Quantitative Easing, and its Effect on JCI

A few days ago, the central bank of Japan (Bank of Japan/BOJ) announced the quantitative easing (QE) policy, in which the BOJ would inject funds worth a total of US$ 1.4 trillion to the economy of the Sakura country. This amount is equivalent to the amount of money in circulation in Japan, so the QE policy will make the outstanding amount becomes doubled. According to BOJ Governor, Haruhiko Kuroda, the policy aims to re-grow the economy, which stagnant for more than a decade by the lack of the amount of money circulating in the community. The inflation rate in Japan itself has already minus aka defltaion in the past 15 years. 

The local stock market responded positively to the policy, where Nikkei index jumped 2.2% in just one day after the announcement released. In fact, the market is likely already known of the QE much earlier, where the Nikkei has gained significantly in the last six months (more than 50%), and make it as the stock index with the highest increase in the last year in Asia, or even in the world.

Other than Japan, the QE policies also carried out by the U.S. central bank, the Federal Reserve (the Fed), in which the Fed injected a total of US$ 85 billion per month into the American economy, with the same goal: Maintain economic growth and stability.

The question may be, what is meant by QE? And how can it help the economy of a country? Well, it turned out to be quite complicated and lengthy explanation, but here we will try to simplify it. Okay here we go!

We start from the history. In the past, when there was no object that we call ‘money’, the value of a person's wealth is usually calculated based on the amount of total asset he has, like  some acres of land, a number of cattle, or some tons of crop yields. When a man who have a cow is about to buy a sack of rice, for example, then he will looking for people who have the rice, as well as being in need of beef. If these two meet, then the barter transaction will be conducted, in this case is barter of a cow with a sack of rice.

Over time, the barter system is just not practical, for two reasons. One, it is not easy for the owner of the cow to find people who have rice as well as in need of a cow. And two, the value of a cow is clearly different from a sack of rice. A rancher takes a few years to rear a cow, while rice farmers can harvest three times a year to obtain hundreds of sacks of rice. So, if a cow is then exchanged for only a sack of rice, in this case the rancher has been harmed.

That’s why people then tried to create a medium of exchange that is: 1. Liked/needed/wanted by all people, and 2. Having a definite value. So then there developed various types of medium of exchange, until there is one among the most popular, namely precious metals, particularly gold. Gold is desirable and liked by everyone, so that a rancher can swap his cow with some grams of gold, then he could use a small piece of it to buy a bag of rice. Gold also has clear value, which is based on the degree of purity and the severity. The purer and heavier a piece of gold, the higher the value. Gold also then used as a marker of a person's wealth, where the rich usually has umpteen kilograms of gold in its various shapes, while the poor do not have it even just a gram.

As the time goes by, people began to realize that if they have to carry gold everywhere they go, then it is not practical, because gold is one of the heaviest metals in existence. So eventually they deposit their gold to the goldsmith, to obtain such a certificate on paper, which is evidence of ownership of the gold. Well, this 'certificate' was the forerunner of today’s paper money.

So, if you follow the definition of 'money' which stated above, then a piece of paper money in your wallet is actually has no value at all. It is only a bill, that represents a valuable thing. Imagine a certificate of your house ownership: This certificate does have ‘value’, so it can be mortgaged to a bank if you want to borrow some money. But if you then fail to pay the loan, then the bank would seized your house, not just the certificate, because it is the house that has value, while the certificate, in the end, it is just a piece of paper.

In modern times, as now, the goldsmith mentioned above have evolved into the bank, precisely the central bank, where almost all countries around the world have its central bank respectively, including Indonesia with Bank Indonesia (BI). It is the central bank who issuing the currency, printing or withdraw the money circulating in the nation’ economy, as well as determine the interest rate, all for the concerned country. The central bank's policy related to all three issues (currency, money supply, and interest rate) later referred to as monetary policy.

