anwar nasution the surge of short term capital inflow

8/13/2019 Anwar Nasution The Surge of Short Term Capital Inflow

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The Surge of Short-Term Capital Inflowsand Indonesian Economy Dr. Anwar Nasution, SEADI Project

June 16, 2011


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After suffering from a deficit in 2008, the BOP of Indonesia turnedto a surplus since Q1-2009 because of surplus in both currentaccount and capital and financial account (Table 1);

The surplus in current account is partly because of export boomdue to increasing demand for energy, primary commodities andfood in high-growth China and India;

Except in 2005 and 2008, the amount of portfolio investment islarger than that of long term (FDI);

Inflows of short-term capital are mainly through portfolio

investment and corporate sector rather than banks. Banks aresubject to foreign exchange Net Open Position at 20 percent oftheir capital;

Short-term capital inflows are attracted by a relatively high growthrate of the Indonesia economy and high interest rate disparitybetween Indonesia and international markets (Graph-1). 2

BOP Surplus


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Table 1. Indonesia: Balance of Payments, 2005 - 2010 (billions of USDunless otherwise stated)

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Table 1. Indonesia: Balance of Payments, 2005 - 2010 (billions of USD unless otherwise stated)

2008 2009 2010 20112005 2006 2007 2008 2009 2010 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

Balance of payments 0.6 13.9 14.1 -1.8 10.4 30.3 1.0 1.3 -0.1 -4.2 4.0 -1.0 3.5 3.9 6.6 5.4 6.9 11.3 7.7

% GDP 0.2 3.8 3.3 -0.4 2.1 4.3 0.8 1.0 -0.1 -3.8 3.5 0.8 2.4 2.6 4.0 3.1 3.8 6.1 4.0

Current account 0.3 10.9 10.5 0.3 10.2 6.3 2.8 -1.0 -0.9 -0.7 1.8 2.5 2.2 3.7 2.0 1.8 1.3 1.1 1.9

% GDP 0.1 3.0 2.4 0.1 2.0 0.9 2.3 -0.7 -0.6 -0.6 1.6 1.9 1.5 2.4 1.2 1.0 0.7 0.6 1.0

Goods balance 17.5 29.7 32.8 22.9 34.5 31.1 7.5 5.4 5.8 4.2 6.2 8.4 8.5 11.4 8.8 8.6 9.1 9.2 8.4

Services balance -9.1 -9.9 -11.8 -12.7 -13.8 -9.5 -3.0 -3.3 -3.2 -3.3 -2.5 -3.3 -3.5 -4.5 -3.6 -3.4 -3.9 -2.8 -2.2

Net income & transfers -8.1 -8.9 -10.4 -9.9 -10.5 -15.3 -1.7 -3.1 -3.5 -1.6 -1.9 -2.6 -2.8 -3.2 -3.2 -3.4 -3.9 -5.3 -4.3Capital & financialaccount 0.3 3.0 3.6 -2.1 4.4 26.2 -1.4 2.5 0.9 -4.1 2.4 -1.8 2.5 1.3 4.8 4.4 6.5 9.6 6.2

% GDP 0.1 0.8 0.8 -0.4 3.2 3.7 -1.2 1.9 0.6 -3.7 2.1 -1.4 1.7 0.8 2.9 2.5 3.5 5.2 3.3

Direct investment (net) 5.3 2.2 2.3 2.0 4.2 9.8 -0.3 0.6 0.4 1.3 2.7 0.4 0.5 0.6 2.3 2.0 2.5 4.2 3.0

Inflows 8.3 4.9 6.9 7.9 6.4 12.7 1.5 2.0 1.9 2.5 3.5 1.4 1.0 0.5 2.9 3.3 3.4 4.3 4.5

Outflows -3.1 -2.7 -4.7 -5.9 -2.2 -2.9 -1.7 -1.4 -1.5 -1.2 -0.8 -1.0 -0.5 0.06 -0.6 -1.3 -0.9 -0.1 -1.5Portfolio investment

