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Southeast Asia

Debt monetization: Jakarta approaches a slippery slope

Perry Warjiyo, Indonesia’s central bank governor, may not be the country’s leader, but with Covid-19 ravaging the economy, the population of 273 million have more riding on him than on the president.

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Perry Warjiyo may not be Indonesia’s leader, but with Covid-19 ravaging the economy, the country’s 273 million people have more riding on the central bank governor than on the president.

Make that the rest of Asia, too, where peers are paying close attention to how the governor of Bank Indonesia fares. Intense curiosity surrounds BI’s purchase of government debt directly from the ministry of finance. It will start with $40 billion, returning all interest payments to Jakarta.

President Joko Widodo, also known as Jokowi, uses the rather sanitized term “burden sharing” to describe this long-taboo practice. But in reality it is debt monetization, something nations have generally avoided since the 1930s.

Consciously blurring the line between central bank and government, economists fear, encourages bad behaviour and fuels runaway inflation.

Can Indonesia avoid this worst-case scenario? Yes, Warjiyo says, arguing that BI policy is “aimed at fully supporting economic recovery while also maintaining inflation and exchange rate stability.”

Finance minister Sri Mulyani Indrawati claims Indonesia isn’t getting nearly as radical as observers fear. The monetization, she claims, is little more than a “private placement to BI.”

Perilous path

Economists are not so sanguine. They warn that Jakarta may be starting down a perilous path for an emerging-market nation that hasn’t always had the best reputation for sage and accountable policymaking.

“Debt monetization is not for everyone, especially for countries with weak institutions or a history of government intervention in central bank decision-making,” says Sohaib Shahid, senior economist at TD Economics. “This is particularly true for emerging markets where the church-and-state separation between central banks and governments is not as strictly enforced as in advanced economies.”

Among those economies that could be next in line to monetize their debt are India, the Philippines and Thailand. The common thread is with nations that were set to grow more than 5% in 2020 but which are now grappling with deep recessions. In each case, debt monetization may seem like an easy fix.

Jokowi’s government appears to be taking an ends-justify-the-means approach. Covid-19 fallout risks devastating living standards in the world’s fourth-most populous nation. The 5.32% contraction in gross domestic product in the second quarter could be just the beginning of the red ink to come. Big deficits – both for the budget and the current account – were already a problem even before the pandemic.

[BI policy is] aimed at fully supporting economic recovery while also maintaining inflation and exchange rate stability
Perry Warjiyo, Indonesia’s central bank governor
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The central bank was hardly sleeping on the job before its new mandate took effect. It has cut the benchmark interest rates four times this year, most recently on July 16, to 4%. But with peers easing everywhere in unison, southeast Asia’s biggest economy needs bigger guns to blast away the growing pessimism about the region’s prospects.

The government has put up about $50 billion of government stimulus to jolt the economy.

In a less chaotic world, that might be enough. Indonesia, after all, has come a remarkably long way since the dark days of the Asian financial crisis of 1997/98. Although Thailand and South Korea were upended by that event, Indonesia unraveled fastest and most severely. Massive protests brought an end to the authoritarian rule of president Suharto, who had run the country for 32 years.

In the years that followed, BI managed to tame inflation, which is currently near 20-year lows. It amassed an impressive war chest of foreign-exchange reserves to fend off speculative attacks on the rupiah – nearly $130 billion worth. At about 30%, the national debt-to-GDP ratio is a far cry from 12 years ago, when Wall Street’s crash shook Asia.

Equally important, capital-adequacy ratios among Indonesia’s biggest domestic banks are sounder than during the Lehman Brothers shock.

At the end of 2019, Bank Central Asia, Bank Mandiri, Bank Rakyat Indonesia and Bank Negara Indonesia had combined total assets of more than $300 billion.

“The investor sentiment globally towards the country is very positive,” says Dannif Danusaputro, president director of Mandiri Sekuritas. “The evidence is the deals that are happening in terms of volumes.” He points to Indonesia’s multi-tranche offshore bond in April, which included a rare 50-year bond.

