Bank Indonesia’s new governor has a lot on his plate.
Agus Martowardojo only stepped into his new position on May 24, a month after being unceremoniously shunted out of the finance minister role, yet already problems are piling up. How he handles them will impact the central bank’s image, and Indonesia’s economic strength.
The latter, in particular, is being called into question. On May 2, ratings agency Standard & Poor’s (S&P) downgraded its outlook on the sovereign’s ‘BB+’ rating from positive to stable, the same day as it raised the Philippines’ rating from ‘BB+’ to ‘BBB-’.
The announcement shocked the market, which had expected Indonesia to reach investment grade before the Philippines.
S&P blamed its outlook downgrade on the country’s burgeoning fiscal deficit, which widened from 0.7% of GDP in 2010 to 1.8% last year.
The deficit is largely the product of the government subsidising fuel prices. This generally costs about 20% of government spending, but the cost more than doubled between 2010 and 2012 from IDR82.4 trillion (US$8.43 billion), or 1.3% of GDP, to IDR211.9 trillion, or 2.6% of GDP last year. If Jakarta doesn’t cut fuel subsidies this year the fiscal deficit could grow to 3.8% for 2013 – higher than its legal cap of 3%.
The government and parliament have spent two years squabbling about details of subsidy reductions and the possible social risks. Policymakers are particularly reluctant to implement unpopular reforms with a national election in just over a year.
S&P’s outlook shift has offered a cold dose of reality. Weakening financial statistics do not come without consequence. Its decision could finally spur the government to swallow the bitter pill of reducing fuel subsidies. That in turn will present incoming governor Martowardojo with an inflation headache.
Combine this with a need to reform the central bank itself to make it more efficient and credible, and the coming months could be a trial by fire for the new governor.
Surprise appointment
Martowardojo’s appointment at Bank Indonesia (BI) appears to be a politically expedient means to remove him from his previous role as finance minister.
He had been in this position since replacing the internationally respected Mulyani Indrawati in May 2010, who also left in controversial circumstances. An admired reformer and opponent to corruption (see box), Martowardojo had been expected to remain minister of finance until the general elections in 2014.
Instead President Susilo Bambang Yudhoyono put forward Martowardojo as his sole candidate to take over the central bank once Darmin Nasution’s term ended. Martowardojo expected to switch roles once Darmin’s tenure ended on May 23, but the end of his term as finance minister came even sooner.
On April 18, while attending a G-20 meeting in Washington DC, Martowardojo found out from his aides that he had been replaced with immediate effect by Hatta Rajasa, Indonesia’s coordinating economic minister, chairman of the National Mandate Party (PAN) and father-in-law of the president’s son.
Rajasa – who was appointed as an interim measure – has since been replaced by Muhammad Chatib Basri.
Observers speculate that Martowardojo was moved because he had been standing in the way of government politicians eager to spend money ahead of an election.
“Political analysts are saying the reason why [Martowardojo] has been moved is because he has been too strict as a fiscal guardian, particularly as Indonesia approaches an election year of 2014, when political parties need to raise funds partly through projects,” says Fauzi Ichsan, senior economist for Indonesia at Standard Chartered (see box above).
Switching Martowardojo to the central bank was an opportunity too good to miss.
“They wanted to get rid of him and this was a good way to do it. If he was suddenly fired by the president then people would wonder why,” says Anton Gunawan, chief economist at Bank Danamon.
On paper, Martowardojo isn’t a great match for the role. While most central bank governors are economists by training, Martowardojo’s background is in banking. But economists believe BI’s support net will be strong enough to carry him.
“The system in BI is already established. It’s a good system and the board of governors and the advisers were able to support [Darmin] even though he did not have experience either. So with Agus a similar thing can happen,” says Gunawan.
Interest-rate rhetoric
One strong positive Martowardojo brings to the BI is his integrity. That’s important, as he is likely to face political pressure over what could be some unpopular decisions in the coming months.
If the government does grasp the nettle and reduce fuel subsidies, it will create inflation. Cutting fuel subsidies will raise the fuel price, which will hurt the pockets of vehicle owners and raise the prices of all transported goods. Inflation is currently 5.7%, but could increase to 8.8% if fuel subsidies are reduced, according to HSBC.
One of Martowardojo’s first tasks will be to raise rates to keep rising prices under control. BI operates in an inflation-targeting framework with a base target of 3.5%-5.5%, capped until 2014.
“A surge in inflation could be catalytic for policy tightening from BI, which has in the past responded, even if somewhat belatedly, every time fuel prices have been lifted,” says Su Sian Lim, Asean economist at HSBC, in a research report on May 14.
Indeed, such a move would not be unprecedented. A fuel-price hike of almost 90% in 2005 led the BI to lift its policy rate by 425 basis points (bp) in just over five months. In 2008, a 33.3% price hike resulted in 150bp of hikes over four months.
