Taming
the market tantrum
Ratih Puspitasari ; An economic analyst at Bank Indonesia;
She is currently a PhD student at the University
of York, UK
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JAKARTA
POST, 02 November 2015
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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.” ●
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