[Kabar-indonesia] RI foreign reserves: Our fragile borders

[Joyo at aol.com]

The Jakarta Post
Wednesday, November 1, 2006

Op-Ed

RI foreign reserves: Our fragile borders

Kahlil Rowter, Jakarta

In the last few months Indonesian foreign reserves have
risen steadily at the same time that the rupiah has
strengthened. The two are certainly related. So closely in
fact that we need to look elsewhere for the real reason.
Foreign inflows into the financial market are one leading
candidate. But will it be permanent? And if it isn't, why?

Since the economic crisis in the late 1990s, the exchange
rate has been the most watched economic indicator. Besides
its psychological impact, it is also intimately interwoven
into the fabric of the economy. Many commodities and
services are quoted in U.S. dollars, even those produced and
consumed onshore. Hence many prices move not because of
changes in supply or demand, but due to the volatility of
the exchange rate.

Since Bank Indonesia gave up the intervention band in 1997,
this volatility has reverberated throughout the economy,
often causing decision-making jitters. Not being able to pin
down prices, both output and input, has discouraged
investment which at its core is risk taking. Hence, currency
stability is paramount.

Fast-forward to 2006. We should be pleased that our foreign
reserves have risen from an average of US$35 billion last
year to the current position of a little over $42 billion,
or about $39 billion after paying our debt to the
International Monetary Fund. Part of this increase is due to
export growth thanks to favorable commodity prices. At the
same time imports are still soft owing to the slowdown in
the domestic economy. However, the trade balance is in risk
of tapering off as the global economy cools down and our own
imports start to rise on the back of domestic economic
growth.

The other major factor driving reserve accumulation is the
inflow of foreign currency. Its role can be roughly
estimated by looking at net inflows as a portion of reserve
change. Foreign ownership of government bonds rose from $3.2
billion in December 2005 to $6 billion in September 2006.
While foreign net purchases in the equity market now total
approximately $1.3 billion. These two sums add up to about
51 percent of the net addition in reserves for this period.
It is therefore safe to say that foreign inflows have played
a very significant role in the rise of foreign reserves and
consequently the rupiah.

It should be noted that foreign equity net purchases may not
represent what actually took place. The weakness of this
statistic is that equity brokers are no longer required to
state where their orders originate from. This means foreign
equity buyers can be understated. On the other hand, foreign
participation is mostly indicated by orders from foreign
equity brokers, which could overstate foreign ownership. We
can only hope that capital market supervisors will someday
publish regular equity ownership by institutions, similar to
government bond ownership.

A large share of foreign ownership in a country's foreign
reserves may be necessary and, therefore, an insufficient
cause for concern. But let us examine more closely two
recent periods where it might. The first was May 2006. The
rupiah strengthened from Rp 9,830 per US dollar at the end
of 2005 to Rp 8,775 at the end of April 2006, but then fell
back to Rp 9,220 by the end of May 2006. Why?

Foreign ownership in government bonds in May 2006 dropped
about $133 million, but foreign equity net purchases slowed
down considerably from $340 million to $78 million in April.
What really took place in May were foreign sales of $160
million and purchases of $238 million. But the sales
triggered a price drop in many shares resulting in a
retraction of the index from 1,464 at the end of April to
1,329 at the end of May. Meanwhile reserves still rose in
May by about $161 million.

On a quarterly basis, net portfolio inflow in the first
quarter of 2006 was $3.7 billion, with a $3.6 billion inflow
in bonds and $120 million in equity. While in the second
quarter the position reversed with a net outflow of $1.2
billion, including, most probably, Bank Indonesia promissory
notes (SBIs) and other short-term positions amounting to
about $1.5 billion. At the same time, there was an inflow
into government bonds of about $440 million. Hence, the
decline in foreign ownership in Indonesian assets was rather
small in net terms but large in gross terms. And it
triggered the substantial drop in the rupiah.

In September another fluctuation took place in the financial
market. This time there was a pullback from foreign
investors in government bonds amounting to $340 million. At
the same time foreign equity net purchases halved to about
$100 million from over $200 million in the previous month.
The Jakarta Composite Index actually rose 103 points in the
month. Meanwhile, the foreign reserve increased by $360
million, probably due to export proceeds. Yet the rupiah
fell over Rp 135. Conceivably this occurred due to spikes in
US dollars during the offshore bond investors' exits. This
is just another example of how small movements in financial
assets can trigger large movements in the currency. Such is
the granularity of the financial market.

If Indonesia's foreign reserve is dependent on financial
flows, just how big are these flows, and what about other
countries? One estimate is that about $15 billion out of the
present reserve position of about $40 billion consists of
this so-called "hot money".

In the Philippines the figure is about $2 billion against
their reserves of $21 billion. In Malaysia the figure is
estimated to be minimal after the recent bond sell-off. In
Singapore and Hong Kong this statistic is meaningless due to
their completely open capital accounts.

Furthermore, both countries' reserves are large enough and
their bond and equity markets are deep enough that their
currencies are quite immune to anything but a very massive
foreign investor pullback. It appears that Indonesia is
comparatively vulnerable, especially after taking into
account its shallow bond and equity markets.

Aside from the general risk from a sudden massive investor
pullback it appears even small movements can cause
substantial currency volatility. A recent trend where major
Indonesian firms have been raising debt offshore, enticed by
the low cost and ease of borrowing, only heightens this
risk. Exporters are immune to exchange rate fluctuations,
but what about those with rupiah revenues?

Allowing unhindered flows in and out of the financial market
certainly has its advantages. But, it comes with a price. We
need to re-examine this and carefully consider the costs and
benefits. In the meantime, a closer watch is needed. We
should, at least, start with timelier reporting of foreign
ownership in equity. And this data should be widely
published to enable close scrutiny.

If India has an automatic equity market shutdown when the
index falls below a certain threshold for a given period, we
should also consider something similar.

Comprehensive financial sector vigilance to external impact
needs to be initiated. This should include participation
from market players. This will demonstrate that the
authorities are on top of the risks and at the same time
enable the gathering of near real-time data. Existing ties
among authorities across countries can and should also be
strengthened. Ultimately, only vigilance can save us.

The writer is chief economist, CIMB-GK Securities Indonesia.
The views expressed here are personal.

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Joyo Indonesia News Service
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