Impact of recent market turmoil on Indonesia's financial markets 1 • Prices of Indonesian assets have been under pressure following the volatility sparked by Turkey’s currency depreciation, but performance has been in line with other emerging markets. • Indonesia’s fiscal and monetary policy makers have taken several coordinated measures to boost investor confidence and ensure macro-financial stability, contributing to the relative resilience of Indonesian asset prices. o Policy rates up by 125 bps this year despite on-target inflation; fiscal consolidation in 2018, 2019 • The main sources of Indonesia’s vulnerability to global financial market volatility are structural – shallow financial markets and low level of exports and FDI create a reliance on foreign portfolio flows for BOP financing. • In the near-term, an acceleration of capital outflows would likely lead to further tightening of macroeconomic policies, with attendant risks to current and potential economic growth. o Contagion through financial and corporate sector balance sheets is likely to be contained, but resident outflows may be a risk if expectations develop of large currency depreciation. o Import-restrictive measures may have unintended consequences of further closing Indonesia’s economy. • To reduce structural vulnerabilities, policy makers need to focus on structural reforms: deepening domestic financial markets and boosting exports and FDI. TABLE 1 INDONESIAN FINANCIAL INDICATORS AS OF SEPTEMBER 5, 2018 Date of Chg vs. Change or total Latest latest Unit last trad- In last In last Year-to- value value ing day week month date Stock market Jakarta Composite Index 5,684 05 Sep -3.8% -6.3% -6.8% -10.6% Net purchases by foreign -0.88 05 Sep IDR, tn -- -2.1 -3.8 -51.5 investors Exchange rate: IDR/USD Bloomberg 14,938 05 Sep 0.0% 2.0% 3.2% 10.2% Government bonds Yield: 5-year IDR bond 8.4% 05 Sep bps 20.5 65 65 236 Yield: 10-year IDR bond 8.6% 05 Sep bps 24.6 63 63 204 Foreign holdings of IDR bonds 854 03 Sep IDR, tn -- 7 7 18 IDN sovereign CDS: 5yr, mid- 133 04 Sep bps 9.8 17 16 44 price Interest rates JIBOR overnight 5.4% 05 Sep bps 0.2 0.2 38.9 150.2 International reserves 118.3 31 Jul USD, bn -- -- -1.5 -11.9 Sources: Indonesian Stock Exchange (www.idx.co.id). BI, JP Morgan, MoF. 1 Prepared on September 5, 2018 by Frederico Gil Sander and Dhruv Sharma, with inputs from Abigail. 1 Prices of Indonesian assets have been under pressure following the recent volatility sparked by Turkey’s currency depreciation, but performance has been in line with other emerging markets. Despite minimal trade links with Turkey, as foreigners exited emerging markets as an asset class, Indonesia’s currency and stock markets were hit. Performance was not out of line with other emerging markets (EM), however. The recent volatility adds to earlier pressures from normalization of US monetary policy and uncert ainty generated by ‘trade wars,’ which have led to more meaningful asset price declines since early 2018. - The Rupiah depreciated by 2.0 percent vis-à-vis the USD over the past week (Table 1), in line with other EM fx except the Lira. Year-to-date (ytd), the Rupiah depreciated by 10.2 percent, while the JP Morgan EMCI fx index declined by 13.6 percent (Figure 1). Reflecting overall US dollar strength, the Rupiah has been more stable on a trade-weighted (effective) basis, depreciating 5.9 percent ytd (Figure 2). Figure 1. The Rupiah depreciated along other EM Figure 2. On a trade weighted basis, the IDR has been currencies stable Index: January 2018=100 RHS: IDR per USD; Index: Jan 2011=100 Oct-94 Oct-97 Oct-00 Oct-03 Oct-06 Oct-09 Oct-12 Oct-15 Oct-18 104 USD/IDR 102 0 200 100 2000 IDR trade weighted 180 98 index (Morgan Stanley, 160 4000 96 JP Morgan EMCI 140 6000 94 120 8000 100 92 10000 80 90 12000 USD/IDR 60 88 14000 40 86 16000 20 Jan-17 May-17 Sep-17 Jan-18 May-18 Sep-18 18000 0 Sources: Bloomberg, staff calculations - Government bond yields have risen over the past week (by about 60 bps) and are sharply higher in ytd terms too. Yields on 5- year local-currency bonds increased by 236 basis