1. Should Indonesia impose morestringent capital controls? Victor Burguete Andrs Lindner Miguel Angel Santos Giulia Zanvettor 1

2. What is going on in Indonesia? 2

3. While capital flows to emerging economies resumed in2010, in Asia the recovery started already in 2009 Net Flows to Emerging Markets (US$ Million) 1.400 1.285 Top-30 Emerging Markets Emerging Asia * 1.200 1.000 878 800 656 644 600 400 347 357 285 200 146 0 2007 2008 2009 2010 3Source: Institute of International Finance* Emerging Asia includes: China, India, Indonesia, Malaysia, Phillipines, South Korea and Thailand

4. In 2010 Indonesia experienced a five-fold increase ininflows, boosting its share within Asia from 1,5% to 7,6% 4

5. Indonesias capital surplus is mainly driven by portfolioinvestment (58% or three-times the average of Asia) 5

6. The lions share of inflows (89%) are invested inpublic sector securities denominated in Rupiah 6

7. Why this is an issue?Financial and macroeconomic concernsFinancial concerns: Portfolio flows are much more volatile than FDI Pro-cyclical access to credit in emerging marketsMacroeconomic concerns: Exchange rate overvaluation Inflation Economic overheating 7

8. What is going on in Indonesia? What has been the policy response so far? 8

9. We can analyze policy responses to inflows through the inconsistent trinity of macroeconomic policy Free Capital Flows Inconsistent Trinity: At a certain time a country can have a combination of any two of these three conditionsFixed Exchange Rate Sovereign/Independent Monetary Policy 9

10. Policy Option #12009: Do not respond and let the exchange rate appreciate Free Capital Flows Inconsistent Trinity: At a certain time a country can have a combination of any two of these three conditions Fixed Exchange Rate Sovereign/Independent Monetary Policy 10 It seemed suitable since size of inflow was relatively manageable (5,002 million dollars)

11. Policy Option #12009: Do not respond and let the exchange rate appreciate Benefits/Advantages Costs/Disadvantages Retain independence of monetary policy 11

12. 2009: Inflation was kept well below the Bank ofIndonesia target of 5% +/- 1% 12

13. Policy Option #12009: Do not respond and let the exchange rate appreciate Benefits/Advantages Costs/Disadvantages Retain independence of Large currency monetary policy appreciation in spite of relatively small size of capital inflows No sterilization costs 13

14. 2009: The Indonesian Rupiah appreciated 16.5%against the US dollar - going back to its pre-crisis level 14

15. Policy Option #12009: Do not respond and let the exchange rate appreciate Benefits/Advantages Costs/Disadvantages Retain independence of Large currency monetary policy appreciation in spite of relatively small size of capital inflows No effort to alter the composition of inflows or No sterilization costs to discourage hot money (higher vulnerability to sudden stops) 15

16. Policy Option #22010: Sterilized intervention in foreign exchange market Free Capital Flows Inconsistent Trinity: At a certain time a country can have a combination of any two of these three conditionsFixed Exchange Rate Sovereign/Independent Monetary Policy 16Change in policy response due to size of inflows, whichincreased five-fold to US$26,218 million

17. Policy Option #22010: Sterilized intervention in foreign exchange market Benefits/Advantages Costs/Disadvantages Significantly lower exchange rate pressure: 4.6% appreciation in spite of five-fold increase in flows 17

18. Nominal appreciation of the Rupiah slowed down from 16.5 (2009) to 4.6% (2010) Nominal Exchange Rate (Indonesian Ruppiah / US$)14.000 201013.00012.00011.00010.000 9.000 8.000 7.000 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 18Source: Bank of Indonesia

19. Policy Option #22010: Sterilized intervention in foreign exchange market Benefits/Advantages Costs/Disadvantages Significantly lower Large sterilization costs exchange rate pressure: 4.6% appreciation in spite of five-fold increase in flows 19

20. International reserves at the Bank of Indonesia increased49% in 2010, reaching US$89.750 (13% of GDP) 20

21. The Bank of Indonesia partially sterilized this accumulationof international reserves: Monetary base grew 29% Monetary Base & Liquidity (M2) (Billion Rupiah) 3.000.000 M2 MB 2006 14,9% 23,9% 2007 19,3% 27,8% 2.500.000 2008 14,9% -9,2% 2009 13,0% 16,7% 2.000.000 2010 15,3% 28,9% 1.500.000 1.000.000 500.000 - 2005 2006 2007 2008 2009 2010 21 Source: Bank of Indonesia

