Indonesian Government Imposes Foreign Exchange Controls: Limits Use of Foreign Currencies in Domestic Transactions

I recently pointed out of the growing risks in the ASEAN region, particularly in Indonesia. 

The rupiah has been taking it to the chin and now has crashed to record levels. Question now is: To what extent will the current ‘capital buffers’ hold in the prospect of a sustained US dollar juggernaut vis-à-vis the rupiah??? Where is the breaking point for the system to snap?

If Indonesia’s system wilts and eventually cracks how will this affect the entire region? Do the big bosses of the BSP and their hordes of economists know?

(note: I made an error in my previous post where I mentioned Indonesia’s currency as ‘ringgit’ instead of the ‘rupiah’. Changes had been made above)

Well, in the face of crashing rupiah and record high stocks, the Indonesian government just imposed foreign exchange controls

The Nikkei Asia reports: (April 13; bold mine)

Bank Indonesia, the country's central bank, will require all companies to use the rupiah for domestic transactions starting July 1 to bolster the currency.

In recent months, domestic transactions using foreign currencies, mostly the dollar, have been running around $6 billion a month. Manufacturers, particularly, frequently engage in this sort of trading.

The central bank will impose sanctions on those using foreign currency in domestic cash and noncash transactions, with some exceptions for the government budget and financing of strategic infrastructure projects, with central bank approval. The restrictions were introduced in 2011, but had little effect since there were no clear penalties for breaking the rules.

Eko Yuliantoro, acting head of the central bank's Department of Currency Management, said Thursday the bank will impose penalties on companies or individuals that do not comply with the rules. Violations are punishable by imprisonment up to one year and a fine of up to 1 billion rupiah ($77 million). The bank has formed a task force with the ministries of Finance, Trade, Home Affairs, Tourism and other authorities to oversee implementation of the rules.

Bank Indonesia Gov. Agus Martowardojo said Friday that as of April 7, the rupiah had fallen 4.85% since Jan. 1 and that the trend may continue through the rest of the year. He said it would be difficult to reverse the bearish trend in the rupiah through market intervention. "To address the vulnerability in the national economy, a disciplined monetary policy will be required," Martowardojo added.

According to the central bank, the total foreign debts of Indonesian companies, including state-owned enterprises, has reached $163 billion and only 26.5% of that is hedged. As the U.S Federal Reserve is expected to raise interest rates in the future, a move that could trigger further appreciation of dollar, he will ask all companies in Indonesia to improve their foreign fund management and hedge their dollar exposures.

For the Indonesian government to drastically impose foreign exchange controls appears to highlight signs of desperation from the sustained downside volatility of her currency.

The exchange controls had actually been announced last week, April 9, based on a report from Reuters.

Yet the USD-rupiah has been rising despite the proposed imposition of capital controls this coming July.

The currency markets may have seen or interpreted the government’s actions as potentially contributing to the weakening of Indonesia’s economic conditions or has read through the government's seeming panic, or has downplayed on the purported effects of such capital controls.

The weak rupiah appears to have temporarily benefited the Indonesian economy in terms of record FDI’s in 2014 (see chart here). But this appears as being neutralized by resident capital flight. The upsurge in dollar based transactions—“running around $6 billion a month”—have likely been symptomatic of this.

And in recognition of the risks from the vagaries of capital flows, the Indonesian government dangles tax incentives to foreign firms to stem the risks of capital flight.

From the Wall Street Journal (April 10)

Indonesia will start offering foreign investors a lower tax bill if they reinvest profits here, a measure that could stem capital flight as the U.S. prepares to raise interest rates and buffer the economy from “uncomfortable” rupiah weakness, the finance minister says.

Starting later this month, companies that reinvest dividends will receive a 30% deduction on their taxable income over six years, Finance Minister Bambang Brodjonegoro said in an interview. Those businesses also will be able to use losses to offset profits for up to 10 years, compared with five currently. Other incentives include lengthening tax holidays for certain industries, including the petrochemical sector, which is the biggest recipient of foreign investment in the country.

The tax incentives would be aimed at keeping foreign capital within Indonesia’s borders, a move Mr. Brodjonegoro hopes will stem an exodus of hot money if the U.S. Federal Reserve raises interest rates, as expected later this year. Foreign capital dominates markets in Southeast Asia’s largest economy, and hints of rising rates in 2013 sent both the rupiah and the local stark market into a nose dive.

Nevertheless, Indonesia’s record low rupiah has only caused external trade to plummet as both February exports and imports have crashed to 2008 levels!

February exports and imports plunged 16.02% and 16.24%, respectively according to Reuters.

The surge in currency volatility has apparently contributed to the immense distortion of the Indonesia’s entrepreneurs’ economic calculation and coordination process that has led to the trade collapse! Just how will entrepreneurs do their profit –cost analysis with such intense forex price fluctuations? 

The crash of her external trade has hardly improved her current account deficit. Capital flight could have also been a factor.

Even more, mounting government expenditures comes in the face of growing indications of economic weakness. Add to these the enormous $163 billion of foreign debts where only 26.5% has only been hedged.

So aside from potential shift in the Fed's ZIRP (zero bound policies), the rupiah's weakness has been structural--specifically, a product of domestic policies that has been transmitted to the economy via boom bust cycles.

Well, foreign exchange controls will have unintended consequences.

As Cato Institute’s monetary economist Steve Hanke explained in 1998 (bold mine)

When convertibility is restricted, risk increases, and so the risk-adjusted interest rate employed to value assets is higher than it would be with full convertibility. That’s because property is held hostage and subject to a potential ransom through expropriation. As a result, investors are willing to pay less for each dollar of prospective income and the value of property is less than it would be with full convertibility.

This, incidentally, is the case even when convertibility is allowed for profit remittances. With less than full convertibility, there is still a danger the government will confiscate property without compensation. This explains why foreign investors are less willing to invest new money in a country with such controls, even with guarantees on profit remittances.

So investors become justifiably nervous when it seems a government is considering imposition of exchange controls. At that point, settled money becomes “hot” and capital flight occurs. Asset owners liquidate their property and get out while the getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard capital flight, they promote it.

While the prospective implementation of forex restrictions has been directed at domestic transactions by local enterprises and individuals, it won’t be far fetched where capital controls may spread to foreigners.  Failed interventions beget more interventions

So despite the record setting stocks via the JKSE , I expect the current capital flight dynamics in Indonesia to intensify. And such would magnify the risk of a regional contagion.