CAPITAL FLOW VOLATILITY EXPECTED TO INCREASE, FEW PREDICT

UNCLAS SECTION 01 OF 04 JAKARTA 002234 SIPDIS SIPDIS SENSITIVE DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-BAUKOL SINGAPORE FOR BAKER TOKYO FOR GREWE COMMERCE FOR 4430 - BERLINGUETTE DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR TCURRAN DEPARTMENT PASS EXIM BANK E.O. 12598: N/A TAGS: EFIN EINV ECON PGOV ID SN SUBJECT: CAPITAL FLOW VOLATILITY EXPECTED TO INCREASE, FEW PREDICT IMMINENT CRISIS ¶1. (SBU) Summary: At a two-day seminar in Singapore sponsored by Standard and Poor's and the Malaysian Rating Agency, regional financial analysts and economists predicted that capital flows in to the region would continue to be large, but may become more volatile as investors' risk appetites shift. Most participants were concerned about asset price "bubbles", but they differed on whether capital outflows were a product of -- the benign macro environment of low inflation and low volatility or; -- more structural factors at play, such as long-term shifts in risk appetite and investment returns. Discussants raised questions about the assumed benefits of capital account liberalization, but an International Monetary Fund (IMF) economist warned against building up barriers to capital flows, since no systematic research can support the claim that financial liberalization by itself leads to a higher probability of crisis. While Indonesia has largely corrected the excesses that led to the 1997-98 financial crisis, the combination of the current global re-pricing of risk and Indonesia's open capital markets may prompt increased market volatility in Indonesian financial and foreign exchange markets in the near term. (Note: the conference took place on August 1-2, preceding the dramatic volatility in credit and money markets that began on August ¶9. End note.) What's Inflating the Bubbles? -------------- ¶2. (U) Conference presenters differed on whether recent spikes in asset prices are the result of a surge in global liquidity or of higher risk appetite. Some argued that low interest rates across the world and the historically low level of volatility in global capital markets have driven the dramatic rise in investment in Asia capital markets in recent years. These conditions bred new market participants and deepened capital markets further promoting investment in the region. Others cited demographic and other structural reasons (particularly in Japan) had led to a change in risk appetite prompting investors to move from lower risk assets to ;higher risk assets such as equity, debt and derivative markets. ¶3. (U) Market analysts noted that the benign inflation environment, which has allowed central bankers to keep interest rates low in many Asian and developed countries, is the result of the glut of low-priced goods and services from China and India entering global markets. These same experts worried that low rates, which have spurred borrowing and investment in capital markets, are creating an asset price bubble in capital and property markets. These trends have created an environment where asset prices do not influence consumer prices or vice versa. The de-linking of asset prices and consumer price inflation may have limited the effectiveness of monetary policy and further raised the risk of excessive asset price increases. For example, one analyst asserted that the Bank of Japan is actually considering raising rates despite disinflation in Japan to prevent the perpetuation of an asset bubble. Adding to the risk of a mismatch between asset prices and underlying value of assets is the belief that investors, with relatively short memories expect the positive trends of the last few years to persist. This belief, coupled with central bank market interventions in Asia to keep currencies competitive, have created a dangerous perception of a "one-way bet" increasing asset price and currency appreciation for investment in the region. ¶4. (U) Jesper Koll of Tantallon Investments argued that outflows from Japan and weakness in the yen are long-term trends. He outlined two sources for these outflows. First, is the so-called Yen-carry trade, where investors borrow low-cost yen to invest in high-yielding assets outside Japan. He considered this one important source of increased risk in the global financial system. According to his analysis, foreign banks have rapidly increased borrowing on the Japanese interbank market on behalf of clients, many believed to be hedge funds. The destination of this money and JAKARTA 00002234 002 OF 004 therefore the level of risk associated with these transactions is largely unknown. This has led to a growing surcharge on foreign bank borrowing (relative to Japanese bank borrowing) in the Japanese interbank market because of increased risk associated with these transactions. Central bank intervention to stabilize regional currencies has perpetuated the yen carry trade by prohibiting currency adjustment that would erase the gains from these trades. ¶5. (U) Koll said that the second set of outflows from Japan comes from Japanese banks and households facing low domestic returns. This trend is likely to continue, he argued, because the long-term constraints on domestic growth in Japan such as, the low birth rate and high labor costs will continue to make