RI foreign reserves: Our fragile borders

Jakarta Post

November 01, 2006

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.