I

ndonesia could suffer from a '€œvery fast reversal of capital flows'€ next year, as investors flee emerging markets in exchange for safer assets, the Asian Development Bank'€™s (ADB) chief economist, Wei Shang -Jin, has warned.

Speaking in an interview in Jakarta on Tuesday, the bank'€™s newly appointed chief economist identified the upward trajectory of global interest rates as the number one external threat to Indonesia'€™s policy makers next year.

'€œThere will be a shock,'€ warned Wei, a professor of economics and finance at Columbia University in New York, who was appointed the ADB'€™s chief economist on Aug. 6.

'€œA US interest rate increase could cause global release of capital out of emerging markets, including Indonesia, back to the US,'€ he explained.

When asked what was his major concern about Indonesia'€™s economy, Wei replied that the country was particularly vulnerable to a tighter global liquidity environment due to its capital-flow structure.

A large fraction of financing in Indonesia'€™s external balance still came from short-term portfolio investments instead of long-term foreign direct investment (FDI), Wei noted.

While witnessing a widening deficit in its current account, Indonesia posted a US$4.3 billion surplus in its balance of payments for April-June, thanks to the hefty $14.5 billion surplus in its capital account.

From the capital account surplus, portfolio investments, which comprise '€œhot money'€ funds stashed in stocks and bonds, hit $7.7 billion, while FDI stood at $4.8 billion.

'€œCertainly, I would say economically that the capital flows structure is something to watch out for,'€ Wei said. '€œIn case foreign investors stop financing the current-account deficit, what would you do?'€

The Federal Funds rate, a benchmark interest rate in the US, currently stands at a record low of 0 to 0.25 percent, with US Federal Reserve chairwoman Janet Yellen already signaling the possibility of hiking it next year, in line with the positive progress in the US'€™ economic recovery.

Bank Indonesia (BI) Governor Agus Martowardojo has estimated that the benchmark US rate could be lifted to around 1 percent by the end of next year, a move that would make US assets more attractive due to their higher returns, triggering portfolio outflows from emerging economies.

'€œBeyond monetary and fiscal policies, I would stress [the need for] prudential policies that can make both banks and financial institutions better able to deal with the reversal of capital flows and rising interest rates,'€ Wei continued.

Finance Minister Chatib Basri has also identified a Fed Funds rate hike as the greatest risk facing Indonesia'€™s economy next year, as it could potentially weaken the rupiah and deviate macroeconomic assumptions, weakening the fiscal balance.

The rupiah is expected to trade at 11,900 per US dollar throughout next year, according to the proposed 2015 state budget.

The markets were more pessimistic, however, in their rupiah forecasts, given the possibility of tighter global liquidity due to a hike in the Fed Funds rate. France-based BNP Paribas forecast the currency would weaken to 12,800 per dollar by the end of next year, while Japan-based Nomura saw it falling to 12,700.

Last year, the rupiah was included as one of US-based Morgan Stanley'€™s '€œFragile Five'€ '€” namely, the currencies most vulnerable to outflows due to the country'€™s dependence on foreign funds to finance its current-account deficit.

'€œWith the current-account deficit likely to remain around 3 percent for 2014, we believe macro-rebalancing pressures have not gone away,'€ Morgan Stanley analysts Deyi Tan and Zhixiang Su wrote in a note released last week.

At the moment, policy adjustments to soothe the macro-rebalancing pressures in Indonesia were still behind the curve, they added.