The stock market stabilized again on Tuesday after a 4.21 percent decline in the Jakarta Composite Index on Monday.

This development simply reflects the risk of market volatility inherent within the torrent of short-term, foreign capital inflows into the financial market, which were credited in part for the 46 percent growth in the Indonesian stock exchange last year.

Those who have poured tens of billions of dollars in short-term or “hot” money into the financial market here since last August are mostly skittish investors who could fly out of the country at the slightest sign of a problem.

The main trigger of the steep fall that brought down the index to 3,478.55 on Monday was the concern among foreign investors over the strong inflationary pressures over the past three months. Traders said foreign investors sold a net Rp 1.63 trillion (US$181 million) worth of shares during the day, bringing their cumulative unloading to Rp 3.16 trillion over the last three days.

Analysts blamed the investor jittery on Bank Indonesia’s decision last week to maintain its policy rate at 6.5 percent, the level maintained since August 2009, despite the 6.96 percent inflation throughout last year or 100 basis points above its inflation target.

The central bank argued since the inflation was caused mainly by sharp food price-rises due to supply disruptions — hence not related to the demand side — it did not see any urgent need to raise its benchmark interest rate.

However, the market, shocked by the high inflation, had expected at least a slight rate increase, also in anticipation of stronger inflationary pressures from planned fuel-price increases within the next few weeks and the upward trend in rice prices until the next harvest begins in March.

The central bank is really in a dilemma. Raising rates can further encourage hot capital inflows to take benefit of the higher interest rate differentials and to make currency bets.

Analysts argue that hiking the rate early in an inflation cycle indicates fewer rate increases later on. Moreover, the risk of a sudden, massive capital flight has been decreased after the central bank put in place a set of new rules to ensure a more orderly outflow. Banks also have been obliged to hold more foreign exchange in reserves.

These measures and the fact that quite a portion of the short-term foreign funds have been invested in medium- and long-term government bonds  should have made the central bank confident in raising its rate by 25 basis points as  a strong signal to the market.

But Bank Indonesia’s persistent reluctance to raise rates against the money tightening in Malaysia, Thailand and Singapore, has made foreign investors jittery about upcoming developments in Indonesia’s economy.

The falling stock prices are a crude expression of investors’ concern about our future economic outlook, though subject to reversal the next day if the news turns positive.

The market perception now is that the government fiscal policy and the central bank’s policy management have not adequately addressed the increasingly strong inflationary pressures.  

Investors may determine each day how much their holdings are worth from the market prices and it is this basic elasticity in the value of financial assets that allows financial markets sometimes to become uncoupled from the economic fundamentals.

Certainly, the government should address the market concern by demonstrating a stronger commitment and better policy coordination to check inflation.

But to a certain extent, the price fall on Monday was good for long-term stability because the skyrocketing prices during the second half of last year were partly fueled by speculative sentiment.

These prices are now seeking their new equilibrium level.

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