Like water, the foreign capital inflow is something that should be welcomed, but the excessive one can be destabilizing, if it is not managed properly.

In the aftermath of the crisis, the global economic environment has been characterized by two speedy recoveries. The recovery in advanced countries is slower than we expected because of balanced sheet problems in banks, households and governments. With the economic recovery faltering in advanced countries, the low interest rate in advanced countries is very likely to be maintained, at least until next year.

On the other hand, the economic recovery in emerging countries has been much faster than expected.

In this environment, the huge excess liquidity in global financial markets is ready to search for high yield assets in emerging countries.

For Indonesia, the prospective ratings upgrades to “investment grade”, a stable macroeconomic condition, and lower financial risk are among the pull factors that have made Indonesia an attractive investment destination.

Traditionally, the main concern of large capital inflows is that the foreign funds may be utilized to finance an unsustainable current account deficit that could pose the risk of abrupt reversals in capital inflows (de Gregorio, 2010). This scenario could lead to painful consequences as a large exchange rate correction would potentially create a mismatch and balance sheet problems, as we saw in the 1997/1998 Asian financial crisis.

Fortunately, today is somewhat different. First, emerging countries such as Indonesia are currently experiencing a current account surplus. Second, the characteristics of the inflows are different from those on the eve of the Asian crisis. Before the Asian crisis, they were dominated by the external debt of domestic firms in the form of direct lending, corporate bonds and commercial papers to finance domestic investments.

The recent inflows are mostly invested in short-term portfolio instruments such as central bank bill and government bonds. Thus far, there is no indication that the inflows have been intermediated by banks to finance the real economic activities, so that the potential balance sheet problem in the event of a sudden stop would be very limited.

Still, the rapid capital inflows pose some policy challenges. First, they have created upward pressures on the rupiah, which have led to concerns about the declining export competitiveness. Nevertheless, given that our exports are dominated by natural resources, concerns about our competitiveness should not be exaggerated.

Furthermore, appreciation should allow producers to have access to cheaper imported goods, particularly machinery and raw materials to accelerate revitalization of their manufacture and to improve efficiency.

Second, given the short-term nature of inflows, the risk of a sudden reversal is high. Third, monetary policy to anticipate inflationary pressure down the road can be very problematic as an interest rate hike would invite further inflows. Fourth, the inflows have created additional liquidity to the financial system. Bank Indonesia’s (BI) efforts to sterilize the inflows have consequences on the mounting sterilization costs, which could create adverse consequences on the central bank’s balance sheet.

The challenges mentioned above are a classic trilemma faced by a small open economy. We cannot achieve the three objectives of having free capital flow, exchange rate stability and an independent monetary policy simultaneously. So, what is the central bank’s strategy? The central bank’s policy has been to strike an optimal balance among the three objectives by adopting a “policy mix”, combining exchange rate flexibility, reserve accumulation, discouraging the very short term inflows and managing liquidity.

First, we have allowed some room of the nominal exchange rate appreciation in response to the wave of inflows. While the appreciation has helped reduce the inflation stemming from imported prices, foreign exchange intervention is needed to prevent the exchange rate from a large misalignment and excessive volatility. Considering that the inflows are highly vulnerable to the risk of reversal, the intervention also allows the central bank to accumulate the foreign reserve as self-insurance.

Second, to contain excessive short-term capital flow, especially in the form of BI certificates (SBIs), the central bank has issued a regulation requiring investors to hold SBIs for one month. This policy has encouraged the diversification of foreign portfolio capital flows and reduced the speed of inflows to the instrument.

Third, the loss of monetary policy freedom as a result of rapid inflows can partly be resolved by adopting the quantitative approach in monetary policy. BI just recently announced an increase in statutory reserve requirements to manage liquidity.

At the same time, the bank issued a policy aimed at maintaining financial stability through a macroprudential policy by encouraging banks to manage credit and liquidity risks through LDR linked reserve requirement. The policy is particularly important to prevent an excessive credit growth once the capital flows are intermediated by banks to the real sector.

In sum, managing excessive and persistent short-term capital inflows is necessary to avoid destabilizing the economic recovery. But, managing “too much of a good thing” is inevitably costly, especially for the central bank. Concerted efforts among the authorities are thus imperative in managing the inflows. This includes the fiscal prudence to avoid further inflows driven by fiscal expansion.

The writer is lead economist at the Monetary Policy and Research Department, Bank Indonesia. The opinions expressed are his own.

Popular

RI, Australia strengthen partnership on taxing crypto assets

Analysis: Indonesia denies normalization with Israel to enter OECD

Citroen to produce electric cars in Indonesia