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A combination of global and domestic economic concerns took a toll on the Rupiah in Summer 2013, sharply exacerbating a downward trend that had afflicted the currency for the preceding two years. By the end of August, the Rupiah shed some 15% of its value against the US dollar since the beginning of the year and was trading around a four-year low. The currency’s low valuation and high volatility have become a headache for financial institutions operating in Indonesia and for anyone engaged in cross-boarder transactions, like foreign investors.
The driving force behind the summer slide was the expectation of a gradual withdrawal of monetary stimulus in the US. The Federal Reserve’s Open Market Committee (FOMC) on May 1 sent out mixed signals about how much longer it would keep buying $85 billion a month worth of bonds and mortgage-backed securities. An improving US labour market, ironically, made investors wary that the world’s largest economy may be weaned off life support, with knock-on effects for global liquidity. Traders responded by selling off emerging market assets, which are considered risky to hold at times of economic uncertainty. Emerging economies from Brazil and South Africa to India and Indonesia felt the effects.
The Indonesian Stock Exchange’s main gauge, the Jakarta Composite Index (JCI), dropped from an all-time high of 5,208 points in May to below 4,000 points in late August, undoing the impressive gains made earlier in the year. Indonesian bonds also declined substantially over the same period, driving the up the yield on 10-year government bonds to their highest level since March 2011. Indonesia’s sudden fall from grace with the global investor community in Summer 2013 was partly a response to exaggerated market enthusiasm. Once investors acknowledged the eventual end of quantitative easing in the US and the inevitable slowdown in China; one of Indonesia’s main export destinations, Indonesian assets looked pricey and the stock market rally seemed unjustified.
The Rupiah depreciation, meanwhile, began much earlier and cannot be blamed wholly on global sentiment. It is to a large degree a problem of Indonesia’s own making. While the country enjoyed a consumer spending boom and high prices for vital export commodities during the global recovery from the 2009 credit crunch, the government did little to fix inefficiencies in the economy. It has not solved the dependence of the country on raw exports such as coal, copper and crude palm oil and it missed the opportunity to relieve the state budget of wasteful fuel subsidies while inflation was low. Inadequate infrastructure continues to burden domestic industries with high logistics costs, while the labour market penalizes formal sector employment with rapidly rising minimum wages as well as tightening restrictions on outsourcing and the employment of foreign staff. All these factors have hurt the competitiveness of Indonesian exporters.
Indonesia recorded its first-ever full-year trade deficit in 2012 and it was only thanks to strong capital inflows that the country achieved a small surplus in its balance of payments. The complementary relationship between trade and investment created a dependence that became all too obvious when global funds suddenly pulled large amounts of portfolio investments out of the country in 2013. The withdrawal of capital exposed the full gravity of Indonesia’s current account deficit and the risk to the Rupiah. In the second quarter of 2013, Indonesia suffered its largest current account deficit since the Asian Financial crisis, largely caused by high fuel imports and low demand for major export commodities.
Tasked with maintaining the stability of the Rupiah, Bank Indonesia (BI) is grappling with slowing economic growth on the one hand and rising inflation on the other. Annual GDP growth slowed to 5.8% in the second quarter of 2013, while annual inflation jumped to 8.6% in July, marking the highest rate in more than four years. The sharp rise in consumer prices can be partly attributed to the lower exchange value of the Rupiah, which makes imported goods more expensive. Caught between a rock and a hard place, the central bank raised interest rates several times beginning in June, despite the effect this might have on credit lending.
It is doubtful whether tighter monetary policy alone will strengthen the exchange value of the Rupiah as long as Indonesia’s balance of payments remains negative. Meanwhile, BI’s second main instrument to prop up the currency, direct intervention in the forex market, could not halt the downward trajectory of the Rupiah. The central bank has steered clear of committing to a concrete threshold where it would start to sell dollars and buy Rupiah; its trades appear to aim mainly at preventing excessive moves to the downside. The bank’s stash of foreign currency dropped from $112.8 billion at the beginning of the year to $92.7 billion at the end of July. That leaves ample firepower to dissuade attacks on the Rupiah, but it does not alleviate the pressure arising from the current account deficit.
In a bid to address this issue, the government on 23rd August 2013 announced a host of measures aimed at improving the trade balance and attracting foreign investment. The measures include the removal of export quotas on mineral and metal ores as well as higher import tariffs on luxury goods such as cars, private planes and yachts. They also entail tax incentives for labour-intensive industries. These measures flank Bank Indonesia’s move, announced on the same day, to make it easier for banks and exporters to access US dollar liquidity. The central bank also extended the time period for dollar term deposits. While most economists praised these measures as a move in the right direction, their effect on the balance of payments will be limited. In the long run, the depreciation of the Rupiah itself may prove to be the most potent tool in rebalancing Indonesia’s trade with the rest of the world, albeit at the cost of temporarily higher inflation and falling purchasing power.
Rising borrowing costs and lower domestic purchasing power can be expected to put a damper on business activity and consumer demand, the impact of which will be felt across Indonesia’s economy, but particularly at banks, consumer goods makers and retailers. Banks will have to prepare for lower net interest margins and slowing demand for loans but these adjustments would have come sooner or later anyway, to avoid excessive lending and a build-up of default risk.
Export-focussed industries are faced with higher costs for imported components but will eventually benefit from the lower value of the Rupiah, which makes their goods and services more competitive abroad. While the government is keen to stabilise the Rupiah and prevent it from falling further, it may grow comfortable with the currency’s new level as it seeks to boost exports and limit imports. The vast domestic market will remain one of Indonesia’s main pull factors for foreign direct investors, but it may yield just a little bit in favour of the country’s export potential, assuming structural issues from infrastructure bottlenecks to red tape are tackled.
Had the reasons behind Indonesia’s worsening foreign trade position been addressed earlier, the sudden capital flight of summer 2013 may have been averted. At this point, investors can take consolation in the fact that concerted efforts by the government and Bank Indonesia demonstrate that the authorities have woken up to the structural problems affecting Indonesia’s economy. In the short run, the emergency response should at least slow down, if not arrest, the depreciation of the Rupiah. In the medium run, measures to boost exports, attract more foreign direct investment and increase the proportion of domestic funds in the capital markets should put Indonesia’s balance of payment on a more stable footing. Long-term adjustments, such as labour market reform, meanwhile, will only materialize after the 2014 general elections. Since the country’s banks are in a much stronger position today than they were in the late nineties and overall dollar debt in the economy is lower, any fears of a repeat of the 1997 crisis would appear to be misplaced.
Global Business Guide Indonesia - 20th September 2013
Capital: Jakarta
Population: 259 million (2016)
Currency: Indonesian Rupiah
Nominal GDP: $936 billion USD (IMF, 2016)
GDP Per Capita: $3,620 USD at Current Prices (IMF, 2016)
GDP Growth: 5.0% (2016)
External Debt: 36.80% of GDP (BI, Q2 2016)
Ease of Doing Business: 91/190 (WB, 2017)
Corruption Index: 90/176 (TI, 2016)
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