Pity Indonesia. One year ago, the country was lauded for the openness of its domestic bond market.
In the months before Standard & Poor’s upgraded it to investment grade status in May 2017, Indonesia’s domestic bond market was a magnet for foreign investors, attracted by the combination of the country’s high growth and high bond yields.
Today, Indonesia is experiencing the reverse phenomenon.
Rising US interest rates and contracting global liquidity have prompted foreign capital outflows across emerging markets. In Indonesia, this trend has been exacerbated by concerns that the Jokowi administration is tolerating fiscal slippage in the run up to a general and presidential election next April.
As Manu George, director of fixed income at Schroders in Singapore, told FinanceAsia: “Those parts of Asia, which are still dollarized, always discover how the risk-reward ratio tilts away from them once US interest rates rise. The home market (ie US) starts becoming far more appealing for yield-hungry US investors.”
It is something that emerging market policymakers have feared ever since 2013’s taper tantrum sent their currencies and bond markets into a tailspin. But the situation is all the worse in 2018 thanks to US exceptionalism: second quarter growth of 4.2%, not that far off Indonesia’s 5.27%.
Perhaps more worrying for Indonesia, many of the country’s dollar-denominated bonds have come under selling pressure because of concerns that corporate and state-owned borrowers did not adequately hedge their foreign exchange risk when market conditions were far more benign.
Companies are believed to have used knockout derivative structures to reduce their hedging costs. But investors worry that these have left them exposed following sharper-than-expected falls in the rupiah, which is now at a 20-year low against the dollar.
Year-to-date, the currency is down 10.49% against the dollar, hovering close to the psychologically important Rp15,000 mark.
Is Indonesia heading back down the same road as 1997 when its companies could not repay their foreign currency debt and a liquidity crunch rapidly mutated into a solvency crisis?
The country’s predicament is re-focusing policy makers’ attention on two interlocking issues: should they facilitate unfettered foreign capital flows into their domestic bond markets and if they do, should they be punished by those same investors for running a current account deficit to finance their country’s future growth?
Clifford Lee, head of Asian fixed income at DBS in Singapore, says that the current crisis roiling many emerging market countries is throwing up “existential questions for Asia about what constitutes a developed local currency bond market”.
Looming over the debate is China, whose own domestic bond market is still largely insulated from the vagaries of foreign investor sentiment by a government that has always been keen to maintain control and do things at its own pace.
Can the Beijing Consensus be applied to wider Asian domestic bond markets? Lee suggests that it can.
“At the heart of the issue is whether Asian countries want open and Western-style bond markets, which are vulnerable to sell-offs by foreign portfolio investors, or more controlled bond markets limited to domestic players,” he commented.
One thing about which Asian policy makers have become very conscious is that “open” is not always a two-way street where Western markets are concerned.
Few Asian countries have forgotten the bitter pill that the International Finance Corp (IFC) forced them to swallow after the Asian Financial Crisis. They did not see Western countries being forced to take the same medicine after the Global Financial Crisis.
Over the past couple of years, increasingly protectionist policies and political rhetoric appear to demonstrate that even the US no longer practices what it has always historically preached about the benefits of unfettered capitalism.
“Individual markets have to calibrate what works best for them,” Lee concluded. “One lesson everyone is learning is how the Western model is not necessarily the most ideal when applied in its entirety.”
Over the longer-term, Indonesia is keen to reduce the influence of foreign investors.
Where government bond holdings are concerned, the Ministry of Finance’s risk manager, Scenaider Siahaan, recently set a 20% target by 2023. This would be roughly half the level that foreign investors held back in January (41.5%), before they began to cash out. At the end of October, the figure stood at 37%.
But over the short-term, the government needs them. As such, the country’s tax department, led by former borrowing head, Robert Pakpahan, hopes to tempt them back with a reduction in the 20% withholding tax that foreign investors pay on rupiah-denominated debt.
This tax has long been the bane of many a foreign portfolio manager. As recently as early October, CalPER’s fixed income portfolio manager, Scott Grimberg, flagged it at the annual Institute of International Finance meeting in Bali.
“There are pretty strong institutional investment barriers in countries like India, Indonesia and China,” he said. “Policymakers don’t do the easy things to help me invest in their markets and so I have to conclude they just don’t want my money.
“Why bother?” he concluded.
Schroders' George told FinanceAsia that Pakpahan’s plan would certainly increase his interest in assigning a higher weighting to Indonesia.
Adam McCabe, head of Asian fixed income at Aberdeen Standard Investments, also argues that countries like Indonesia realize they need to do all they can to attract capital to finance their current account deficits.
