In December 2020, Bank Indonesia released a Blueprint for Money Market Development 2025. The goal of this document is to set the ground rules for developing a more active money market in Indonesia, part of a larger and longer-term effort to deepen Indonesia’s capital markets. An op-ed in the Jakarta Post, penned by someone in Bank Indonesia’s legal affairs division, touted the benefits of the plan: “Consisting of the rupiah market, the foreign exchange market and their derivative markets, the money market supplies liquidity.”
Liquidity is the key. The defining feature of a money market is the trading of highly liquid, short-term financial instruments – repurchase agreements, three-month government bonds, currency swaps, commercial paper, and the like. According to Bank Indonesia, assets traded on its money market will have a maximum term of one year, and most will be much shorter.
The main benefit of the money market is that it can serve as an alternative to traditional bank loans and give companies flexible financing options. If a company needs cash fast to cover an unexpected expense and it doesn’t have sufficient credit with its bank or want to go through the loan approval process, it can turn to the money market and get it in a pinch. Money markets have been around for decades, but have been growing more rapidly in recent years. As they have grown, they have come to pose a much greater systemic vulnerability.
There are two main problems with money markets. On the borrower side, when companies start funding their daily operations from short-term borrowing on money markets it creates obvious issues. It means you have to continuously roll over short-term debt just to keep your business operating, and if that market should seize it can be disastrous. For whatever reason, as money markets grow they seem to incentivize these kinds of risky funding strategies.
The second problem is that since these investments are so short-term, money markets have been at the heart of the last several global liquidity crunches. When investors panic they tend to pull their money out of the market, and since money markets are explicitly built on short-term, liquid investments they come under intense pressure immediately during the onset of any kind of financial panic.
Time and again, money market operations have proven to be systemic liabilities during periods of financial uncertainty. During the Global Financial Crisis, the multi-trillion-dollar money market in the U.S. nearly collapsed, as panicked investors tried to get their money out all at once. The U.S. Treasury was forced to step in and backstop the market, and former Treasury Secretary Hank Paulson has often mentioned the vulnerability that money market funds continue to pose to the financial system.
During the COVID-19 market panic of March 2020, money markets were again at the root of a global liquidity crunch. As detailed in this report from the Bank of International Settlements, panicked investors rushed into cash, causing turmoil in both U.S. and overseas short-term dollar funding markets. The implosion of these markets was once again staved off only when the U.S. Federal Reserve intervened. But it’s hardly surprising. A market structured around highly liquid assets is, as the name implies, going to be one of the first dominoes to fall during a liquidity crisis.
Money markets serve a purpose, if prudently used and carefully regulated. They can help to hedge against certain types of risk, and can be important sources of short-term financing. But as they get bigger, they increase the risk of volatility and systemic failure. Money market operations have proven vulnerable to liquidity crunches and have consistently required last-minute rescues. And unfortunately, liquidity crises are something Indonesia is particularly vulnerable to, given the country’s current account deficit and overall relationship with debt.
The goals of Bank Indonesia’s money market blueprint are laudable – deepening domestic capital markets, and creating more flexible, efficient and inclusive financial options for investors and businesses. But given the built-in vulnerabilities of money markets, the risk will have to be very carefully managed and weighed against the benefits. In a financial system that is still working to prove it can be reliable, transparent and fair this is likely to be an uphill climb.