But raising rates would inevitably constrain economic growth. Indonesia’s real GDP growth was 6% year on year in the first quarter of 2013, but this could easily slow to 5.5%-5.8% if interest rates rise by 50bp, according to RBS.
On the positive side, slower growth would reduce the volume of imports, helping to narrow the current account deficit. Monetary tightening and an improving fiscal deficit would also strengthen the rupiah, making the currency a carry play at a time when most policymakers are still cutting rates. This would prompt capital inflows and support the currency.
But the prospect of higher interest rates in the second half implies that Indonesian government bond yields will rise. And currency strengthening could be offset by further increases in inflation. That could lead international investors to sell out of the local-currency bond market.
This is a potential problem, given that they owned a record 33.94% of government bonds on May 14, according to the Indonesia Bond Pricing Agency.
“If foreign holdings drop to a 30% share, that would be quite drastic given the shortness of the time frame we are looking at and that deleveraging risk may place pressure on the rupiah,” says Enrico Tanuwidjaja, South-east Asian economist at RBS.
A price worth paying
Martowardojo should consider reduced economic growth and greater rupiah volatility as necessary prices to pay to ensure Indonesia’s economy makes a full recovery.
“The adjustment is not something we are singing joyful songs about, but it is necessary, because over the longer term you need to realign the fuel prices with the market price in order to have more fiscal space to finance the much-needed infrastructure investments,” says Tanuwidjaja. “Once it has a higher fiscal flexibility, then Indonesia will be back on track.”
But such adjustments won’t be popular, particularly with politicians who would prefer headline-friendly, short-term solutions in an election year. Martowardojo can already attest to how far they are willing to go in pursuit of such aims.
If he ever feels his resolve weakening Martowardojo should look to the Philippines, where policymakers were equally willing to ride out a difficult period between 2008 and 2012 to secure the country’s long-term health. By following a similar path, Indonesia could at last receive an investment-grade rating.
Martowardojo has already voiced his willingness to take aggressive action in the event of a fuel-price hike. Hopes are high that he will succeed.
“He turned around Bank Mandiri [he was previously CEO at Indonesia’s largest lender] and he’s got guts. Also, as a conservative banker he is not going to be against markets which means that when it comes to FX policy, for example, he is unlikely to believe in excessive suasion that borders illegal capital control,” says Ichsan.
“In terms of defending the rupiah you raise interest rates or you deplete your FX reserves more rapidly. BI credibility has been affected by the excessive suasion in the FX market over the last 18 months. It will take a lot of convincing but [Martowardojo] will try to allow markets to function properly. Seeing is believing, but knowing him, he will do it.”
Doing so would also help burnish the central bank’s reputation. Some economists feel the bank has done itself few favours over the past decade with its lethargic pace of regulatory reforms. Its image has also not been helped by periodic high-profile arrests over corruption charges.
Former BI governor Burhanuddin Abdullah was convicted on graft charges for five-and-a-half years in 2008 (later reduced to three years by the Supreme Court in 2009), while former deputy governor Miranda S. Goeltom was found guilty of cooperating to commit corruption and sentenced to three years in prison on September 27, 2012. The Jakarta Post reported that the Supreme Court rejected her appeal on April 26.
Martowardojo, who has an impeccable record as an anti-corruption campaigner, was unavailable for comment ahead of his appointment to the central bank.
Belief in Basri
Ultimately Martowardojo’s success as BI governor will depend on him picking his fights. Sometimes he will need to stick to his principles, but he will also need to co-operate with President Yudhoyono, vice-president Boediono, the head of the new financial regulator OJK Muliaman Hadad and new finance minister Basri.
The BI will need to work closely with the OJK, which has inherited some of its market supervision powers, to ensure there is no regulatory crossover and that the transition of banking-sector regulation is completed without incident. Meanwhile Martowardojo will need Basri’s help to succeed in many of his tasked reforms, including deepening the FX market.
The two could develop a good working relationship. Basri is widely credited as a capable economist, a believer in free trade and a tough reformist. He is also a protégé of Indrawati, Martowardojo’s predecessor at the finance ministry.
Yudhoyono’s decision to appoint a technocrat was particularly welcome after Martowardojo had been so abruptly removed. Some believe the rating outlook downgrade by S&P forced the president’s hand.
“The [S&P] rating outlook downgrade and the warning by Moody’s [which followed a few days later] give technocrats an excuse to push Yudhoyono to do the right things, because it will affect his legacy if Indonesia is downgraded while he is president. I would not be surprised if Martowardojo’s first and foremost task will be to regain the confidence of the rating agencies,” says Standard Chartered’s Ichsan.
Martowardojo’s biggest difficulty will be to balance Indonesia’s monetary and fiscal credibility against government clamouring to avoid unpopular decisions a year before an election.
“The election is going to take place very soon so some of the key areas like nationalism and protectionism are really going to be brought to the surface along with all the political games,” says Tanuwidjaja.
