The yen carry trade and the Indonesian economy

David E. Sumual, Jakarta
After failing in two previous meetings, the governor of the Bank of Japan (BOJ), Toshihiko Fukui, was finally able to convince his colleagues to raise the bank‘s benchmark rate by 25 basis points (bps) to 0.5 percent recently. So far, Fukui seems to have delivered on his previous pledge to keep the increases gradual. As a result, financial players flocked back to the old financial game -- what is referred to as the yen carry trade -- driving the yen to a five-year low of 120.5/US$ at the beginning of last week.
At its simplest, the carry trade is merely the act of borrowing cheaply in a country with the lowest interest rates and investing the funds in higher yielding assets in other currencies -- usually in liquid assets such as bonds and stocks. Investors usually don‘t hedge the currency risk, as hedging only offsets the profits one would earn from the rate differential between the countries.
With Japan having nearly-zero interest rates since September 1995, investors -- especially those investing in hedge funds -- have been encouraged to take advantage of the carry trade by shortening the yen. As such, the yen has tended to weaken over the years. Previously, investors also applied the carry trade strategy to the dollar.
This took place when Federal Reserve (Fed) chairman Alan Greenspan pushed down the Fed rate from 6.5 percent to its lowest ever level of 1 percent in 2000-2004. The Fed provided cheap credit and some of the funds went overseas, especially to emerging Asian economies. No wonder then that these double sources of liquidity from both Japan and the U.S. had massively inflated asset prices, including commodity prices in the first half of the 2000s.
Presently, the big source of liquidity comes only from Japan. As the world‘s largest creditor country, the BOJ is acting like the world‘s central bank, supplying liquidity to the world via the yen carry trade. In essence, the world is massively long on the dollar, the euro and Asian currencies, including the rupiah, but, in contrast, short on the yen.
This process of blowing up the financial balloon has been taking place for years, waiting for the right moment to burst.
So what exactly is the scenario in emerging Asian economies -- especially Indonesia -- if the yen carry trade unwinds? Well, as the yen appreciates strongly, Indonesian assets will surely become less desirable. Investors previously benefiting from the interest differential over Japan will move to dump stocks and bonds and whatever else they bet on.
This chain reaction would speed up when local players begin jumping on the bandwagon, using the momentum strategy to follow the existing trend, thus pushing the rupiah down. This would also have a knock-on effect on interest rates, as the central bank may increase rates in response to the ailing rupiah.
The severity of the impact on Indonesia of the yen carry trade unwinding actually depends on the magnitude of the speculative money inflows over the past few years. In Indonesia‘s equity capital market alone, stock ownership by foreign investors has soared over the past five years.
Foreign stock holdings stood at Rp 505 trillion in January 2007, up 37.7 percent from their January 2006 levels, and representing about 70 percent of the stock value listed on the JSX. Over the same period, foreign holdings of government bonds rose by 56.9 percent to Rp 55.5 trillion, representing 13.1 percent of total domestic government bonds, up from only 8.7 percent last year.
Ironically, foreign players can also own monetary instruments such as Bank Indonesia Certificates (SBI), thus increasing the costs of monetary operations. Alarmingly, foreign funds placed in SBI rose 52.4 percent from Rp 16.3 trillion in January 2006 to Rp 24.8 trillion in January 2007, representing around 11 percent of the total outstanding Bank Indonesia Certificates. With Rp 3.2 trillion in foreign holdings in corporate bonds, the total hot money is therefore estimated to be around US$65.7 billion, or 145 percent of Indonesia‘s foreign reserves.
Nonetheless, some measures have been taken by the central bank and the government in a bid to ensure another financial crisis does not take place. Bank Indonesia (BI) is surely concerned over the magnitude of the short-term capital inflows that may destabilize monetary conditions. After an unprecedented 5-year bull run due to expectations of higher earnings amidst much lower political risks, Indonesia‘s stock market is no longer as cheap as before (the Jakarta Composite Index has gone up by about 320 percent). Meanwhile, the dependence on short-term funding in the banking sector remains. Due to the relatively low rates of longer-term deposits most time deposits still have maturities of one-month. This makes the financial system very vulnerable to external shocks.
Against this backdrop, BI has applied some currency trading restrictions by issuing BI regulation No.7/14/2005. Previously, BI had also sent a strong message that it would not follow the policies of Thailand by restricting foreign ownership in the capital market.
BI is also considering issuing longer term SBI with a maturity of more than 6 months. At the same time, BI is very prudent in lowering its benchmark rates, concerned that pushing interest rates down too much would encourage speculation -- in the property sector for example.
Even with a rate hike last week by the BOJ, the rate differential between Indonesia and Japan will still be sizable, giving a little more room to the Indonesian central bank to decrease rates further. Bank Indonesia‘s benchmark rate of 9.25 percent is still 4 percent higher than the Fed rate and it is 8.75 percent higher than the BOJ rate.
At the same time, the Indonesian government is also bringing forward plans to issue T-bills to mid 2007. These T-bills are expected to gradually replace the role of SBIs as a monetary instrument. This policy would allow the government to increase borrowing in the domestic currency and reduce the risk of a currency crisis becoming a debt crisis, as in 1997. Moreover, the government can also use idle money usually placed into SBI as fiscal stimulus.
Clearly, Indonesia‘s finances are in much better shape than in 1997. The country also has a lower foreign-denominated debt level and abundant forex reserves. And like many other Asian countries, Indonesia adopts a floating exchange rate. This provides a sort of buffer in the case of a sudden reversal of short-term capital flows.
Meanwhile, the chances of the carry trade unwinding during 2007 are actually still small for several reasons. Political pressure from Japanese politicians to not raise rates further will intensify over the next couple of months with Shinzo Abe‘s government facing upper house elections in July.
Prime Minister Abe has reiterated repeatedly that the Japanese central bank should keep borrowing costs near zero to support the economy. Indeed, Abe‘s government is seemingly worried that further interest rate hikes would push up the value of the yen, thus hurting exporters.
For the time being, the yen may continue to weaken in the near term as the Japanese central bank keeps interest rates low and traders continue their game of building a fragile house of cards.
The writer is an analyst with Danareksa Research Institute. The views expressed here are his own.