Indonesia’s currency struggle has become very public of late.
Over the past three months, the rupiah has suffered a big drop against the US dollar. The fall, mirrored by the Indian rupee, followed US Federal Reserve indications at the end of May that it could soon start to phase out its quantitative easing (QE) programme that had kept bond yields so low across emerging markets.
The prospect of US economic recovery resulted in rapid and large-scale outflows from Indonesia’s domestic bond market, pushing the benchmark 10-year government bond yield up by 250 basis points (bp) in six weeks. It was at 8.725% as Asiamoney went to press.
Foreign investors recoiled further as it became apparent that Bank Indonesia (BI) had its head in the clouds as far as inflation was concerned. The country’s headline inflation for July came in at 8.6% year-on-year, well above the central bank’s 7.75% prediction.
The outflow of foreign capital worsened the country’s longstanding current account deficit, an issue it has failed to tackle in any seriousness despite years of economic growth. The deficit reached US$9.8 billion in the second quarter, from US$5.3 billion in the first.
As the current account worsened, it placed further pressure on the rupiah. By early September it had weakened to levels not seen since 2009, trading at IDR11,184 to the US dollar at press time.
The currency’s fall has occurred despite Bank Indonesia’s attempts to defend it, impacting on foreign currency reserves, which fell from US$98.1 billion in June to US$92.67 billion in July.
All of this has weighed on Indonesia’s economy. Gross domestic product (GDP) growth slowed from 6% year-on-year in the first quarter to 5.8% year on year in the second, while the budget deficit is projected to increase from 1.8% of GDP last year to 2.4% in 2013.
Indonesia risks falling into a vicious circle of negative sentiment.
Indonesia’s reaction
While capital outflows and a weakening currency sent India flailing throughout June and July, Indonesia seemed to deal with similar issues in a calm and appropriate manner.
The central bank hiked rates until the BI rate was at 6.5% and the overnight deposit (Fasbi) rate stood at 4.75% – a total of 75bp of hikes over two months. The market reacted well, as it appeared that policymakers were committed to financial stability.
Then on August 15, following a higher-than-expected inflation figure, the central bank left both key policy rates unchanged.
Authorities made it clear they were comfortable with the inflation target and a weaker rupiah. Central bank governor Agus Martowardojo and deputy governor Perry Warjiyo both told local press that by September the BI’s focus would shift towards tackling slowing growth.
The announcement must have relieved some political pressure. President Susilo Bambang Yudhoyono will step down from his position in less than a year and nobody in power is keen to implement measures that could reduce growth further before a competitive election.
But foreign investors were not pleased. Confidence that the central bank was committed to containing inflationary pressures dissipated, investors pulled more capital from the bond market and the currency weakened further.
Policy confusion
In a roundabout attempt to entice investors back to the market without having to hike rates, the government launched an emergency fiscal package on August 23. These policies were ostensibly aimed at deterring imports, promoting foreign investment and supporting the currency.
The scope of the package was varied, while the market’s reaction was muted. The benchmark Jakarta Composite Index ended the day down 0.04%, the rupiah strengthened 0.3% from IDR10,830 to IDR10,770 and government bond yields were unchanged.
A lack of any further movement, down or up, was largely due to confusion over the long-term impact of each measure, as well as the lack of clarity over policy direction.
“Addressing multiple objectives may lead to offsetting consequences. Accelerating infrastructure spending and boosting investment, for example, may help support growth, but will widen the current account deficit,” says Hak Bin Chua, South-east Asia economist at Bank of America-Merrill Lynch.
“Lifting the import quota for beef and horticulture products may help reduce food inflation but widen the current account deficit.”
Another reason for the market’s lukewarm response was that most measures are medium and long term. Many believe the government is unlikely to implement them before the 2014 election.
“We retain our bearish view on the rupiah after what could be judged as a damp-squib policy package from the Indonesian authorities to deal with external imbalances and IDR weakness,” says Euben Paracuelles, economist at Nomura.
Worse still, Paracuelles argues that the measures – many not yet fully explained – could create a further disconnect between the market’s perception of policy effectiveness and the central bank’s objectives.
This has the potential to scare investors, which is hard to reverse.
On the back foot
Bank Indonesia has finally taken note of deteriorating market sentiment.
It called an emergency meeting on August 29, hiking the policy rate and the Fasbi rate by 50bp, to 7% and 5.25% respectively, as well as raising the lending facility rate to 7% from 6.75% and signing an extended bilateral swap agreement with the Bank of Japan worth US$12 billion.
The question is whether these moves are too little, too late.
“Swap lines are activated only under extreme events. An activation signals desperation,” says Vaninder Singh, economist at RBS.
“Despite Bank Indonesia’s announcement, the country continues to face an unpalatable policy mix of slowing growth, high inflation, and an illiquid FX [foreign exchange] market,” says Prakriti Sofat, analyst at Barclays.
Despite raising rates, the central bank has conceded that it cannot contain price hikes. It has raised its inflation forecast to between 9% and 9.8% by year-end. That’s much higher than its July estimate of between 7.2% and 7.8%, but it’s probably still too optimistic. Many economists expect the figure to reach 10.5% at the beginning of 2014.
The rupiah could fall further. Previous commentary focused on the dangers of breaching the INR10,000 to the US dollar mark. Barclays estimates that the currency could reach INR12,000 in six months.
Risks ahead
Rising inflation and a weakening currency will only worry investors further, as will the fact that BI’s FX reserves are now dangerously low.
Reported FX reserves are US$92.7 billion. However, taking into account the central bank’s forward book, recent FX swap auctions and US-dollar term deposits, the usable figure is closer to US$81.9 billion, according to Nomura. This equates to 4.5 months’ worth of imports – one of the lowest reserve-adequacy levels in Asia.
Total financing requirements will rise from US$29 billion in the first half to US$39.5 billion in the second half, with limited room for FX reserve drawdowns.
Because of this, it is possible that the central bank will have to accept external help before year-end, according to Paracuelles.
“There are already a few existing backstops and regional swap-line agreements that provide buffers,” he says. “The contingent facility from the World Bank and other multilateral agencies, and the swap agreements under the multilateralisation of the Chiang Mai Initiative in 2010 provide about US$12 billion of external liquidity support.”
The country could also set up new bilateral swap agreements such as the recent one with Japan. The support should be sufficient for Indonesia to avoid a balance-of-payments crisis, but the experience is unlikely to be a relaxing one for international investors, who may retract further.
A clear path
The government and the central bank must prioritise outlining a clear path, says Andrew Colquhoun, sovereign director at Fitch Ratings, in an August 22 note entitled Policy Management is Key in India and Indonesia.
“Rapid private-sector credit growth, widening fiscal deficits or sustained higher inflation could lead to a broader and more sustained loss of confidence among investors,” he says.
“This could potentially undermine economic and financial stability, and ultimately lead to negative rating action. Conversely, demonstration by the authorities that they remain committed to managing policy consistent with sustainable growth would support credit profiles.”
The August 29 hike was encouraging, but BI needs to follow up with at least another 50bp of hikes before year-end to show its commitment to tackling inflation.
Finally, it should address the lack of transparency in Indonesia’s FX market, allowing for better price discovery. This is particularly important as the Fed is likely to begin QE tapering in September.
The central bank cannot afford to stray even for a moment until inflation is under control, FX reserves increase, and the volatility induced by a withdrawal of easy money from the global system has run its course.
Indonesia relies heavily on external investors. It must do everything in its power to retain their confidence.