22. Total net sterilization cost: US$791 million: 0.11% of GDP and 0.9% of Central Government budget The annual cost for these instruments is US $1,049 million, whilst the average return on reserves is US $259 million Potential large effect in the future, as the stock of instruments has to be continuously rolled-over With full sterilization (allowing for 6.0% growth + 5.0% target 22 inflation), net cost would have been higher: US $1,341 million a year (0.19% of GDP and 1.56% of Central Government Budget)

23. 2010: Sterilized intervention in foreign exchange market Benefits/Advantages Costs/Disadvantages Significantly lower Large sterilization costs exchange rate pressure: 4.6% appreciation in spite Central Bank notes and of five-fold increase in flows term deposits kicked-in additional flows 23

24. 2010: Sterilized intervention in foreign exchange market Benefits/Advantages Costs/Disadvantages Significantly lower Large sterilization costs exchange rate pressure: 4.6% appreciation in spite Central Bank notes and of five-fold increase in flows term deposits kicked-in additional flows Lost of independence of monetary policy led to inflationary pressures 24

25. 2010: Average inflation closed at 6.2%, but finishedthe year with a run rate above 7.0% 25

26. 2010: Sterilized intervention in foreign exchange market Benefits/Advantages Costs/Disadvantages Significantly lower Large sterilization costs exchange rate pressure: 4.6% appreciation in spite Central Bank notes and of five-fold increase in flows term deposits kicked-in additional flows Lost of independence of monetary policy led to inflationary pressures No effort to alter the composition of inflows or to discourage hot money 26

27. What is going on in Indonesia? What has been the policy response so far? Are capital inflows likely to continue? 27

28. April, 2011: Rating agencies upgraded Indonesiafrom BB to BB+, one notch short of investment grade 28

29. From Jan-Apr 2011 international reserves increasedan additional 18%, totaling US $113,814 million 29

30. All prospects indicate that there is a significantprobability that inflows to Indonesia may even increase On April 8th 2011 Indonesia reached BB+ with positive outlook All three agencies highlighted the possibility of Indonesia having another upgrade in the near future Indonesia authorities expect the country to reach Investment grade by 2012 Other developing countries which compete with Indonesia for funds (Peru, Brazil, India, Turkey) are imposing capital controls There are no indications that interest rate differentials between Indonesia and developed countries are going to zero-in in the short-term 30

31. What is going on in Indonesia? What has been the policy response so far? Are capital inflows likely to continue? Our proposal: More stringent capital controls 31

32. Indonesia in the past has displayed a relatively largevulnerability to financial crises /sudden stops 32

33. In terms of GDP volatility, Indonesia also displayshigher vulnerability to crisis when compared to Asia 33

34. One explanation lays in the fact that Indonesia has thelowest financial depth in Asia as proxied by M2/GDP 34

35. Indonesia also has one of the weakest financialmarkets in Emerging Asia 35

36. Our proposal explores a third policy response to large and sustained capital inflows Free Capital Flows Inconsistent Trinity: At a certain time a country can have a combination of any two of these three conditionsFixed Exchange Rate Sovereign/Independent Monetary Policy 36

37. Imposition of More Stringent Capital Controls Benefits/Advantages Costs/Disadvantages Alter the composition of flows (towards longer term) 37

38. There is significant empirical evidence supporting the ideathat capital controls alter the composition of inflows Country Study Country Results Cardoso, Goldfajn (1998)*** Brazil Reinhart, Smith (1998)** De Gregorio, Edwards, Valds (2000)*** Edwards (1999)*** Edwards (1999)*** Hernndez, Schmidt-Hebbel (1999)*** Chile Labn, Larrin, Chumacero (1997)*** Laurens, Cardoso (1998)*** Reinhart, Smith (1998)** Valds-Prieto, Soto (1995)*** Colombia Reinhart, Smith (1998)** XCzech Republic Reinhart, Smith (1998)** 38Malaysia Reinhart, Smith (1998)** Source: Magud, Reihart, Rogoff (2011)

39. Imposition of More Stringent Capital Controls Benefits/Advantages Costs/Disadvantages Alter the composition of flows (towards longer term) Allows more independent monetary policy 39

40. Evidence from the Chilean case support the idea that capitalcontrols allow for more independent monetary policy Country Study Results Brazil Edison, Reinhart (1999)*** X De Gregorio, Edwards, Valds (2000)*** Edwards (1999)*** Chile Edwards (1999)*** Hernndez, Schmidt-Hebbel (1999)*** Valds-Prieto, Soto (1995)*** X Source: Magud, Reihart, Rogoff (2011) 40

