Indonesia - Capital controls part II: the credit event

The future is uncertain for the holders of Indonesian debt as the risk of a further tightening of capital controls looms.

Ignore the IDR at your peril?

Will Indonesia fade gently into the night as it drops off most investors’ radar screens, or will the country deliver further shocks and uncertainty to the market? We fear the latter, and are wary of Indonesia re-emerging in the headlines over the coming months for the wrong reasons: we believe there is a risk of a further tightening of capital controls, a move which could have credit implications for holders of Indonesian debt.

The offshore IDR market has been torpedoed by Bank Indonesia

Many in the market may be forgiven for reducing their focus on Indonesia following last week’s tightening of foreign exchange regulations. As we warned at the time, the new regulations will kill the offshore IDR market. While spot transactions are unaffected, the rules preventing the lending of IDR offshore means that while a foreign bank can buy IDR it cannot really do anything with the cash offshore, and so will try to sell it back to a local financial institution at the earliest opportunity. The $3 million limit on outstanding speculative forward trades also reduces the attraction of this market as a way of expressing an IDR view. As such, once the offshore market has managed to settle its outstanding IDR cash flows, we would expect the market to cease to exist. BI’s tighter FX regulations do not compel the offshore IDR market to end, they instead create conditions that force its demise.

The current status quo is unstable

Unfortunately, we fear that current FX regulations in Indonesia are not a sustainable solution to the country’s problems. Reducing offshore speculation will not lend any significant support to the IDR since these flows played a minor role in determining FX trends. (The fact that USD/IDR has moved higher as the offshore market unwinds its positions suggests it was actually long-IDR!) The greater cause for the sharp weakness of the rupiah over the past 18 months has simply been the country’s fragile underlying balance of payments position. The latest balance of payments figures are available only for March 2000, but the IMF programme assumptions provide an insight into the scale of the country’s problems.

For 2000, the IMF was assuming an overall balance of payments deficit of $10 billion or 6.5% of GDP, as hefty capital outflows swamp a current account assumed to be around $6 billion. The eventual balance of payments deficit last year is likely to be far lower than this figure, since Indonesia did enjoy some modest capital inflows and the current account surplus is estimated to have been $2 billion-$3 billion above target. However, we would still estimate a residual $3 billion-$5 billion financing gap for last year, which would explain the weakness of the rupiah. This would follow an actual balance of payments deficit of $8.5 billion in 1999.

Balance of payments problems will persist in 2001

It is unlikely that 2001 will see a marked improvement in Indonesia’s external flexibility. Lower oil prices will reduce the current account surplus. Meanwhile, the government’s intention to borrow $4.6 billion this year compared to around $4 billion in 2000 will be hampered by delays to IMF loan dispersals associated with Fund concerns over the conduct of monetary policy.

Private capital inflows are also impeded by the fragility of the economy (the authorities are several years away from re-establishing efficient financial intermediation, as demonstrated by the fact government bonds currently comprise 70% of banking sector asset, and NPLs a large portion of the remaining 30%).

In addition, the investment climate in Indonesia is currently impeded by several major issues of uncertainty: President Wahid is in the midst of a long-running and damaging dispute with the central bank, whose governor he wishes dismissed and imprisoned; Wahid is also facing the risk of impeachment as the legislature (another institution of state with frosty relations with the president) assesses the validity of a series of corruption charges; the market is anxiously awaiting the impact of the government’s planned devolution of fiscal responsibility to provinces, a move expected to markedly reduce central government revenue and thus limit its ability to fund future banking sector restructuring. The recent changes to FX regulations will merely exacerbate the problem since a fluid regulatory climate will require a higher risk premia on financial assets in the minds of foreign investors. Moreover, existing IMF reservations about the efficacy of economic policy formation are likely to have increased.