(net) 4.2 4.3 5.6 1.7 10.3 15.2 2.0 4.16 0.04 -4.5 1.9 1.9 3.0 3.5 6.2 1.1 6.1 1.4 3.6Assets, net -1.1 -1.8 -4.4 -1.3 -0.1 -0.5 -0.8 0.06 -0.06 -0.5 0.1 0.4 -0.3 -0.3 -0.4 -0.1 -0.1 -0.4 -0.6

Liablilities, net 5.3 6.1 10.0 3.0 10.4 15.7 2.8 4.1 0.1 -4.0 1.8 1.5 3.3 3.8 6.6 1.2 6.2 1.8 4.2

Other investment -9.4 -3.8 -4.8 -6.2 -10.1 1.2 -3.2 -2.3 0.4 -1.1 -2.3 -4.1 -0.9 -2.8 -3.7 1.3 -2.1 3.8 -0.3

Government -0.8 -2.5 -2.4 -1.4 1.5 -0.2 -0.4 -1.5 -0.1 0.5 -0.1 -2.0 3.1 0.5 0.1 -0.9 -0.4 1.4 0.1

Private -8.6 -1.3 -2.4 -4.7 -10.3 1.4 -0.6 0.3 0.2 -1.5 -0.9 -2.1 -4.0 -3.3 -3.8 2.2 -1.7 2.4 -0.4

Reserves 34.7 42.6 56.9 51.6 66.1 96.2 59 59.5 57.1 51.6 54.8 57.6 62.3 66.1 71.8 76.3 86.5 96.2 105.7

Sources: Bank Indonesia. Indonesia Financial Statistics , various issues

Bank Indonesia. Indonesia Balance of Payments Report , various issues

IMF. International Financial Statistics, various issues


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Graph 1. Interest Rate Disparities

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Graph 1Interest Rate Disparities

INA-JPN

INA-SGP

INA-USA


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The surge of short-term capital inflows and surplus in BOPhave :i. caused upward pressures on the Rupiah appreciation both in

nominal and real terms;ii. driven asset prices bubbles in the narrow and shallow

financial markets;iii. encouraged excessive risk taking by domestic corporate

sector and banks that borrow from overseas and;iv. eroded monetary autonomy to manage exchange rate,

interest rate and attain the inflation targeting. Graph 2a shows that NEER of the Rupiah appreciated by 7.03

percent between June 2005 and June 2010 while its REER erodedduring the same period (Graph 2b).

The strengthening of the Rupiah has caused the Dutch disease toIndonesian economy. 5

Appreciation of the Rupiah


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Graph 2aNominal Effective Exchange Rate

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Nominal Effective Exchange Rate, 2005-2010

NEER Rupiah

NEER RMB


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Graph 2bReal Effective Exchange Rate (REER)

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Real Effective Exchange Rate 2005 - Apr 2011

REER Rupiah

REER RMB


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Costs of the Dutch disease

There are four costs of the Rupiah appreciation to Indonesiaeconomy, namely:

erodes external competitiveness of the economy. Competitiveness of Indonesiaeconomy further eroded due to undervaluation of the Chinese RMB, inadequatinfrastructure and bad investment and business climate;

reduces efficiency of the economy as the stronger Rupiah provides incentive fomobility of resources from more productive traded sector economy to lessproductive non-traded sector. The shift ignites bubble of assets including landand property markets. Traditional policy instrument such as high interest ratemay dampen the bubble but exacerbate the imbalance and capital inflows;

creates regional disparity as the booming natural resources are mainly producedoff Java island while the affected agriculture and manufacturing sectors areprimarily located on the labor surplus island of Java;

make financial system less efficient and encourage them to take excessive risks

as their source of funding are more relied on seemingly low cost foreignborrowin s.


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Limited Capability To Sterilize And Control The Capital Inflows

Partly due to the narrowness and shallowness of Indonesias money andcapital markets and their less integration with global markets, BankIndonesia alone has a limited capability to either:i. reduce the volume of capital inflows;ii. alter the composition of capital flows towards longer maturities;

iii. reduce the exchange rate pressures to avoid the Dutch disease;iv. maintain independent monetary policy.

