India and Indonesia get the wobbles with the threat of tighter money

Emerging economies, including those in Asia, have benefited from the rush of cheap capital from the old industrial world, where quantitative easing policies have generated vast sums, into markets with the prospect of a positive rate of return. During the global financial crisis, Indonesia, China, India and Australia became the darlings of international capital markets. With the growing signs of turnabout in the United States, and the early harbingers of recovery in Europe, there are already pressures on emerging economies as capital flight back the other way begins to anticipate a major shift in the short-to-medium term structure of world growth

The economies most affected by tightening in their capital markets are those with economic weakness to begin with. India’s reform agenda has stalled and the upcoming election raises big questions about how it might be energised. The new Reserve Bank of India Governor, Raghuram Rajan, faces a crisis of capital outflow and intense pressure on the rupee. Will the Indian authorities hold their nerve as devaluation drives up interest rates, as they should? India requires a wholesale micro-economic reform and public finance makeover. As its performance slides compared to its neighbours in East Asia, now would seem the time to define a clear way forward on India’s development and regional ambitions. In New Delhi last week, Shekhar Shah’s National Council for Applied Economic Research (NCAER) took the lead with an all-star review of the changes that need to be put in place if India is truly going to be able to fulfil its destiny in the Asian century and not simply end up an also-ran.

While Indonesia appears to have been doing much better, with solid real growth over 6 per cent in recent years, the aphorism that ‘good times beget bad policy outcomes’ has come to have resonance in the country and there are worries about a retreat to protection and investment nationalism, especially in the presidential election cycle coming up to April 2014.

In this week’s lead essay, Peter McCawley points out that the latest developments in Indonesian markets, and the slump in the value of the rupiah, reflect both long-term and short-term factors. ‘The longer-term factors include a range of issues (which) have been a source of comment within Indonesia for some time. At the broadest level, something of an inward-looking mood appears to have been influencing policies during the past year or so. Senior policy makers have emphasised that the broad approach being promoted, which is one of looking for ways to strengthen Indonesian industries, is not protectionist. Policies of this kind, policy makers argue, will strengthen the resilience of the Indonesian economy by providing greater economic security which will shield both Indonesian producers and consumers from the vagaries of uncertain international conditions’.

As McCawley argues, the long-term aim of building up domestic Indonesian industries and emphasising goals such as food and energy security is not without merit. But many of the well-publicised policies used to promote them over the past few years have been nakedly interventionist, with a strong anti-market flavour.

As the gloss has dropped off the Chinese-led mining boom, policies to promote value adding and local controls now seem peculiarly ill-advised. As McCawley argues, ‘in good times, when the international economy is strong and when international financiers are keen to invest in emerging market economies, developing countries such as Indonesia perhaps have room to take risks with experimental structural policies. But when international conditions are more difficult, markets and investors are less tolerant’.

But the immediate worry in the short term is the pressure through the international market, with the slowdown of economic growth in China leading to a fall in demand for Indonesia’s exports and the US Federal Reserve foreshadowing an end to quantitative easing and the remarkable global flight of capital that it brought to emerging markets.

The current problems of the Indian economy feed straight into anxieties in Indonesia and concerns that — as in the Asian Financial Crisis of 1997–98 — economic problems in one Asian country (in this case, India) might spread through a process of contagion to other countries across the region.

We are a way off that outcome yet. Much has changed in the circumstance and policy competence of Asian economies in the past decade and more. The authorities in Indonesia know what is required: the country has an excellent team at the helm of economic management, with strong macro-economic policy settings and the right policy instincts. There are more doubts about India, despite the wealth of economic expertise with which the country is endowed. Friday’s statement by Prime Minister Singh was strong on maintaining the commitment to reform but disappointing on strategy needed to ensure that it will be delivered.

If Indonesian policymakers are wise, they will focus intensely, as India also needs to, on capturing the moment of uncertainty for mobilising effective discipline towards the deeper structural reform that both countries, in their different ways, so sorely need.

Peter Drysdale is Editor of the East Asia Forum.