BI's new rupiah measures

The new measures launched on Monday by Bank Indonesia to soak up excess liquidity from banks succeeded in curbing a further slide in the rupiah exchange rate, which fell last Friday to as low as Rp 9,540 to the U.S. dollar before closing the week at Rp 9,465. The local unit has strengthened slightly to Rp 9,340 at the close of Monday's trading.

We remain, however, unconvinced that this trend will continue until some factors of uncertainty, notably those related to the U.S. Federal Reserve's plan to raise its rate and Indonesia's ability to maintain fiscal sustainability amid the steep rise in fuel subsidies, due to the sharp hike in international oil prices.

Bank Indonesia introduced on Monday a new instrument -- a seven-day intervention rate to supplement the overnight facility it has so far auctioned daily -- and increased the compulsory reserve requirements for commercial banks, which was previously set at 5 percent for rupiah deposits and 3 percent for dollar deposits. The new requirements will vary depending on the deposits raised by each bank.

The central bank also will issue six-month promissory notes (SBI) starting next week to supplement the one-month and three- month SBIs; it has also decided to maintain the bimonthly auction of these SBIs by postponing an earlier plan to reduce the frequency of auctions to once a month.

The central bank's new open market instruments were credited by most analysts with absorbing a large portion of the Rp 40 trillion in excess liquidity, thereby decreasing the amount of currency in circulation for speculation.

These new instruments also provide new investment vehicles to commercial banks with excess liquidity, especially as corporate lending will likely remain constrained by high business risks.

We believe banks will likely become even more hesitant about extending credit now, as the risk of bad loans has increased in the wake of the steep rise in oil prices and the tightening of Chinese monetary policy to save its economy from a rough landing.

Hence, unless the market can be assured of the government's ability to cope with inflationary pressures ensuing from the oil hike and depreciation since early last month, the currency will remain highly vulnerable to wild fluctuations.

Indeed, these two factors are causing the government a dilemma. Certainly, given the current political scene, it would be political suicide if the government raised domestic fuel prices now -- but maintaining fuel prices at their current levels will only raise subsidies and consequently increase inflationary pressures further.

Hopefully, last week's decision by the Organization of Petroleum Exporting Countries (OPEC) to pump more oil into the market would help decrease prices over the summer months.

The other uncertainty factor -- when and how much Fed rates will be increased -- is also looming over the rupiah, because higher U.S. interest rates will suck investment out of Indonesia if local rates are not raised as well. While most analysts expect a rise in Fed rates later this month, until this question is resolved, investors will remain nervous about the rupiah.

True, it is not only the rupiah that has been weakening due to a strengthening dollar on the back of the Fed plan, and most Asian currencies have also depreciated. But, as was the case during the 1997 regional financial crisis, the rupiah has been suffering the most due to the additional factor of political uncertainty -- this time, the upcoming presidential election.

The rupiah saw the steepest decline -- more than 8 percent -- over the past month among regional currencies, compared to only 0.21 percent in the Philippine peso, 1.75 percent in the Thai baht and 0.41 percent in the Singaporean dollar.

We believe, therefore, that the new open market instruments will not be enough to shore up the rupiah. Bank Indonesia must eventually increase its interest rate, especially if the Fed rates go up later this month as expected.