Banking stability needed to support currency peg

The government seems determined to adopt a currency board system (CBS), under which the rupiah will be set at a fixed exchange rate to the U.S. dollar, to stabilize Indonesia's currency exchange rates. Manggi Habir, research director of PT Bahana Securities, discusses the issue.

Question: Do you consider that Indonesia is ready to adopt a currency board system (CBS)?

Habir: Indonesia's foreign exchange reserves will have to be sufficient to match all the rupiah in circulation. I think our present reserves of about US$17 billion are insufficient for this task.

Another big concern is that if a CBS is introduced at a time when uncertainty is high or confidence is low, a lot of people will choose to convert currency into dollars when the exchange rate is set at, let's say, Rp 5,000 or Rp 5,500. If that happens, you will have a contraction of the foreign exchange reserves, making it necessary to contract the money supply -- the central bank will have to raise interest rates on Bank Indonesia Certificates to absorb the rupiah, which will cause commercial banking interest rates to go up. If that happens, what you will have is very tight liquidity.

My greatest concern is for the banking sector, which is currently facing liquidity problems. Under a CBS, banks cannot go to the central bank for liquidity (assistance). So, there is no lender of last resort.

Considering that situation, what advantages can we obtain and what risks will we expect if we implement a CBS at present?

If the CBS was implemented in a situation where we had enough foreign exchange reserves to cover the whole money supply and the banking system was strong, it would give us a stable exchange rate which would be a very positive thing for the business community.

But with all the concerns that I have mentioned, I don't think we are in the right condition to implement a CBS effectively. The risk is high because interest rates could increase sharply and people could rush to buy dollars.

Q: What impact would a turbulent U.S. dollar have on our economy?

H: If the dollar, to which the rupiah will be anchored under the planned CBS, fluctuates, our economy will be affected.

Q: Do you think Indonesia needs supports from the International Monetary Fund (IMF), which is leading a $43 billion bailout package for the country?

H: The need for IMF involvement is more to do with restoring confidence in the market and ensuring that the Fund provides all the aid it has promised. Even though the IMF is no longer trying to attack the CBS directly, it is still worried about the conditions required to implement a CBS. If the confidence is not there, speculators on the international market might begin to attack the rupiah again once the CBS is in place.

Q: Do you think a CBS would be contradictory to the economic reforms agreed with the IMF?

H: According to Steve Hanke, an American advising President Soeharto on currency board systems, it will be complementary to the IMF reform measures.

I think banking reforms recommended by the IMF first need to be undertaken before implementing the CBS.

Q: Considering that the government appears quite confident about a CBS, how do you think money markets will react if such a system is introduced?

H: If it is introduced immediately, before the General Session of the People's Consultative Assembly (to elect the president and vice president for the next five-year term), markets will react unfavorably because there is no political certainty and negotiations between domestic debtors and their foreign creditors have not yet shown concrete progress. With progress on both of these fronts, markets will surely react better.

Q: So, when is the most appropriate time for Indonesia to introduce a CBS?

H: I think the end of this year or early next year will the earliest appropriate time to introduce a CBS because by then debt problems in the private sector may have settled down, the banking sector should have been strengthened -- minimum capital for commercial banks is being raised to Rp 1 trillion -- and we will have seen how the next cabinet performs for more than six months. Furthermore, we expect that the country's current account deficit, which has arisen through increased exports and decreased imports, will have lessened by then, thereby helping increase our foreign exchange reserves.

Commercial banks are still trying to increase their capital base through mergers and by inviting new foreign and domestic investors. Banks are also suffering from an increase in non- performing loans -- about 5 percent to 15 percent of total loans. There is also a liquidity problem among banks.

At the end of this year, or early next year, we will know the market exchange rate and interest rates will be falling.

Q: But if the exchange rate settles down and interest rates fall, do we still need a CBS?

H: No, but at least we will have options. Actually, I have a question: If the CBS is a such a good system by which to overcome an exchange rate problem, why are there only five countries throughout the world which have adopted it? (riz)