A prophecy and a flight from the Indonesian Rupiah – Part I

The well-known statement “I think, therefore I am” has a bit more philosophical depth than I am willing and able to deal with so I shall simply use it as a diving board out into the skewed version I often use in class: “I think something will happen and my very actions based on this expectation shall prove me right!” This is what economists refer to as a self-reinforcing feedback loop or, in slightly more common parlance, a self-fulfilling prophecy. It is also somewhat kinder than what one of my high school teachers said in reference to undersigned when I was being more than usually silly in class: “Matt thinks, therefore he makes a fool of himself.”

Several ex-wives have said something similar…

Anyhow, back to economics. The basic mechanism of a self-fulfilling prophecy is:

a) I expect the price of a good I am interested in to rise;

b) I act upon that expectation and buy more of it – perhaps in the speculative thought of exploiting price differentials between now and the future;

c) others also act upon the same expectation; so

d) our increased demand drives up the price. It works the same way in the opposite direction, where expectations of a falling price lead to a decrease in demand which drives down the price.

Commonly, the strongest feedback loops are to be found in highly speculative goods such as shares, gold and currencies. An additional spice herein is also the simple fact that investors/speculators tend to follow “trend-setters” – i.e. high profile actors on the market. Just think of those Animal Planet documentaries where the lead wildebeest (for reasons known only to him!) veers off to the left and the entire herd follows him. Financial firms and well know fund managers tend to be at the front of the herd and other, lesser, actors follow at their peril. (Economists will be somewhere in the middle frantically trying to explain why their predictions were wrong.)

My last year in Jakarta, Indonesia, was a case study in how protectionist policies coupled with fear that was exacerbated by recent memories of crisis created a self-fulfilling prophecy. It also made some rather cynical economics teachers a good deal of money! Yes, you heard me; economics is not about the colour of mermaids or whether falling trees make a noise (this is for your ToK class). Economics is an applied science.

Spot the leader

At the time of writing, the Indonesian Rupiah (IDR) has fallen in value by about 16% against the US dollar (USD) over the past year. I clearly remember sitting around with the lads in October 2012 having a beer by the pool at Jon’s place. In the 10 minute window of opportunity one has during sessions with very blokey guys – i.e. before the usual wet towel fights and arm wrestling started – Tom was wondering why interest rates in Indonesia were so much higher than in the UK, US or indeed the EU. “Why not take USD1,000 and get 7% interest in Indonesia rather than 0.5% in the US?!” Tom is a biologist and as such spends most of his day talking about things that civilized people do not bring up during polite conversation. Nobody ever learned about reality by staring into a bubbling Petri dish.[1]

Yes, the dollar is becoming more valuable, which means that the IDR is becoming….

(Source: Yahoo Finance at www.finance.yahoo.com)

In my most kindly and avuncular manner, I explained. “Tom, you shaven-head biologist. How did you survive teenagerdom?” Then, after putting forth my biological reservations against anyone as ignorant as he having children, I explained. The interest rate differential between the UK/US/EU and Indonesia is in fact a risk premium. It tells us that the market has “built in” the expectation of the IDR falling in the foreseeable future. In other words, the 6.5 percentage points difference between Indonesian and UK/US/EU rates would in all likelihood be more than countermanded by a fall in the value of the IDR.

So, if Tom were to put in USD1,000 in October he would get IDR9,000,000 and in one year’s time at 7% interest could extract IDR10,165,000 – yet the actual “home ground” value of this IDR10,165,000 would not be worth the equivalent of USD1,000 at 7% interest due to the depreciation (= decrease) in the value of the IDR. Look at the diagram illustrating the price of the USD to the IDR between Sept 2012 and Sept 2013. Tom’s IDR10,165,000 at a rate of USD1 to IDR11,200 would have been worth USD907 a year after our pool-side chat.

Tom, cunning Northumbrian lad that he is, came up with a cunning plan. “Ha! I have what biologists call a Cunning Plan! One can open a US dollar account here in the same Indonesian bank, put the USD1,000 in it…and get the 7% interest. Thus, one has guarded against depreciation. Didn’t think of that did you Homo Economicus?!”

“Wrong, oh Shining Pate. Unchain yourself from the microscope and visit my class on occasion. Do you really think that the Indonesian bank will give you 7% interest on US dollars?! I.e. that a financial institution would not build in the expectation of the IDR depreciation and thus be willing to in fact bear the full risk of depreciation?” Of course Tom checked and of course the interest rate for a dollar account was around 0.5%. He had to buy the beer the following Friday. All good.

There are a couple of valuable lessons to be learned here:

1. Don’t mess with economists
2. Never assume that you are the ONLY one to discover an exploitable price differential – today’s world of instant information means that in all probability it is already known
3. Any exploitable “gap” between two prices or rates of return will be discovered…and filled
4. Expectations are strongly self-fulfilling – if the IDR is considered overvalued then it will in all likelihood depreciate as the various players act upon expectations
5. See number 1 above

So, let me wind down the hyperbole a tad in finishing this first part of the IDR Saga. What was it that made me so confident that a) the Indonesian bank would have pretty much the same dollar interest rate as the UK/US/EU, and; b) why was I so confident that the IDR would depreciate rather considerably over the next year? The reason is simply that basic economics gives us a number of metrics/variables by which to measure the (relative) strength of a currency, including but not limited to: inflation rates, relative interest rates, growth in trade partners’ economies, current account deficits, foreign direct investment (FDI) legislation – and the distinct possibility of a fear-factor-generated self-fulfilling prophecy. These are the subject of Part II and underpin why I was confident enough to bet Tom a case of beer about the dollar interest rate.