points (bps) ytd (Figure 3), while 10-year bond yields increased by 204 bps in the same period. There are some signs of heightened currency risk as the spread between IDR- and USD-denominated 5-year bonds widened by about 137 bps (ytd). However, given that yields on US Treasury bonds have also risen, markets do not appear to be pricing in non-currency credit risk. Figure 3. Bond yields increased substantially in 2018, but Figure 4. Stock markets dropped in line with global equities not in the recent week Percent Index points 10 6800 1300 9 Indonesia 5-year (IDR) 6600 8 1250 6400 7 JCI 6 Indonesia 6200 1200 5-year 6000 5 currency risk 1150 4 5800 3 5600 MSCI: EM 1100 2 credit risk 5400 1050 1 5200 USA 5-year 0 5000 1000 Oct-10 Oct-12 Oct-14 Oct-16 Oct-18 Feb-18 Apr-18 Jun-18 Aug-18 Oct-18 Sources: Bloomberg, CEIC, MSCI, staff calculations 2 - Indonesia’s stock market index, the Jakarta Composite (JCX) plunged 3.8 percent on September 5 and is down by 6.3 percent over the past week (Figure 4), with USD 140 million in foreign outflows in the period (Table 1). The plunge on September 5 was the single worst trading day since the U.S. presidential elections in November 2016. The JCX’s performance was worse than other EM stock markets, which fell by 4.7 percent over the past week. Indonesia’s policy makers have taken several measures to boost investor confidence and ensure macro- financial stability, contributing to the relative resilience of Indonesian asset prices. - Fiscal policy has been consistently prudent. Deficits have been contained, and government debt stands at 29 percent of GDP as of end-2017, of which 70 percent is denominated in local currency (Table 2). Although regional elections took place this year and presidential elections follow suit in 2019, MoF expects the budget deficit to come in at 2.2 percent of GDP this year, and at 1.6-1.9 percent in 2019 – well below the legal ceiling of 3.0 percent of GDP for the general government. - Indonesia medium- and long-term debt as of Q1 2018 % of 2017 GDP By currency By holder residence* Total Local Foreign Local Foreign Household 16.3 0.3 16.3 0.3 16.7 Private Financial Corporate 2.9 4.4 2.9 4.4 7.3 Private Non-Financial Corporate 10.1 7.7 10.1 7.7 17.8 Financial SOE 2.0 0.4 2.2 0.1 2.3 Non-Financial SOE 1.7 2.4 1.9 2.2 4.1 General Government 17.2 12.2 11.7 17.8 29.5 ... of which to official creditors** 0.0 5.3 0.0 5.3 5.3 Total 50.2 27.4 45.1 32.5 77.6 Shares (percent) ... of public debt 58.2 41.8 44.2 55.8 ... of government debt 58.5 41.5 39.8 60.2 …of private corporate 51.7 48.3 ... of total debt 64.7 35.3 58.2 41.8 *Assumes all private LC debt is held by residents and all FC debt by non-residents. Because about 20 percent of domestic bank loans are in foreign currency, this over-estimates the debt held by non-residents. **As of December 2017 Sources: IIF (private debt), BI (public debt), Form 18K (official debt), CEIC (GDP) - Monetary and macroprudential policies have also prioritized stability, especially since the 2013 taper tantrum. BI has kept real interest rates consistently positive, and this year increased rates by 125 bps despite inflation remaining within the central bank’s target range of 3.5 percent. BI increased rates most recently 3 on August 15, responding to the Lira crisis. BI has also implemented macro-prudential measures to manage volatility, notably requiring hedging of foreign currency corporate debt. BI is looking at lowering the cost of hedging to encourage exporters to convert export proceeds into domestic currency, although it has not considered imposing a conversion requirement. - With respect to exchange rate policy, BI accumulated reserves in 2017 while other currencies were appreciating due to strong capital inflows. In recent months, the central bank has not defended a specific level of the exchange rate and allowed market-driven depreciation. Use of reserves to smooth currency volatility has been in line with other central banks, and reserves remain at healthy at 8 months of imports. In addition to reserves, BI has swap lines with Japan and in the context