Making sense of the rupiah depreciation

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J. Soedradjad Djiwandono

IO – Public discussions have recently been dominated by issues associated with the weakening of the Indonesian Rupiah against the US Dollar (USD). In this newspaper alone, Dr. Fuad Bawazir, Prof. Didik Rachbini and others have come up with their own unique narrative in op-eds to warn the authorities not to treat the consequences surrounding Rupiah depreciation lightly.

This write-up is not explicitly concerned with the fate of the Rupiah and the policy enacted to deal with our predicament. I will discuss the strengthening of the USD within the current system and the practice of global monetary workings and payments. This does of course have ramifications on Rupiah exchange rates, as well as the policies enacted to stabilize them against the greenback, as support for the suggestion to avoid treating the problem lightly.

I have no quarrel with those arguing that the “trigger”, or what could be considered the source of the recent depreciation of the Rupiah (along with the currencies of other emerging economies) is in fact external, pinpointed as the strengthening of the USD. Here, the only debate would be in terms of what we precisely mean by the “strengthening of the USD” and what factors contribute to it.   However, to explain why one currency depreciates more than another or how what has recently happened to the Rupiah looks similar to or different from the events of 1997/98, it does not seem correct to look at or blame external factors. Instead, one should assess domestic factors, i.e., those related to each country’s fundamentals and the monetary and economic management of each respective country as well.

If this ultimately degenerates into a financial crisis, it is more often than not a result of the combination of external and domestic factors. I described in detail the financial crisis that Indonesia experienced in 1997/98, in my Bank Indonesia and the Crisis: An Insider’s View as “home-grown, but not home alone”. To argue which factors are more dominant is academic, but to state that it is solely external (or otherwise) is certainly not correct.

The mighty dollar
“Strong economy and hawkish monetary policy pushback greenback ever higher, and other currencies are suffering”.  That is the opening sentence of a news report in The Guardian (04/10/2018) describing the soaring USD, a troublesome and threatening reality for emerging markets.

The strengthening of the USD, which has recently been acutely felt and realized globally, started at the beginning of this year or even earlier. The reason behind this development is generally understood, if sometimes only superficially. It may therefore still be useful to briefly review the facts, for clarification.

Allow me to start by referring to fundamentals that support the strengthening of the USD. There is no doubt that the US economy has recently become the most robust among the developed countries. It exhibits a steady GDP growth rate a bit over 3 per cent, coupled with a 3.7% rate of unemployment, its lowest in close to five decades, along with an inflation rate which only very recently was around 2%. This has been combined with President Trump’s stimulus policy of tax cuts and increased expenditure for investment in infrastructure on the fiscal side, together with a hawkish policy by the Fed on the monetary side. The latter includes what everyone points to: a program of raising fed fund rates which started a couple of years back, and will most probably continue at least through next year. The Fed will also implement a program to reduce its holding of securities while streamlining its balance sheet, ballooning from a bit over USD 800 billion in 2008 to more than USD 4 trillion at present.

The other policy which indirectly contributes to the strengthening of the USD is President Trump’s ongoing tariff war against China (and basically against any other economy holding a surplus in its trade with the US). As we have been observing the tariff war that originally started on a limited scale, concentrated on trade with China, has been continually widening in volume and in coverage to include more economies, both those considered “adversaries” as well as those thought of as “allies” of the US. Recent developments showed that China and other trade partners have begun to feel pressure from these moves, as reflected in the weakening of their currencies against the USD.

However, the strengthening of the USD, coupled with increases in interest rates in the US, have had the corollary effect of pushing up the yield of investment in USD or dollar-denominated securities. These two phenomena, together with President Trump’s tax cut, have in turn been impelling reversal of capital by those previously investing in emerging markets, flowing it back to the US. Basically, this results in a reduction of global liquidity, previously abundant thanks to the loose monetary policy and quantitative easing exercised by the Fed, ECB, BoE and even the BoJ. Again, be aware that all emerging economies have been suffering capital outflows. Naturally, countries whose steep exposure to borrowing in USD, or those with large debts in national currencies held by foreigners – such as the classic case of Indonesia’s bonds, 40% owned by foreigners – would feel more pain than those in a different economic environment.

Tax cuts and increased fiscal disbursements are a recipe for widening budget deficits in the near future, one that in turn implies increased borrowing down the road. Such new debt can only be taken on at steeper interest rates, and this is thus how the market perceives interest rates climbing in the future. The Fed, as the purported guardian of momentary stability, would not risk any overheating of the American economy, and would thus faithfully stick to a tightened monetary policy, thus launching interest rates upward and retiring matured securities (over the objection of President Trump). The future trajectory is thus made clear: interest rates would rise; only the level and magnitude, as well as the pace, are still to be decided, after careful deliberation by US Federal Market Committee (FOMC) members in their meetings. Most media commentary on recent developments alludes to the interest rate increases and tariffs or even the “trade war”, but only serious analysts brought up the other issues mentioned above, even less touching on the reasoning behind each decision.

