CBS: A cure-all or experiment?

By Joe L. Spartz

JAKARTA (JP): Whether the proposed currency board system ultimately turns out to be a Damocles sword or a panacea for the ailing rupiah depends on a number of factors and conditions.

They are sufficient foreign currency funding, pegging rates, public trust and credibility, ability of the banking sector to cope with its implementation and, last but not least, strict safeguards in order to minimize inevitable abuse of the system.

As a condition sine qua non, the system would require the full backing of the local money supply, estimated at Rp 400 trillion by foreign currency reserves.

Existing foreign currency reserves, however, add up to less than US$20 billion. And in view of the IMF's outright opposition to an early CBS introduction, the bail-out package for Indonesia may have to be renegotiated for a number of key areas.

Unless mechanics, timing and implementation of the currency board system (CBS) can be worked out in a manner acceptable to the IMF, committed bail-out funds are unlikely to be included in the foreign reserve back-up of the local currency.

A possible scenario would be a short-lived Icarus flight crash-landing shortly after a high-flying CBS take-off, leaving the country's entire financial system worse off than before, with dollar exchange rates exceeding disastrous Rp 20,000 levels.

In addition to the CBS's funding problem, an unrealistic dollar peg could well contain the seeds of the CBS's self- destruction. Pegging the dollar at the government's overly optimistic Rp 5,000 budget rate would inevitably trigger a massive dollar buying spree, whereas fixed exchange rates of 10,000 would result in further bankruptcies and massive lay-offs.

Both public trust and the system's credibility, without which the CBS is doomed to fail, represent additional obstacles to overcome.

As evidenced by financial market reactions following its initial announcement, this condition remains largely unfulfilled and could possibly jeopardize the entire CBS plan.

Even though no detailed mechanics or operating guidelines of the system were disclosed to the public, the rupiah initially strengthened by about 30 percent overnight in the expectation that the government would proceed with its CBS plan regardless.

The short-lived rebound of the rupiah, alas, did not signify a public trust in the proposed system and both financial and business managers soon voted with their feet to the next money changer, driving the rupiah down to its erstwhile levels.

Likewise, the spread between dollar buying and selling rates has returned to its previous 50 percent level, which does not augur well for the claimed cure-all remedial benefits of the CBS.

Another no-less critical obstacle to any CBS implementation would be its ensuing and inevitable abuses. A cheaper dollar would represent an irresistible lure for large businesses and conglomerates with major unhedged offshore loans to liquidate or reduce their foreign debts with heavily subsidized dollars.

Foreign exchange reserves would be depleted at an astonishing rate with rupiah bank interests, over which the central bank would have lost all means of intervention, would unavoidably reach dizzying heights.

A currency board system, if properly conceived and implemented, would definitely go a long way in stabilizing the rupiah. Drastic measures are unquestionably needed to halt the free-fall of the rupiah and to restore a heavily undervalued currency to more realistic levels.

Adopting a blue-print of the Hong Kong CBS model for Indonesia would, in all probability, lead to its early and potentially disastrous demise and only a strictly tailored CBS version would have a chance to succeed.

Rather than providing a free-for-all fixed foreign currency exchange, the proposed CBS should be restricted in scope with pegged forex facilities limited to selected productive or employment-generating business sectors only.

Speculative transactions such as rupiah hedging, bank loans and financial instruments, rather than actual rupiah deposits exchanged at fixed CBS rates and so forth should be strictly excluded from any CBS facilities.

Likewise, CBS exchange facilities should not provide for the financial bail-out of already completed and no-longer employment- generating projects, which would at any rate represent a direct violation of the IMF agreement.

For these, both foreign lenders and local debtors should face the music on their own and CBS fixed exchange facilities limited to productive and employment-generating activities of the private sector, where they belong.