of the Chiang Mai initiative, and officials have also mentioned that they can access IMF flexible credit lines if needed. - The Government is also considering measures to limit imports, notably sequencing infrastructure products to reduce related capital goods imports, increasing tariffs on consumer goods2, and implementing import- substituting measures to reduce the current account deficit3. The main sources of Indonesia’s vulnerability to global financial market volatility are structural – shallow financial markets and relatively low level of exports and FDI, which create reliance on foreign portfolio flows for BOP financing. Although policy makers have undertaken almost every available measure to safeguard stability, addressing structural problems will be needed to create a sustainable buffer against volatility. - The high share of foreigners in Government domestic currency bond markets (Figure 5) and large swings in bond yields and fx rates that follow portfolio flows, as well as the large share of foreign borrowings of the corporate sector (47 percent of total – see Table 2) reflect a shallow financial sector. Indonesia’s credit- to-GDP ratio of about 47 percent is well below other Asian peers (Figure 6). Deepening the financial sector will enhance domestic liquidity and provide a buffer to Government bond and currency markets. Figure 5. The share of domestic-currency Government Figure 6. Indonesia’s credit-to-GDP ratio is below what debt held by foreigners remains high would be expected given its level of income IDR trillion (LHS), percent (RHS) Vertical axis: domestic credit provided by financial sector (percent of GDP); horizontal axis: log GNI per capita 2.500 Foreign holdings proportion of 45 250 total (RHS) 40 CHN HKG 2.000 35 200 AUS 30 THA KOR 1.500 150 MYS 25 VNM Total Indonesian FJI 20 SGP 1.000 government bond holdings 100 15 KHM MNG NPL IND LKA PHL MDV 10 BGD 500 50 PAK Foreign holdings of Indonesian 5 MMR BTN IDN, 47,2 BRN government bonds - 0 0 Sep-12 Sep-14 Sep-16 Sep-18 6,0 7,0 8,0 9,0 10,0 11,0 Sources: Ministry of Finance, World Bank staff calculations Sources: WDI, World Bank staff calculations 2 MoF announced on August 14 a 7.5 per cent import tariff to be applied to 500 consumer goods, including those bought online, and that energy projects at state companies that require a large amount of imports would be delayed. 3 Starting 1 Sept 2018, biodiesel must be mixed in non-subsidized diesel (it was already required to be mixed in subsidized diesel) in a 20:80 proportion. This is projected to cut diesel fuel import by ~1.2mn kiloliters. 4 Figure 7. The current account deficit has widened and the Figure 8. Indonesia punches below its weight with respect basic balance turned negative to exports and FDI Percent of GDP, 4-quarter moving averages Percent of GDP, 2013-2017 averages 100 91,0 3,0 Current account balance Direct Investment, Net 7 b. Exports Basic balance a. FDI 90 5,7 2,0 6 80 71,8 68,6 70 5 1,0 60 3,7 3,5 4 50 0,0 3 40 21,6 2,2 2,1 2,1 28,8 2,0 1,8 30 -1,0 -2,3 21,8 21,3 2 20 12,1 -2,0 1 10 0 0 -3,0 -4,0 Sources: Bank Indonesia, World Bank staff calculations Sources: WDI, World Bank staff calculations - Indonesia’s current account deficit has reached 2.3 percent of GDP4 in the second quarter of 2018 ( 4 Calculated as 4-quarter moving average. 5 - Figure 7. The current account deficit has widened Figure 8. Indonesia punches below its weight with respect and the basic balance turned negative to exports and FDI Percent of GDP, 2013-2017 averages Percent of GDP, 4-quarter moving averages - ), driven primarily by higher imports of capital goods and parts, which have been growing due to renewed investment in the mining sector following the increase in commodity prices, and to the Governme nt’s infrastructure push in the past three years. Given Indonesia’s large infrastructure gap and potential for future mining exports, the composition of imports does not appear to be concerning. The concern is primarily with how imports are financed. Indonesia attracts little FDI compared to peers (Figure 8a), and in recent quarters