While it is not directly related to our main point of discussion here, it is still relevant to explain how the USD succeeded in becoming mightier. According to Gilian Tett, the US Managing Editor of Financial Times, the USD currently accounts for 62% of global debt, 56% of international loans, 63% of foreign exchange reserves and 44% of foreign exchange turnover, combining the aggregated cost of all trading deals (FT, 28/09/2018). This is the reality, despite efforts by the EU to make the Euro a global currency at par with the USD and China’s success in pushing the Yuan to jump in the “basket” of the SDR two years ago. It is a bit strange, for instance, as Professor Carmen Reinhart of Harvard University noted, that when China loans money to low-income countries in Africa and Asia such transactions are in dollars, not Renminbi. I do not know for sure whether this is also the case with Chinese loans to Indonesia, negotiated by Minister of State Enterprises Rini Soemarno several years ago. My guess is that it was in dollars; never mind President Joko Widodo’s previous suggestion that Indonesia and ASEAN start dealing in Renmimbi. These are just anecdotal notes, explaining how the USD became more dominant than ever.

Pressures on EM currencies
Why do all the above developments create pressure on emerging country currencies, including our Rupiah? This has some bearing on previous developments in the system of international finance and payments. Since the global financial crisis (GFC) of 2008, part of the policies implemented by advanced economies was to flood the system with liquidity to ensure survival through the crisis and recover from its devastation. This happened with central banks pumping liquidity by way of lowering interest rates close to (or even below) zero and through purchases of securities from banks, the so-called “quantitative easing” (QE). In this way central banks hoped other banks would provide loans for businesses to revive their operations and for the economy to grow.

During this period giant US and EU corporations like Starbuck, Google, Amazon and others accumulated funds from their revenues and profits invested in emerging economies, through different channels for better returns. For the EMs such capital flows have been instrumental as a source of financing for economic growth. Meanwhile, this has also been a period when EMs took on big debts, with all the implications, not always well thought out in advance (such as the way that historically most financial crises had been linked to high leveraging in a previous period.

Now, the strengthening of the USD, as previously alluded to, becomes more attractive for these funds previously invested in emerging economies; as a result, we see a reversal in capital flows.  Meanwhile, higher interest rates and a debt repayment burden in an appreciated dollar make new loans that EMs desperately need more expensive: the world observes both sovereigns and corporations in emerging economies had been steeply raising their debt level throughout this period of very low interest rates, for years after the GFC. The IMF Managing Director just recently repeated her warning about increases global leveraging, prior to the Annual Meeting convened in Bali, pointing out how a global debt-to-GDP ratio at 36% prior to the GFC is now 52%.

The unconventional monetary policy addressing the 2008 global financial crisis by the Fed, BoE (Bank of England) and the European Central Bank (ECB) as well as the Bank of Japan (BoJ), started from a US mortgage loan meltdown and spread globally after the demise of Lehman Brothers in September 2008, successfully avoiding a 1930s-style global economic depression. However, this maneuver has also incurred a high cost, in the form of a prolonged recession and very slow recovery. During this period of more than 9 years, while the world was flooded with liquidity it suffered anemic economic growth, a condition partly exploited by emerging economies to attract this liquidity, even if at a steeper risk.

Now, when relatively robust economies normalize, characterized by stronger currencies plus additional stimuli (the US tax cut and fiscal stimulus) capital reversal accelerates. The repatriation of capital is not simply a market correction; it is not just a short-time phenomenon. Judging from the nature of the external factors related to the rebalancing of growth and development, as well as other, associated, factors, from economic fundamentals to policies and uncertainties, it is more likely that we will face these developments with lingering uncertainty.  In my discussions with small interest groups, I have been warning them that we are not in a hundred-meter dash, but rather in a long -distance run – if not a marathon.

Concluding notes
Assessments argue for similarities and for the opposite, regarding both the problem of Rupiah depreciation and the policies deriving from it, between the current case and the Asian financial crisis of twenty years ago. I suggest both sides have come up with worthwhile arguments, which differ only in stress and shade. I would like to add another aspect to the debate: I cannot help but think that the difference the economic management between now and then has also been affected by a different political environment. During Suharto “New Order” officials involved in the economic portfolios all had to shy away from politics, while now and since the advent of the era of reform everyone is free to state their political preference. Because of that iron rule, holders of economic portfolios twenty years ago were forced to be more technocratic than today, with both positive and negative implications. Intellectuals abide by professionalism and integrity, exuding trust and confidence in a proper sense of technocracy, very crucial in public management amidst uncertainties. Losing them is a recipe for disaster: once they are lost it is close to impossible to recoup trust and confidence.

I would like to underline here that it is not erroneous for government officials to argue that Rupiah volatility (or more precisely its depreciation) has been associated with or caused by external factors, easily attributed to the strengthening of the USD. However, focusing on external factors while playing down or even ignoring domestic ones not only blinds us from understanding the real issues, but also constrains the discovery of effective means to resolve pressing problems.