In later development, monetary policy is limited to the determination of level of interest rate and money supply, because when a central bank has set a kind of currency that is valid in a country, then the currency will generally applied without any further change (such as in Indonesia, the currency is Rupiah, and will not changed into Ringgit, for example). For rare examples, there are also some cases that the type of currency in a country is changed, for example in Europe, where today most countries use the Euro (€), after previously each country has its currency respectively.

Back to monetary policy. Monetary policy related to interest rate and money supply is able to determine the growth or deterioration of a country's economy. For example, when there is unemployment in Indonesia in large numbers, and economic growth also stalled, then BI as central bank could lower the interest rate. In this way it is expected that employers would be willing to take loan from the bank to finance their businesses, which in turn create employment, and ultimately grow the economy. Related to this, the central bank will also print more money to be channeled to the banks, then the banks channel it to the employer in the form of loans. By employers, this money will be used to purchase assets from others, and others will use the money to buy goods from someone else, and so on, so the amount of money in circulation (money supply) increases. 

When the money supply continues to increase until causing inflation, the interest rate could be raised again, and the money supply could be reduced (if interest rates rise, the value of bank loan will also go up, so employers will automatically accelerate their debt payments, which was meant to return the money to the bank). And so on. 

Therefore BI Rate, or the benchmark of interest rate determined by the the BI, is one of the most influential factors for the Indonesian economy. The BI openly publish BI Rate once a month. As of April 2013, the rate was 5.75%.

New Monetary Policy: Quantitative Easing

Other than monetary policy related to interest rate and money supply, since 2001, there is a a new kind of policy, which is referred to as quantitative easing or QE, which at the time was pioneered by the Bank of Japan (BOJ).

Unlike the usual monetary policy where there are only two options, namely lowering the money supply and at the same time raise the interest rate, and vice versa, lowering interest rates and raise the money supply (see the paragraph above again: Lowering the interest rate means automatically increase the money supply, and vice versa), then the QE is to raise the money supply without lowering interest rates. QE can be done if the benchmark interest rate in the country concerned has been very low, which is already close to or even reach zero (the current benchmark interest rate of the Fed and the BOJ are ranging from 0 - 0.25%). And this policy is carried out by the Fed and the BOJ, in which the two central banks increase the amount of money circulating in the communities (in this case the American people and Japanese) by way of purchase of financial assets owned by commercial banks and/or other financial institutions, while interest rates remain unchanged. By the commercial banks, the money is used for loans to community or entrepreneur. 

This QE policy, if implemented in developing countries, will lead to hyperinflation. However, if applied in developed countries, say in this case the Japan or United States, especially Japan which in the last fifteen years experienced deflation, then QE will only cause a little inflation. On the other hand deflation that occurs continuously within a country can also have a negative impact on the economy, since deflation reduces the money supply. The reduction of money supply in the community can cause a reduction in economic transactions (buying and selling), as the medium of exchange (read: money) needed to perform the transaction is rare to find. While economic growth is only possible if there are buy and sell transactions, right? Where the workers' sell their labor power and expertise to the company, and companies sell products to the public, including to the workers, and so on. If one cycle in the economy stalled, for example when a number of companies goes bankrupt, then that is where there will be a slowdown in growth or even economic decline in the country concerned.

Okay, back to QE. In conventional monetary policy, increasing the money supply in a country will automatically lower the interest rate, and vice versa. But if the money supply increases while the interest rate does not lower, then what is the one that lower? The answer is the yield. When the money supply increases, the price of goods will go up, including the price of a financial asset (eg company). Then, if the price of a company is increase but on the other hand the value or quantity of products produced by the company in question has not changed, then it is its yield that come down. A simple example might be like in the stock, where if a company's stock price rose but on the other hand the net profit or equity of the company in question does not increase, then the yield of the stocks would be down.

For example, a stock has earnings per share (EPS) Rp50, while the stock price was Rp500, then the yield is 50 / 500 = 0.10 = 10%. When the stock price rose to Rp600, while its EPS still Rp50, then its yield becomes 50 / 600 = 0.08 = 8%, or lower from the previous yield.

