Bond’s Danger Signal
Inflation in the US, which might trigger an interest rate hike by the Fed and reduced liquidity injection, is becoming the biggest fear of emerging markets, including Indonesia. Investor’s money which has been anchored here might just return home, in great numbers and fast.
SLOWLY but surely, the foreign capital parked in rupiah-denominated government securities are leaking out. The trigger is persistent volatility in the global bond market. Markets are anticipating inflation in the United States, which will have widespread effects around the globe.
The US economy, which just received a stimulus injection of US$1.9 trillion, will grow rapidly this year. The Federal Reserve had even projected a 6.5 percent growth. Theoretically, if the economy grows so quickly, inflation is sure to follow. What makes the market unsure is the Fed’s insistence that inflation will not stay high for extended periods of time, which they conveyed together with their growth projections in their March 17 announcement. As such, the Fed has promised to maintain the interest rate to near zero until at least the end of 2023, and to not reduce liquidity injections into the market, which has now reached US$120 billion per month.
The market doubts this projection. It is impossible for inflation to stay low if the economic recovery succeeds while dollar from stimulus injections are aplenty. As a result, the bond market in the US continues to roil with volatility. The 10-year US Government Bond yield, which is the main market benchmark, climbs to 1.75 percent, its highest in the last 14 months. If the bond yield has gone up, that means the price has gone down. This also indicates that there is higher risk in investing in bonds.
Certainly, this volatility has spread to emerging markets. Inflation in the US, which might trigger an interest rate hike by the Fed and reduced liquidity injection, is becoming the biggest fear of emerging markets, including Indonesia. Investor’s money which has been anchored here might just return home, in great numbers and fast.
Three emerging markets have immediately reacted to this worst-case scenario. The central banks of Brazil, Turkey and Russia immediately raised their interest rates. This is an anticipatory move. Those countries are offering incentives so that foreign investors do not pull out.
Alas, the story is different here. Bank Indonesia (BI) must take the reverse course. Due to the pandemic, it now shoulders the responsibility to aid the government in economic recovery. That is why it lowered interest rates last month despite the bubbling market. Low interest rate is a classical recipe to boost economic activity. And while central banks from other emerging markets have raised interest rates simultaneously, the BI board of governors has decided to maintain interest rates after they convened on Thursday, March 18.
Other than its lack of maneuverability in managing interest rates, BI must also share the burden of government’s budget deficit by purchasing government bonds in the primary market. This policy is the same as BI printing money to finance the deficit. To foreign investors who hold assets in rupiah, this is not a desirable policy. If BI keeps printing rupiah, its value will be eaten away by inflation. Consequently, the rupiah will depreciate against the main currencies.
BI once stated that its purchase of government bonds would be conducted for 2020 only. In fact, this policy has continued since the government is unable to control its growing deficit. Since the start of the year until March 16, there has been an additional Rp65 trillion liquidity injection from BI’s bond purchases.
If investors are worried that government and BI’s policies can increase the risks of investing, they will react quickly. That is what has been happening since early February. Foreign investors started to sell the government bonds. On February 5, there was Rp997 trillion of foreign capital invested in all marketable government securities, by March 16, that value had dropped to Rp951 trillion.
The exodus of more than US$3 billion of foreign capital in such a short time should be a sign of danger for both BI and the government and they should reevaluate their economic recovery policy. If this outflow continues, instead of recovering, our economy will sink into an even deeper slump.