outward investment more lucrative than domestic investment. Nevertheless, these outflows are largely in the form of dollar denominated assets that are generally low risk. Thus, he argued, the current liquidity in the market is a function of risk tolerance not money supply. ¶6. (U) Experts predicted that, over the long term, the U.S. dollar would depreciate against currencies in the region due to the large U.S. trade imbalance. In addition, experts expect Asians to invest a greater portion of their savings within the region over the longer-run. Therefore, there are long-term forces for both asset price appreciation and currency appreciation in the region. None of the parties expected this trend to occur rapidly or linearly. In the short term, the current low inflation rates in countries may have contributed to loose monetary policies that have raised the risk of asset price bubbles, potentially introducing instability in regional capital markets. Analysts also noted that the emergence of a large number of retail investors participating in Asian markets in recent years also increases the tendency of markets to regularly overshoot with excessive optimism or pessimism. Participants also warned that any slowdown in growth in China or the United States is likely to affect capital markets in the region negatively as well. Will the Bubble Burst? -------------- ¶7. (U) Many commentaries on the tenth anniversary of the Asian financial crisis asked if another crisis in Asia was imminent. The short answer was no. This largely reflects the significant progress that Asian economies have made in correcting the weaknesses present prior to the 1997-98 crises. Some of the measures of progress mentioned by include: -- Asian banking systems are adequately capitalized and profitable; -- Bank credit portfolios are increasingly diversified; -- Bank managers have a stronger ability to manage risk; -- Banking supervision policies and practices have been significantly enhanced; -- Fiscal deficits are at manageable levels; -- Domestic bond markets have deepened; -- Asian banks have largely avoided short-term foreign currency borrowing to finance long-term investments; and -- The rate of growth of credit remains well below rates experience on the eve of the crisis. Most analysts concurred that the current instability in credit markets is a rationalization of the market at the margin rather than sign of weakness in credit markets as a whole. ¶8. (U) Nevertheless, the increased level of risk-taking in Asian capital markets and rapid appreciation of asset prices in recent years present risks to stability in the region. Many panelists noted that corporate credit quality may be deteriorating as the availability of cheap credit contributes to the under-pricing of JAKARTA 00002234 003 OF 004 risk. Chew Peng, Managing Director for Asia Corporate and Government Ratings at Standard and Poors, noted that the ratio of sub-investment grade debt issuers to investment grade debt issuers has increased over the past two years, highlighting the fact that poor quality borrowers have gained access to capital markets. In light of this trend, Standard and Poors expects an increase in default rates across the region if the cost of capital increases and global economic conditions become less benign. The improvement in banking sector profitability in Asia has been due to unsustainably high net interest margins (3-4% range). Bankers around the world have also increased the number of cross border transactions in recent years, according to one presenter. Analysts also pointed to the significant increase in leverage in the U.S. credit markets as an indicator of increased default and world market volatility. Many also consider an oil price shock the largest threat to economic instability in the region. As a result, experts expect an increase in market volatility in Asia this year, a trend that has already emerged in recent weeks. ¶9. (U) A number of panelists noted that the move away from bank finance to bond market finance in Asia has reduced the volatility in the region as the average bond market investor is less highly leveraged than banks. Others noted risks associated with the rapid expansion in bond market financing in Asia. First, there may be maturity mismatches developing from this form of finance as companies borrow short term in the debt markets to finance long-term projects. In addition, the number of highly leveraged hedge funds active in these markets has grown. Dr. Yeah Kim Leng, Chief Economist at the Ratings Agency of Malaysia, noted that the number of hedge funds in Asia jumped from 752 to 952 over the period 2000-2006, while assets under management increased 611 percent in the corresponding period. Dr. Yeah also argued that the emergence of sovereign wealth funds in Asia, while positively contributing to capital market deepening and diversification of state funds away from low-yielding treasury bills, also increases the risk exposure of Asian governments. Capital Flows: Spread Risk or Create Instability? -------------- -------------- ¶10. (U) Experts had disparate views on the overall benefits of liberalization of capital flows in developing countries. An exhaustive 2006 review of international experience with financial liberalization, presented by IMF staffer M. Ayhan