Yield Hunting in Indonesia
The level of the Indonesian rupiah determines all things in this crucial southeast Asian market.
By Margaret Elliott
Indonesia can't boast about having the highest yields or the fastest
growth rate-but don't let that distract you from its considerable charms.
The Indonesia market has recently become an intriguing variation on the
emerging market derivatives theme, with a few anomalies. It boasts one of
the most liquid markets for cross-currency forwards and swaps in the region,
and has become the center for a variety of other derivatives plays as well.
Investors looking for high yields have been attracted to its bond market, which offers interest rates of 12 percent to 14 percent, as well as to its
rising stock market. "It is the search for yield that drives the Indonesian
market," says Rajiv Pandit, director of global derivatives, Asia, for
BZW in Singapore. "The development of nondeliverable forwards-as has
happened in other Asian derivatives markets-provides liquidity in this market."
Nondeliverable forwards are instruments that do not require the deliverance of the underlying at expiration and therefore allow foreigners who often
cannot own the underlying to operate in these markets. After a relaxation
last year in the trading band of the Indonesian rupiah, which is pegged
to depreciate up to 6 percent a year against the U.S. dollar, investors
are also seeking to take long and short positions.
As elsewhere in Asia, the government's currency policy is the pole around which the debt market derivatives circle. The Bank of Indonesia has tried
to maintain an artificially weak currency in order to boost exports, but
at the end of last year it announced it would end that policy. It has also
demonstrated a tendency to widen the band in which the rupiah trades against
the dollar. To date, the rupiah has tended to trade in the top half of the
band, but in the last six months, the band has widened enough to knock out
some of the binary trading ranges.
The change in the government's policy toward its currency stands to reason, says Gustiaman Deru, a director at ING Barings in Hong Kong. "Effectively,
the commitment to currency depreciation against the dollar prohibits the
government from pursuing a free monetary policy. Now that the economy is
less sensitive on the export side and more sensitive on the import side,
the high interest rate differential with the dollar is not desirable."
Evidence of this shift can be seen in the drop of 250 basis points over
the last year in both short- and long-term interest rates.
"If the band were to widen and ultimately disappear, and the rupiah becomes free floating-and if history is any indication-the currency should
simply appreciate," says Tony Keane, head of interest rate trading
at HSBC Markets in Singapore. "However, more recent developments in
liquidity management suggest that this may not be the case. Indeed, as Bank
Indonesia takes more control over monetary policy it is entirely feasible
that the currency may remain relatively stable." One trader says investors
are already putting on rupiah calls with a knockout barrier on the downside,
effectively constructing a cheaper product with full upside potential. Corporates
too are looking for fixed-rate swaps rather than leaving their financing
open to the dollar.
As in most emerging markets, plain vanilla is the dominant flavor. The
vast majority of the activity involves the use of short-term foreign exchange
forwards against dollar LIBOR.
Currency swaps, however, have been used by investors as a good way to
pick up yield. They've also been used by domestic and international corporates
to hedge investments and cash flows. In fact, the increasing liquidity in
the currency swap market has allowed investors to go further out than most
areas in Asia-sometimes as far as 10 years. Any deal longer than three years,
however, remains uncommon.
Because the rupiah has been trading in a constrained band, a number of
collared products involving digital and barrier options have also grown
up around the Indonesian rupiah swaps business, as they have around the
Thai bhat and other Asian currencies. "These products," says one
derivatives trader in Singapore, "allow investors to implement views
on the direction of the market as well as the shape of the volatility curve."
This is a sharp reminder that Indonesia, like all emerging markets, is
plagued by that least forecastable of risks-event risk. Elections are scheduled
for early June, though few expect that a political change, or a more distinct
shift in currency or monetary policy, will not happen until afterward. And
last summer's minor riots still stick in traders' memories.
Equity derivatives are quite common, with over-the-counter deals put
together by a wide range of banks for one of two reasons. "Either a
customer is interested in a directional trade that reflects a point of view
on an index or sector, or the customer uses equity derivatives to get over
investment prohibitions and get access to the markets," explains Christian
Queck, a director of ING Barings in Hong Kong. Queck sees fairly substantial
deals still being done in Indonesia via equity derivatives. As investors
come to trust the market more, however, he expects to see an increase in
Credit derivatives are also available and becoming widely used. These
are fairly simple deals, put together to strip out sovereign risk, to arbitrage
between classes of bonds or to combine the credit risk of one country with
the currency risk of another. ING's Deru points to one fashionable trade
of the moment: mixing the credit of Indonesia with the Philippines peso.
Customers that trade Indonesian issues in the Eurobond market often issue
synthetic notes that effectively sell off the sovereign risk associated
with the deal. The result is a note that gives the yield of the Indonesian
Eurobond without the exposure to the default risk of the government. Another
common trade involves selling an Indonesian state agency issue and buying
an Indonesian corporate issue. According to Deru, the spread can be between
150 and 300 basis points, depending on the quality of the corporate issue.
It's unlikely, however, that Indonesia will fall out of favor among yield seekers any time soon. "It won't be a steady tightening of the spread
between rupiah and dollar," says HSBC's Keane. "There will continue
to be moments of anguish in this market."