Wed, 14 Nov 2007
Helmi Arman, Economist

The U.S. dollar has weakened over a broad range of currencies except the rupiah. Increased uncertainty over fuel subsidies may be to blame.

The dollar has to weaken. That's the view one finds in almost all corners of the market nowadays.

The dollar bears do have a point. America is running a large current account deficit, house prices and interest rates are heading downwards, and the economy may be set for a slowdown.

Data on the website of the International Monetary Fund (IMF) gives a clear indication of dollar aversion among the world's biggest fund managers, a.k.a. the central banks. The portion of dollar assets that central banks around the world hold as part of their foreign currency reserves appear to be dwindling; and the euro is becoming increasingly preferred over the dollar.

Five years ago, some 70 percent of the reserves held by central banks were dollar-denominated. By the middle of this year, the figure was down to 65 percent. Meanwhile, the portion of euro-denominated assets concurrently rose from 22 percent to around 26 percent.

Dollar aversion is also indicated by the decline in the rate of increase in U.S.-treasury securities held by foreigners (i.e., both official and private investors). Three years ago holdings of U.S.-treasuries by foreigners were increasing at a 23 percent annual rate; today, they are rising at just slightly over nine percent.

As a corollary, each day we've been seeing the dollar reach record lows against currencies such as the euro and British pound. The greenback is also touching multi-year lows against the yen, Australian dollar and even the Philippine peso.

The big question many are asking is: why is the dollar not weakening against the rupiah?

As far as trade data goes, no worrying signs of trade surplus deterioration are to be seen as yet as a result of the surge in oil prices. Indonesia's oil imports spiked in September, but the increase was offset by a commensurate decline in non-oil imports. This left the trade surplus relatively unchanged compared to the previous month.

Of course, no clear picture of what's happening today is discernible until the October trade data is released. But given the information at hand right now, it seems that the recent depreciation of the exchange rate could be linked to a certain extent to an apparent sell-off by foreign investors in the bond market.

The yield on Indonesia's 10-year government bond has risen by around half a percentage point compared to six months ago. And the data does show a decline in non-resident ownership of government bonds in the first working week of November.

Some attribute this to an unwinding of carry trades (i.e., investments that exploit cross-country interest rate differentials using leveraged money), which is not country specific.

However, for Indonesia, the situation appears to be exacerbated by growing concern over the country's inflation outlook. With oil prices rising, many fear a rerun of the surge to double digit inflation rates seen two years ago, when the government hiked fuel prices by more than 100 percent on average.

It's true that Indonesia isn't the only country affected by rising oil prices. Yet the perceived economic risk for this country is higher considering it still subsidizes fuels sold to households, heavily.

Despite promises by politicians and government officials not to hike domestic fuel prices, no one can really say today what may happen if crude oil prices continue to increase. Already last week there were media reports of a high ranking government official drawing up plans for rationing fuel.

The issue is that with fuel prices still being administered by the government and oil prices sky-rocketing, bond investors simply don't know how large the extent of any adjustment in fuel prices -- should there be any -- will be.

So the strength of the rupiah right now appears to hinge on a reduction in uncertainty, which will materialize if 1) oil prices fall back substantially or 2) the market can ascertain the extent of any fuel price increase and its impact. In 2005, once the magnitude of the fuel price adjustment and the ensuing impact on inflation was known, foreign investors came rushing back into the bond market and propped up the rupiah.

Exactly two years ago we were shown how keeping fuel prices artificially low was unsustainable. We were also shown how difficult it is to predict the impact of abrupt adjustments in policy.

Is there anything anyone can do now to ease the uncertainty? It's tempting to look back with hindsight right now and say that fuel prices should have been floated to market prices back in 2005 so that oil price shocks could be absorbed gradually.

But, unfortunately, we're faced with a different reality today.

With fuel prices fixed, the economy faces the risk of another abrupt adjustment. Inflation becomes pent-up and few can ascertain whether or not it will be released.

As the saying goes: even donkeys don't fall twice into the same pit. Will we?

The writer is an economist at PT Bahana securities




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