Author: Hartadi A. Sarwono, Indonesian Banking Development Institute
The resurgence of capital flows to emerging economies took on renewed importance with the growing attractiveness of investment in Asia and elsewhere compared to investment in industrial economies.
The success in managing capital flows generates a great deal of benefit in development, but failure can jeopardise both internal and external stability. A surge in capital inflows can also pose a range of policy challenges, including macroeconomic risks through excessive credit expansion, an overheating economy and an overvalued real exchange rate. There is also risk of currency crisis and financial instability if conditions are suddenly reversed.
There is no single recipe for success in reaping the rewards and avoiding the risks from capital flows, and authorities need to use all the available instruments at hand. Bank Indonesia has implemented a range of policies to manage the resurgence of capital inflows since 2009. The authorities’ first priorities were sound and sustainable macroeconomic and financial policies to create an environment conducive to encouraging capital flows. Bank Indonesia also pursued prudent monetary policy under its Inflation Targeting Framework, at the same time as the government maintained a sustainable fiscal policy with a budget deficit below 2 per cent of GDP and effective control of government debt .
Strong fundamentals are necessary, though not sufficient to manage a surge in capital flows. That calls for other measures that together help maintain stability. In Indonesia, these measures do not aim to control the volume of portfolio flows. Rather, they are designed to reduce volatility and sustain financial stability by maintaining a flexible exchange rate through selective foreign exchange intervention and by targeted macroprudential measures.
The role of exchange rate flexibility in managing capital flows is critical. Exchange rate flexibility can serve as a shock absorber that eventually helps to lessen the chance of overheating and dampen pressure on other asset prices. But an excessive appreciation of the rupiah during a period of capital inflows also has potential to disrupt the economy more generally. Against this background, Bank Indonesia conducted a sterilised intervention in the foreign exchange (forex) market. This helped to contain excessive exchange rate volatility, while allowing the rupiah to move in line with Indonesia’s economic fundamentals. Yet this strategy cannot be used to cushion against large and persistent capital flows. It is just one aspect of the broader policy mix.
Bank Indonesia also undertook a parallel intervention in the government bond market. During a period of capital flow reversal caused by foreign holders selling off government bonds, Bank Indonesia used some of the rupiah absorbed from its intervention in the forex market to purchase these government bonds in the secondary market. Thus far, the intervention has successfully stabilised markets and avoided a further drop in the rupiah and government bond prices.
Bank Indonesia then tightened its money market operations to sterilise the liquidity generated from its intervention in the forex market and to prevent undue impact from short-term capital inflows. As part of this strategy, Bank Indonesia has lengthened the duration of Bank Indonesia certificates (SBIs) and introduced non-tradable monetary instruments to absorb both excess rupiah liquidity (using rupiah term deposits) and excess forex liquidity (using forex term deposits). These instruments are non-transferable, thus reducing the ability for financial assets to be traded by foreign investors. These policies have improved the ability of the central bank to absorb excess liquidity, and have also helped to eliminate carry trade and arbitrage.
In some circumstances a purely macroeconomic policy response is simply not adequate. For this reason Bank Indonesia also introduced its capital flow management scheme and a series of macroprudential measures (MPMs). The two are often described in similar terms, but their primary objectives do not automatically overlap. Indonesia’s capital flow management scheme comprises administrative measures designed to limit short-term and volatile capital flows by containing the scale, or influencing the composition, of these flows, while MPMs are prudential tools primarily designed to limit systemic financial risks, irrespective of where they originate.
As part of its capital flow management strategy, Bank Indonesia issued a month-long holding period for SBIs. Besides preventing a sudden, large-scale reversal of capital, the policy was also designed to channel capital flows from these certificates into more productive portfolios, such as government bonds and equities. Macro-prudential measures includsed a policy on reserve requirements to absorb undue liquidity stemming from substantial capital inflows and excess liquidity in the banking system. Bank Indonesia also implemented other measures to manage excessive credit growth in certain sectors by strengthening the loan-to-value ratio. This policy is expected to shift funds into more productive lending and could also strengthen the banking sector.
This policy mix has been beneficial in sustaining capital inflows and lessening risk. The policies are supposed to maintain capital inflows, shift the composition of investment, expand foreign direct investment (FDI) and eventually contain exchange rate volatility. Unfortunately, from the second half of 2012, the rupiah has come under increased pressure from global financial market uncertainty and the impact of the widening current account deficit. The latter was caused by an expansion of imports following strong domestic demand growth, coupled with slackening exports. After a prolonged period of strong capital inflows, Indonesia now faces capital outflow due to more volatile external conditions and higher risk premiums. Exposure to capital flow reversal has increased, depreciation of the exchange rate has accelerated, and losses to foreign exchange reserves have mounted. Capital flow reversals, combined with increasing risks in investment, have led to a decline in stock prices, rising bond yields and a further weakening of the exchange rate.
Against this backdrop, Bank Indonesia decided to bolster its existing monetary and financial policy mix in these new circumstances. The Bank gradually raised its policy rates to strengthen control over inflation and to mitigate the possibility of a downward spiral into depreciation and inflation. This policy is also part of broader effort to ease the balance-of-payments deficit back down to a sustainable level. Bank Indonesia continues to allow the exchange rate to move flexibly in response to the changing fundamentals but it may need to guard against the risks of disorderly adjustment. Deepening Indonesia’s financial market is a medium-term priority, and this will be facilitated by measures to create a deep, sound and liquid financial market and a wider, variety of financial instruments. The promotion of corporate bonds, for example, is crucial to taking advantage of capital inflows and channelling them into productive sectors — especially to fund badly needed infrastructure. A deep financial market can also insure economies against unanticipated shocks in the financial market.
Dr Hartadi A. Sarwono is a former deputy governor of Bank Indonesia in charge of monetary policy, and currently serves as president and CEO of the Indonesian Banking Development Institute.