Atracting dollars without risk (2)

By C.J. de Koning

This is the second of two articles on the monetary crisis.

JAKARTA (JP): Indonesia's monthly trade surplus grew to US$2 billion by last March. International funding for trade transactions, however, decreased dramatically over the same period.

One can compare exchange rate developments to interest rates. The simplest way is to look at them over time.

For instance, with the rupiah at 15,000 to the U.S. dollar and a rupiah interest rate at, say, 60 percent per annum and a U.S. dollar interest rate of 6 percent per annum, the interest gained in one month for Rp 15,000 is Rp 750 -- but the exchange rate loss is open-ended. With a highly fluctuating rupiah that went from 5,000 per U.S. dollar at the end of 1997 to Rp 17,300 per dollar in mid-January, back to 8,000 and weakening to 15,400 last Friday, the realized exchange losses during most periods far outstripped the interest gains. Therefore, only the foolhardy investor would move back to the rupiah.

This is all the more apparent when one takes into account outstanding obligations from the past. With a substantial overall open currency position, not only taken by the private sector but also by government companies in which, in the latter case, dollar obligations were combined with rupiah cash inflows, it is simple to see what rupiah depreciation does to local profit and loss accounts. Exchange losses have far exceeded interest gains, grounding airlines and badly affecting other companies.

Where the theory of high interest rates coupled with strong exchange rates fails is that it does not take into account past debt and open currency obligations running into the present. The theory only deals with current and future behavior. It does not and cannot match current patterns of behavior by various economic groups with expected patterns. It also does not address the net win or loss positions for the groups involved in the Indonesian economy emanating from the interest gain over the exchange loss. The theory -- as currently applied -- creates a loss-loss situation rather than a win-win situation.

The cashflow imbalance resulting from supply and demand for U.S. dollars is very well illustrated by the interest differential between onshore and offshore U.S. dollars for one- month periods. As of the end of November, it stood at 1.75 percent. But by the end of December, it had shot up to 9.06 percent and 12.4 percent on January 23. It currently stands at 9.4 percent. This means that onshore dollars attract a 9.4 percent interest rate over the interest rate for offshore dollars in, for instance, London.

The question, of course, is: What about the future?

Luckily many of the negative capital outflow factors are either turned into a neutral or positive direction. For instance, with the help of the Japanese Exim Bank and others, new sources of trade financing are opened up. Also, Singapore, Australia and other countries are setting up schemes to support Indonesia's trade financing. Foreign banks agreed at the Frankfurt meeting that they would at least not lower trade finance levels. Bank Indonesia has worked out a scheme with some local banks to encourage working capital financing.

Furthermore, nearly all overdue trade finance debts from local to foreign banks have been settled, as well as many outstanding currency swaps and interbank loans.

Last but not least, new money is expected to come in from international agencies as well as from donor countries. Foreigners are also looking to buy Indonesian assets and have started, albeit modestly, to invest in the Jakarta Stock Exchange again. The Frankfurt agreement also will have some positive effects on U.S. dollars demand from the Indonesian corporate sector.

The short-term outlook for dollar supply and demand, therefore, looks more promising, especially when taking trade surpluses into account. Of course, this is with a situation of a substantially weakened banking and corporate sector, and with a substantial budget deficit. Political uncertainties may furthermore complicate the equation.

One instrument may help overcome the dollar supply and demand gap faster than any other instrument, and thereby accelerate the rupiah's recovery making lower rupiah interest rate levels possible. This would turn net interest gains and exchange losses into positive territory again (the win-win position). It would also lower inflationary pressures and ease the budget deficit.

This instrument can be called the liquidity equalization method. The method works as follows: Bank Indonesia issues promissory notes (SBIs) in U.S. dollars to foreign investors free of any withholding tax.

The sales of such SBIs can be arranged through designated banks with international networks. The SBIs can be issued for a period of one week, one month and three months. An interest base of Libor or Sibor can be chosen plus a margin. This margin can be determined on the date of issue, but should be in line with the offshore-onshore U.S. dollar interest differential for Indonesia.

Currently, an applicable rate could be 8 percent over Libor for a one month SBI, with a slightly higher rate for 3 months and a slightly lower one for a one week period.

This interest differential has to be paid by someone since Bank Indonesia cannot be expected to pay this difference. The liquidity equalization method sets up a situation in which borrowers who -- by borrowing or incurring obligations offshore -- cause capital outflow and thereby should pay through a variable tax rate over the principal outstanding amount of offshore obligations via a liquidity equalization tax. U.S. dollars raised abroad at a premium would be equalized over all foreign currency borrowers at a variable tax rate.

Assume that $30 billion is raised at, say, 8 percent over Libor. Additional premium costs $2.4 billion per annum to be spread out over $138 billion in debt equals a 1.74 percent premium for all borrowers per annum. If more is raised, the interest rate spread can be lowered and the equalization tax rate can stay the same or also be lowered.

The liquidity equalization method attracts short-term U.S. dollar deposits, which carry the lowest risk factor for foreign investors. Dollars are used to build up Bank Indonesia's foreign exchange reserves to meet dollar demand, thereby lowering the dollar liquidity gap from the dollar rather than the rupiah side.

Such reserve building would strengthen the rupiah, allowing lower rupiah interest rates, lower inflation levels and lower budget deficits while improving the ability of banks and companies to meet dollar demand since less rupiah would be needed.

It would also improve asset price levels as expressed in rupiah, thereby attracting foreign investors into the local stock market again. It is a short-term instrument, which means that structural reform remains necessary.

The downward risks of the liquidity equalization method are small and the upward potential is high. So why not give it a try?

The writer is the Indonesia country manager of ABN AMBRO Bank. The article was written in a personal capacity.