Investors will look back on 2010 as one of the best years ever. Increasing by 44 percent from December of last year, the Indonesian Stock Index was among the best performers in the world.
At the same time, the rupiah strengthened by a little over 4 percent, bringing total returns in US dollars close to 50 percent.
Government bond prices rose significantly in the same period, with 10-year bond prices increasing by 20 percent. The question now is whether we will see a similar performance next year. We should review the main themes of 2010 and see if they will continue in 2011. We should also look at what trends are developing and how they will impact the year ahead.
The main domestic reason for the rise in stock prices was low interest coupled with limited real sector investment opportunities, which pushed money from banks into the market. Foreigners saw Indonesian stocks as cheap, with price earnings ratios (PER) of 17 times, and bought Indonesian stocks in large quantities.
Our reserves grew to US$27 billion by November 2010. About two-thirds of this was in portfolio investment, of which $9 billion was in government bonds.
The inflows also resulted from huge amounts of liquidity pumped in by central banks in developed countries to save their economies in 2008 and 2009. Lack of investment opportunities at home pushed this liquidity to emerging countries. Aside from China and India, Indonesia became attractive for its growth potential and high bond yields.
Equity market earnings per share (EPS) were about 30 in 2010. An additional attraction came from the Office of the State-Owned Enterprises Minister with 30 percent market capitalization giving around 50 percent in dividend payout ratios.
Consensus estimates for Indonesian market EPS in 2011 is 17 percent and PER at 15 times. This is high compared to other emerging markets with 2011 PERs estimated at 11.5 times. Only India and the Philippines are estimated to have similar levels. Historically, however, the Indonesian market gives over 20 percent EPS. Furthermore, with comparatively larger dividend payouts by major firms, the Indonesian market can still give very decent returns. Indonesia is also on the brink of a sovereign rating upgrade that will enlarge the investor base. Improving performance in neighboring countries also means favorable comparisons for our market.
On the global scene, the US FED’s recent statement about further easing means there will be more liquidity. And, as home investment opportunities are still nowhere to be seen, more funds will flow to emerging markets.
On the domestic front, the main risk in the short term is inflation. Recent price increases in food and other staples and the government’s plan to reduce fuel subsidies point to higher inflation down the road.
Why, then, is Bank Indonesia still keeping its policy rate steady?
Raising rates while capital is flowing in is certainly unwise. This is the problem facing many central banks in emerging markets today. More generally, this indicates the trilemma theory (sometimes called the “unholy trinity”) at work.
A country can only achieve two out of three ideal international finance goals: 1) achieving monetary policy independence; 2) having free capital flows; and 3) achieving a stable currency. It appears Bank Indonesia lost its policy independence in order to achieve the other two goals.
Thus, BI is holding interest rates and taking limited steps to lower the risk of sudden capital outflows by lengthening the terms of foreign ownership in SBIs (BI debt papers). How long it can hold off raising rates is crucial. Given its role in staving off inflation early on, the bank should start raising rates soon and not front load its rate hike. By keeping its powder dry it tells the market that rate hikse will be protracted. And in doing so, the market should react to lower actual inflation.
With inflation still in the single digits, policy interest rates will most probably be raised to double digits.
Thus, deposit rates will not catch up with stock market returns and money will continue to flow from bank deposits into the stock market.
From all sides we see the momentum for further inflows to the market is intact, at least in the short run. That is the demand side story. The appropriate response now should be to increase supply in the form of IPOs and secondary offerings and further bond issuances.
That is how we can avoid prices rising through the roof. It also lowers the risk of a bubble developing.
Although most investors are still considered rational, massive inflows can cause prices to rise too fast, setting off irrational behavior. That is exactly what we do not want to see happen.
The writer is a lecturer in economics at the University of Indonesia.
Opini The Jakarta Pos 23 Desember 2010