Restrictions on certain types of short-term capital flows could be beneficial; however, the likeliness of them being introduced at this point still appears small.
Movements of global currencies against the dollar have become ever more volatile. The rupiah is no exception; weekly swings of 3 to 4 percent are not an uncommon sight nowadays.
Recently, Brazil introduced a 2 percent tax on purchases of bonds and equities by foreigners. This was an apparent bid to curb short-term capital inflows that have propelled the Brazilian real by up to 27 percent from its lowest point in February.
In Asia, it is Korea and Indonesia that have seen the strongest currency appreciation year to date. Hence, ever since Brazil's move, many have been wondering what the likeliness is for Indonesia to follow suit, i.e. to introduce some kind of restriction(s) on short-term capital flows.
So what are the options in this regard?
While equity and bond market capital inflows have their pros and cons, in general they appear to have contributed to the economy - through their role in financing economic development, boosting liquidity and helping foster transparency in the financial markets.
Yet there has been one type of capital inflow that has served little to the economy other than to accentuate fluctuations of the exchange rate.
These are the purchases of Bank Indonesia Certificates (SBIs) by offshore institutions. If there's a place where more regulation could be beneficial, than this is probably it.
SBIs are short-term debt securities with one-, three- and six-month maturities issued by the central bank for use in conducting monetary policy.
The funds parked by commercial banks in SBIs are kept out of the system; so unlike government bonds, they are not used to finance economic development or government expenditures.
Of course there can be numerous reasons why foreign investors buy SBIs. But it is common knowledge that a substantial portion of foreign "investment" in SBIs is the result of so-called arbitraging activity.
Offshore financial institutions lock in risk-free profits by exploit-ing discrepancies between the interest rate on SBIs and the implied interest rate on borrowing in the offshore (non-deliverable) forward market.
Whenever the implied interest rate on "borrowing" rupiahs in the offshore forward market is lower than the SBI rate, the trade becomes profitable and SBI-bound capital inflows intensify - putting pressure on the rupiah to strengthen.
The problem is that the offshore forward rate can fluctuate significantly and lead to sharp hikes in the implied borrowing rate. In that case, the trade could cease to be profitable, causing the inflows to reverse and putting downward pressure on the rupiah.
It may be tempting for Indonesia to avoid all this unnecessary volatility by erecting barriers against SBI foreign purchases.
This could be either in the form of Brazilian-style taxes, a prohibition of SBI purchases by offshore institutions, or alternatively a restriction on the tenor of SBIs that could be sold to offshore institutions.
If foreign purchases of SBIs were restricted to at least three months, for instance, arbitraging activities could be cut significantly as the offshore forward market for tenors longer than one month is still relatively illiquid.
Yet whatever the measures one takes, the difficult part of erecting restrictions is in ensuring the party doesn't move elsewhere.
Short-term government T-bills (SPNs) are now still relatively illiquid and not as easy to get a hold of as SBIs.
However as T-bill supply rises and the secondary market deepens (particularly in the one-month tenor) going forward, there's no guarantee that the arbitrageurs won't use T-bills in the place of SBIs in the future. That could bring us back to square one.
To date, the main thing that seems to be holding back the authorities from taking action is the high risk of spooking the markets.
For instance, capital controls that Thailand introduced in 2006 had to be undone within hours after the equity market went nervous and experienced a 15 percent fall.
In Indonesia, foreign investors have taken up nearly one-fifth of outstanding government bonds, so unsettling them could have significant implications to fiscal policy and government finances.
This represents a clear disincentive for the authorities to act.
Besides, Indonesia's currency appreciation so far hasn't eroded export competitiveness just yet. On a trade-weighted basis, the rupiah's position now is merely close to where it was before the 2008 crisis.
So in the meantime, it's probably a safe bet to assume that policy makers will hang on to the status quo.
Yet if short-term capital leads to a further dramatic appreciation of the local currency, then they better start considering their options
The writer is an economist at Bank Danamon Indonesia. The views expressed are his own.
