Rupiah and Growth

KOMPAS/PRIYOMBODO

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Cartagena is a city that is in no rush. Life seems to move without a deadline. It is quiet, yet colorful. Writer Gabriel García Márquez has described this city on the Colombian coast as “a place of amethyst afternoons and nights of antic breezes”.

However, a number of economists met last week in this unhurried city to discuss an issue that forces us to quicken our pace: the challenge of the international financial architecture.

Economist José Antonio Ocampo, on the board of governors of the Central Bank of Colombia, spoke about the importance of cooperation in macroeconomic policies, especially between large countries. He also discussed the importance of efforts to prevent financial crises. Roberto Junguito, the former Colombian finance minister, and José Dario Uribe, former covernor of the Central Bank of Colombia, spoke about the Latin American experience, particularly Colombia’s.

I was asked to present a view from the Asian perspective. The discussion was interesting, as it revolved around the experiences of Latin America and Asia in mitigating capital flow fluctuations. Emerging markets (EMs) have a long experience in this: the financial crisis in Latin America in the 1980s and 1990s, the Asian financial crisis in 1998, the 2013 taper tantrum (the US Fed’s tapering its quantitative easing program) and, of course, the current period.

Source of vulnerability

Why are several EMs in Latin America and Asia, including Indonesia, vulnerable to this upheaval? Almost all recent studies indicate that this fluctuation occurs in countries that have problems with their current account deficit and balance of payments. The crisis, or financial market turmoil, generally starts from a drastic influx of portfolio capital flows resulting from a decrease in the Fed’s interest rate, which seeks higher returns in EMs.

Short-term capital flows do indeed drive the emerging market economy (EME), but it is not sustainable. When the Fed normalizes its monetary policy by raising interest rates, it produces an outflow of capital. Financial markets are shaken and exchange rates fall, especially in countries with problems in current account deficit and balance of payments.

What is about the present condition? At Cartagena, Masahiro Kawai of the University of Tokyo showed that besides Argentina, Egypt and Turkey, conditions in EM countries were still relatively normal. These three countries have acute problems with current account deficit and inflation.

What about Indonesia? The rupiah depreciation is still normal, and actually not at its worst. The current account deficit is also in the 2 percent range against the gross domestic product (GDP), and inflation is below 4 percent. Therefore, there is no need for the market to panic.

However, we must be very careful. Harvard University’s Carmen Reinhart pointed out that the external debts of EM governments were relatively under control, but private sector debts were increasing and had the potential to become problematic. If private debts became problematic, then there is a risk that the government must bear them.

I am not smart enough to know the truth of Reinhart’s statement. I do not want to be that gloomy. However, it is wise to take note of her warning. On the other hand, we have seen that the yield on 10-year US Treasury bonds is continuing to rise and is even predicted to reach 4 percent by 2019. If this is true, the bond yields in Indonesia will increase substantially and perhaps force Bank Indonesia to prioritize stabilization above growth.

KOMPAS/DIDIE SW

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Stabilization or growth?

Here are several things that need to be discussed. First, I want to discuss the argument on current account deficit and balance of payments. Before the 1998 crisis, Indonesia frequently experienced a large current account deficit, but still the economy was stable. Australia had an average 3.2 percent current account deficit in 1959-2017, but was not affected by capital flows anyway. Why? The answer is that the current account deficit – and not the portfolio – was financed by foreign direct investment, especially in the export sector.

What is the difference? Direct capital is not easy to move, while portfolio investment can be moved quickly to cause turmoil in financial markets. Why the export sector? Because exports generate foreign exchange, so that when profit is repatriated, the balance of payments is unpressured by a currency mismatch. That explains why the economy is relatively stable even though the current account deficit is relatively large.

Presently, as I mentioned, the current account deficit is actually not too large. However, the financial markets are being pressured. Why? Because the capital inflow is unable to compensate for the deficit in the current account. As a result, the balance of payments has a deficit. Why are the net capital inflows relatively small? This was caused by the fast outflows of foreign capital since mid-2017 in anticipation of the US’s monetary policy. It means that the main cause of Indonesia\'s economic vulnerability to fluctuations in capital flow is its dependence on portfolio capital flows to finance its current account deficit.