In addition, the financial costs of sterilization operation are also high for thcentral bank as well as the opportunity costs for the whole economy. BI

buy the foreign currency by issuing SBI at 6.75 percent interest rate andinvest the reserve mainly in the US Government bonds that earn very lowyields at 3 percent. The high opportunity costs are the forgone returns ondevelopment projects, including infrastructure.

Another issue associated with portfolio in foreign currencies is the potentialosses from currenc a reciation.


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Under the IMF Program in 1997-2003, Indonesia shifted to independentfloating in 1997, supported by inflation targeting as a monetary policyoperating strategy. This means that an exchange rate target is no longerused as a nominal anchor for monetary policy.

In theory, flexible exchange rate requires a smaller war chest of foreign

reserves as the system reduces the need for market intervention. Theneed for self-insurance is also reduced with the availability of credit incase of need after the revision of the IMF conditionality, multilateralizationof Chiang Mai Initiative and bilateral currency swap agreements betweencentral banks.

In reality, for a number of reasons, Indonesia and other Asian countriesaccumulating large international reserves following the Asian financialcrisis in 1997-98. Table 1 shows that during the past ten years, 2000-2010nominal value of the reserve position of Indonesia has risen more thandouble, although the percentage share of GDP has gone down from 15percent of GDP in 2003 and 12 percent in the second quarter of 2010(Table 2).

Accumulation of Foreign Exchange Reserves


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Table 2 - Foreign Reserve and Currency in Circulation,1998-2011

Year Foreign Reserve as % of Currency in Circulation as %

of

Inflation

(%)

Short-

RunInterestRate (%)

MB PSD SBI GDP MB PSD GDP

1998 316.8 - 556.4 24.9 64.57 - 5.08 59.55 39.681999 208.8 - 337.1 19.32 71.29 - 6.6 2.13 12.522000 197.1 - 414.1 17.81 71.41 - 6.45 8.99 13.592001 225 - 518.3 17.46 71.42 - 5.54 11.91 17.852002 215.8 - 386.9 16.37 71.19 - 5.4 9.62 12.452003 187 38.58 295.4 15.46 67.73 13.97 5.6 4.4 8.552004 162.8 80.74 316 14.14 63.62 31.56 5.53 6.23 7.422005 140.5 84.28 466.5 12.15 60.42 36.23 5.22 16.21 13.442006 131.3 93.15 188.1 11.68 60.11 42.64 5.35 6.41 9.63

2007 137.1 108 212.1 13.17 58.17 45.81 5.59 6.41 7.792008 145.3 94.32 282.5 10.12 76.7 49.79 5.34 11.16 11.492009 170.8 112.8 277.2 12.24 69.39 45.81 4.97 2.75 6.72010 168.7 153.36 437.00 13.61 50.19 45.64 4.05 6.96 6.06

2011* 186.2 155.3 415.7 14.9 47.02 39.22 3.76 5.98 6.10Sources: Indonesia Financial Statistics , various issues; International Financial Statistics , May 2011 issue. Notes: MB = Monetary Base; PSD = Public Sector Debt which is the total of government bonds plus Treasury Bills (data for 1998-2003 are not available), and

Shariah Base Government Bonds issued in international market; SBI = Bank Indonesias Certificate; GDP = Gross Domestic Product; Short -Run Interest Rate =JIBOR 1 Month*Data MB, PSD, SBI using April data; GDP denominator using GDP data in 2010; Inflation using May data; interest rate and currency using Feb data


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Fear of Floating (1)

There are least four reasons why emerging economies, includingIndonesia, accumulating large international reserves (Calvo andReinhart, 2000 and Ruiz-Arranz and Zavadjil, 2008).

