The risk of short-term capital

The risk of short-term capital

By Winarno Zain

JAKARTA (JP): The rapid rise of the share price index of the
Jakarta Stock Exchange (JSX) in the past several weeks was
surprising indeed. After hitting 300 early this year, it bounced
back to over 600 before declining.

Analysts have attributed the rise mostly to buying by foreign
investors. This dramatic rise in share prices cannot yet be
explained by corporate fundamentals. Most of the publicly listed
companies are still plagued by weak balance sheets. Their sales
and profits are still under pressure and they are still burdened
with bloated debts.

The rally in the JSX share prices may indicate that investors
are being caught in what Alan Greenspan, chairman of the U.S
Federal Reserve Bank, termed as "irrational exuberance". Capital
is still flowing into the JSX despite the fact that share prices
have been too high in relation to the earning prospects of the
companies this year. A too rapid rise in share prices without
real accompanying improvements in economic fundamentals carries
the risk of creating a bubble economy that if burst, could
trigger a severe recession.

The recent return of capital to Indonesia confirms the pattern
of investors' behavior which has recently been noticed. Indeed,
an examination of this behavior could give us a better
understanding of why capital flows in and out of a country.
Whatever emerges, it is clear that capital, after fleeing the
country 21 months ago and triggering the worst economic crisis in
Indonesian history, is now coming back.

This capital is flowing back in the midst of frightening
political violence in several places in Indonesia. Even the
massacres in Lhokseumawe, in Aceh province where 41 people were
killed by the military in early May, could not halt the rise of
share prices in the JSX. As investors, they could not be
oblivious to the worsening political situation in the country.
Therefore, share prices, in some ways, must reflect concerns
about the overall situation. It is likely of course that this
share price level is also a reflection of "discounts" that
investors have already taken into account in their pricing, which
means that had the Lhokseumawe and other incidents not occurred,
share prices would have risen higher.

This capital flow phenomena is the result of a unique behavior
in investors which has been mentioned in several International
Monetary Fund publications. In a globalized economy, where the
national economy is more and more integrated with the world
economy, it is important to understand investor behavior. Moods,
and hence decisions, have a significant influence on the
stability of the national economy.

It cannot be denied that what we are witnessing now is the
work of the "contagion effect"; the rapid spread of an economic
crisis from one country to another.

When Mexico was hit by an economic crisis in early 1995, even
Indonesia could feel the ripple of that crisis. After Thailand
was hit in 1997, the crisis quickly spread to other Asian
countries. The ripple was felt as far as Latin America. But the
good thing about the contagion effect is that it works both ways.
Capital which has started flowing into Indonesia now is the
result of investors regaining confidence in other countries in
Asia. Capital has already started flowing into South Korea and
Thailand, two countries whose economies have started recovering.
As Indonesia is located in the same area with these countries
experiencing strong economic recovery, it is benefiting from the
investor perception that the Indonesian economy is not different
from the economies of neighboring countries. This time, it is the
wind of investor confidence which is blowing across Southeast
Asia. It is not the economic tornadoes of the summer of 1997,
which blew with such fury from Thailand to neighboring countries,
devastating everything in its way, turning the "Asian tiger"
economies into a house of cards.

Indonesia is also benefiting from another peculiar investor
behavior. It has been known that investors possess a "herd
instinct". They follow the direction where fellows are going.
Investors, like herds, do not want to be left behind. They are
always ready to jump on the bandwagon. This attitude comes from a
lack of understanding of the countries where they put their
money. The lack of transparency in these countries also created
problems for them. They could not distinguish one country from
another.

This current capital inflow should provide a breathing space
for the government. It provides higher liquidity to the economy,
which helps to push interest rates down and strengthen the
rupiah. As the market takes care of improvements in the monetary
and exchange rates systems, the government can now focus
attention on restructuring the financial sector and bad debts.

Reforms in these areas are urgently required, since prolonged
banking and debt problems will not sustain capital inflow. Once
the market finds the banking crisis and debt overhang have not
been satisfactorily resolved, capital will stop
flowing.

