Hardly a day passes in Indonesia without calls for restrictions to stop the “wall of foreign money” entering the country.
It is true that large and volatile capital flows can cause exchange rate overshooting and asset price bubbles, while a sudden reversal can be destabilizing.
At the same time, capital inflows present a tremendous opportunity to raise investment, especially as Indonesia has a limited domestic savings pool and high cost of capital. A careful assessment of the costs and benefits of restricting capital inflows is therefore needed.
The size of inflows during January-September 2010 has been impressive (see table). In contrast to public perceptions, only about one-tenth of net capital inflows this year have been purchases of Bank Indonesia (BI’s) short term securities (SBIs). Foreign investors buy SBIs to take advantage of high interest rates, bet on the strengthening of the rupiah, and exploit arbitrage opportunities. These flows tend to be very volatile.
But foreign investors have also recognized Indonesia’s strong growth potential, and have invested for the longer-term:
The surge in direct investment has been directed toward electricity generation and manufacturing. Foreign investments will ease bottlenecks, raise employment and productivity, and add to Indonesia’s export potential.
With strong foreign demand for Indonesian assets, several important domestic companies are issuing stocks to finance expansion programs. Foreign inflows are reducing their capital costs.
Foreign bond purchases have reduced the government’s financing costs and extended the maturity profile of its debt. Lower interest payments increase room for spending on health, education and infrastructure projects.
But capital inflows also pose a formidable challenge for macroeconomic management. A direct consequence of the inflows, in the absence of central bank intervention, is the strengthening of the currency, which can undermine exports.
To prevent currency appreciation, a central bank can buy foreign exchange and sell local currency back to the market. But unless it then drains out (“sterilizes”) the extra liquidity by selling open market instruments or imposing higher reserve requirements on banks, rapid credit growth can fuel inflation and asset price bubbles.
Sterilization is a useful tool for dealing with temporary inflows, but it has costs — ultimately borne by the government budget.
To date, BI has absorbed the capital inflows through a combination of currency appreciation and intervention. In terms of underlying fundamentals, the rupiah remains fairly valued according to IMF estimates and export growth is robust.
Foreign reserves are now more in line with regional peers, improving the country’s ability to cope with a reversal of inflows.
Sterilization costs have been reduced through an increase in reserve requirements. Similar to other emerging markets, BI has recently taken steps to address weaknesses in domestic financial markets (macro prudential measures) in a way that cannot be achieved with conventional macroeconomic policy.
For example, the introduction of a one-month holding period has made SBIs less liquid, and therefore less attractive to foreign investors.
So far, so good. But strong capital inflows are likely to continue because of the better growth prospects in Indonesia than in the advanced economies.
Short-term responses such as sterilization and capital controls are not likely to be effective in the medium-term.
The best approach is to convert potentially reversible “hot” portfolio flows into direct foreign investment and IPOs, and thus to reduce the volatility and lengthen the maturity of capital inflows.
This requires reducing entry barriers and improving the infrastructure — as well as encouraging capital market development to foster IPOs and corporate bond issuance. An interesting idea suggested by Coordinating Economic Minister Hatta Rajasa is the issuance of long-term infrastructure bonds.
In the financial sector, capital inflows can fuel domestic lending booms, resulting in non-performing loans. Banks and their borrowers have so far been prudent in Indonesia, but BI needs to monitor closely credit quality and the buildup of debt on bank, corporate, and household balance sheets.
BI also needs to address weaknesses in the legal and institutional framework, as described in the recent Financial Sector Assessment Program (FSAP) conducted by the IMF and World Bank.
The current migration of capital from mature to emerging markets presents a great opportunity for Indonesia. The country still needs capital.
Channeled in the right direction by deeper domestic capital markets and a well-supervised financial system, capital inflows can boost growth and living standards.
BI can contain the macroeconomic risks with careful use of its tool kit including currency appreciation, exchange market intervention and macro-prudential regulation.
The writer is senior resident representative, International Monetary Fund, Jakarta.
