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What is Tapering? Is it Good or Bad?

This December may be the 'anxious months' for investors and traders, as there are several issues that feared would cause further decline of Jakarta Composite Index, whereas its position was already low. One such issue is the problem of tapering, and that is what we will discuss in this article.

Before we get into the discussion about tapering, first I want to comment on the hike of BI Rate, which has reached 7.50% (and could rise again). The hike, as you know, aiming to reduce the amount of money (Rupiah) in circulation, where it is expected to be able to suppress the rate of inflation, as well as strengthen the value of Rupiah, which at this point had already been through the level of Rp12,000 's per US dollar. So if we take this point of view, the BI rate hike is actually good for the economy.

But on the other hand the BI rate hike could also slow down the economic growth, because it could cause banks to tighten their lending, including to the property sector (mortgage loans). A rise in interest rates due to the increase in the BI rate could also cause the banking business become more vulnerable to the risk of bad debts, which ultimately led to losses for the bank. But so far there the performance of the banking sector in the long term is still good, no matter if the rate goes up or down.

That's why, when the BI rate either raised, unchanged, or lowered, you can not directly interprete whether it would be good or bad for the economy. BI Rate hikes could mean good if the goal is reached while the 'side effects' was not too significant. On the other hand, the BI rate hikes could also mean bad if it fails to achieve its goals, while the side effects are more dominant.

But if we assume that the guys in Bank Indonesia (BI) must be very aware about the direction of monetary policy, then the current position of BI rate is must be the best for the current national economy, or at least according to Agus Marto et al. The point is, wheter the BI Rate is at 5%, 6%, 7%, or whatever, then it is the most appropriate to the economic situation in Indonesia. I mean, sure you would agree that Agus Marto is not the type of big mouth lawyer like Farhat Abbas, or rude politician like Ruhut Sitompul, but he does understand the economics.

Okay, then how does it with Tapering?

The term 'tapering' is actually a term in the world of sports, that is a situation where the athlete take a rest on one day before the game. For example, if Mike Tyson will have a boxing match on June 5, then of course he will train in much advance, can be many months before the match. But just one day before the game, on June 4, he will rest completely, perhaps by simply watching TV at home all day. This break condition is called tapering.

While in the world of economy, especially monetary, tapering is the reduction in bond purchases by the Federal Reserve (the Fed, the U.S. central bank). So initially, in order to encourage economic growth, the Fed printing money in a certain amount and then distributed it to the community, by buying bonds issued by companies. This policy known as quantitative easing (QE). With the increase of money in economic circulation, it is expected that the level of consumption, investment etc. will also be increased, which in turn would grow the economy.

The amount of new printed money is U.S. $ 80 or 85 billion per month. Of course, the Fed can not continue to funnel the money into the market, because it can lead to inflation and weaken the currency of U.S. Dollar itself.

So after reaching a certain limit, the distribution of the new money should be reduced, and this is what is meant by tapering. Why it is called tapering? Because the goal is to 'rest' the economy after being driven to 'train' continuously. Training for what? To be able to grow. When an American company/people receive money from the Fed, then it does not mean that the economy could automatically direct to grow, but the people would have to spend the money on consumption, investment, etc., then the economy will (expected to) grow. The efforts to spend the money for good cause, like for example an employer who immediately build a factory after obtaining a bank loan, which could be analogous to 'train' for the purpose to improve the economic conditions of their own, and ultimately grow the national economy as a whole.

But of course, just like a real sport athlete, the people should also take a break from their activities of spending the new money after a certain time, and that's why tapering is required. Because if the Fed continuously funnel new money into the community while the community itself was 'tired', then the money is not going to help the economy, but will only cause inflation.

So a little different from the BI rate hike where the objective is to reduce the amount of money (Rupiah) in circulation, the tapering is aim to reduce the rise of the amount of money (US Dollar) in circulation (the Fed still adding new printed money to the community, only the amount of the addition is reduced). But market concerns remain the same: If the money supply is reduced, then it means that there is no more money to be spent, and it could hamper the economy. As a result when last month the BI rate was raised, JCI had fell. Similarly, if later the tapering is actually effective, the Dow Jones could fall as well. And if the Dow fallen, usually JCI will be dragged down.

But would the decrease occur for a long period of time or just temporary? Well, that's what we do not know. If we use the example of JCI, the BI Rate position at this moment (4,200’s) is much different compared to its initial position before starting to be raised, ie 5.75% (now it is 7.50%), and consequently the JCI has gone far down from its peak position, ie 5,200’s. Although one thing to be noted here is that JCI reached its peak in April only because driven by the euphoria over the influx of foreign funds, rather than fundamental factors.

As for Dow Jones, since tapering itself is still not yet in force, then the index is still rising. But since the issue of 'United States Shutdown' has dissapeared some time ago, there are many analysts who remind the investors about 'the dangers' of this tapering. Well, if we read again the above, the fact is that tapering, when it is effective, will have a positive impact. Should the Fed finally enact tapering, then it means that America has reached the economic condition where the tapering is required. If until now the Fed has not imposed tapering, then it means that it is still not needed yet. As simple as that, and nothing is to worry about.

However, this does not mean that the Dow Jones will not be corrected at any time later, either when it the tapering is finally effective, or delayed further. If you check the valuation of stocks that of Dow components, many of which have been recorded PER more than 20 times, or already relatively overvalue. For comparison, the average PER in the current JCI position, for ten stocks with the largest market capitalization outside UNVR and HMSP (because the two are extremely high in its PER), is less than 11 times.

That's why if viewed from the side of valuation, the Dow is prone to be dropped, though of course we do not know when it will happen. But my point is, the tapering is not a real problem at all, but just another magazine-cover-story after the Euro Crisis, Greek Crisis, Debt Ceiling, Fiscal Cliff, and the United States Shutdown. Trust me, after the ‘story’ disappears by itself there would be another story, and other stories, and so on until.. forever.. as long as stock market exists. If you are include those who are still easily worried by stories like this, just calm down, you'll also be familiar anyway :)

However, through this blog I will strive to continue to deliver an update on the latest issues related to national and global economy, so just stay tuned!

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