“Current market conditions suggest we’re in a period where capital is more scarce and competitive,” he told FinanceAsia.
Grimberg, meanwhile, has previously said that he’s not so sure that “emerging market policy makers have quite caught up with just how intense the competition could get as the world moves back to 1990s-style levels of capital availability.”
In Indonesia’s case, its current account deficit has also started to come under pressure again after falling from 3.2% in 2013 to 1.7% in 2017.
The government estimates that it has moved back to a 3.3% to 3.4% range during the third quarter. It is now back above the 3% threshold that economists demarcate as a sustainable deficit.
There are, however, growing arguments that financial markets need to stop fixating on current account deficits in developing countries with favourable demographics.
They are led by the G20 Eminent Persons Group on Global Financial Governance. It has just published a seminal paper on ways to help countries create resilient domestic bond markets that benefit from foreign flows, but can also withstand volatility.
It concludes that the world needs to “make it possible for developing countries to finance sustainable current account deficits where they are fundamentally needed at their stage of development without recurring bouts of instability that set back growth.”
It has two main answers. One is for far better co-operation between supranationals like the IMF and ADB so that they can co-ordinate technical assistance to developing countries.
The second is to create a global financial safety net for countries de-stabilized by short-term flows. It suggests the establishment of a standing global liquidity facility under the IMF.
In the meantime, Indonesia has had to fall back on two very traditional policies to keep its domestic bond market functioning.
On the one hand, it has raised interest rates to stay ahead of the Fed. So far this year, Bank Indonesia has raised short-term rates five times to 5.75%.
Year-to-date, government bond yields have, consequently, risen 207bp to 8.388%, compared to an 80bp spike in US treasury yields to 3.199%.
Bank Indonesia has also relied on a form of insurance which has been very popular with Asian governments ever since the 1997 financial crisis: foreign exchange reserves. The latter have dropped about 13% since January following its intervention to prop up the rupiah.
The rupiah’s decline has brought back painful memories of the Asian Financial Crisis. Fund managers believe this sensitivity is one of the main reasons why the central bank has “overreacted”.
“All central banks worry about their currencies, but there is an added layer of sensitivity in Indonesia,” one stated. “I think they should have just let the currency find its own level.”
Aberdeen’s McCabe says that Indonesia’s sensitivity has also been heightened by the impending election, with Jokowi’s political rivals potentially using the currency’s level against him.
A number of economists have also pointed out that Indonesia benefits far less from a depreciating currency than other Asian countries because it has a smaller manufacturing base. This means that it cannot take advantage of more competitively priced exports.
And the impact on the country’s borrowers is becoming particularly painful at the lower reaches of the credit spectrum. In the international bond markets, companies such as B minus rated property developer Lippo Karawaci and B rated Jababeka are trading at 19.2% and 11.97% for 2022 and 2023 paper respectively.
Some fixed income analysts still argue that these levels say more about sentiment than fundamentals. In Lippo Karawaci’s case, the bonds have also been under additional pressure since Lippo Group chief executive, James Riady, was taken in for questioning about a bribery case.
Concerns are growing, however, that some are exposed to foreign exchange risk because of failed hedging strategies. McCabe says that concerns about cash flow and foreign currency exposure are now fanning out beyond Indonesia’s private sector to the quasi-sovereign sector too.
It is one of the reasons why a $1 billion 10-year and 30-year bond by state-owned/controlled electricity company, PT Perusahaan Listrik Negara, (PLN) did not receive a strong investor reception in mid-October.
The 10-year tranche has also dropped a point since launch and the 30-year by two points. The group’s previous benchmark bond – its $1.5 billion May 2027 bond – has also widened almost 100bp since mid August.
However, DBS’s Lee reiterates that Indonesia can weather the storm. His government also threw its weight behind the country in October when the Monetary Authority of Singapore put a $10 billion swap line in place.
“It’s not going to be like 1997 when the liquidity tap was turned off,” Lee concluded. “The vulnerabilities are different and the impact will be more muted.”
He also notes that Asian borrowers have become far more conscious of foreign exchange risk.
“It’s one of the reasons why we’ve never gone back to the days of Thai banks raising funds in Indonesian rupiah and Filipino banks in Malaysian ringgit,” he added.
But if Indonesia does not want to keep paying the same price then it needs to do more to build up its domestic liquidity pool, something for which it has been long criticized.
As Aberdeen’s McCabe concludes: “All things being equal, we always favour markets where local savers are the dominant players.”