By the way, this yield is one of the most basic measure in calculating the valuation of an asset, say a company's valuation. In stock valuation, this yield is known as Price to Earning Ratio / PER, but the calculation is reversed, ie the stock price divided by EPS. And because of the calculation is reversed, then the number is also reversed in its interpretation: The greater the PER, the more expensive/overvalue the share/stock. As for the yield, the greater the yield rate, the more cheap/undervalue the stock.

Back again to the QE. Although the yield of a company would down because of QE, but money obtained by the company in question (in the form of bank loans) can be used to increase business capital, attract more labor, and ultimately increase profits. So, the yield will eventually rise again. On the other hand the increasing money supply in the community are also expected to speed up the wheels of the economy (read: increase the frequencies of buying and selling), which in turn boost economic growth. Everyone’s happy, everybody wins.

However, there are a number of assumptions that must be met in order for the QE policy can achieve its goal of economic growth. First, the bank must properly extending the credit properly. Second, the company should use the loan money properly. And third, people who earn money (eg from his salary as an employee of the company) also have to use the money properly! If any one of these elements is not functioning properly, for example when the company obtained a bank loan for working capital but the effort was not going well, then it does not increase the economic growth, while the money supply is already increasing. When this happens continuously, where some institutions/companies began to fall and go bankrupt for failing to pay their debts, that would lead to a financial crisis in the country concerned, which can also spread to other countries. Actually, that's what happened in America in 2008, and also similar crises that ever happened before,  where the trigger is always the same: There are several large financial institutions that insolvent and defaults (fails to pay its debts). In 2008, the institutions are Lehman Brothers, Merrill Lynch, and some other smaller institutions.

Correlation between QE and Jakarta Composite Index (JCI)

When the banks and financial institutions in the United States and Japan obtain cash from the QE, then they will spend it to make a profit. The most simple way is to distribute it to companies in the form of loans, then take advantage of interest. Or, they can use the cash to buy financial instruments in countries considered to have the potential for economic growth, which is commonly referred to as emerging markets. Incidentally, Indonesia is one of the emerging market countries (thanks to our economic growth of more than 6% per year), and one of the financial instruments are stocks. That's why if you notice, foreign funds are continue to flow into the exchange, which in turn increases the prices of stocks and the index itself, and that is due to the QE policy of The Fed, and now the BOJ, too. Only the QE of BOJ is seems not to affect the JCI too much, because the money is going into the local stock market (Nikkei).

The question now is, would the influx of foreign funds into the stock market have positive impact? Or negative? If we consider the purpose of the Fed and BOJ in doing the QE, which is to enhance the economic growth of the country concerned (U.S. and Japan), then the effect of QE on Indonesia is dependent on what way the money come in here. If U.S. financial institutions use the funds to invest in physical (real sector) in Indonesia, such as making the company, set up factories, opening plantations and mines, etc., then the Indonesian economy will also grow, where the companies will also experience an increase in their capital and profits.

But if the money went into investment instruments that are only on paper (portfolio sector), including stocks, then the QE money will not give any impact on economic growth in Indonesia, because the investment will not increase the capital value of companies that listed on the stock exchange, but only raise the price of its shares. And if the stock price continues to rise rapidly and continuously due to the influx of the funds, while the real value of the company remain unchanged, then we will arrive at the condition of economic bubble, and this bubble could burst at any time when the money is pulled out from the stock market. 