In the case of Indonesia, panic is often triggered in the bond market due to the large role of foreign investors in financing the government’s budget deficit. Every time an external shock occurs, foreign investors release their portfolio investment in the bond market. As a result, the yields increase and the rupiah weakens, as in the capital market.

Second, to overcome this, the central bank usually undertakes a stabilization policy. This policy option is known as the impossible trinity, or the unholy trinity. In essence, it is impossible for a country to simultaneously implement three policies (stable exchange rate, free capital movement and independent monetary policy). The central bank must choose two out of the three.

In the case of Indonesia today, when we are following the free foreign exchange regime, the choice available to the central bank is between allowing the rupiah to follow the market (rupiah depreciation) and raising the interest rate. Of course the three can be combined, wherein the interest rate is raised slightly, the exchange rate is allowed to weaken slightly, and the policy regulating capital flows is restricted through a macroprudential policy.

In Cartagena, I disclosed that the effectiveness of fiscal and monetary instruments was often limited. If capital inflows or outflows are excessive, BI and the government will be forced to take a drastic combination of steps, such as in the 2013 taper tantrum. And that will impact growth.

Let us look at 2013. At that time, Indonesia, India, South Africa, Turkey and Brazil were categorized as the fragile five – the five countries that were vulnerable to capital fluctuations – because they had a high current account deficit. To prevent Indonesia from falling into the financial crisis that was triggered by the huge current account deficit, the government and BI were forced to cut fuel subsidies by increasing fuel prices by an average 40 percent; raising the BI rate by 200 basis points, and allowing the rupiah to follow the market. This policy combination was known as the expenditure reducing and expenditure switching policies. Indeed, within seven months, Indonesia – along with India – managed to stabilize its economy. The capital then started flowing in again, the current account deficit declined to this day and, along with India, Indonesia emerged from the fragile five category.

I remember The Economist published in February 2014 an article titled "Indonesia: Fragile No More". The New York Times ran an article in mid-2014 titled "Markets of the Once \'Fragile Five\' Countries are Now Soaring". Indonesia and India were praised. However, the turmoil reoccurred. In 2015, for example, the rupiah weakened to Rp 14,700 per US dollar on concerns over the normalization of the US monetary policy and fiscal risks due to unrealistic tax targets. In recent days, we have also witnessed pressure on the rupiah.

Third, in 2013 there was room for the government and BI to choose stability over economic growth. The reason was that economic growth was still above 6 percent then, so there was room to "accept" slower economic growth (growth fell from 6 percent in 2012 to 5.6 percent in 2013). Today, it is different: the economy is growing by only 5 percent. It can be imagined that if we applied a policy of the same dosage strength as in 2013, economic growth will fall below 5 percent. Here, the problem becomes more complicated.

Limited impact of stabilization

Fourth, stabilization policies have limited impact. They are not a long-term solution. If we do not resolve the root of the problem, then the capital flow fluctuations will recur. Therefore, economic reforms must be undertaken to increase productivity through improvements in human resources quality, infrastructure development and improved governance. The government has indeed started to take this step, but its effect will only be felt in the medium term.

Kompas

Muhamad Chatib Basri

Moreover, manufacturing exports should again be boosted through inviting foreign investment to export-oriented sectors, especially the manufacturing sector. This is possible only if the investment climate is improved. The government can also apply the reverse Tobin Tax. If short-term capital inflows are taxed under the Tobin Tax, then in a reverse Tobin Tax, the government provides tax incentives if investors reinvest their profits in the long term. Equally important is improving financial deepening in the bond and capital markets by increasing the role of domestic investors and savings.

Another policy alternative is to reduce short-term private foreign debts. The way to do this is by asking the private sector to assign a certain percentage of its foreign debts to be held in BI for a certain period of time (lockup period), for example, one year. This will increase the costs of short-term debts.

The situation is not simple, but we cannot stay gloomy forever. The turmoil has repeated. Last week’s meeting in Cartagena carried a message: We must hurry. There are no more purple afternoons and breezy nights. The world economy is not Márquez’s Cartagena.

Muhamad Chatib Basri, Lecturer, Economics and Business School, University of Indonesia