Taming the market tantrum Ratih Puspitasari  ;  An economic analyst at Bank Indonesia; She is currently a PhD student at the University of York, UK

                                               JAKARTA POST, 02 November 2015

                                                                                                                                                           

                                                                                                                                                           

The speed and complexity of capital flows surpass anything the world has ever seen before.   When international financial openness was first introduced, it was with the intention of mutual benefits for both the investing and receiving countries. Capital-surplus countries benefit from higher financial returns abroad, while capital-scarce countries enjoy more physical investment opportunities. This is particularly relevant for more structural and long-term foreign investment, like the foreign direct investment. However, portfolio (stocks and bonds) investment is another story. While portfolio inflows can in some periods be beneficial for the receiving countries, at other times they might be quite detrimental, or useless at best. An immediate problem associated with the surge or reversal in portfolio flows is its effect on exchange rate volatility of the receiving country. Worse still, it is often market hysteria and herding behaviors that exaggerate exchange rate volatility associated with capital flows. Herding behavior occurs because there is an asymmetric information problem. Because not everyone in the market holds the same amount of information, transactions initiated by a significant portion of market players could send signals to uninformed players that other players possess some particular information that they themselves are missing, which is of course not always true. This herding behavior can indeed create waves of hysteria in the market. This is what seems to have happened to stock prices and exchange rate volatility in emerging economies during the last few weeks. It is common knowledge that exchange rates and stock price volatility everywhere in the world are particularly hard to predict, but the last few weeks’ ups and downs of the emerging economies’ exchange rates and stock prices were beyond unpredictable. Financial markets have been erratic, which from the standpoint of any psychologist could be seen as a symptom of bipolar behavior. Uncertainties regarding the stance of US monetary policy appeared to have increased tensions in emerging financial markets since September 2015, which were exaggerated by excessive market hysteria. When the Fed finally decided to postpone a policy rate increase in the last Federal Open Market Committee (FOMC) Meeting, market fluctuations slowly appeared to subside. However, as speculations on the timing of monetary policy rate hikes still linger, especially sometimes at the end of this year, it is difficult to expect calmer market behavior anytime soon. The last few weeks’ market volatility was actually not the first time since the Fed sent some signals about policy normalization. In fact, when the Fed first announced the plan to “taper” the QE by discontinuing the monthly large-scale asset purchase program in May 2013, market reactions (also known later as the “taper tantrum”) was also unexpectedly dramatic especially on the capital flows and asset prices of emerging markets. During the tapering talk, emerging markets suffered from sharp market corrections, rapid currency depreciations, drops in stock prices, a slowing in capital flows and increases in external financing premiums. The effect was particularly severe in Brazil, India, Indonesia, South Africa and Turkey where on average between May and August 2013 the stock markets in the five countries fell by 13.75 percent, exchange rates depreciated by 13.5 percent, bond yields rose by 2.5 percentage points and reserves declined by about 4 percent. What lessons should we learn from the “taper tantrum”? Although negative global sentiments affected all emerging economies alike, there were some country differences in how taper news affected emerging economies, especially in terms of exchange rate depreciation and asset price falls. It turns out that some macroeconomic fundamentals and policies played a major role in determining how severe taper talks affected these economies. In particular, countries with larger capital account surpluses, better fiscal positions, lower foreign debt ratios, lower inflation, higher gross domestic product (GDP) growth and more reserves experienced lesser currency depreciation, lower stock price drops and lower increases in bond yields. In addition, countries that applied active capital flows management before taper talks seems to have fared better because capital flows shifted toward longer-term and less volatile investments. The implementation of macro prudential policies have also been able to reduce vulnerability risks in the run-up to the volatile episodes of 2013. The country differences in how the 2013 taper tantrums affected emerging economies provide us with at least two lessons. First, the importance of domestic macroeconomic fundamentals and prospects should not be underestimated. Second, credible and long-term oriented macroeconomic policies are far-reaching. The stated features of necessary macroeconomic fundamentals may seem obvious, but really they are easier said than done because the features of sound macroeconomic fundamentals are the products of long-term macroeconomic policy management discipline and determination. With the prospects of global economic growth, especially in China, looking gloomier than expected and the decline in commodity prices continuing, emerging economies including Indonesia face problematic challenges in the near future. In particular, it is difficult to expect a rise in exports when global demand is weaker and commodity prices are subdued. Amidst the uncertainty in the global situation, the latest policy actions by the Indonesian government appeared to have headed toward the right direction. In particular, spending on infrastructure projects is underway, but it has to be particularly speeded up and consistently executed during this period. In the short run, projects of massive scale create job opportunities, maintain the purchasing power of the working class and thus sustain GDP growth. In the long run, infrastructure encourages industrialization. Transportation infrastructure is also expected to contain inflation in the future. There may be higher pressure on the current account deficit because of higher imports to support infrastructure projects, or because of foreign direct investments. Nevertheless, current account deficits should not be a major issue as long as the increasing deficit is spent on productive projects to reap economic benefits in the long run. The launches of economic packages by the Indonesian government are timely and should also send positive sentiments and signals to markets that the government realizes the existence of certain barriers to economic investment and production activities and thus is willing to overcome the obstacles. The message has been delivered, but the real implementation is awaited. As a small open economy, the future global economic and financial situations are mostly exogenous to us. There is literally not much we can do to change the global situation. However, the extent to which the global situation affects our domestic economy depends on how domestic macroeconomic management is carried out. As Kabat-Zinn, a professor of medicine and an author on mindfulness, once said, “You cannot stop the waves, but you can learn to surf.” ●