So the question, is the foreign investment comes into Indonesia through the real sector, or only through instruments of portfolio investment like stocks and bonds? Well, let just read the data taken from Bank Indonesia, figures in millions of U.S. Dollars:

Year	2007	2008	2009	2010	2011	2012	Average
Direct Investments	6,928	9,318	4,877	13,771	19,241	19,853	12,331
Portfolio Investments	9,981	3,059	10,480	15,713	4,996	14,661	9,815
Others	-289	3,446	3,794	3,987	4,954	6,123	3,669
Total	16,620	15,823	19,151	33,471	29,191	40,637	25,816

Here’s the good news: In the past six years, the average foreign investment that entering Indonesia is more to the real sector, ie US$ 12.3 billion per annum, compared to investment into stocks and bonds amounting to US$ 9.8 billion per annum. On the other hand, although the growth tends to be unstable (ups and downs), but the amount of foreign investment in Indonesia had hit a record US$ 40.6 billion in 2012, growing more than two times higher than in 2006, where most of the investment had entering the real sector (foreign direct investment/FDI).

While foreign investment in the portfolio, here are the details:

Year	2007	2008	2009	2010	2011	2012	Average
Stocks	3,559	322	787	2,132	(326)	1,698	1,362
Bonds	6,422	2,736	2,736	13,582	5,322	12,963	7,294
Total	9,981	3,059	10,480	15,713	4,996	14,661	9,815

As you can see, from total foreign investment that coming into the portfolio instruments, most of it coming into bonds, not the stocks/equities. In fact, in 2011, foreign investment in the stock was down despite the investment in bonds is still quite high (perhaps this was the cause of stagnant JCI throughout the year 2011), but on the other hand the foreign investment in the real sector at the year recorded US$ 19.2 billion (see again the table above), and perhaps that's the one that causes Indonesia recorded 6.5% of economic growth in 2011. While in 2012, foreign investment in the real sector still flowing as before, and foreign investment in stocks and bonds also increased significantly, especially in the bond. However, the total funds that entered the stock market during the year 2012 was US$ 1.7 billion, still much less than the record of 2007, amounted to US$ 3.6 billion. 

In conclusion, based on the above data, our JCI position at the closing of 2012 can not be said to be a bubble, because the amount of foreign funds into stocks, which helped push JCI up, still far less than foreign funds into bonds and real sectors, particularly real sectors, which encourage economic growth. If foreign investment in bonds is also regarded as 'investment on paper', then the total number of (foreign investment in stocks and bonds) is still smaller than the investment in the real sector. I do not know whether foreign investments that entering Indonesia come from QE proceeds or not. But clearly, the influx of foreign investments has contributed to the real growth of the Indonesian economy, because it is more widely used for working capital and like, rather than just to buy stocks, and of course it is good.

But anyway, at the end of 2012, the JCI was in a position of 4,317. While today (April 11, 2013), the JCI is in a position of 4,926, or approximately 14.1% higher. While the number of foreign funds into the stock, if calculated from the beginning of 2013, also has reached Rp17.9 trillion or about US$ 1.9 billion. So how's that? Well, do the math! Let's say by the end of the First Quarter of 2013, ie until the date of March 31, 2013, the total foreign funds into the stock was US$ 1.8 billion. If this continues, where in the following quarters in the year 2013, foreign funds into the stock also reached US$ 1.8 billion per quarter, then at the end of 2013, foreign funds into the Stock Exchange would reached US$ 7.2 billion (1.8 multiplied by 4). Is that a realistic figure? Obviously not! As you can see in the table above, a record number of foreign funds into the Indonesian stock market was only US$ 3.6 billion, at the year of 2007. And yes, that caused the JCI rose very dramatically at the year, before fell insanely in the following year, ie in 2008. 

Therefore, I notice that in the near future, the flow of foreign funds into the stock market will be slow, or even reduced (the fund is taken back). Because if the foreign funds continue to come in, and JCI also continued to rise, then honestly I can not imagine what will happen in the year 2014. On the other hand, if you see that the influx of foreign investment is far more to bonds than stocks, then perhaps the owners of the funds is preferred to 'play safe' with the pursuit of a fixed income amounting to 10 - 12% per year (standard interest rate on the bonds in Indonesia), rather than expecting a capital gain from the rise of share prices, which may be because they see that the Indonesian stock market is volatile. 

Hufftt.. okay, that’s enough for this week, we’ll continue it later.

Original article was written on April 11, 2013