Another BI regulation fails the market test

John Le, Jakarta

It has been five months since Bank Indonesia introduced regulation 7/14/PBI/2005, entitled, "Restrictions on Rupiah Transactions and Foreign Currency Lending by Banks", which aimed at restoring integrity and stability to the rupiah.

Contrary to Bank Indonesia's intention, however, it has also been five months of rough riding for the rupiah in the foreign exchange market.

In the month of August 2005, for example, the rupiah was traded as high as 11,200 to the dollar. In the dollar-rupiah options market, the one-month volatility rate, which serves as a useful indicator for the volatility of the rupiah, was quoted at more than 25 percent.

This raises some basic questions -- what has gone wrong with regulation 7/14/PBI/2005? Why has it not stabilized the rupiah as intended?

Let us start with some simple facts. The gist of regulation 7/14/PBI/2005 is intended to block out foreign speculators and hedge funds from trading on the rupiah freely, thus, driving the currency beyond the control of Bank Indonesia.

This means that offshore parties cannot transact with onshore parties using foreign exchange, swap, and derivatives, without declaring to Bank Indonesia the economic basis for doing so.

If an offshore party wants to do a simple foreign exchange, buying dollars and selling rupiah, it must first be able to declare to Bank Indonesia that such a transaction is done in order to buy Indonesian assets (i.e., fixed income, equities, etc.). Similarly, swap and derivatives, such as foreign exchange options, are permitted as long as they are used to hedge an underlying economic investment in Indonesia.

While this regulation is successful in blocking out foreign speculators from playing with onshore rupiah via direct foreign exchange and their derivatives instruments, the intended effect of stabilizing the rupiah is far from being accomplished.

In fact, the rupiah itself is now more prone to volatility due to the creation of a vibrant and unregulated offshore market for the rupiah as a result of this regulation.

Without direct access to the onshore market, foreign players are now jumping onto the now mighty non-deliverable-forward (NDF) for the rupiah in the offshore market. This means rupiah transactions can be settled in dollars, based on an exchange rate set by the offshore players. This market lies beyond Bank Indonesia's legal jurisdiction.

The dual existence of onshore and offshore markets for the rupiah naturally gives rise to price differential. Many foreign banks, with operations both onshore and offshore, are taking advantage of this arbitrage opportunity.

If the rupiah is traded at a higher price in the offshore market than the onshore market, the banks will sell rupiah in the former and buy in the latter. This simultaneous purchase and sale of rupiah in two different markets allows foreign banks to book a handsome profit in the foreign exchange market and its derivatives instruments.

However, arbitrage is the least of Bank Indonesia's problem. The biggest worry for Bank Indonesia now is that foreign banks, with both onshore and offshore operations, are serving as conduits for foreign speculators and hedge funds, to drive the onshore rupiah market.

This can happen whenever offshore speculators spot a weakness in the rupiah, they will buy dollars and sell rupiah in massive amounts in the NDF market. This selling of rupiah will then drive the onshore rupiah market through trades with foreign banks that have branches in Indonesia.

An example of rupiah manipulation was the energy subsidy crisis during the month of August 2005. Bank Indonesia could not control the massive speculation done offshore against the rupiah, which caused a run on the rupiah onshore, despite billions of dollars spent on defending the currency.

Clearly, the experiment with regulation 7/14/PBI/2005 so far has not worked. The rupiah has not been stabilized; and in fact, it has been more volatile since the inception of this regulation in July 2005.

The only true achievement of this regulation so far is that it has successfully driven the speculators into establishing a vibrant and dynamic offshore market for the rupiah.

More dangerously and unintentionally, the NDF market has the ability to move the onshore market without legal repercussion from Bank Indonesia.

So it is time for Bank Indonesia to stop wasting its time and resources on issuing ineffectual regulations that only bark but cannot bite.

The writer works as foreign currency trader for a foreign bank based in Jakarta. He can be reached at legonave@yahoo.com.