First, as tools for intervention in the exchange market to avoidlarge exchange rate fluctuations and prevent adverse impacts on

their economies. Graph 3 shows large proportions of both theRupiah denominated SBI and SUN (government bonds) owned byforeign investors. This is because domestic institutional investors(such as insurance companies and pension funds) are at the earlystage in Indonesia. Unlike in Japan, Indonesia has no Postal

Savings that can mobilize low cost domestic saving to absorb thesovereign bonds. The second biggest holders of SBI and SUN arethe domestic bank.

The crises at the peripheries of the euro zone indicates thatsecurities denominated in domestic currencies are shielded fromcurrency risk but not from interest rate risks.


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Graph 3Foreign Ownership of SUN and SBI

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Foreign Ownership of Government Bonds (SUN) and SBI(in billions Rupiah)

SUN

SBI

Sources: Indonesia Financial Statistics , various issues


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The second reason for accumulating foreign exchangereserves is to prepare for a defense against speculativeattack and foreign exchange instability due to shortfallsin exports and capital flow reversals.

Third, the less volatile exchange rate minimizescurrency risks and provides incentives for overseasborrowing, particularly when international interest ratesare lower than domestic interest rates.

The fourth reason is to provide for a fiscal space whenfacing economic crisis. Because they were treated badlywhen they sought help during the crisis in 1997, Asiancountries are quite reluctant to turn to the IMF.

Fear of Floating (2)


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Tools For Controlling And Mopping Up Short-Term Capital

There are three groups of tools have been used by BankIndonesia and government to indirectly discourage and mopup capital inflows, namely: regular prudential rules of the banking system; market instruments to influence interbank money market

and to do sterilization operation by buying foreign currencyto accumulate foreign exchange reserves;

non-market instrument; The first group of policy instruments include

i. reserve requirement ratioii. NOP (net open position), which is now 20 percent of

bank capitaliii. limiting LDR (loan-to-deposit ratio) to raise cost of

banking operation funded by foreign borrowings.


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For a number of reasons, reserve requirement gained popularity in emergingeconomies with narrow and shallow money and capital markets, such asIndonesia.

The first reason is because the reserve requirement system can be effectively usedto reduce the volume of capital inflows and to alter their composition towardslonger maturities. To control capital inflows, in 1990, Chile imposed 20 percent

non remunerated reserve requirement to be deposited at the Central Bank for aperiod of one year on liabilities in foreign currency for direct borrowing firms. Second, because it can be used as a tool to slow down the growth of bank credit.

For this objective, BI raised the reserve requirement ratio of Rupiah deposit from 5% to 7.5% in 2008 and now 8 percent.

Third, it can complement monetary policy as raising reserve requirement is asubstitute for raising interest rates to dampen bubble in the real estate sector.

Fourth, the reserve requirement can be used to contain liquidity risks particularlyduring the downswing.

On the negative side, however, the reserve requirement taxes the banking systemthat encourages market disintermediation.

To ease the financial cost of the reserve requirement, starting from 2008, BI offersremuneration at below market interest rate.

Reserve Requirement


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Market Instruments (1)

The market based tools at BI disposal are: SBI (Bank Indonesias certificate of deposits); FASBI, remunerated overnight placement of

banks excess liquidity at the central bank; FTO (fine tuning operations).

SBI is the primary money market instrumentavailable for open market operation to sterilize the

short-term capital inflow. The maturities of SBIs areranging from 1 month to 12 months.


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Market Instruments (1)

To prolong placement of short-term capitals inIndonesian securities, BI requires to hold SBI atleast for 1 month. In addition, the central bank stopissuing SBI for 1 and 3 months and replace themwith term deposits with same maturity;

At present, Indonesia has neither put a limit onaccess of foreign investors to domestic securitiesnor imposed taxes on foreign capital inflows nor exit

levy on capital outflow. The proportion of government bonds (SUN), T-bills,SBI and FASBI to monetary base and GDP are,respectively, shown in Table 3 .


