One of the most visible results of Indonesia’s economic recovery in recent months is the rapid flow of capital entering the country. The Indonesian exchange reserve has reached a level never before achieved.
There is no indication yet that the capital inflow will abate anytime soon, and within a matter of weeks, Indonesian reserves could surpass the US$80 billion mark.
Global funds, wary of the slow pace of recovery in the advanced economies, are betting that Asian economies will continue to outperform other regions, and deliver more respectable returns on each dollar.
Global funds’ Asian portfolios are still underweight, which means that a slight shift in global allocation would result in significant amount of capital inflows to Asia, including Indonesia.
The IMF estimates that capital flows to Asia would reach nearly $800 billion this year, double the level of last year. The attractiveness of Indonesia to fund managers is not only due to its solid macro-economic fundamentals, but also because of interest rate differentials since Indonesia has the highest interest rates in the region.
It is therefore understandable that concerns have been voiced over the risk of rapid capital inflow. This concern has been reinforced by a bullish stock market in the region.
The Indonesian Stock Exchange’s (ISX) share price index rose 15 percent this year, raising questions whether a asset market bubble is imminent. It was frequently mentioned that average price earnings ratios (PER) of publicly listed companies in the ISX has been very high.
But this argument lacks substance as, because of the current PER at 15-17, stock valuations have not been higher than trend averages and not out of line with its peers in the region.
It is true that some blue chip companies have capitalization values that are 20 to 30 times higher than their earnings, but that is because of internal factors specific to the companies. In order to sense
whether the asset bubble is imminent, one has to look at property prices as well.
We have not seen any extraordinary jumps in real estate prices in Indonesia, and the same goes for property markets across Asia, except in some urban areas in China, and some up-market segments in Singapore and Hong Kong.
Given this situation, any policy response that would amount to capital control would be inopportune and could distort economic policy making.
Capital flows to our economy should be welcome and encouraged because it provides several benefits. A surge in capital inflows tend to result in appreciation of currency exchange rates that could contribute to the downward pressure of inflation through cheaper imports.
Increased reserves and currency appreciation could give more confidence to the market and compel rating agencies to upgrade their ratings on the countries sovereign debts.
These in turn could bring down borrowing costs for future loans and existing refinanced loans for public and private corporations.
Increased liquidity and stock price increases could also contribute to the lower cost of capital for
corporations raising funds for expansion.
However it should be noted that there are downsides to rapid reserve accumulation and exchange rate appreciation.
Rapid appreciation of the domestic currency could undermine the competitiveness of tradeable sectors, as international prices for their products go up causing lasting damage even when inflows abate or reverse.
Increased liquidity also poses a risk to financial fragility when it leads to excessive foreign borrowing and foreign currency exposure, possibly fueling a domestic credit boom and asset bubbles that could prove devastating if followed by a sudden reversal in capital flow.
The urgent task of the authorities in the face of rapid capital inflows is to minimize the down risk and prevent its damaging effects. It has to be acknowledged that formulating the right mixture of policy responses to deal with these challenges is complicated as it deals with trade-off of various conflicting objective and outcomes.
Several questions need to be asked by the authorities before designing policy responses, to deal with a surge in capital flow.
First, is the international reserve large enough to meet all external liabilities, and has it enough buffers to withstand shocks created by a sudden reversal of capital flow.
Second, to what extent could further currency appreciation be tolerated without endangering tradeable sectors.
Third, is the financial system strong enough to withstand asset boom and bust cycles, without risking their fragility?
To date, both the central bank and the government have not come up with comprehensive policies designed to face challenges from adverse consequences of a surge in capital inflows.
A policy response from BI remains ad hoc in nature, without clear strategy and priorities. What BI has been doing is sterilizing the monetary effect of capital flows by increasing its reserves through issuing BI certificates (SBI).
These policies are costly to BI because of large interest differentials between the interest rate the central bank has to pay to SBI holders, and the low yield BI gains by placing their reserves in foreign bonds and notes. By doing so, BI injects more liquidity to the market, creating upward inflationary pressures, something that they should be preventing in the first place.
Last year, when nominal GDP growth was at 10.8 percent, the broad-money supply (M2) grew 13.6 percent. This is the first time in several years the growth of M2 exceeded the growth of nominal GDP, indicating that excessive liquidity has also built up.
BI has to reign in excessive monetary growth, because if this development is allowed to continue at a time when economic recovery is expected to be firmer, upward inflationary pressures would pose serious problems.
The accommodative monetary stance that has been supporting growth would be in jeopardy.
The idea of imposing capital control to deal with rapid capital inflows has been floated recently, but the matter is not so simple, because capital control consists of several variants. Choosing which variant needs to be applied depends on the nature and origin of the capital flows.
The objective of imposing capital control has to be clear from the outset, since it is not something separate, but is part of the overall macro economic policies.
The authorities should be clear whether the objective of capital control is to reduce the level of capital flows, or whether it is to alter the structure and composition of external liabilities.
Whatever the objective is, the most important thing is to establish and maintain credible economic policies that provide confidence to the fund managers, and make them comfortable to keep their funds here and so that they would not think of creating problems and risk for the national economy.
Any policy response that would amount to capital control would be inopportune and could distort economic policy making.
The writer is an economist.
