JP/7/KELLY

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.