Batara Sianturi, chief executive of Citi Indonesia, says it has become much easier to market the economy in the last decade.

“Look, it’s a country of 270 million people – that’s a lot,” he says. “And a growing middle class of about 50 to 60 million people which are bankable. And we have around 80 million small to medium enterprises in the country.”

What’s more, Batara says, “this is a country that has a net interest margin of between 4% to 5%. You cannot find a banking margin of 4% to 5% elsewhere. That’s why you are seeing a lot of foreign investors really interested in acquiring big Indonesian banks because that’s where the opportunity is.”

On top of that, he notes, “you have a low banking penetration that means the upside is high and this is also a country with a very high digital literacy and social media interaction. Biggest in Facebook, biggest in Twitter, biggest in WhatsApp.”

Investors also know full well, Batara says, that Indonesia “is the only country in Asean which joined the $1 trillion GDP club. It is also the only Asean country that belongs to the G20 organization.”

Work in progress

These are all important selling points, but will they be enough to help Indonesia weather 2020? Widodo’s monetization scheme suggests he is not taking any chances.

According to Febrio Nathan Kacaribu, head of the finance ministry’s fiscal policy agency, Jakarta’s debt-to-GDP ratio is set to swell to somewhere between 33.8% and 35.8% in 2021, from 29.8% at the end of 2019, as coronavirus costs skyrocket. The budget deficit is set to blow past 6% in the months ahead – it was 2.2% at the end of last year.

“We will continue to look at various financing sources to maintain the health of the debt ratio,” Febrio says.

One of those sources, clearly, is liquidity from the central bank. It will fall to BI to underwrite the outsized budgets to come. Widodo’s team is concerned with not only reviving growth over the next 12 to 18 months, but also preserving the remarkable progress Indonesia has made over the last 12 to 18 years. In other words, avoiding a return to the chaotic days of the late 1990s.

Bank Indonesia has been quite right amidst the crisis
Dannif Danusaputro, Mandiri Sekuritas
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The plan, though, is a work in progress. And, naturally, questions abound. One is how such aggressive government intervention could warp secondary bond trading, a lucrative business for Indonesian banks.

Japan, for example, has seen days in the last few years when zero trading took place in the secondary debt markets thanks to the central bank hogging the market. And Japan is arguably not monetizing the debt, since its bond purchases are motivated by keeping interest rates low rather than funding fiscal spending.

If spreads are artificially narrow thanks to BI money, will it become hard to know how to price bond deals or when to pull the trigger?

The risk, says Trinh Nguyen, an economist at Natixis, is the “crowding out of the private sector” at a time when coronavirus trauma is already threatening profits.

For now, the industry is giving the blurring of the central bank and the finance ministry the benefit of the doubt.

“I think Bank Indonesia has been quite right amidst the crisis,” says Dannif. “We have regular discussion with the central bank where they view this as a long haul, not a sprint.”

Rizal Gozali, vice-chairman at Credit Suisse, is also supportive.

“Only time will tell, but I think it is the right way,” he says.

The key, Gozali says, is “closely monitoring” the market. And so far, economists including Helmi Arman of Citi Indonesia, find little cause for alarm.

“We’ve done some research on it and we think the impact will be relatively benign in the near term because a lot of the risks that may impact inflation or the current account will have to go through the credit channel,” Arman says. “The debt monetization creates liquidity, but as long as the liquidity doesn’t translate to uncontrollable credit growth, I think the risk is manageable for now.”

That’s quite a big if. As Indonesia ventures into uncharted territory, investors should be aware of several risks.

Middle-income trap

It is easy to forget how close Indonesia veered toward failed statehood in the late 1990s. After the violent protests that drove Suharto from power, many pundits were worried that this archipelago of 17,000-plus islands, which is home to the world’s biggest Muslim population, might go the way of the Soviet Union.

For Jakarta, the Asian financial crisis began as a liquidity reckoning. As investors fled, the rupiah crashed, making it impossible for the banking system to make dollar debt payments. IMF economists parachuted in, only to discover that domestic banks existed largely to support Suharto-linked cronies and their conglomerates.

