Bank Indonesia deputy governor Hartadi Sarwono stated last week that the Central Bank would seriously study limitations on foreign ownership of the central bank's certificates (SBIs) in an effort to tame rupiah volatility.
On the next trading day, the market responded with a 1.7 percent drop in currency performance against the US dollar.
This was followed by Hartadi's last Friday statement that BI was unlikely to impose controls on the flow of foreign money into its short-term debt.
Furthermore, as quoted by media, he mentioned that Bank Indonesia remains comfortable with its current policy and was of the view that the inflows and outflows of foreign funds continue to be manageable without causing sharp fluctuations in the exchange rate.
We note that the idea of capital control in Indonesia is not new. It first surfaced back in 1997-1998 during the Asian financial crisis.
We also noted that Hartadi had mentioned the idea of limiting foreign ownership in SBIs back in 2007 with no further implementation.
The question is whether Indonesia needs this type of action? To answer this question, we take a look at experiences in other countries.
The IMF previously stated that the effectiveness of capital controls was mainly on the basis of the impact on capital flows and policy objectives such as to maintain exchange rate stability, provide greater autonomy in monetary policy or preserve domestic macroeconomic and financial stability.
On the back of the aforementioned aims, several countries had implemented capital controls to limit short-term foreign inflows. Those countries are Chile (1991-1998), Brazil (1993-1997), Malaysia (1998-present), and Thailand (1995-1997 and 2006).
Surprisingly, based on several studies, the effectiveness of capital controls in achieving these goals was mixed. For example, Thailand's capital controls carried out in 2006 were aimed to prevent further appreciation that would hurt export performance and increase speculative investments.
Nevertheless, the Thai central bank's move did not stem the 14 percent appreciation of the currency after the policy was implemented and surprisingly exports rose by over 30 percent in 2007.
In the case of Brazil, they controlled the capital inflow by imposing 2 percent tax on foreigners' purchases on domestic portfolio investments in order to prevent severe volatility of their currency. The result was a weakening in their currency in the short term before appreciation thereafter.
Indonesia, as the country that implements capital liberalization, could not avoid the volatility of its currency as a result of foreign capital outflows and inflows. During this year's financial crisis, the foreign inflows to BI certificates and government bonds had reached Rp 48 trillion (US$5 billion) and Rp 103 trillion respectively.
Thus, such a capital control regulation was seemingly a challenging idea to curb currency volatility at the same time.
However, we must not forget that the control of foreign inflows could result in negative sentiment if not accompanied by further prudent monetary policy (eg. improving supervisory frameworks in the banking system).
We believe that the volatility of the rupiah in 2010 would not arise from Indonesia's economic fundamentals as we expect a resilient 4.34 percent economic growth in 2009 to moderately grow to 5.20 percent next year.
Thus, the volatility if any in the coming period would stem from the reversal of capital flows as the consequence of expected global economic recovery in 2010 (i.e. money flowing back from emerging markets, including Indonesia, to recovering developed market such as the US).
Closer to home, based on the latest data, our competitors in the region, Singapore and Thailand have already begun to post significant quarter-to-quarter economic growth in the third quarter of 2009.
Thailand grew 2.1 percent quarter-to-quanter, a rebound after negative growth in Q2 while Singapore successfully graduated from the mini crisis as they posted a repeated positive quarter-to-quanter growth since Q2.
As Thailand is the closest competitor in the capital market, the combination of possible positive economic growth in 2010 and relatively attractive price to earnings ratio (PE) of 11.8x compared to Indonesia's 15.2x would shift some capital from the Indonesian market to Thailand. This could pressure the rupiah going forward.
Thus, we believe that to control capital flows in the short term on SBIs does not make good sense given possible pressure on the currency on the back of global economic recovery in the upcoming period. However, in our view, the best thing that the government can do to maintain rupiah stability is to propel economic growth and at the same time retain political and social stability.
The writer is an economist at PT. Bahana Securities
