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.