Kose, indicates that capital liberalization does not necessarily provide faster economic growth or result in better risk sharing. The study also concludes that there is little systematic evidence to support widely-cited claims that financial globalization in itself leads to deeper and more costly developing country growth crises. ¶11. (U) The IMF work does indicate that financial liberalization offers corollary benefits such as institutional development and macroeconomic policy discipline. The benefits only appear significant when there are pre-existing supporting conditions, a basic level of financial system regulation and generally sound government policies. In their absence, the evidence suggests that financial liberalization does make countries more vulnerable to financial instability relative to countries with stronger institutional development and financial supervision. ¶12. (U) The IMF study noted that when researchers looked at specific types of capital flows, the benefits foreign direct investment and equity investment are more robust. Debt flows tended to promote excessive borrowing in weakly regulated financial systems and resulted in currency and maturity mismatches. A University of California at Berkeley Economist also said there is some evidence that foreign investment improves corporate governance. This may not hold true, according to recent research, if foreign owners have a majority stake in the company: when foreign owners control firms, their incentives are the same as domestic majority owners. ¶13. (U) Nobel Laureate economist Joseph Stiglitz argued that the most successful developing countries delayed capital account liberalization until a much later stage in development in an effort to maintain export competitiveness and reduce volatility. He argued JAKARTA 00002234 004 OF 004 that premature capital account liberalization, even with a basic level of supporting institutions, carries huge risks with limited concrete benefits. He contends that the biggest cause of financial crises to date have been hard currency borrowing by developing countries that leads to massive debt service problems. He also noted that developing countries with weak institutions and open capital markets are extremely vulnerable to changes in sentiment on the part of investors. Stiglitz also stressed that an open capital account requires developing countries to hold large foreign currency reserves to protect against capital outflows. In his view, this practice is expensive and counterproductive to development, as governments invest reserves in U.S. treasuries for a significantly lower return than they pay out to investors. Stiglitz also asserted that the gains from economic globalization tend to flow to the upper echelon of society and the corollary risks tend to accrue to the poor unless there are institutions to ensure distribution. ¶14. (U) Stiglitz and other panelists noted that China and India have been shielded from large financial crises because of their limited exposure to portfolio capital flows. They argued that financial repression helped shield both economies from the Asian financial crisis, despite the fact that China had many of the same institutional weaknesses as Indonesia and Thailand, i.e. weak banks and weak corporations. Others noted that China's current exchange rate policy which has required massive sterilization of foreign currency inflows for trade and has created significant short term foreign currency liabilities in the banking sector. Comments: Implications for Indonesia -------------- ¶15. (SBU) Indonesia, like many Asian countries, has largely corrected the excesses of the late 1990s that led to devastating economic and political crises. Nevertheless, the risk of significant and sudden volatility in Indonesian financial markets remains high. Indonesia had been a significant beneficiary of the recent search for yield in global financial markets, due to the country's relatively stable foreign exchange rate, the large spread between comparable US and Indonesian interest rates, and the sizeable returns on Indonesian equity investments in recent quarters. Capital inflows during the first quarter of 2007 were close to $3 billion. Because Indonesia has very few controls on these funds, both foreign and domestic investors can move their money out of these investments at any time - something that worries economic policy makers. ¶16. (SBU) A recent JP Morgan market assessment noted that foreign investors have recently reduced their exposure to Indonesian bonds and local depositors have begun to shift their funds from local currency to US dollar denominated deposits. If the current global re-pricing of risk exacerbates these trends, the Rupiah may come under significant pressure. While the large-scale foreign currency exposure in the banking sector that prompted the 1997-98 crisis has been substantially eliminated, volatility in foreign exchange, debt and equity markets could impact overleveraged investors in Indonesia. As local investors liquidate positions, spillover effects may include a downturn in real estate prices and an increase in nonperforming assets in the banking sector. Moreover, instability in local capital markets would inevitably discourage longer-term investment from both foreign and domestic sources. HUME