CBS may rock banking industry and forex reserves

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.