Tuesday, April 27, 2010

Indonesia's Capital Inflow and the Downside Risks that Follow

WARNING SIGNS. Soaring stock prices and rising Rupiah are outwitting you now; in fact an economic bubble is stealthy lurking behind the shadows because of the overcrowding capital inflows which have flooded Indonesia in recent weeks.

You are simply not a savvy foreign investor if, given current global economic situation, you overlook Indonesia as a place to invest your money.

Back then you used to have well-developed and industrialized countries in the table as your priority to invest because they, in reality, tended to be more secure compared to developing countries.

But while United States economic recovery is still beset with various obscurities, and European’s economic stability is disrupted by the debt-troubled PIGS economies (Portugal, Ireland / Italy, Greece, Spain), currently you may want to wait a little longer before you can be finally sure to invest your money there again.

This is the moment when you should start to notice that in the east, several Asian emerging economies can be considered as less risky places to invest as they are trouble-free and actually withstand the global financial crisis better than developed economies.

Indonesia is one of those economies, recording an impressive 4.5% economic growth during the crisis and has seen significant upgrading in its investment grade rating because of its imposing economic performance.

Besides, its economy is bolstered with political stability, violence-free democracy, and huge domestic market. In the midst of the financial storm which has left most economic frameworks in the world shattered, what Indonesia’s economy boasts in its disposal would surely make you and your fellow investor friends to turn heads.

Indeed, money is flowing in. The rise of demand for one country’s investments theoretically would lead to a higher demand for the currency of the country itself, and the unusually strong Rupiah these days, which surges to 30-month-high level to almost Rp. 9,000 per US Dollar, is a clear reflection of the rising number of foreign investors who have crammed the Indonesia’s market.

The problem is: when someone has too much money in his hands, sometimes it will engender more convoluted quandaries than he previously expects.

While many will perceive the improvement of Indonesia’s image in the eyes of the foreign investors is a good thing for Indonesia, actually policymakers should be wary about the long-run corollaries that can possibly occur when Indonesia is inundated with too much capital inflows.

The most important thing to bear in mind is that the stronger-than-ever Rupiah at the moment, unfortunately, may not make all Indonesians better-off.

For instance, just ask Indonesian exporters who surely have been monitoring the rapid rise of Rupiah in recent weeks with deep anxiety.

In fact, the too-strong Rupiah –whose rate moves in an unpredictable fashion, appreciating swiftly in such a short-period like what we have seen in recent weeks– will be a huge blow for them as Indonesian goods will be more expensive overseas and could eventually damage Indonesia’s exports as a whole.

Yet because of the excess amount of capital outflows, another problem like inflationary pressure is also lurking behind the shadow.

Too much capital inflow can stimulate a considerable rise in money supply and, eventually, inflation. The government could welcome capital inflow to the country, but if inflation’s presence on the economy goes unnoticed and largely ignored, inflation could nibble our economic growth and disrupt our economic development.

If it is already too little and too late and the inflation has soared, Paul Volcker, the former Federal Reserve chair, can be asked about how hard and costly it was he tried to trim down the inflation rate during his tenure.

In addition to the spat over the unusually strong Rupiah and the looming threat of inflation, it is also worth noting that the increasing demand for Indonesia’s investment has lead to yet another problem: the current swell of the price for Indonesian shares and assets to such abnormally level, which emerges concern whether an economic bubble is just around the corner.

For many economists, the most feared weapon that an economic bubble possesses inside its arsenal is its ability to swell and burst almost any time and in such an impulsive way –and very often when it truly bursts, it generates a devastating repercussion. The burst of the housing bubble in the mid-2008 in the United States, in fact, was deemed by many as the key trigger to the worst financial crisis that Americans have ever seen in almost a century.

And economists hate to deal with economic bubble very much: knowing the fact that the term that economists keen to pay heed the most is always ‘stability’; economic bubble, in contrast, has always been notorious for its ‘volatility’.

Economic bubble can possibly emerge because of the fact that the largest share of Indonesia’s massive capital inflow these days, unfortunately, is dominated by short-term investment or hot money.

It is an ‘easy-come, easy-go’ investment: when those investors with their hot-money find more attractive countries to invest, they will simply cash in their chips, pulling their investments out from Indonesia which will cause the once-soaring price of investments and assets to freefall all of a sudden.

With such ominous threat from the burst of the investments and assets bubble, economists’ fear about Indonesia’s excessive number of capital inflows is indeed understandable.

Some may rejoice current news about the massive number of new investors which deluge the country, the insurgence of Rupiah, or the soaring stocks prices in recent weeks; but when we look through the other side of the prism, they actually also leave economists and policymakers in conundrum.

This is basically because failing to solve this excessive capital inflows problem in the short-run may likely lead to bigger problems in the economy, which will require a higher sterilization costs in the future and impede the long-term plan of Indonesia’s economic expansion.

What seems to be a good thing, in actual fact, can also mean exactly the opposite –just like the dilemma faced by Indonesia because of its excessive amount of capital inflows which is seemingly good for Indonesia’s economy, but in actual fact hides perilous threats underneath.

This article was published in The Jakarta Post on Tuesday, April 27 2010

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