In essence, BI may have removed a minor source of IDR weakness (offshore speculators) but at the greater cost of reduced foreign capital inflows. (This begs the question of why impose the new restrictions at all? We can only speculate at answers such as a desire to deflect attention from Wahid’s ongoing political problems, or a degree of frustration at the IMF’s policy prescription.)

Fiscal room more manoeuvre is limited

Meanwhile, existing capital controls do not provide the authorities with latitude to undertake a greater degree of inflationary deficit financing in order to help finance a budget deficit of around 5% of GDP. Indeed, Indonesia’s fiscal position is so fragile – public sector debt/GDP has risen from 25% pre-crisis to 100%, in large part due to a 55% of GDP bill for financial sector restructuring – that future monetisation risks are acute. (Especially so since IMF forecasts of a stabilization of debt/GDP at 100% optimistically assume 6% GDP growth, relative price stability, and real interest rates below the level of real GDP growth. On the latter point, one year real yields are currently 6%, above 5% real GDP growth.)

With the spot market unrestricted on capital account transactions, fresh liquidity creation by BI could translate into purchases of overseas assets and a weaker IDR. Admittedly, increased monetisation of fiscal liabilities may not be a priority of the government (if for no other reason than relations with the IMF), but the issue is worth stating to highlight how the latest re-regulation does not significantly increase BI’s ability to conduct monetary policy in isolation of the rupiah.

What next? Carry on with the present arrangement?

What is the future direction of FX regulations? Three scenarios present themselves. The first is simply a continuation of the current status quo. As noted above, the implication would be a steady up trend in USD/IDR as Indonesia fails to attract the portfolio inflows needed to fund its balance of payments deficit (towards 10,000 by end Q1 and 11,000 by end 2001), and increased domestic interest rates reflecting an increased risk premia on rupiah assets needed to attract foreign investors. (Note the double blow to the public finances – reduced foreign funding, and a greater risk of real interest rates remaining noted above, the implication would be a steady up trend in USD/IDR as Indonesia fails to attract the portfolio inflows needed to fund its balance of payments deficit - towards 10,000 by end-Q1 and 11,000 by end-2001 - and increased domestic interest rates reflecting an increased risk premia on rupiah assets needed to attract foreign investors. (Note the double blow to the public finances – reduced foreign funding, and a greater risk of real interest rates remaining above real GDP growth.)) However, assuming our interpretation of the balance of payments implications of the latest re-regulation is correct, this may not be a viable solution. It seems unlikely the authorities would settle for a regulatory framework that offers no discernable benefit over the previous situation, and in fact exacerbates balance of payments problems. As such, two alternative, contrasting paths may be taken by BI.

Deregulate to try to entice foreign capital back to Indonesia?

Secondly, BI could focus economic policy on attracting foreign capital inflows. This would likely require Wahid to end his damaging dispute with BI and parliament, and also for the government to delay implementation of its hastily conceived plans for devolving fiscal responsibility to the provinces. In this vein, BI could roll-back some of its FX regulations. In our opinion, this would be the preferred solution since relations with the IMF would improve while capital inflows would increase, aiding a recovery in the IDR. This is the path the IMF favours as it urges Indonesia to create a more stable, transparent macroeconomic policy framework. Unfortunately, President Wahid does not appear married to the idea of liberalization and deregulation.  IMF advice in this area does not appear as if it will be accepted anytime soon, and hence we would realistically only expect this policy option to be accepted if Wahid were to resign/be impeached.

Re-regulate once more

Thirdly, in the event of laggardly capital inflows and/or increased tensions with the IMF, the authorities might try the route of further re-regulation. Spot transactions for selected capital account transactions, notably portfolio flows, could be restricted. This would limit the degree to which the rupiah is affected by an easing of monetary policy, and hence such capital controls could be imposed as part of a policy of supporting economic growth via a monetary easing. This policy option could become tempting if, for instance, the government encountered difficulties in funding its fiscal deficit amid subdued foreign capital inflows and/or the expected problems associated with fiscal devolution, or if the IMF withdrew support for the government. (In the fiscal year ending March 2000 – the joys of up-to-date data – domestic fiscal deficit financing amounted to IDR3.6 trillion and foreign financing IDR28.1 trillion!)

