Despite the “dovish” reputation of Janet Yellen, nominated to take over as the US Federal Reserve chair in 2014, the central bank is already committed to reducing its bond-buying program by US$10 billion starting in January this year.
This decision was primarily motivated by the central bank’s confidence in the stability of the US economy. This decision will have a significant impact on the global economy, particularly emerging economies including Indonesia.
Even though the Fed eventually delayed the tapering from its original schedule last September due to less than expected macroeconomic improvements, this signal had led to a global portfolio rebalancing that affected most emerging economies.
In particular, emerging economies that experienced fiscal and current-account deficits, such as Indonesia, were more prone to this shock and thus were affected more severely. As a huge amount of capital was withdrawn from Indonesia, its currency depreciated sharply, resulting in short-term financial instability in August through October.
Hence, considering its existing twin deficits issue, Indonesia will face another wave of threats when the QE tapering really happens next year. From an external balances perspective, the prolonged current-account deficit that has been plaguing Indonesia for five successive quarters will still make the rupiah prone to further undergoing currency depreciation.
This is exacerbated further by the huge share of foreign funds invested in Indonesian capital markets.
As dollar liquidity tightens, vast funds withdrawal from capital markets will occur, resulting in the plummeting stock index and soaring bond yields.
Then, this fund withdrawal will drain the Indonesian capital account and reduce its ability to finance its current-account deficit. As a consequence, its balance of payment will deteriorate and the rupiah will suffer.
When the tapering occurs, it is also very likely to raise interest rates again to dampen consumption and reduce imports.
Meanwhile, from a fiscal policy perspective, Indonesia will experience another fiscal deficit in the proposed 2014 state budget, which is estimated to reach 2 percent of next year’s gross domestic product (GDP). When QE tapering occurs, the weakening rupiah will cause energy subsidies to swell further and widen the fiscal deficit.
Accordingly, oil and gas imports will increase and undermine the current-account deficit further. Higher oil and gas imports, coupled by rupiah depreciation, will result in higher imported inflation. With more inflationary pressures, consumption will be hampered and economic growth may slow. Therefore, if no concrete actions are taken, this issue could result in a downward spiral, thus adding more pressure to economic stability.
Fortunately, some of Indonesia’s other macroeconomic variables are still relatively strong enough to anticipate QE tapering. From a public finance perspective, government debt as a percentage of the GDP is only around 23 percent. This low government debt, accompanied by sufficient foreign reserves, may minimize additional shock to rupiah’s volatility.
Moreover, Indonesia’s financial sector is still firm enough in facing external shock, such as that caused by QE tapering. Thanks to the adoption of BASEL II and the implementation of macro-prudential policies to preserve financial stability, Indonesian banks have healthy liquidity position and good capital management. When the tapering occurs, this prudent financial sector will prevent, or at least, minimize the magnitude of adverse shock transmission from the financial sector to the real sector.
In addition, the delay of QE tapering also gave Indonesia more time to improve its macroeconomic fundamentals. To reduce financial volatility, the central bank has made some attempts to narrow Indonesia’s current deficits by tightening its monetary policy, i.e. rising its benchmark policy rate. When the tapering occurs, it is also very likely to raise interest rates again to dampen consumption and reduce imports, thus minimizing the impact of additional inflationary pressures and improving the trade balance.
Furthermore, it has been sustaining its foreign reserves amount to maintain rupiah liquidity. It also established and increased bilateral swap agreements with Japan, China and South Korea to maintain its foreign reserves. To some extent, these central bank policies are expected to be able to narrow Indonesia’s current-account deficit and reduce the impact of QE tapering on financial stability.
Bank Indonesia also cooperates with the government in facing QE tapering, which is mainly aimed at managing its twin deficits issue. For instance, the government launched the first and second rescue packages, increased the investment limits in certain industries, eased investment regulations and announced tax incentives for investments in agriculture and metal to promote exports. It will also reduce luxury car imports, control the subsidized oil usage and mandate higher biodiesel usage to cut oil imports.
Ultimately, QE tapering will still have adverse effects on the Indonesian economy, particularly considering its unsolved twin deficits issue. Once the tapering starts, dollar liquidity will tighten and Indonesian economy will face huge funds withdrawals. This will lead to currency depreciation and financial instability, thus undermining overall macroeconomic performance.
However, the exact severity of the impact is very difficult to measure since such phenomenon has never happened before. In addition, different timing and bond-buying reduction amount may result in different impacts on the Indonesian economy.
To conclude, even though QE tapering is expected to undermine the Indonesian economy severely, its impact is expected to be less significant than the 1997-scale financial crisis vis-à-vis macroeconomic performance and financial stability.
The writer, a graduate of the University of Manchester, is a research analyst at a multinational bank. The views expressed are his own.