Saturday, October 11, 2008

Indonesia: Do costly Credit Default Swaps and a weak rupiah spell 1997?

Credit Default Swaps -- explained in more detail here (Newsweek/Time) and here (CBS, video) -- may not only be the key to understanding the perils in the US economic crisis, but the potential for the financial crisis to bring misery to Southeast Asia -- particularly Indonesia.

Credit Default Swaps are used to insure investments in the region's resource economy. A Newsweek article I quoted (here) explains how this financial instruments have come to be used:
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
As I noted in a previous post, investors bailed out of the Indonesian stock market on Wednesday, leading to the closure of the Jakarta market Thursday.* Were those investments backed by CDS?

India's ET reported on the Jakarta market's closure Friday afternoon in Jakarta:
Indonesia's five-year credit default swaps (CDS) surged to as high as 725 basis points at one point, from 600 basis point early on Friday. That was well above the 410 bps at which the similarly-rated Philippines' CDS was trading at.

"People just want to get their money out of Indonesia," said a Singapore-based fund manager. "We haven't forgotten what happened 10 years ago."
An article in the FT suggests that the rising cost of CDS for Indonesia, and the contaminant drop in the rupiah, may spark a contagion of currency devaluations with consequences reminiscent of the 1997 crisis:

Before its Wednesday suspension, Indonesia’s benchmark stock index was down 21 per cent this week, the worst weekly fall since at least April 1983, while the rupiah declined a further 0.7 per cent to 9,635 per dollar, near its lowest level in three years, reported Bloomberg on Wednesday.

Credit-default swap contracts on Indonesia meanwhile jumped 80bp to 560 on Wednesday afternoon, meaning it costs $80,000 more a year to protect $10m of the country’s debt from default for five years.

“Too much of the Indonesian market is tied to commodities,'’ Kim Yong Tae, of Yurie Asset Management in Seoul told Bloomberg. “Also, the currency is very weak, suggesting that a lot of speculative money is pulling out of the market.'’

And that is precisely what happened in 1997.

The FT writer's argument goes that Indonesia is headed into a spiral of a weakening currency relative to the yen and other major currencies. One big difference this time around is that some countries in the region such as Thailand, are no longer deeply in debt.

There is surprisingly little information available on the Internet concerning the price of Credit Default Swaps in other Southeast Asian economies such as Malaysia and Thailand (except in relation to those that had been held by Lehman Bros).
* The Bangkok market dropped almost 10% on Friday. Singapore dropped 7% and the island slipped into recession. Jakarta was closed. As for other Asian markets, Hong Kong dropped 7%, and Tokyo dropped 10%.

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