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Table 3 Money Market Instruments, 1998-2009

Year

FASBI as % of SBI as % of

Government Bonds

T-Bills as % of as % of

MB PSD GDP MB PSD GDP MB PSD GDP MB PSD GDP

1998 - - - 56.93 - 4.47 - - - - - -

1999 - - - 61.94 - 5.73 - - - - - -

2000 15 - 1.36 47.59 - 4.3 - - - - - -

2001 11.3 - 0.88 43.4 - 3.37 - - - - - -

2002 25.77 - 1.96 55.78 - 4.23 - - - - - -

2003 17.72 3.66 1.46 63.31 13.06 5.23 242.4 50 20.04 - - -

2004 25.94 12.87 2.25 51.51 25.55 4.47 201.6 100 17.51 - - -

2005 23.86 14.31 2.06 30.13 18.07 2.6 166.8 100 14.41 - - -

2006 13.99 9.93 1.24 69.81 49.53 6.21 141 100 12.54 - - -

2007 12.89 10.15 1.24 64.63 50.91 6.21 125.9 99.13 12.09 1.1 0.87 0.112008 1.23 0.8 0.09 51.44 33.39 3.58 151.2 98.11 10.52 2.9 1.89 0.2

2009 8.21 5.42 0.59 61.62 40.68 4.41 141.8 93.61 10.16 6.14 4.05 0.44

2010 17.76 14.96 1.43 38.60 32.51 3.11 112.97 95.16 9.12 5.75 4.84 0.46

2011 4.18 3.35 0.33 44.79 35.81 3.58 119.90 95.86 9.59 5.17 4.14 0.41Sources : Indonesia Financial Statistics , various issues

Notes: MB = Monetary Base; PSD = Public Sector Debt which is the total of government bonds plus Treasury Bills (data for1998-2003 are not available); SBI = Bank Indonesias Certificate which is the total of SBI 1 month, 3 month, and 6 month; GDP =Gross Domestic Product


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Long-Term Sovereign Bonds

The government began to issue long-term bonds in 1998and a small amount of short-term Treasury bills (T-bills)in 2007.

The long-term government bonds issued in 1998-2000

were mainly for recapitalizing the collapsed domesticbanks during the Asian financial crisis in 1997-98. Smallamount of the bond was used for financing budget deficitthat has been controlled between 1 to 2 percent of

GDP. Indonesia reenter international bond markets in2004 and Samurai bond market in 2008. The law bans BI to buy long-term government bonds in

primary market. They are also not being used by the

central bank as an instrument for OMO.


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In 1987 and 1991 the Minister of Finance gaveorders to transfer large amounts of deposits ownedby the government agencies and large state-ownedenterprises at state-owned banks to central bank.

The transfer immediately reduced stock of monetarybased without cost to the central bank.

At that time, government sectors deposits at centralbank were unremunerated. The cost of suchoperation was borne by the owners of the depositsand the banks that lost funding. Such a non-marketintervention affects the efficiency of resource

allocation.

Non-Market Instrument


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Balance Sheet of Bank Indonesia

As shown in Table 4, there are two major items on the asset side ofcentral banks balance sheet, namely: foreign exchange reserves, and domestic credit of the central bank to (a) buy government

securities; (b) provide loans and discounts to commercial banksand (c) others.

The are three kinds of central bank liabilities, namely: monetary liability, which is currency in circulation. By law the

central bank has a monopoly right to print money and receives

seigniorage from it, which is the difference between the face valueof the money and its production cost; non-monetary liabilities such as central bank securities (SBI). The

central bank pays interest on its securities; deposits owned by (a) the government, (b) commercial banks

(including required reserves and excess reserves) and (c) others.

bl


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Table 4Bank Indonesias balance sheet

Assets (Sources of Monetary Base) Liabilities (Uses of Monetary Base)

Foreign Exchange Reserves Currency in circulation

Domestic credit Central bank securities (SBI)

Government securities Deposits

Loans and discounts to banks Government

Net other assets Commercial banksOthers

Equity capital

Monetary base (sources) Monetary base (uses)

I f ili i i BI b l h


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Sterilization operation of BI alters the composition ofits balance sheet. It buys foreign currency either bycrediting commercial banks balance sheet at BI orissuing new Rupiah, the domestic currency. To mop

up the liquidity BI selling SBI, the main monetaryinstrument at its disposal.