FDI has not covered the current account deficit. Indonesia also punches below its weight with respect to exports (Figure 8b), which weakens the structural current account position and exacerbates external funding needs. As a result of weak exports and low FDI, Indonesia needs to rely relatively heavily on volatile portfolio flows to finance even productive imports. In the near-term, an acceleration of capital outflows may likely lead to further tightening of macroeconomic policies, with attendant risks to current and potential economic growth. Should pressure from capital outflows intensify, the currency is likely to depreciate further despite some intervention using reserves, real interest rates will increase further, and the fiscal impulse may become more negative. Measures to restrict imports may be implemented more forcefully, and the Government may consider expediting asset sales. Moreover, while politically unpalatable, the Government could access the IMF’s flexible credit line for as much as USD 112 billion (vs CA deficit of USD 25-30 billion). - Contagion through financial and corporate sector balance sheets is likely to be contained. Not only is the financial sector small, but it is well capitalized (Tier 1 capital represents 22 percent of risk-weighted assets), loans in foreign currency are under 20 percent of total loans, and Indonesian corporates limited been required to hedge their foreign currency debt and therefore solvency risks due to depreciation are contained. A higher risk would be of resident capital outflows in face of a large expected depreciation, or ahead of a possible imposition of capital controls. While this risk is mitigated by Bank’s solid financial position and rising interest rates that compensate for depreciation, there may be a psychological threshold (for example, a specific level of the Rupiah/USD exchange rate) affecting expectations that could drive significant outflows. - SOEs have increased their borrowing, but non-financial SOE gross debt remains at under 5 percent of GDP, about 60 percent of which in foreign currency (as of Q1 2018). This brings total debt of the general government and non-financial SOEs to 35 percent of GDP. Therefore, fiscal risks from contingent liabilities, while deserving of monitoring, are not elevated at present. - To maintain foreign capital inflows and avoid resident capital outflows, the policy response is likely to continue to be firm, which eventually will dampen economic activity, possibly significantly. If policy tightening is not followed by structural reforms that address bottlenecks to potential output, growth could be lower for an extended period. - The recent focus of policy makers on reducing imports through restrictions, import substitution and reassessing infrastructure projects would likely be intensified if outflows accelerate, increasing risks of slowing potential output, especially as such policies also carry the risk of unintended consequences. In the past tariff and non-tariff barriers, as well as local content regulations, have restricted imports, often of intermediate goods needed for exports, reducing Indonesia’s export potential and attractiveness to expo rt- oriented FDI. Moreover, given Indonesia’s large infrastructure gap, restricting capital goods imports could slow down the pace of building productive infrastructure and limit Indonesia’s growth potential in the medium-term. In addition, large infrastructure projects with significant import requirements generally come 6 packaged with long-term financing (e.g. from bilateral or multilateral sources, or through PPPs), which are less volatile than portfolio debt flows. To reduce structural vulnerabilities, policy makers need to focus on structural reforms: deepening domestic financial markets and boosting exports and FDI. - Instead of focusing on curbing imports, Indonesia may consider this as an opportunity to remove bottlenecks to boosting exports and attracting FDI. o World Bank research has shown that Indonesia’s low levels of FDI are linked to its high level of restrictiveness to foreign