But the election cannot serve as an excuse to postpone needed action. S&P is already more leery of Indonesia’s credit outlook because of its indecision over unpopular but necessary reforms. A tougher stance is needed, and Martowardojo at least should provide one at the central bank. The big question is whether he can stick to his principles in this new role, after seemingly being punished for doing so in his old.
For the sake of the central bank’s integrity and the country’s economic health, it’s to be hoped he can.
BOX 2
Building better markets
A priority for Agus Martowardojo as the new governor of Bank Indonesia (BI) will be to make the institution more dynamic, efficient and modern. There are three key areas in which he has the greatest potential to spur reforms.
The first is Indonesia’s foreign exchange (FX) and money markets, the second is the architecture of the banking sector, and the third is macro-prudential policy – a new and relatively undefined regulatory space.
On the FX side, Indonesia’s onshore swap market is very limited, so anyone wanting to hedge liabilities has to use the non-deliverable forward (NDF) market.
Developing the swap market would encourage more offshore fundraising through bonds and loans; at present many companies must leave their US-dollar debt positions unhedged or issue bonds through the illiquid and limited onshore bond market.
“BI has been trying to improve [the FX market] but not that successfully. There are some policies involving the repatriation of export proceeds,” says Bank Danamon’s Anton Gunawan. “But afterwards the money can go anywhere because we have a law of free capital mobility.”
Keeping dollars onshore by law is unfeasible, he says, but if the FX market becomes more attractive the money is more likely to remain in Indonesia.
But Indonesia’s FX instruments are not up to international standards. For example, the minimum time frame for a forward transaction in Indonesia is seven days, whereas most international forward trades are completed overnight.
Forwards lock in the exchange rate at which market participants can buy and sell currencies at a future point, so are key hedging instruments for foreign investors.
The central bank should also focus on legitimising its benchmark rate for US dollars in Indonesia. The Jakarta Interbank Spot Dollar Rate (Jisdor) is in place, but is little used; many prefer to go through Singapore instead.
On May 20, BI set its first fixing for the rupiah at IDR9,760 per US dollar. This is 0.2% stronger than the equivalent rate in Singapore (9,778). It’s a step in the right direction. A well-used onshore rate may reduce the currency’s volatility, as traders won’t have to take NDF transactions into the offshore market.
Money-market fix
Martowardojo should also try to improve Indonesia’s money market. Volumes in the interbank money market – comprising short-tenor instruments of up to a year – are essentially flat, despite the gradual increase in asset transactions.
Most transactions are between a single bank and the central bank, rather than interbank. Because of this, the transmission of monetary policy tends to be limited.
“If they want to make this transmission better, they need to improve the FX market and also the money market – this is very important,” says Gunawan.
A further hindrance is Indonesia’s inefficient repo market, in which instruments are borrowed for money. A repurchase (repo) agreement is a type of short-term borrowing in which a dealer sells government securities to an investor and buys them back, usually the next day.
Repos are meant to add liquidity but many institutions prefer bilateral agreements. The central bank should force market participants to use repos instead, either directly or by removing the double taxation currently in place.
However, increased inflows and transactions could also make the market more volatile, as it would have a magnifying effect on global market sentiment. This makes it all the more important that the country secures the long-term support of international investors.
Banking rules
The central bank also has to play a key role in overseeing the government’s plan to reform the banking sector.
In January 2013, commercial banks in Indonesia were grouped into four different categories, depending on their core capital levels. The groups determine the kind of business activities a bank can engage in, and how many branches it can set up.
New branches must be supported with core capital, and branches close to Jakarta will be more expensive than those elsewhere. The aim is to promote financial inclusion.
Additionally the BI released a rule in July last year that states that financial institutions, regardless of nationality, can only own up to a 40% stake in a local bank. Non-financial institutions can own up to 30% and individuals 20%.
The rules are relatively flexible; banks with existing shareholder-owning stakes of more than 40% that are deemed to have good corporate governance as of December 2013 won’t have to change. The OJK takes over supervision of bank ownership from January 1, 2014.
But under this rule the central bank rejected Singapore-based DBS’ bid to buy a controlling stake in Bank Danamon on May 22, after more than a year of negotiations. Instead, DBS can only buy a 40% share, after meeting certain regulatory conditions. The ruling will affect foreign interest in Indonesia’s bank sector.
“If there is a limited chance of ultimately gaining majority control [in local banks] this may deter some long-term investors from looking to establish and build a local franchise,” says Alfred Chan, financial ratings director at Fitch.
Macro-management
The central bank will also be responsible for the nascent macro-prudential division, designed to ensure stability of the financial system.
This will become increasingly important, as incurred losses in the banking sector are largest when a downturn is preceded by a period of strong credit growth. And Asia has seen rapid credit growth as a result of loose monetary conditions and strong economic expansion.
“Asian central banks that leave monetary conditions too easy for too long, whether to promote growth or to avoid attracting capital inflows, could see overheating pressures build,” says Mark Young, managing director of financial institutions at Fitch.
Keeping track of debts in Indonesia’s banking system will be a key priority for Martowardojo.