First came Mario Draghi. Then it was Haruhiko Kuroda’s turn. Now, Perry Warjiyo has signaled “whatever it takes” as Covid-19 fallout savages Southeast Asia’s 2020.
The reference here is to then-European Central Bank President Draghi’s 2012 catchphrase for a level of monetary activism unseen in generations.
A year later, Governor Haruhiko Kuroda wowed markets with his pledge for the Bank of Japan to “do whatever it can” to revive growth.
Now, in Jakarta, Warjiyo is grabbing the aggressive-easing mantle. The Bank Indonesia governor is raising the bar in tantalizing ways that has the rest of Asia looking on with keen interest while also prompting considerable apprehension.
In mid-July, BI began buying debt directly from the government – US $27 billion to start – from a $40 billion fiscal deficit-financing scheme. Transactions will see BI return all interest payments to Jakarta.
It’s by any measure a perilous path. So-called “monetizing of debt” has long been anathema to free-market evangelists.
Economists warn that by so consciously blurring the lines between central banks – which are supposed to be nominally independent – and governments, it runs the risk of bad behavior or runaway inflation.
Indonesian President Joko Widodo, however, is taking an ends-justify-the-means approach as the coronavirus drives the world’s fourth-most populous nation toward recession.
Such a downturn would be the first since the 1997-98 Asian financial crisis. It would hit Indonesia uniquely hard given its current high poverty rate and twin current-account and budget deficits.
These are three pre-existing conditions no economy wants while battling a pandemic that shows no clear sign of easing.
BI has already been plenty assertive in the conventional sense by slashing official benchmark interest rates four times this year. The most recent move, on July 16, lowered the seven-day reverse repo rate down to 4%.
However, even these repeated applications of a machete to interest rates did not have the desired effect.
On the day of the last rate hack, Warjiyo said Southeast Asia’s biggest economy probably shrank “around 4%” in the April-June quarter. But he also hazarded a guess that the Covid-19 shock may have peaked as of June.
Given the clusters popping up everywhere from Tokyo to Manila to Northeast England, not to mention the pandemic’s unchecked rampage across the United States, that may be optimistic.
And with China’s previously ballyhooed recovery losing vigor and the US contracting a record 32.9% in the second quarter, Indonesia will not easily export itself to recovery.
With fewer export markets to ship its oil, gas, cement, rubber and other resources, it’s falling to Widodo and Warjiyo to get creative about reviving Indonesia’s animal spirits.
On the surface, Indonesia has come a long way since the 1997-98 Asian financial collapse. Inflation is at its lowest ebb in 20 years, national debt-to-GDP is a reasonable 30% and foreign currency reserves are near a record at $130 billion. Asset quality among the four-biggest banks is stronger than in 2008, when the global crisis hit.
But Jakarta’s debt monetization gamble raises questions about what the government knows that global investors don’t. At best, this might be the top tick of Indonesia’s 20-year revival. At worst, it could signal big trouble ahead.
Monetization is a “slippery slope” for any economy, never mind emerging markets, says Sohaib Shahid of TD Economics.
“With the burden of monetization on their backs, central banks need to tread carefully,” Shahid explains. “Debt monetization is not for everyone, especially for countries with weak institutions or a history of government intervention in central bank decision-making. This is particularly true for EMs where the ‘church-and-state separation’ between central banks and governments is not as strictly enforced as in advanced economies.”
There’s no doubt Indonesia’s economy needs a powerful jolt. Demand for new loans plunged 33.9% in the second quarter from a year ago. Retail sales dropped 20.6% in May year-on-year, following a 16.9% slide in April. Gareth Leather of Capital Economics says more recent data “suggests that output remains very weak.”
Warjiyo claims he’ll be careful in carrying out and surveilling the “burden-sharing” pact with the Ministry of Finance. If inflation perks up, he says, BI “will not hesitate to pursue the necessary policies on the monetary side.”
Yet his unprecedented approach raises several crucial questions.
One: how will government authorities know when imbalances are bubbling up under the surface? Ten years of quantitative easing from Washington to Frankfurt to Tokyo have warped credit markets.
All that monetary largesse moved the financial goalposts investors use to assess risks and gauge economic fundamentals. Credit spreads, stock valuations and data on everything from employment to inflation have been obscured.
How, then, can Warjiyo discern when the “inflation genie,” as economists call it, is out of the proverbial bottle? By the time BI officials register signs of froth in consumer prices, real estate values or stocks, it might be too late, some analysts suggest.
For all the upgrades over the last two decades, the kleptocratic system dictator Suharto built over 32 years ending in 1998 has proven remarkably enduring with the transition to electoral democracy.
That kleptocracy still has tentacles in every sector of the economy, including natural resources. Vestiges of the labyrinthine Suharto Inc continue to concentrate wealth in the hands of cronies represented in Parliament more than two decades later.
Jakarta would be wise to remember that markets are paying very close attention, says analyst Thomas Rookmaaker of Fitch Ratings. For Indonesia, “it would raise the potential for government interference in monetary policymaking and could undermine investor confidence.”
Another risk is creating a bull market in moral hazard. Early in his first term, Widodo put some impactful reforms on the scoreboard by ramping up infrastructure investment, boosting public transparency and improving tax collection.
