CBS may rock banking industry and forex reserves

The government's plan to adopt the Currency Board System (CBS) has raised public debate on its advantages and disadvantages. Economist Kwik Kian Gie looks at the risks of the system.

JAKARTA (JP): Hong Kong, whose foreign exchange reserves by far exceed its annual import value, can expand its money supply every year in line with its economic growth even though it has to provide US$1 for each HK$7 it adds to the market because its U.S. dollar (anchor currency) reserves are also increasing.

Meanwhile, Indonesia will have difficulties expanding its money supply if it pegs its currency to a fixed rate of the U.S. dollar because its foreign exchange spending for the importation of goods and services always exceeds its revenue from exports, thereby threatening the position of its foreign exchange reserves.

Before the reign of the New Order government, the government controlled all foreign exchange by prohibiting any citizen from holding foreign currencies. Such a foreign exchange regime encouraged the emergence of a black market, where people could buy and sell U.S. dollars at a conversion rate far higher than the official rate.

After Indonesia made some progress in its economic development, the New Order government introduced a free foreign exchange regime. Anyone was allowed to buy any amount of dollars at a fixed official rate whenever they needed and for whatever reason they wanted. When the demand for dollars surged, threatening the position of the country's foreign exchange reserves, the government devalued the rupiah -- from Rp 378 to Rp 415 against the dollar in 1971, to Rp 615 in 1978, to Rp 970 in 1983 and to Rp 1,644 in 1986.

When the economy showed further progress, the conversion rate development was left to the market mechanism but the government still controlled its float. Bank Indonesia, therefore, determined its rates for the conversion of various currencies every morning.

As the economy showed further progress, the government left the conversion rates to float in line with developments of supply and demand but introduced an intervention band, from which it determined whether or not it would intervene in the market to prevent the market from experiencing wild fluctuations.

In July 1997, the dollar value increased steadily and the government, instead of intervening in the market, expanded the intervention band eight times and finally lifted the band in the following month, thereby leaving the foreign exchange market to develop completely freely in line with supply and demand.

The dollar value then skyrocketed, reaching its peak at Rp 16,000, before falling back to Rp 10,000. Soon after the government announced its plan last week to adopt the Currency Board System (CBS), the dollar value fell further to Rp 7,000 but rose again to Rp 9,600 last weekend as controversies were mounting about the plan.

The government has not clearly explained how it would adopt the new system, but President Soeharto indicated that the system would be able to end market speculations. Minister of Finance Mar'ie Muhammad said the government was still preparing supporting facilities and regulations for the implementation of the new system, while economists and businesspeople had different reactions and different scenarios.

A scenario said that the government might set the conversion rate of the dollar at Rp 5,000. If the broadly-defined money supply is estimated at Rp 378 trillion, the country must provide $75.6 billion in foreign exchange reserves.

Some analysts said the country will only need foreign exchange reserves equivalent to base money, currently estimated at Rp 78.3 trillion. The country, therefore, will need foreign exchange reserves of only about $15.6 billion.

Businessman Peter F. Gontha opted to differ. He said Indonesia will only need foreign exchange reserves of $11.34 billion, equivalent to 15 percent of the broadly-defined money supply or Rp 56.7 trillion. Because Indonesia currently holds foreign exchange reserves of about $19 billion plus standby loans, foreign assets and committed loans from the IMF, no major problems will hinder the adoption of the CBS.

However, many economists are confused that the solution to such a severe economic crisis marked by stagflation -- a combination of economic stagnation and inflation -- could have such a simple solution.

History shows that shortages in foreign exchange reserves have repeatedly caused turbulence -- devaluation, liquidity tightening, interest rate hikes and rushes on banks. The latest turbulence was the free fall of the rupiah's value after the lifting of Bank Indonesia's intervention band on Aug. 14, 1997.

There will be at least two major risks after the adoption of the CBS, if a rush on dollars causes sharp declines in foreign exchange reserves. Indonesia will then have no adequate amount of dollars to finance its imports and its banking system will be ruined.

No bank will survive if the rush draws down, for example, Rp 19 trillion from the banking system, causing a scarcity of rupiah supply and drastically raising interest rates. Because the rupiah supply is pegged to the foreign exchange reserves, the government will no longer be able to ease the money supply by producing cash without being supported by an increase in the foreign exchange reserves.