Inflows into Indonesian bonds have only limited spillover to the rupiah.
In the first quarter, net purchases come in at nearly one standard deviation above the 10-year average. Overseas investors bought IDR600 billion of the country's debt as it appears in the fourth week of June, and have purchased IDR80,43 trillion year to date. Still, the rupiah ranks sixth among the top 10 world weakest currencies as of July 5th (Egan, 2023). As the dollar stands at Rp. 15,000 today, the value of the rupiah has fallen 55 percent since 1999.
As venture benchmarks, the money and bond markets are moving in tandem. The two markets are aligned because of substantial foreign debt property (Yung and Kondo, 2023). Yet rupiah is losing its traditionally close relationship to local bonds. According to data compiled by Bloomberg (2023), the 90-day correlation between the rupiah and government bond yields has fallen to below zero since the beginning of last month. A level of 0 means no correlation, while a level of 1 would mean the two move in lockstep.
Generally, the main factors that lead to that issue are growing expectations for rate cuts and cheaper hedging costs. The Federal Reserve has not yet met the disinflationary target and will continue to be hawkish for the rest of the year. Meanwhile, Bank Indonesia (BI) kept the seven-day reverse repurchase rate steady at 5.75 percent and delivered a clear message for no forward hikes.
It has become clear that this relative interest rates issue results in falling hedging costs. Thus proceeds falling hedging costs---mean more investors are choosing to offset their foreign exchange risks and suggest the rupiah will remain under pressure. Such a move was captured by investment risk premiums in Indonesia as the 5-year credit default swap (CDS) premium stands at 84.48 bps---revealing a 1.41 implied probability of default on a 40% recovery rate supposed. Besides, the expectations for more easing will help pull down bond yields, but simultaneously weaken the allure of currencies.
As high-volume capital inflows lead to rapid consumption, it's triggering a rise in inflation and the likelihood of a persistent current account deficit (Goeltom, 2008). While the headline inflation slumped to 3.52 percent, the core is mounted to 3.58 percent from the previous month of 2.66 percent. The trajectory of inflation is the current main driver of bond yields.
Despite BI and the market likely having agreed about the expectations of where rates will end up, the volatility of the rupiah and mount core inflation rules out the rate cuts option anytime soon.
The dynamic between bond yields and the rupiah began changing as large borrowings by the administration to support pandemic-restoration stimulus prompted BI to take the bizarre stride for debt to be monetized.
Indeed, regardless of BI independence amputated, as a transitory measure in the 2020 monetization of debt aims to stabilize the country's finances in crisis conditions and avoid collapse. By doing so, the government saves the budget, and government securities in the bond market are also absorbed. Yet its stretch to 2022 has unknowingly left the issue of divergence to the present day. That is why, even while the rupiah is the most visibly terrible performing currency---so-called junk currency, the benchmark sovereign bond is still better than its peers.
Less foreign ownership could have a silver lining to the rupiah by reducing hot money flows. It would make the rupiah market less volatile and much easy for authorities to monitor and manage sentiment. This job is quite hard to do if the foreign share of government bonds is high. The higher the share of foreign holdings of government bonds, the more elevated the exposure to risks associated with sudden capital outflows. In periods of financial stress, such flight by nonresident investors would imply that local bond yields would likely be more sensitive to global risk aversion shifts and potentially translated into disorderly market conditions (Cerutti et al., 2021).
The Indonesian market is vulnerable to capital flight of US$3,920.96 million (1994), $4,051.83 million (2000), $5.56 billion (2008), $32.02 billion (2011), and ($2.3 billion (2013). Nonetheless, the share of nonresident investors is also beneficial in the other way. It improves the government bond market liquidity and jack up the availability of financial resources---leading to lower funding costs domestically.