Option three may contain credit implications

If the authorities move down this latter path, we would also fear a credit shock. Since a move to sweeping re-regulation would be a response to balance of payments problems, the authorities may try to reduce one key source of capital outflows – debt servicing. 

Last year, the estimated $8 billion current account surplus included an invisibles’ deficit of around $20 billion. One obvious method of stabilizing the balance of payments and thus complementing tighter FX regulations, would be a further round of sovereign and corporate debt restructuring with a view to reducing both debt repayment and servicing. If the movement to re-regulation were driven by balance of payments weakness and if re-regulation was already on the understanding of reduced IMF involvement in the economy, then a debt restructuring would be a natural extension of capital controls. Malaysia was able to prevent its capital controls being a debt default event, but then the Malaysian government has a domestic debt/GDP ratio of less than 40%, and enjoyed a strong degree of external flexibility prior to the MYR-peg.

A MYR-peg, without the MYR or the peg

For holders of Indonesian debt, the potential credit implications of this scenario would be extremely negative. USD/IDR would be able to stabilize, initially, under this scenario, but the medium-term outlook for the exchange rate and would be bleak if we saw the authorities significantly reduce real interest rates and undertake increased inflationary deficit financing behind the wall of capital controls. (On a technical point, capital controls would be unlikely to be associated with an IDR-peg since even strict capital controls would not fully insulate the exchange rate from monetary policy trends, especially in Indonesia – a sprawling country where full enforcement of regulations would be difficult. Under a currency peg, fiscal rather than monetary policy must be the primary tool of demand management, and Indonesia clearly does not have sufficient fiscal flexibility for this.)

Currency board concept - not again!

Of course, one policy option we have not suggested is an IDR currency board. This is a very bad idea that unfortunately refuses to die a dignified death. Rumours of a currency board re-emerge periodically and no doubt BI’s search for unorthodox solutions to balance of payments problems means they may resurface once more. However, we rule this out as a policy option simply on the grounds that two crucial pre-requirements for a stable currency board – fiscal stability and a stable banking system – are not met. The government’s fiscal weakness means that it cannot fully rule out monetisation, something a currency board forbids. Similarly, the fragile banking system would be unable to cope with the long periods of high real interest rates and inverted yield curve a currency board might impose on the economy at times of particular balance of payments weakness. In short, a currency board would be a broad-based credit default event. 

Keep an eye on the IMF’s relations with Wahid

Which of these three scenarios is likely going forward? If we assume the IMF maintains its support of Indonesia under the current FX regime (as seems likely from the fact the IMF refrained from calling the latest capital controls, capital controls) then we may persist with the current arrangement for some months. If we were correct about the upward pressure on real interest rates and the IDR these regulations will create, however, and if Wahid remains in office, then we would not rule out Wahid moving towards the re-regulation option. 

If the IMF places further obstacles to loan disbursement, then the odds of further re-regulation increase markedly. Unfortunately, the optimistic scenario of further liberalization and a more stable investment climate do not appear likely under Wahid, who has tended to favour more unorthodox solutions. With the offshore market for the IDR expected to have a remaining life span of merely a few days, few people will be concerned about the attendant FX implications, other than the fact that a weak IDR will place a marginal drain on regional sentiment over the coming weeks. However, our fears towards a further re-regulation of Indonesian FX regulations are real, and while we do not yet view markedly tighter capital controls as probable, they remain highly possible. As such, Indonesia may yet re-emerge onto the front pages in 2001 for the wrong reasons. A worrying thought to keep at the back on ones mind every time we see renewed conflict between Wahid and the IMF. 

Desmond Supple is Head of Credit Research for Barclays Capital. Email: [email protected].

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