27 May 2007

Hot Money

Reslian Pardede

The hot money phenomenon in Indonesian capital market has prompted a debate over the possibility of another economic crisis. Hot money is the very short-term fund from overseas that is invested in liquid instruments such as capital market instruments or foreign currency. Is the worry justified?

Considering the fact that the foreign reserve of Bank Indonesia is currently at its high record (USD50 billion) many believe that Indonesian government would be able to manage the would-be huge money outflow while keeping a crisis away from the economy. However, I would argue that the possibility of another crisis is just a matter of degree of the magnitude of the real problem itself. The fundamental problem of the hot money itself is often being played down. Even at a normal scale, hot money would create enormous volatility in the financial market especially that of the emerging market because of its size and its short-term period of investing.

Hot money would not only increase the volatility or fluctuation of the prices but would also disconnect the prices from their underlying assets these are the fair value of the companies (for stocks and bonds) and the countries’ economy condition (for currency). It is as if the price became the signify that engaged in its own world, the world of symbol, isolated from the signified i.e. the underlying assets as described by Ernst Cassirer. The signify is supposedly the symbol, something that represents, the signified. But according to Cassirer the signify could then create its own structure and values which are no longer attached to the signified. Is that what happened with the superior performance of the Jakarta Composite Index (JCI) lately? Has the JCI turned into the signify that is disconnected from the fair value of its underlying assets?

Theoretically, the stock prices, aggregately represented by the index, should reflect the fair value of the listed companies. However in reality the price does not always accurately mirror the fair value due to the nature of the price determination or price discovery itself. But in normal situation, there prevails in the market a mechanism that allows correction to happen “guiding” the price back to its fair market value. What exactly this fair value and how it is determined is another discussion. But we could say here that when the price is getting too high it will be “forced” to come down and vice versa. It’s a matter of timing. However certain situation might arise that the correction is being put on hold. This would result in an even bigger correction than it should be. The liquidity shock stemmed from hot money is one example of the situations. Instead of moving in accordance with the changes in fundamental conditions of the companies, price is now largely moved by the liquidity.

Let us take JCI as an illustration. In May 23, 2007, JCI set its highest record at 2.104 after previously creating new a series of high records. For the first 5 months of 2007 (up to May 23) JCI has grown by 16.6%. Meanwhile, the economy only grew by 5.4% p.a. for the first quarter of 2007 or 1.35% for 3 months. We obviously could not do a par-to-par comparison on the index and the economic growth because the index or stock price is based on the ongoing-concern assumption. But the discrepancy between the index growth and the economic growth in itself has been already quite big. It is even bigger should we consider the JCI past performance in 2006 that stood at 55% making it the 3rd best performer worldwide after China and Russia. Therefore, the 5-months performance in 2007 cannot be the continuation of any correction that should have happened in 2006. This discrepancy might even get worse if we take into consideration the problems in real sector that has made the real sector fall behind the financial sector. JCI seems to have been pulled off its root i.e. the fair value of the companies.

It is therefore plausible to argue that Indonesia is currently experiencing a bubble. This bubble phenomenon apparently is not the monopoly of Indonesia. Some other Asian countries particularly China are undergoing similar situation. Shanghai SE A Share Index grew phenomenally by 112% in 2006 and 56% for the first 5 month of 2007. But perhaps China should be seen as a different case from Indonesia. The bubble here in Indonesia is due to the hot money inflow flooding the market with excess liquidity and the effect of the US stock market performance. According to Bank Indonesia (BI), the central bank, in April 2007 around Rp 45 trillion foreign funds are invested in SBI (a sort of treasury bills), Rp 77 trillion invested in bonds and Rp 5.6 trillion invested in stock. BI also estimates that a total of US$10 billion (Rp 90 trillion) of short-term funds may leave the country any time from now. This amount comprises US$1.5 billion in SBI, US$5.5 billion in bonds and US$3 billion in stock. It is a huge amount for Indonesian market. The average daily trading volume of stock in Jakarta Stock Exchange in 2006 was only around Rp 2 trillion and the average daily trading volume of bonds in SSE was about Rp 3 trillion. This small trading volume is corresponding to the small market capitalization. The market capitalization of the Indonesian stock market now is ranging from Rp 1,200 – 1,400 trillion and the market capitalization of the bond market in 2006 was around Rp 470 trillion. It is considerably small compared to other stock market in the region. For instance, the market capitalization of Hong Kong stock market in the end of 2006 was US$ 1,715 billion (Rp15.435 trillion) and the Singapore stock market was US$ 393 billion (Rp3.537 trillion). Accordingly, it is easy to see how the hot money would affect the market with the size as small as Indonesian.

So, should we just sit there and watch the bubble burst out by itself? The current monetary system does not leave much room for the government to mitigate the risk i.e. the liquidity risk. Under the current system, the government has a limited control on the flow of funds coming in and going out of the country. Hot money is the phenomenon of the free market with the free-floating currency regime that indicates how vulnerable the financial market of a country can be. The most vulnerable of all is the emerging markets. Hot money put our financial market and economy at the mercy of the foreign (hedge) fund managers with million of asset under management.

Regardless of whether the phenomenon of hot money this time will trigger another crisis similar to the one in 1997 – 1998 or not, a huge and short-term funds flow could drift the prices away from the fair value of their underlying assets and thus create instability in the financial market and possibly the economy. The hot money flow ought to be kept in check. It is certainly not an easy job but obviously something has to be done.*


johnorford said...

nice article. i disagree about keeping hot money in check.

other countries like china and thailand are trying to keep hot money in check by various interventionist measures.

i think indonesia's hands-off approach is the most sensible in the long run. corrections are a fact of economic life, and it's best to let the markets deal with them rather than govts meddle with them.

also the krismon, was I suspect, more a problem of suharto govt. economic interventionism (fixed exchange rate!!!) in the years prior which /exacerbated/ the correction.

The Institute for Ecosoc Rights said...

All of you may also be interested in seeing a discussion going on at the Indonesian version of this article.

reslian said...

hi john,

"other countries like china and thailand are trying to keep hot money in check by various interventionist measures."

yes, they are. thailand seems to have failed. china is "survived" so far ;-) (don't know for how long though).
with this article, i am not by all means trying to support a fixed monetary regime. i am not there yet to discuss what can be done as far as the policy concerns. i am fully aware of the complexity of the issue. however i believe something has to be done. i'm wondering if the governments in the region that are more susceptible to this phenomenon could work together without having to employ a fixed monetary system.

"i think indonesia's hands-off approach is the most sensible in the long run. corrections are a fact of economic life, and it's best to let the markets deal with them rather than govts meddle with them."

yes indeed, corrections are, using your words, a fact of economic life. in the article i did mention it though i was referring to "normal" corrections i.e. corrections due to the arrival of new information as the efficient market hypothesis says.

hot money, on the other hand, could cause excessive corrections that will create huge volatility and may drag the whole system down albeit temporarily.

too much volatility will cost the economy some money: central bank, exporters, importers, investors, mutual funds, etc. it could be quite frustrating to see the prices go up and down significantly with no fundamental justifications. madness.

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