VZCZCXRO1693
RR RUEHCHI RUEHDT RUEHHM
DE RUEHJA #2234/01 2280632
ZNR UUUUU ZZH
R 160632Z AUG 07
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC 5799
RUEATRS/DEPT OF TREASURY WASHDC
INFO RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHKO/AMEMBASSY TOKYO 0668
RUEHBJ/AMEMBASSY BEIJING 4213
RUEHBY/AMEMBASSY CANBERRA 1010
RUEHUL/AMEMBASSY SEOUL 4131
RUEAIIA/CIA WASHDC

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