investment, including but not limited to limits to foreign ownership. o Looking at specific sectors, Indonesia could reassess the regulatory environment in the mining sector, where uncertainty in recent years has inhibited meaningful investment until prices increased in late 2017, preventing export volumes from picking up quickly to take advantage of higher prices. Indonesia could also accelerate reforms to facilitate investments in tourism. o The Government targets an additional 6 million tourists per year by 2020, which could increase service exports by about USD 5 billion. This will require investments in human capital (including management skills), local infrastructure (especially sanitation), and opening the economy to greater foreign participation in transportation and hospitality services. - Developing the domestic banking sector requires boosting competition, which is limited due to the dominance of state-owned banks, and reviewing the barriers to increased product offerings (e.g. long-term credit, hedging instruments). Capital markets do not yet provide sufficient funding nor do they represent a competitive alternative to banks. The Government may therefore use the current volatility to accelerate reforms to deepen financial markets by a) reviewing the legal and regulatory framework to facilitate an active investor base and the tax framework to enhance harmonization and eliminate distortions; b) strengthen the Company Law and corporate governance; and c) improve accounting and auditing standards, including passing the Financial Reporting Act. Annex: Additional Tables Table A1: Indonesia's vulnerabilities Basic Share of foreign Credit-to-GDP balance 1/ holdings 2/ 3/ Indonesia 0.2 37.6 47.0 Thailand 8.5 14.1 164.7 Malaysia 4.2 32.2 145.3 Philippines 1.8 na 66.3 1/ Current account balance plus net direct investment 1/ Source: CEIC 2/ As of end Q4, 2017 2/ Source: ADB Asian Bonds Online 3/ Domestic credit provided by financial sector (% of GDP) 3/ Data for 2017 except Malaysia, 2016 3/ Source: WDI 7 Table A2: Financial Market Moves Jan-June 2017 Jan-June 2018 June-July 2018 Aug 2018 2/ Equity and Debt Portfolio Flows (USD million) Indonesia 9,166 -3,896 -354 457 Malaysia 2,411 -1,708 -1,985 44 Philippines 1/ 408 -1,219 -354 -74 Thailand 4,886 -2,175 -1,948 595 Currency: change in the LCY/USD exchange rate, monthly average, between the end and beginning of the period Indonesia -0.4 5.0 2.5 0.7 Malaysia -4.1 1.1 2.1 1.0 Philippines 0.2 5.0 2.4 -0.4 Thailand -4.0 1.8 4.0 -0.3 Bond Yields: change in basis points of the monthly average yields between the end and beginning of the period Indonesia -76 127 42 7 Malaysia -33 31 -8 -6 Philippines 8 70 28 0 Thailand -15 31 0 -3 Stock market: change in monthly index average betwen the end and beginning of the period Indonesia 8.5 -8.5 -0.3 1.7 Malaysia 6.7 -5.4 -5.3 3.7 Philippines 9.2 -16.6 -3.0 4.0 Thailand 0.1 -7.5 -6.4 3.4 1/ equity only 2/ portfolio flows through 8/17; changes are average through 8/22 vs July. Sources: portfolio flows, IIF; Currency, Bond Yields and Stock Market: CEIC Table A3: Pre-AFC, Pre-Taper Tantrum, and Now 1992-1996 2009-2012 2013-2017 GDP growth Indonesia 7.6 5.8 5.1 Malaysia 9.6 4.2 5.2 Philippines 3.5 4.8 6.6 Thailand 7.6 3.7 2.8 Currency: change in the LCY/USD exchange rate yearly average from the previous year Indonesia 3.7 -0.6 7.5 Malaysia -1.7 -1.7 7.0 Philippines -0.8 -1.2 3.6 Thailand -0.1 -1.6 1.8 Reserves excluding gold as % of imports of goods, services & income Indonesia 24.9 49.6 51.0 Malaysia 34.0 56.5 47.7 Philippines 21.2 78.7 73.1 Thailand 41.9 68.3 60.7 8 Fiscal: overall balance, % of GDP 1/ 2/ Indonesia 0.3 -1.3 -2.4 Malaysia 1.6 -4.6 -3.0 Philippines 0.1 -1.4 0.2 Thailand 2.9 -1.1 0.0 Total external debt as % of GDP Indonesia 49.0 27.4 33.5 Malaysia 37.2 56.6 69.5 Philippines 53.7 35.2 26.1 Thailand 50.8 29.3 33.2 Current Account Balance, % of GDP Indonesia -1.9 0.0 -2.4 Malaysia -5.5 10.3 3.3 Philippines -3.5 3.5 1.9 Thailand -6.2 3.4 6.6 Source: IIF except fiscal balances, IMF 1/ Data for Indonesia starts in 1993 2/ Data for Thailand starts in 1995 9