CBS: A cure-all or experiment?

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.