Federal Reserve & Indonesia: Limiting the Impact of Higher Interest Rates
US Federal Reserve Chairwoman Janet Yellen reminded global investors to prepare for a sooner-than-expected US interest rate hike (Fed Funds Rate, FFR) provided that the economy of the USA - the world’s largest economy - continues its improving trend. In fact, speculation has emerged that the FFR will be raised before the end of 2014 although Yellen stated more than once that the ‘close-to-zero’ interest rate environment would be maintained for a considerable period after the US bond-buying program (quantitative easing) has ended.
The bond-buying program has been steadily reduced by chunks of USD $10 billion starting from USD $85 billion per month at the start of the year to USD $15 billion per month in September. The program will most likely end in October 2014.
Higher US interest rates and a stop to monthly US dollars printing would mean an end to the era of cheap US dollars. In recent years, many US dollars went to lucrative (yet riskier) assets in emerging markets causing various emerging benchmark stock indices to reach record highs (for example Indonesia’s Jakarta Composite Index). This trend can reverse in case the Fed decides to tighten its monetary stance further, thus resulting in capital outflows from these emerging economies. As foreign funds dominate both the stock market and government bonds in Indonesia, the shock can be heavy. As such, the looming US monetary tightening is one of the major challenges of the Joko Widodo-led government that will be inaugurated on 20 October 2014. The central bank of Indonesia (Bank Indonesia) already announced that it will maintain a relatively high interest environment in Indonesia to combat possible capital outflows in the months ahead. Since November 2013, the benchmark interest rate in Indonesia (BI rate) has been kept at 7.50 percent.
If the US monetary tightening will be gradual (as has been the case since January 2014) and the policy changes are in line with statements of the Federal Reserve then it may be a relatively quiet transition. Particularly as investors are seemingly confident that president-elect Joko Widodo will improve the economic and financial fundamentals of the country (for example by reducing fuel subsidies later this year). But perhaps a big shock could occur when the US economic recovery would make a sudden jump, thereby fuelling market expectations that the Federal Reserve will raise its FFR soon.
Finance Minister Chatib Basri said that Indonesia is particularly vulnerable to outflows of hot money as the country has no Financial System Safety Net (FSSN) yet. Moreover, Indonesia can be hit hard as the Indonesian rupiah exchange rate has already depreciated sharply since mid-2013 and it still has to cope with a wide current account deficit (which erodes investors’ confidence in the financial fundamentals of the country). Therefore, an important task for Joko Widodo (popularly known as Jokowi) is to improve the country’s financial fundamentals in order to make Indonesia an attractive investment for foreigners.
Basri mentioned several policies that should be conducted by the new government in an effort to limit the harm done by capital outflows. Firstly, the government must improve economic fundamentals, particularly the trade deficit and the current account balance. Currently, the trade balance is heavily burdened by expensive oil imports. Secondly, through the bond stabilization framework, the government should buy back securities that are dumped by foreign investors. The government should also request state-owned companies to buy these securities (using funds from the Hajj Fund and Social Security Fund).