What followed was a revolving door of governments – each less effective than the previous one. The election of Susilo Bambang Yudhoyono as president in 2004 was a game changer. The general-turned-politician hit the ground running. His bold steps to cut red tape, curb corruption, improve infrastructure, increase transparency and take a hands-off approach to BI cheered global investors. In 2011, Indonesia was back in the orbit of investment-grade nations.

Since taking the reins in 2014, Widodo has put a few more reform wins on the scoreboard. Early on, he supersized infrastructure investment, a vital step towards increasing national competitiveness and attracting investment from multinational companies. He further increased government transparency and tax collection, and scaled back some budget-busting subsidies.

Indonesia risks losing an opportunity to realize its potential by tackling real structural reforms to raise purchasing power
Trinh Nguyen, Natixis

The worry now is that BI’s largesse reduces the urgency – and political will – to make the kind of bold, disruptive upgrades required to take on vested interests dating back to the Suharto era that benefit from economic inefficiencies and opacity. The problem, says Nguyen at Natixis, is that monetization makes sense in a crisis, but it is “not likely to generate high productivity growth in the future.”

That’s precisely what Indonesia needs to do to beat the dreaded middle-income trap, whereby per-capita income gains stall below $10,000. Indonesia is currently about $4,200 in nominal terms.

“Indonesia risks losing an opportunity to realize its potential by tackling real structural reforms to raise purchasing power,” Nguyen warns, largely because the government is too busy trying to make quick fixes rather than address the underlying, longer-term issues.

Nguyen does not expect monetization to lead to higher inflation when the economy is contracting or growing at a lacklustre pace. But, she says, the resulting “higher debt burden and potential downgrades for credit ratings will not do much to help its long-standing challenge of raising the fiscal revenue ratios, expanding external sources of income, and increasing the purchasing power and welfare of its people.”

In other words, the $40 billion of government debt that BI is charged with buying is only likely to increase from here. And, in the process, structural impediments that Widodo isn’t addressing – such as improving the ease of doing business and curbing the entrenched economic nationalism in politics – mean it is hard for low-income families to move up the economic ladder.

Moral hazard risk

Debt monetization, says Shahid of TD Economics, is often seen as “good politics.” However, it may come at a cost in the longer run. Any government, he says, “would welcome lower bond yields caused by the purchase of government debt by the central bank.”

At the same time, a weaker rupiah versus the dollar – so long as it’s an orderly move – could support asset prices, support exports and narrow current-account imbalances. A win-win-win, from any political perspective.

Monetization also, in theory, could make it easier to reduce taxes because the central bank is essentially disappearing the debt-repayment burden. Governments can ramp up spending without having to worry about the bill coming due, or any negative ratings-agency implications.

But it is hard to deny that there is a moral hazard risk from monetizing the debt, so it is crucial to make clear that this is only a temporary solution. Fitch Ratings, says analyst Thomas Rookmaaker, is hanging on Jakarta’s “assertion that the move is a one-off driven by the unusual circumstances of the pandemic.”

If it were extended, Rookmaaker adds, “it would raise the potential for government interference in monetary policymaking, and could undermine investor confidence.”

The more important element of Indonesia’s experiment is ensuring there is a clear timeline. And triggers for scrapping monetization based on, say, a certain pace of GDP growth or level of unemployment.

“There are still a few aspects of the burden-sharing mechanism that are unclear, particularly with regard to the exit strategy,” says analyst Anushka Shah of Moody’s Investors Service.

Some argue that Jakarta’s debt monetization is just the end result of a slippery slope of central bank intervention since the financial crisis, partly because of the rise of so-called Modern Monetary Theory, which encourages central banks to backstop governments. But it is clear there are major risks to this approach, as well as potential upsides.

Indonesia’s importance in southeast Asia means the move will become an important test case for elsewhere. The show has begun, and investors, ratings analysts and other governments are watching with interest.

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