At the end of transaction, the stock of both foreignexchange reserve and SBI increase by the sameamount. In the process, BI exchanges SBI, its highcost interest bearing non-monetary liability, withforeign currency assets that, at present, earn much

lower yields.

Impacts of sterilization operation on BIs balance sheet

E i C f S ili i O i


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Expensive Cost of Sterilization Operation

Graph 4 shows the rising cost of financial costs of openmarket operation for BI as it mops up more liquidity.

The central bank has to: issue more interest bearing security (SBI); pay interest rates to larger amounts of FASBI and FTO; invest more in foreign portfolio that earns low returns.

The decline in the exchange value of the US dollarfurther reduces the earnings from portfolio denominatedin that currency;

sell foreign currencies at lower rates. The larger financial losses from holding bigger foreign assets

negatively affect liquidity position of the central bank that mayerodes the equity capital of BI from the minimum Rp2 trillion.

E i C Of S ili i


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In 2009, Bank Indonesia suffered from losses ofRp1.1 trillion as compared to a surplus of Rp28trillion in 2008. Around 73 percent of BankIndonesias outlays in 2009 was for monetary

operation, around 13 percent each for paymentsystem and general expenses and the other 0.5percent for bank regulation and supervision.

The central bank law says that the governmentinjects additional capital to meet the minimum capitalrequirement.

Recapitalization, however, tarnishes reputation and

independency of the central bank.

Expensive Cost Of Sterilization

G h 4


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Graph 4Increasing cost of OMO

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OMO Outstanding, 2000 - Apr 2011(in billions Rupiah)

FTOSBIS/Wadiah

FASBI

SBI 9 bulan

SBI 6 bulan

SBI 3 bulan

SBI 1 bulan

Sources : Indonesia Financial Statistics , various issues

R d ti


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There are a number of policies can be introduced toalter capital flows composition towards longermaturity, such as:

i. privatization of infrastructure to allow private sector

participation (PPP) in this sector;ii. to issue long-term bonds for financing

modernization and expansion of the existinginfrastructure facilities such as electricity, road,seaport, airport, drinking water and wastetreatments;

iii. to establish Export Processing Zones (EPZ)particularly on Java to create employment for thesurplus uneducated and unskilled labor force.

Recommendation

R f


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References:

Bergsten, Fred C.2010. A Proposal Strategy to Correct the ChineseExchange Rate, Testimony before Hearing on the Treasury DepartmentsReport on International Economic and Exchange Rate Policies. Committeeon Banking, Housing and Urban Affairs, US Senate. September 16.

Calvo , G . And C.M. Reinhart. 2002. Fear of Floating. Quarterly Journal ofEconomics. 117:379-408.

Cecchetti, Stephen G and Piti Disyatat . 2010. Central Bank Tools andLiquidity Shortages. Federal Reserve Bank of NY Economic Policy Review .16(1): 29-42.

Gochocco-Bautista, Maria S, J. Jongwanich and J-W. Lee. 2010. HowEffective are Capital Controls in Asia? . ADB Working Paper Series No. 224.October.

Rodrik, Dani . 2010. Making Room for China in the World Economy. Papersand Proceedings of the 122 Annual Meeting of the AEA, Atlanta, Ga.,January 4-6, 2010 . AER : 89-93.

Ruiz-Arranz, Marta and Milan Zavadjil. 2008. Are Emerging Asias ReservesReally Too High? IMF Working Paper. No. WP/08/192. August.

Schaechter, Andrea. 2001. Implementation of Monetary Policy and theCentral Bank Balance Sheet . IMF Working Paper No; WP/01/149. October.


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Terima Kasih

anwar nasution the surge of short term capital inflow

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