NNIP: Pressure on EM central banks

So far, EM debt markets have remained orderly. Yields have not risen much, despite the continuous re-pricing of Fed rate hikes, the protectionist noise coming from the US and the recent increase in geopolitical risk that has caused oil prices to spike. In the past few months, portfolio flows have been unconvincing while hard-currency spreads and local-currency yields have crept up. So far this year, though, the moves have remained within a 40-bps range for hard-currency spreads and a 10-bps range for local-currency yields.

This resilience can be explained by narrowed EM macro imbalances and benign EM inflation. The weakening US dollar of the past quarters also played an important role. With oil prices rising now, some doubts have arisen about the sustainability of the low and stable EM inflation picture. At the same time, the strengthening dollar in the past weeks has caused some modest depreciation in EM currencies. EM central banks, which on balance have been able to keep their easing bias so far, are feeling more pressure now.

The rising oil price in combination with a strengthening dollar and rising US bond yields clearly creates a more challenging environment for EM assets. The good news is that most emerging economies can handle these pressures thanks to lower macro imbalances and a credible macro policy mix. And if market pressure were to intensify anyway, they should be able to prevent a serious confidence crisis thanks to large foreign exchange reserves. But this is a general observation about the EM universe as a whole. There are still vulnerable markets that are struggling in the current global environment. Among the most fundamentally challenged countries, Turkey remains the most vulnerable due to its large external financing requirements and the government’s aggressive growth maximisation strategy. We are also keeping a close eye on the Philippines and Colombia, although the latter benefits from rising oil. 

Indonesia’s increasing vulnerability

We visited Indonesia last week and came back with increased concerns about the country’s economic policy direction and the prospects for rates, currency and equities.

In the last few years, Indonesia’s main problem has been its growth performance. Despite abundant liquidity in the financial system, credit growth has been low and declining. Consumer and business confidence has been weak, due to subsidy cuts several years ago, political uncertainty and a campaign to improve tax compliance and reduce informality in the economy. Disappointing growth has been the main reason why Indonesian equities struggled. Debt markets have performed better thanks to relatively prudent macro policies that kept fiscal and current account deficits in shape. Inflation has been low and stable for more than two years. This has enabled the central bank to reduce interest rates by 3 percentage points since 2015. In this environment, foreign investors have kept a large position in Indonesian local-currency bonds. The 40% foreign ownership ratio is one of the highest in the emerging world.

The large foreign portfolio inflows in debt markets strengthened the rupiah and enabled the authorities to increase foreign exchange reserves by some 30% since 2015. The strong currency has been one of the main factors keeping inflation in a tight 3%-4% range for years.

But in the past months, re-pricing of Fed expectations has created a less favourable environment for the EM carry trade and Indonesian authorities have begun to move away from their orthodox macro policy approach. The central bank seems to be reluctant to hike interest rates and prefers to intervene in the FX market to prevent the rupiah from weakening. Meanwhile, the government has chosen to intervene in the energy and utility sectors by capping fuel and electricity prices. All seems to be focused on preventing inflation from rising ahead of next year’s general elections.

A larger policy focus on social inclusion is legitimate and much has been done already – social expenditure has tripled in the past eight years – but price interventions tend to create unintended macro imbalances that make investors wary. In Indonesia’s case, fuel subsidies caused large fiscal and current account problems during the second Yudhoyono administration (2009-2014). The current president, Joko Widodo, had to invest a lot of his political capital to eliminate the fuel subsidies in 2014. His introduction of a new fuel price cap was a surprising and risky move. The costs of the subsidy will have to be paid by Pertamina, the state oil company, but if oil prices move higher than USD 80 a barrel, the government will probably have to step in to cover part of the company’s losses and prevent a large NPL problem later on. We can assume that the new subsidy scheme will stay in place until the April 2019 elections, but there is no exit strategy in the event that oil prices move more than anticipated. In this situation it is difficult to make projections for Indonesia’s fiscal accounts.

We have to stress that Indonesia’s macro imbalances remain low and still manageable, but macro policies have become more interventionist and less orthodox. In an environment of rising US yields, a higher oil price and possibly a strengthening US dollar, this is making the country clearly more vulnerable for a market correction. Foreign direct investments are low, which means that Indonesia relies heavily on portfolio investment flows. With foreign ownership of Indonesian bonds already at 40%, and with the central bank not showing enough commitment to adjust interest rates if necessary, pressure on Indonesian assets is likely to increase.