Be Wary

AFP PHOTO/BRYAN R. SMITH

The closing numbers are displayed after the closing bell of the Dow Industrial Average at the New York Stock Exchange on August 1, 2018 in New York. Wall Street stocks finished mixed, with the Nasdaq lifted by strong Apple results while trade-war fears weighed on the Dow.

"Every time short-term capital flows into emerging economies, the financial markets become vibrant. Then the policymakers cheer: investors love our country, this time the situation is different. Whereas in fact, this is the beginning of a financial crisis."

I remember a recent conversation with economist Carmen Reinhart. I was silent, as there was truth to his words.

Under pressure

And in the present day, Indonesia is under pressure. Will the pressure continue? What should we do? To answer this, there are several things that need considering.

First, the world economy is currently moving towards a "new normal". The 2008-2009 global financial crisis forced the US Federal Reserve (the Fed) to adopt quantitative easing (QE) by pumping liquidity. As a result, the US interest rate reached a low of 0.25 percent, which triggered capital inflows to emerging markets (EM), including Indonesia.

A relatively high number of investors pursued returns in emerging markets was. However, this was only temporary. When the US economy began to improve, the Fed began normalizing its monetary policy. The Fed rate is expected to return to pre-QE rates, possibly within the range of 3-3.5 percent. It is currently at 2 percent.

If this process is gradual, the impact is limited. However, this does not seem to be the case. Why? In December 2017, the US Congress approved the tax deduction policy. As a result, US budget deficits rose, projected at more than US$1 trillion for 2019. US President Donald Trump must finance his deficit with bond emissions. It can be expected that bond yields in the US will increase significantly, which will in turn encourage the Fed to accelerate its interest rate hikes.

Not only that, fiscal expansion from tax cuts has occurred at a time when the US is approaching full employment (maximum production capacity). It can be imagined that demand will rise, even as production capacity is limited. As a result, inflation will rise. There is no other option but for the Fed to accelerate its interest rate hikes. Is it possible for the Fed to delay increases to the interest rates? The answer is yes, but only if US inflation does not increase or if the US faces recession (I see this potential in the medium to long term).

Second is the capital outflow, especially in countries with large current account deficits that are financed by portfolio investments. In a free foreign exchange regime like Indonesia, the options for Bank Indonesia (BI) are limited: allowing the rupiah to weaken, raising the interest rates, or a combination of both. BI decided on the final option, and raised interest rates by 100 basis points (bps) and accepted a weaker exchange rate.

We need to appreciate BI and the government. Why? Not many people are aware that the exchange rate pressure could have been far worse if BI did not raise its interest rates and fiscal management was not properly maintained as it is today. Imagine if this situation happened in 2015-2016, when our fiscal risks were so large due to unrealistic tax targets and a budget deficit approaching 3 percent. The market then would punish us, as has happened in Turkey or Argentina. At present, the rupiah depreciation is around 7 percent, lower than India, Brazil or South Africa, because of the relatively good response.

However, I want to point out that the US normalization is not yet over. This year, the Fed will likely raise its interest rates twice more, then three more times in 2019. Moreover, the threat of the US-China trade war will worsen the situation. The prospect for Indonesian exports could be disrupted, let alone on the back of the weakening renminbi. In short, we will still face rupiah pressure and fluctuations afterward, as well as increases to the interest rate.

The impact will be visible at the end of 2018 and 2019. Moreover, inflationary pressures will begin to increase at the yearend due to the rising prices of imported goods. In this context, employers must choose between imposing increases on consumer prices or withhold the price increases – which means reducing profit margins – or a combination of both. So now the business world is under pressure.

Third, how do we counter this? The most common answer is to improve the current account deficit. Of course this is true, but it is not enough. As I have written, in the 1980s and 1990s, Indonesia experienced a substantial current account deficit, yet the economy remained stable. Australia, Canada and New Zealand had large current account deficits, yet they were not vulnerable to fluctuating capital flows. Why? An excessive current account deficit actually does not pose a danger as long as it is financed by foreign direct investment (FDI) in the export sector, especially manufacturing, and not foreign portfolio investment (FPI). External financing in the form of a portfolio – especially a short-term one – causes volatility.

The calculation I made shows that FPI has a much higher coefficient of variation (CV) – meaning that it fluctuates more – than an FDI. This can be imagined if the current account deficit and budget are dominated by FPI financing. Look at Indonesia: around 25 percent of the government\'s budget deficit is financed through global bonds (owned by foreign investors), the remaining 75 percent are rupiah bonds. However, 35-40 percent of rupiah bondholders are foreign investors. This means that half or more of our budget deficit financing sources come from FPIs. So when there is a shock in the US, foreign investors leave Indonesia. As a result, our financial markets are highly vulnerable and volatile.

Solution

So what is the solution? Pursue financial deepening by encouraging more funding sources from local investors to decrease the proportion of external financing. Give incentives, so that state-owned enterprises (SOEs), pension funds, insurance and haj funds invest in government bonds and sukuk. Expand retail bonds or private placements. Apply the reverse Tobin tax.

If short-term capital inflows are taxed in the Tobin tax, in the reverse Tobin tax, the government offers tax incentives when investors do not repatriate profits but instead reinvest them.

In addition, create financial market instruments or products so that Indonesians or Indonesian exporters have the option to place portfolio investments in foreign currencies in the country (onshore). It is better for Indonesian exporters or investors to invest in onshore rather than offshore foreign currencies. This will help increase the domestic supply of dollars.

Of course, the most important step is to improve the current account deficit by increasing productivity and competitiveness, and not by withholding imports. Why? Because 90 percent of our imports are capital goods and raw materials. If imports are suddenly withheld, production, including production for exports, will be disrupted and the economy will be impacted. Remember that increasing productivity takes time, so too with the import substitution industry. One of the quickest solutions to increase exports is to revise the Manpower Law to enable the labor-intensive export manufacturing sectors to start moving again.

The short-term solution? Prioritize infrastructure projects. Decide which projects are an immediate need, and the others can be postponed to the following year. This must be done because the import volume is very large.

What else? Last week, BI announced that our current account deficit swelled to 3 percent in the second quarter. One of the main causes: oil and gas.

The deficit in the oil and gas balance needs to be redressed by increasing fuel prices. Experience shows that subsidies encourage smuggling due to price disparities. Fuel subsidies also encourage the migration of non-subsidized fuels to subsidization. As a result, imports soar. Increasing fuel prices will reduce the deviation. Moreover, increased fuel prices and electricity tariffs will also reduce the burden on state-owned oil and gas company Pertamina and state-owned electricity company PLN.

In turn, this will reduce fiscal risks from the failure of SOEs to pay or from contingent liabilities (the burden that arises due to problems in SOEs). This will calm the market. When fuel prices are raised, compensate the social assistance.

What must also be considered is the burden of LPG subsidies. Unfortunately, this solution is not politically possible, let alone in the midst of the populism ahead of the general election.

The government\'s measures to reduce the fuel imports with bio-diesel must be appreciated. However, this is not new. In 2013, I tried to do it, but implementing it is not always easy. Hopefully, it will work this time.

Another solution is to develop tourism. Tourism is a realistic short-term solution. It also creates jobs.

Unfortunately, time is not with us. In the next few months, we will be busy with the general election. In the midst of this hustle and bustle, I want to stress that we will be facing very serious economic problems in two years. And there will be no room for us to say, "This time, it is different."

Muhammad Chatib Basri, Lecturer, Economics and Business School, University of Indonesia; Co-founder, CReco Research