41. Imposition of More Stringent Capital Controls Benefits/Advantages Costs/Disadvantages Alter the composition of flows (towards longer term) Allows more independent monetary policy It some cases lead to lower pressures on the RER 41

42. The empirical evidence is mixed in the case of RER pressure, ranging from reduces pressures to no effects Country Study ResultsBrazil Edison, Reinhart (1999)*** X De Gregorio, Edwards, Valds (2000)*** Edwards (1999)*** X Edwards (1999)*** XChile Edwards, Rigobon (2004) Hernndez, Schmidt-Hebbel (1999)*** X Laurens, Cardoso (1998)*** X Valds-Prieto, Soto (1995)*** XSource: Magud, Reihart, Rogoff (2011) 42

43. This may be due to the fact that empirical evidence oncapital controls affecting size of inflows is also mixed Country Study Country Cardoso, Goldfajn (1998)*** Brazil Reinhart, Smith (1998)** De Gregorio, Edwards, Valds (2000)*** Edwards (1999)*** X Hernndez, Schmidt-Hebbel (1999)*** Chile Labn, Larrin, Chumacero (1997)*** X Laurens, Cardoso (1998)*** Reinhart, Smith (1998)** Valds-Prieto, Soto (1995)*** XColombia Reinhart, Smith (1998)** XCzech Republic Reinhart, Smith (1998)** XMalaysia Reinhart, Smith (1998)** 43Source: Magud, Reihart, Rogoff (2011)

44. Imposition of More Stringent Capital Controls Benefits/Advantages Costs/Disadvantages Alter the composition of Control may have flows (towards longer term) redistributive effects: - Can be circumvented by Allows more independent large firms (or more monetary policy expensive to circumvent for smaller firms) It some cases lead to lower - Controls make access pressures on the RER to international funds more expensive (potential Lower sterilization costs impact on small firms with restricted access to An additional source of local financial market) 44 fiscal revenues

45. Summary of policy responses Performance Sterilized Capital No response Indicators intervention control Composition of inflows Independentmonetary policy Lowersterilization costReduce pressure on RERChange the sizeof capital inflows 45

46. What is going on in Indonesia? What has been the policy response so far? Are capital inflows likely to continue? Our proposal: More stringent capital controls What specific type of control? 46

47. Low opportunity cost in international market mayrender the Chilean type of control inefficient Effective Annualized Tax Rate on Capital Inflows7,00%6,00%5,00% for RFR of 5% for RFR of 1% for RFR of 0.5%4,00%3,00%2,00%1,00%0,00% 0,25 0,5 0,75 1 3 5 10 20 47 Holding period (in Years)

48. An effective capital control should aim at three goalsI. Making carry trade less attractive Can be achieved partly by levying a tax on foreign investment in debt instruments Derivative instruments typically used by carry traders, such as Non-Deliverable Forwards, should also be taxedII. Altering the composition of flows We do not recommend imposing different statutory taxes according to the holding period at exit (cumbersome and costly to administer) Any significant fixed percentage tax on entry for public debt instruments should help change the composition of inflows toward longer maturitiesIII. Allow more room for independent monetary policy A wedge between local interest rates and effective interest rates for investors, would be able to increase the 48 interest rate without attracting new inflows

49. Our specific proposal for a capital control in Indonesia Establish a tax of 4% on foreign investments on fixed income instruments issued by the government Establish a tax of 4% on margin deposits on currency futures markets Leaving the tax for equity at 0% 49

50. We can see how rapidly the implicit tax rate fallswhen the holding period of the investment increases 50

51. Parallel to the implementation of the capital control,Indonesia should also aim at balancing the budget Indonesia Fiscal balance (% of GDP) 2004 2005 2006 2007 2008 2009 2010 0,0 -0,1-0,5 -0,5-1,0 -0,9 -0,8 -1,1-1,5 -1,3 -1,6-2,0-2,5 Deficit 0.8% of GDP US$ 5,560 million Income from tax on capital US$ 1,050 million-3,0 Need to reduce public spending US$ 4,510 million-3,5 (equivalent to 0.6% of GDP or 2.1% of expenditure)-4,0 51Source: Bank of Indonesia

52. What is going on in Indonesia? What has been the policy response so far? Are capital inflows likely to continue? Our proposal: More stringent capital controls What specific type of control? Final remarks and conclusions 52

