ANALYSIS-Indonesia inflows surge raising risk of controls

October 5, 2010

By Neil Chatterjee and Aditya Suharmoko

JAKARTA, Oct 5 (Reuters) – It’s taken a year, but Indonesia’s central bank has finally won over markets into accepting its dovish policy outlook. Still, it doesn’t feel like a success.

Instead, the policy that is designed to reduce the allure of Indonesian assets to yield-hungry investors is attracting capital into the country’s debt markets and increasing the risk that authorities will take steps to control the tide.

Foreign buying of government bonds has revived in the past month as markets accepted the central bank will keep to its promise of holding its policy rate at a record low well into 2011, a view underlined by a policy meeting on Tuesday.

Foreigners now own a record 28.2 percent of the market, well above the levels seen in other Asian countries.

Like other emerging markets, Indonesia is concerned that a flood of capital into the country now could just as easily flood out later — such as when developed markets stabilise and look poised to start a monetary tightening cycle — and so knock the economy for six.

The Asian financial crisis in 1997/98, when capital flight brought several Asian economies including Indonesia’s to its knees, remains a raw memory.

“Judging by the recent pace of inflows over the past weeks I wouldn’t be surprised if at some point we see more administrative measures,” said Helmi Arman, bond strategist at Bank Danamon in Jakarta.

In June, the central bank imposed a 28-day holding period on its popular bills and pushed investors towards longer-dated bills and government bonds to cope with the foreign money flooding into the short end of the debt market.

The move calmed volatility but has done little to reduce the allure of Indonesian debt, which yields several times more than equivalent debt in developed markets.


Foreign bond investment had eased up in anticipation of a central bank rate rises this year. Instead, Bank Indonesia raised bank reserve requirements in September, persuading markets that raising rates would be a last resort.

The latest Reuters poll at the end of September showed expectations for the first rate rise to be in the first quarter of 2011.

Indeed, Tuesday’s rate meeting and data on Friday showing September inflation slowed more than forecast — as the central bank had predicted earlier this year — may push expectations back further.

“This will strengthen BI’s resolve to keep the BI rate at 6.5 for much longer,” said Danamon’s Arman, who doesn’t expect the central bank to raise rates until the second quarter of 2011.

With inflation potentially under control for now, and renewed worries over a double-dip recession leading central banks in the United States, Japan and the United Kingdom to weigh measures to loosen monetary policy further, BI is suddenly looking prescient.

Controlling its historic problem of inflation — which hit 12 percent in 2008 and lead to a 26 percent slide in the rupiah — will improve its credibility and odds of a ratings upgrade.

Foreign demand has lopped 260 basis points off the 10-year government bond yield this year. It now yields 7.46 percent, a record low but 5 percentage points over U.S. 10-year bond yields and well above corresponding debt in Thailand and Mexico.

The central bank is convinced it has chosen the lesser of the evils by keeping rates at a record low. If it raised rates, capital inflows would be even greater, it argues.

“If the BI rate increases, there will be additional capital inflows,” said Deputy Governor Hartadi A. Sarwono at a briefing.

The inflows have pushed the rupiah up 5.4 percent this year.  Last week, Finance Minister Agus Martowardojo expressed his concern, saying he did not want to see the currency overvalued.  “We have other initiatives to tackle hot money,” he told Reuters.

Indonesia’s views are echoed elsewhere. Asian central banks spent an estimated $16 billion last week on currency intervention to curb strength in their currencies against a weak U.S. dollar and policymakers have warned of measures to control the inflows.

Brazil doubled a tax on foreign bond purchases.


Analysts say Indonesia is unlikely to impose outright capital controls for fear of scaring off investors and hurting its chances of securing an investment grade credit rating, which the finance minister says could happen as soon as next year.

It also knows that investors can be quick to turn against a country that imposes capital controls. Draconian controls imposed by Thailand in 2006 sparked the biggest one-day plunge in its stock market, forcing authorities to back track.

“They know the long-term damage that can do,” said Wellian Wiranto, an economist at HSBC in Singapore.

So any measures are likely to be ones that encourage investors further along the yield curve, similar to those put in place by the central bank in June, analysts say.

These could include the introduction of 12-month central bank debt to draw funds away from its shorter-term bills and steps to drain liquidity by pushing banks to lend more.

But the central bank risks sudden outflows in 2011 if it falls behind the curve in any bout of global risk aversion or when developed nations finally start normalising policy rates.

“Vulnerability to the volatility of international capital flows remains significant,” said Enrique Blanco Armas, a senior World Bank economist. “The capital inflows are making policymaking and monetary policy more difficult.”

($1=8932 Rupiah)

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