Unfortunately, the government, under the weight of political
lobbying from powerful businesses is dragging its feet, slowing
the progress of financial reforms. It is wasting the opportunity
to make the economic recovery more solid. The risk is that the
market will be unimpressed with the lackluster progress on
reforms and so will review their positions in Indonesia. It
should be understood that the capital that is entering the JSX is
short term, and because of its speculative nature, will
definitely flow out again once they find the economic recovery is
fragile.

They are highly sensitive to the speed of economic reforms and
political situations. Sentiments could be swayed by external
developments as well, such as a rise in U.S. interest rates,
which is a distinct possibility, given the strong growth of the
U.S. economy. Their presence in Asia is also influenced by the
success or failure of Japan to overcome its recession.

The size of their portfolios and earnings from Asia is small
in terms of total global investments. But for Indonesia it could
be a significant amount, and could have a significant influence
on the economy. What they are seeking is just, and in the words
of Denis Detray, former World Bank chief in Indonesia, it is "0.5
percent margins". This "0.5 percent margin" may be peanuts for
global investors, but in the current economic fragility, it could
have a devastating effect on the Indonesian economy.

In the long run, what we need is a better quality of capital
than what is now flowing in. What we need is the kind of capital
that makes long term investments, to be used for building new
physical assets such as factories and expanding current
capacities. This kind of capital is more productive, creates more
employment, has longer term commitments and does not pack up and
leave the country that easily when a crisis hits. This kind of
capital flows in as foreign direct investments (FDIs).

Sadly, the approval of FDIs dropped by 90 percent between
January to March this year from a year ago, reflecting the fears
of foreign companies on the situation in Indonesia. Speculation
abounds whether FDIs will flow in again after the elections.
However, the fact of the matter is that Indonesia is still too
attractive for investors to bypass.

The abundance of natural resources, low wage rates and the
size of the population will attract FDIs. Barriers to foreign
investments have also been reduced. Unfortunately, this favorable
climate has been dampened by other constraints, such as the
weakness in the institutional framework, legal, administrative
and accounting standards. Labor unions have been highly militant
in recent months and strikes have been common occurrences,
causing losses of billions of rupiah for the companies. Investors
will look more seriously into these issues before they decide to
come in.

One of the benefits of the current capital inflow is that the
government now has more room for further lowering interest rates,
without worrying about adverse effects on exchange rates and
capital flows. Combined with lower inflation, lower interest
rates mean a further decline in real interest rates. The better
macroeconomic environment could create expectations of an
increase in sales and profits for the corporate sectors, thus
inducing more investment.

Precautions are still being called for, however, since these
moves would be overshadowed by a possible U.S. Federal Reserve
decision to increase interest rates. Concerns about overheating
in the American economy are mounting and the expectation in the
market on the rise of interest rates in the United States is
increasing. A rise in U.S. interest rates could throttle the move
for monetary balance. This shows that an economic recovery too
dependent on short term capital still carries a lot of risks and
therefore should be followed with measures in other areas for a
more sustainable recovery.

Fortunately, the sign of recovery is apparent in other areas
as well. Government statistics, released recently by the BPS,
showed that the 1.34 percent growth in the first quarter of 1999,
is mainly due to an increase in agricultural production. A more
favorable weather and stable input price has increased rice
production and trillions of rupiah are being spent by the
government for social safety nets; poverty alleviation programs
and other expenditures related to the general election. These
expenditures have raised aggregate demand and production.

It is unfortunate, however, that the economic turnaround has
not been accompanied by a turnaround in exports. In the absence
of a strong domestic rebound, exports were expected to be the
engine of economic growth but the latest figures show that
exports are still weak, compared to last year. A combination of
trade financing problems, supply bottlenecks due to security
reasons, the declining price of some commodities and the Japanese
economy that is still mired in a recession have combined to
weaken export growth.

There is a possibility that Indonesia is losing markets as
overseas buyers are turning to other countries. The great
depreciation of the rupiah, apparently, has not helped.
Therefore, the government should be more vigorous in pursuing
economic reforms in other areas, otherwise, the recovery would be
in danger of losing its steam.

The writer is economic columnist, and former deputy editor of
SWA business magazine.