He also moved to trim budget-busting subsidies and shook up the bureaucracy by putting more services and data online. Since then, though, critics say Widodo has mostly rested on his laurels in his Covid-hit second term.
Now that he has BI operating as his government’s dedicated ATM, what incentive is there for Jakarta to take on vested interests and implement disruptive reforms?
As Jakarta takes the debt monetization route, its grade in Transparency International’s corruption perceptions index isn’t where development economists would prefer.
To be sure, Indonesia is making huge progress, improving to 85th place from 107th in 2014. But it still trails Kuwait, Lesotho and Trinidad and Tobago.
This raises another question: Do Indonesia’s in-house authorities have the investigative capacity and power to ensure that the new tidal waves of liquidity pouring in from BI to the government won’t fuel fresh graft? Stay tuned.
Finally, there is the risk of getting trapped. The Bank of Japan has much to teach BI about the perils of engaging in unconventional support; it has a habit of turning conventional.
Since 1999, BOJ-determined interest rates have been at, or below, zero. In the early 2000s, then-governor Toshihiko Fukui pulled off a couple of modest rate hikes. The financial empire, though, struck back and the central bank eventually returned rates to zero.
A valid question is whether Indonesia and other Asian governments learned the wrong lessons from Japan. For 21 years, Japan has been running ever-bigger QE experiments.
That has especially been so on Kuroda’s watch since 2013. Years of gorging on debt, equities and other assets drove the BOJ’s balance sheet to the $5 trillion mark, equivalent to the size of Japan’s annual output.
For developing Asia, this is a don’t-try-this-at-home moment. The reason Japan gets away with such monetary profligacy is that roughly 90% of its government bonds are held domestically. Tokyo also runs a current-account surplus.
All this makes the risk of sudden capital flight exceedingly low in Tokyo. Japan, too, arguably gets points for experience: In the 1930s, Tokyo went the debt monetization route and came out safely on the other side.
Even so, Japan is indeed an example of how extraordinary monetary policies quickly become normalized.
First, banks, companies, consumers and lawmakers get used to free money. Then they build interest-free loans into planning for the next fiscal year. Sub-zero rates are quickly viewed as an entitlement.
At BI, Warjiyo’s team must draw up a clear and enforceable exit strategy that politicians and CEOs understand. Otherwise, BI’s direct purchases of government debt could become a permanent feature to be expanded and likely abused.
Indeed, it is possible that prefectural leaders across the vast archipelago, from Banda Aceh to East Nusa Tenggara, might start to lobby for their own BI debt purchases.
Anushka Shah, a Moody’s Investors Service vice president, speaks for many when she says, “There are still a few aspects of the burden-sharing mechanism that are unclear, particularly with regard to the exit strategy.”
Finance Minister Sri Mulyani Indrawati is already shooting back. She claims the burden-sharing is a one-off necessitated by the Covid-19 crisis that is unprecedented in its scope and nature.
“The government,” she says, “is committed to maintaining fiscal discipline, to bringing down the budget deficit gradually to below 3% and to adhering to fiscal discipline in 2023 and beyond.”
Yet Asian peers will pay close attention to any signs of mission creep as they, too, mull monetization.
India has been most explicit about giving direct purchases a try. It’s highly likely the Reserve Bank of India will soon go the Indonesia route. Other economies now engaged in Japan-like debt purchases in secondary markets include the Philippines and Thailand.
In March, Bangko Sentral ng Pilipinas (BSP) bought more than $6 billion of debt from the national treasury, though on a temporary basis.
The transaction was done using a three-month repurchase agreement. Yet these agreements can be extended, which could elongate the practice. It’s a risky gambit that could undermine confidence in the BSP and weaken the peso.
The Bank of Thailand has also upped purchases of government debt, largely from the secondary market. As Covid-19 risks increase, Prime Minister Prayut Chan-ocha’s government is rolling out a roughly $60 billion stimulus package which includes support for bond-market liquidity.
The opacity surrounding the disbursements and stubborn strength of the Thai baht has markets abuzz with chatter about possible monetization to come.
Further afield, public institutions in Chile, Colombia, Hungary, Poland, South Africa and elsewhere are wading more and more into private debt markets.
This comes as what economists call “Modern Monetary Theory” garners increasing attention. MMT is at the center of debates about how much central banks should print money to support governments under pressure to spend more.
Some argue that the risks are low, considering the dire state of global demand.
“The monetization of fiscal is not going to generate inflation because the private sector is weak and will likely remain sluggish into 2021 as the support is not adequate to offset the decline of activities,” says economist Trihn Nguyen of Natixis.
Perhaps, but BI’s experiment will inevitably prompt credit rating agencies to boost their scrutiny of the nation’s debt trajectory. Indonesia will thus have to act prudently to protect its investment-grade rating and avoid a headline-grabbing downgrade.
As Andrew Wood of S&P Global Ratings puts it: “How these policies affect the credibility of these institutions will likely depend on a number of factors, including whether bond-buying schemes like this one persist, even as economic and financial conditions normalize.”
That’s credit industry-speak for, “Be very careful, Jakarta.”