Dealing with fickle financial markets

Fajar Hidayat, Jakarta

Chameleons (family name: Chamaeleonidae) are small to medium- sized reptiles that are famous for being able to change their skin color in line with their surroundings. Their skin color changes under the influence of temper, temperature, and illumination. Such changes also play vital roles in communication.

Finance theories do not explore the correlation between animals and the financial markets, despite the fact that chameleons could serve as an appropriate analogy for the behavior of the financial markets. The markets can change their "color" to reflect their response to the investment atmosphere, and their hopes and fears.

That new "color" is reflected in market consensus, i.e., a collective opinion and agreement among the majority of market agents on specific issues concerning financial assets. Such consensus drives the markets in a particular direction regarding assets, i.e., buy, hold or sell.

Market consensus basically is created through formal or informal "polling" among market investors and professionals, e.g., fund managers, bankers, dealers, traders, economists, analysts, observers, etc. The best sources for getting a sense of the consensus are investment newsletters, market updates, and the press.

Just as chameleons use color to communicate, so the financial markets use the prevailing consensus to articulate expectations. Through such a consensus, the markets announce that they expect a particular situation to occur.

An example of how this consensus conveys the markets' expectations may be seen in Indonesia's current financial market instability. The instability was triggered by the weakening of the rupiah on the money market, which then adversely affected the stock, bond and mutual fund markets.

The depreciation of the rupiah was precipitated by soaring global oil prices, which dramatically boosted the demand for dollars to finance oil imports and created an imbalance between dollar supply and demand. The fact that domestic fuel prices are heavily subsidized means that the government has to pay significantly more to cover the cost of the subsidies. This aroused market fears over the possibility of an unsustainable budget deficit.

The market consensus was: The rupiah will remain weak as long as oil imports remain high. The markets therefore hope to see a fuel price hike soon to reduce fuel consumption and the demand for dollars to finance oil imports, and to reduce fuel subsidy spending so as to lower the deficit.

This consensus was reflected in the money market through "herd behavior" after the rupiah breached the psychological barrier of Rp 10,000 to the dollar, with everyone abandoning the rupiah and desperately chasing the greenback. The local unit fluctuated wildly and was only stabilized thanks to packages of monetary measures introduced by Bank Indonesia on Aug. 30 and Sept. 6.

The government, frustrated by the markets' negative response to the Aug. 31 economic policy package, finally announced a plan to raise fuel prices starting early October. Besides ensuring fiscal sustainability, the government hoped that the plan would satisfy market expectations and improve confidence.

However, reality might not always be in line with the government's expectations. The financial markets could reveal their chameleon-like character by once again changing their color, that is, the market consensus. It is not difficult for the markets to build a new consensuses in the light of rapid changes in the economic and socio-political atmosphere. Neither would the markets be breaking the law if they arrived at a consensus that a fuel price hike would not be conducive to the portfolio investment atmosphere.

In fact, this is what has been happening on the stock market lately. The possibility of fuel price increases of fifty percent has made investors worry about the adverse impact on the business sector and the public. The increase would force many listed companies to revise their profit targets due to higher operating costs and reduced demand. The hike would also increase the burden on the people, and strong protests could create economic and socio-political instability.

The power of the consensus was proved by the mass selling of blue chips and widespread profit-taking that occurred on Sept. 14, which drove down the index by 27.2 points to 1,058.6. This situation might only be temporary. Yet, if the upcoming fuel price hike does create instability, the consensus might strengthen to cause a market crash.

If this occurs, it means that the stock market will have a totally different consensus about the fuel price hike. The previous consensus that faulted the government for not increasing fuel prices made the stock market crash on Aug. 29, when the index fell to 994.

A similar situation could occur in the money market if it sees an inflationary spiral after a dramatic fuel price hike. The new consensus then could be to stay away from the less attractive rupiah. The risk of economic and socio-political instability and many other fundamental and non-fundamental factors could also change the market consensus.

The best the government can do, then, is to remain consistent to its economic policies, meaning that the plan to increase fuel prices has to go ahead. The government has to enlighten the market about the rationale behind such a painful measure.

It is imperative to make the markets (and the public) understand the reasons behind the plan and the action being taken to prevent adverse impacts. The government needs to consistently educate the markets and persuade them to support its economic recovery programs.

It would be a good idea, therefore, to hold discussions between the central bank and market players (represented by influential investors, fund managers, bankers, economists and analysts), on the current fiscal and monetary situation and policies.

The writer is an alumnus of Birmingham Business School, UK -- MBA Int'l Banking & Finance.