53. Prisoners dilemma: Most of Indonesia commercial partners(EM) have already implemented some sort of capital controls Country Specific type of capital control Quota on how much each Qualified Foreign InstitutionalChina Investor (QFII) can bring into the country Restrictions on trade of currency derivatives Restriction on the use of bank loans in foreign currencySouth Korea Tight regulations on the foreign currency liquidity ratio of domestic banks Plan to add new measures Caps on interest rate paid upon dollar-denominated borrowing with a maturity below three and five yearsIndia Regulation of Foreign Venture Capital registration Restriction of transactions by Foreign Institutional Investors 15% withholding tax on interest and capital gains earned by foreign investors on Thai debtThailand Borrowing limit of 90% of the purchase price on new condominiums 53 Plan to add new measures

54. Prisoners dilemma: That is also truth for other large netreceiver countries on ratings notch next to Indonesia Country Specific type of capital control IOF tax (Imposto sobre Operaes Financeiras) of 6% on fixed income foreign investmentBrazil IOF tax of 2% on equity foreign investment Tax of 6% on margin deposits on derivatives Caps on interest rate paid upon dollar-denominated borrowing with a maturity below three and five yearsIndia Regulation of Foreign Venture Capital registration Restriction of transactions by Foreign Institutional Investors Reserve requirements for foreign liabilities Taxes on capital gains for non-residents investments Income taxes for settlement of derivative contract withPeru offshore banks Reduction of long net FX Private pension funds limit on trading FX 54

55. Conclusions Everything seem to indicate that the inflow episode affecting Indonesia in 2009 and 2010 will be prolonged Indonesia has displayed a large GDP and RER vulnerability when exposed to financial crisis or sudden stops The Bank of Indonesia seems to have different/confronting priorities and has been stressed by capital inflows Capital controls seem to be a better instrument to deal with a potentially destabilizing inflows: Affect the composition of the inflows without affecting the size Allow for more independent monetary policy Sterilization costs are lower RER pressures may be reduced 55 Commercial partners and countries on the same rating notch have already implemented some type of control

56. Policy response must be proportionate to thesize and length of the inflow episode Graph X - Policy response and size of capital inflows No response zone Sterilized Capital Controls intervention zone zone Small inflows: Allow Inflows too large to Inflows too RER to appreciate do nothing (would large to beSize of capital inflows lead to large RER absorbed appreciation) 56 Time

57. Thanks! 57

58. China: Balance of Payments Summary 58

59. China: Capital Account Summary 59

60. Capital control have been hot in the policy agenda Overall, the message is that one size does not fit all. Since the use of capital Overall, the message is that one size does not fit all. Since the use of capital controls is advisable only to deal with temporary inflows, in particular those controls is advisable only to deal with temporary inflows, in particular those generated by external factors, such measure can be useful even if their generated by external factors, such measure can be useful even if their effectiveness diminishes over time. effectiveness diminishes over time. --IMF Global Financial Stability Report (April, 2010) IMF Global Financial Stability Report (April, 2010) As the capital inflows are increasing fast, many target countries feel the As the capital inflows are increasing fast, many target countries feel the heat. [ ]]As we speak, several countries are putting in place capital controls. heat. [ As we speak, several countries are putting in place capital controls. The fundamental question policymakers are looking at is: what is the role of The fundamental question policymakers are looking at is: what is the role of capital controls as part of macro-prudential policies? capital controls as part of macro-prudential policies? --Angel Gurra, OECD Secretary-General, Economic Council of Finland Feb-11 Angel Gurra, OECD Secretary-General, Economic Council of Finland Feb-11 Temporary and targeted use of capital controls may be appropriate when Temporary and targeted use of capital controls may be appropriate when capital inflows are transitory, add undue pressure on exchange rates, pose capital inflows are transitory, add undue pressure on exchange rates, pose risks to financial stability, and where macroeconomic policies are ineffective. risks to financial stability, and where macroeconomic policies are ineffective. 60 --Asia Capital Market Monitor ADB 2010 Asia Capital Market Monitor ADB 2010

61. Low opportunity cost in international market mayrender the Chilean type of control inefficientChile (1991-1998): All portfolio inflows subject to 30% non-interest bearing reserve deposit of one year (1992) 61

62. Tax of 4% on all foreign purchases of public debt:Returns get positive for a holding period > 0.5 years 62

63. Brazil has a more complex system not discriminatingbetween debt and equity, public and private Looking at capital controls in Brazil, we can identify the following measures: 1) IOF tax (Imposto sobre Operaes Financeiras) of 6% on fixed income foreign investment 2) IOF tax of 2% on equity foreign investment 3) Tax of 6% on margin deposits on futures markets Given that most of the foreign capital flowing to Indonesia take the form of public debt, imposing a tax on equity investments does not seem appropriate for Indonesia. 63