Indonesia's prospects in withstanding increasing global volatility

Published originally in Tempo Newspaper, 5th April 2023 in Indonesian

https://koran.tempo.co/read/opini/481313/dampak-gejolak-ekonomi-global-bagi-indonesia

Freely translated into English

Several recent global developments have drew the attention of economists, policy makers, and firms alike. First, China’s economic recovery is predicted to be smaller than previously thought due to the limited prospects of government budget stimulus. China's recovery is expected to be driven more by domestic consumption rather than a quick recovery in the property and construction sectors, which have been the backbone of the economic boom or the last fifty years.

A smaller recovery and still abundant global energy supply due to supplies from Australia and other countries are likely to depress the prices of industrial metals and coal, which are among Indonesia's main exports. However ample demand from China and India will support prices of palm oil. On the other hand Indonesia’s imports are predicted to remain quite high due to ongoing government investment projects and demand from the ongoing domestic economic momentum. Therefore Indonesia’s trade balance is likely to return to neutral and small deficit.

?Second, the collapse of several banks in the US followed by Credit Suisse in Switzerland -a globally important systemic bank- has caused a sudden tightening of the global money market. Last week, financial institutions in the US borrowed $153 billion from the Federal Reserve to overcome liquidity difficulties, the highest since the global financial crisis of 2008-2009.

The Swiss National Bank's efforts to merge UBS and Credit Suisse have caused holders of Coco debt (a type of debt instrument that increase the bank’s capital under certain conditions) to suffer significant losses. This has led to fears that this banking crisis could spread to Asia as Coco instruments are quite common in the region. This can accelerate the ongoing credit crunch for corporations and consumers, further slowing down economic growth.

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Meanwhile, Indonessia’s domestic banking industry is relatively insulated from the global banking crisis, supported by high capital levels and sufficient profitability levels that reduce the risk of insolvency events, one of the root causes of the collapse of Credit Suisse. Low customer concentration, significant asset diversification, and the relatively low exposure of the Indonesian banking industry to speculative industries such as cryptocurrency and startups, also reduce the possibility of Silicon Valley Bank-like events. Coco instruments are also relatively rare in the Indonesian securities market, coupled with relatively stable Indonesian security yields.

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Third, the Fed’ insistence on a tight monetary policy may end up destabilizing the global financial system. The banking crisis reveals a wide chasm between market expectations of a 2008-style quantitative easing campaign and the Fed’s campaign against inflation. The Fed’s more targeted longer-dated repo line for banks has allowed the central bank for the time being to separate its rescue of the banking sector while maintaining the tighter monetary policy.

This has raised concerns about a global liquidity crunch as counterparty risks escalate rapidly. However, this has not yet materialized. The Fed's swap lines with other central banks (BoJ, BoE, SNB, BoC, and ECB) have been met with few users in the past few days.

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The tightening of global liquidity needs to be anticipated by the government and the private sector. Indonesian foreign-denominated debt maturing in 2023-2024 are expected to be sizable. In addition, still significant foreign ownership in the domestic stock and short-term securities markets can cause significant foreign capital inflows. The foreign exchange supplies can be exacerbated by the decline in prices and demand for Indonesian exports due to limited Chinese recovery and worsening demand from developed economies.

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However, the Rupiah is predicted to remain resilient amidst the increasing global volatility. BI's foreign exchange reserves are still at a sufficient level ($140 billion) strengthened by swap line facilities with major economies such as Singapore and Japan. The domestic foreign exchange market has also become more resilient. Data from the domestic foreign exchange market over the past month showed an increase in spot transaction volume ($59.9 billion) compared to swaps ($23.5 billion), and a decrease in the proportion of 1-week swaps (48.7%), indicating improving investor confidence and deepening of the domestic financial market. Domestic non-deliverable forward (DNDF) instruments have also maintained expectations for the Rupiah exchange rate.

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In addition, the relatively high US inflation should increase Indonesia's real yield differentials and attract back foreign capital inflows after global volatility subsides. The expectation of a Fed pivot has already pushed foreign funds back into the Indonesian bonds in recent days. The Indonesian stock market is still quite attractive due to relatively bright domestic growth prospects.

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Faced with increasing global uncertainty and volatility, Bank Indonesia is likely to maintain conservative monetary policy, keeping the benchmark interest rate at 5.75% - 6.00% for 2023 while considering the direction of the Fed's monetary policy. The special time deposit policy for export proceeds (DHE) will aid in maximizing foreign exchange earnings amid uncertain foreign capital inflows. Meanwhile, pro-growth macroprudential policies should support the steady growth of credit.

The worsening global economy and BI's monetary tightening are predicted to slightly slow down domestic growth momentum. However, this can still be anticipated with pro-growth and prudent fiscal policies such as accelerating infrastructure projects, providing measured support to affected industries, and implementing effective and targeted social assistance distribution. Furthermore, diversification strategies in trade with India and South Asian countries should offset limited demand from China. An effective communication strategy will remain critical in maintaining business and consumer optimism to thrive amidst global volatility