JP/7/KELLY

Is the bond market a bubble?

Kelly K. Knight Austindo Group Jakarta

There is a widespread belief that a bubble is forming in the rupiah bond market, and in the rupiah currency itself, but this might not be true.

Rupiah bonds are going up, along with bonds denominated in other currencies throughout the world, because virtually all short-term interest rates are going down in every currency. The reason is because all governments try to peg the exchange rate of their currencies to the U.S. dollar (either transparently or through intervention, with a fixed rate or a band); and this linkage means that, when U.S. dollar short-term interest rates go down, the short-term interest rates of the pegged currencies must go down too, and their bonds must go up.

The declining dollar interest rates are also causing the dollar to weaken. This is causing strengthening in first, all the other currencies, including euro, and rupiah, and all the commodities.

Thus the strengthening of the rupiah currency and bonds has much to do with America's dollar policy, and little to do with Indonesia itself.

Thus, why doesn't the U.S. government raise short-term interest rates to protect the value of the dollar? Or, why is the U.S. government keeping U.S. currency short-term interest rates low, even when this is now obviously weakening the dollar?

The answer is that low the green back interest rates help to finance its "war on terrorism." Because, if US$ interest rates are low, the U.S. government can borrow cheaply to finance the War.

This is what the U.S. government always does during times of war. The government knows that in times of war, Americans don't care so much about their economy or currency or inflation -- except winning the war. Americans will understand that they must incur pain in war-time; and they will be prepared to incur pain with no political complaints.

The pain of war is not new for Americans because America is almost always "at war" with somebody or other (French and Indian War, Revolutionary War, Civil War, Spanish-American War, World War I and II, Korean War, Vietnam War, Cold War, Iraq I, Afghanistan, Iraq II, etc.). War is not unusual in the U.S., peace is unusual.

As to whether Sept. 11 will be interpreted as an "act of war" by Americans, we have to remember that the last time America was attacked on its own shores was by the Japanese at Pearl Harbor. We should expect a similar U.S. response to Sept. 11. Afghanistan and Iraq are only the beginning.

The end could look more like Nagasaki and Hiroshima -- "real- world" measurements of America's capacity for "payback." The "war on terrorism" means the "war on everyone who hates the U.S." -- and is not a small isolated group of people.

This war has already been declared to include North Korea and Iran, but it might not be limited to them. Hence this war will last a long time, which means that low US$ interest rates (and a weak US$ currency) will also last a long time.

Under normal war scenarios, the U.S. would keep interest rates low for the reason stated above, which would weaken the currency. The pain for Americans would occur in the form of domestic inflation because all imports would become more expensive in U.S. dollar terms.

And the Americans would happily accept this inflation as a normal cost of war. As the Cold War ramped up to a furious pace in the late 1960s, 1970s, and early 1980s, inflation was raging in America and Americans accepted it for more than a decade -- no problem. Gold went to $800/ounce.

Yet the "war on terrorism" will be different from normal war scenarios. U.S. inflation will be cushioned by a deluge of excess supply from China, India, the former Soviet Union, Eastern Europe, and other countries that previously generated no exports because they were not even able to feed themselves.

Their participation in the global economy is not only something new, significant, and growing; it is almost entirely in the form of production, not consumption. Oil was previously a weak spot, not only for U.S. inflation but also for U.S. strategic military purposes, but that problem has been solved.

The U.S. now controls the second largest oil reserve in the world after Saudi. Oil prices are determined "at the margin" and the U.S. now has absolute control of supply "at the margin."

But control of oil is only the first piece of the big puzzle, which is the long-term "war on everyone who hates the U.S."

The pain of domestic inflation is now well-cushioned, so America can play a long term game in financing the war with low interest rates, which implies a continuing weak dollar, and strength in commodities, foreign currencies, and bonds.

Some will incorrectly argue that low US$ interest rates and a weak US$ are unsustainable because they will inhibit the borrowing power of the U.S. government. This argument does not apply in a world dominated by one "empire-building hyper-power", which is what the U.S. is today.

The most recent historical example of such a single empire- building hyper-power was the British Empire, the government debt of which equaled 30 percent to 50 percent of its gross domestic product (GDP) for more than 100 years.

U.S. government debt-to-GDP is only a fraction of that percentage, which shows that the U.S. still has enormous borrowing capacity to finance the extension of its empire.

This leads to a viscious circle (or "virtuous circle", depending on one's perspective): The more the empire borrows, the more it can extend its power. The more it extends its power, the more people want to buy its debt securities.

Low US$ interest rates and a weak US$ dollar are highly sustainable and can last for decades because they will not impede U.S. borrowing power, which means that commodities, foreign currencies, and bonds will be strong for a long time.

How will all this affect Indonesia? First, rupiah interest rates will continue to look fantastic relative to US$ interest rates, which will keep the rupiah currency strong as well as the rupiah bond.

Second, Indonesia's credit rating will improve dramatically because Indonesia will make a "killing" (in US$ terms) from strong commodity prices caused by the weak US$, which will enable Indonesia to repay its debt (US$ denominated). Of course, an improved country credit rating is very supportive for both its currency and bonds.

Third, as the world's most populous Muslim country in the context of the "war on terrorism", Indonesia should be able to find many ways to negotiate "big-bucks" of foreign aid and even debt forgiveness.

As is normal in war-time, the U.S. and its allies are now tossing hundreds of billions of dollars around the world to extend their power. So why shouldn't Indonesia get a mere $20 billion or $30 billion -- peanuts maybe, for the U.S., but significant in terms of strengthening the rupiah and rupiah bonds.

Sometimes the market seems to believe that the rupiah and its bonds are destined to collapse and, to attract capital back into the Indonesia, interest rates are destined to be high. The ideas above will then seem like heresy.

But these ideas lead to an even more heretical thought: Corporate earnings are going to increase because rupiah interest rates will continue to decline, which means that the stock market in Indonesia is going to go up.

These thoughts are those of the author and not necessarily of the Austindo Group.