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