Cablegate: Capital Flow Volatility Expected to Increase, Few Predict

DE RUEHJA #2234/01 2280632
R 160632Z AUG 07





E.O. 12598: N/A

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

-- 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.


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