
On a quarterly basis, net portfolio inflow in the first quarter of 2006 was $3.7 billion, with a $3.6 billion inflow in bonds and $120 million in equity. While in the second quarter the position reversed with a net outflow of $1.2 billion, including, most probably, Bank Indonesia promissory notes (SBIs) and other short-term positions amounting to about $1.5 billion. At the same time, there was an inflow into government bonds of about $440 million. Hence, the decline in foreign ownership in Indonesian assets was rather small in net terms but large in gross terms. And it triggered the substantial drop in the rupiah.
In September another fluctuation took place in the financial market. This time there was a pullback from foreign investors in government bonds amounting to $340 million. At the same time foreign equity net purchases halved to about $100 million from over $200 million in the previous month. The Jakarta Composite Index actually rose 103 points in the month. Meanwhile, the foreign reserve increased by $360 million, probably due to export proceeds. Yet the rupiah fell over Rp 135. Conceivably this occurred due to spikes in US dollars during the offshore bond investors' exits. This is just another example of how small movements in financial assets can trigger large movements in the currency. Such is the granularity of the financial market.
If Indonesia's foreign reserve is dependent on financial flows, just how big are these flows, and what about other countries? One estimate is that about $15 billion out of the present reserve position of about $40 billion consists of this so-called ""hot money"".
In the Philippines the figure is about $2 billion against their reserves of $21 billion. In Malaysia the figure is estimated to be minimal after the recent bond sell-off. In Singapore and Hong Kong this statistic is meaningless due to their completely open capital accounts.
Furthermore, both countries' reserves are large enough and their bond and equity markets are deep enough that their currencies are quite immune to anything but a very massive foreign investor pullback. It appears that Indonesia is comparatively vulnerable, especially after taking into account its shallow bond and equity markets.
Aside from the general risk from a sudden massive investor pullback it appears even small movements can cause substantial currency volatility. A recent trend where major Indonesian firms have been raising debt offshore, enticed by the low cost and ease of borrowing, only heightens this risk. Exporters are immune to exchange rate fluctuations, but what about those with rupiah revenues?
Allowing unhindered flows in and out of the financial market certainly has its advantages. But, it comes with a price. We need to re-examine this and carefully consider the costs and benefits. In the meantime, a closer watch is needed. We should, at least, start with timelier reporting of foreign ownership in equity. And this data should be widely published to enable close scrutiny.
If India has an automatic equity market shutdown when the index falls below a certain threshold for a given period, we should also consider something similar.
Comprehensive financial sector vigilance to external impact needs to be initiated. This should include participation from market players. This will demonstrate that the authorities are on top of the risks and at the same time enable the gathering of near real-time data. Existing ties among authorities across countries can and should also be strengthened. Ultimately, only vigilance can save us.
The writer is chief economist, CIMB-GK Securities Indonesia. The views expressed here are personal.
