Coping with speculators

Coping with speculators

The tendency toward economic overheating and the increasing
globalization of the financial market have been posing heavier
challenges to Bank Indonesia in maintaining monetary stability.
The political overtones in the run-up to next year's general
election make the task of monetary management even more delicate
because wild rumors can trigger sudden speculative assaults on
the rupiah.

The economic trend and political overtones were behind the
central bank's move to widen the intervention band of the rupiah
to the American dollar last week. The band was increased to 5
percent, or Rp 118, from 3 percent, or Rp 66. The central bank
will now intervene when the market rate increases or decreases by
2.5 percent. The intervention band was widened twice last year
and once in 1994 in a bid to improve the central bank's monetary
control, stabilize the exchange rate, and reduce pressure on the
foreign reserves.

The wider band's immediate impacts are the increased risk of
foreign exchange speculation and the transfer of most of this
risk to the speculators. The higher risk will curb the inflow of
short-term, speculative capital. The wider band thus acts as a
shock absorber. As the intervention band grows wider, however,
there is more opportunity for foreign exchange trading by private
market makers, thereby helping the central bank increase or at
least maintain the level of its foreign reserve holdings.

The central bank needs plenty of room to absorb the shocks of
short-term capital flows because it will likely have to maintain
its tight monetary policy to prevent the economy from further
overheating and reduce pressure on the balance of payments. The
tight money policy, in turn, will make the interest rate
differential attractive to hot, short-term funds.

As the wider exchange rate band will encourage more foreign
exchange trading among private market makers, the central bank
will be able to better manage its monetary targets. The bank will
not have to absorb a large sum of dollars from the market when
the dollar hits its floor rate.

The risks associated with massive flows of speculative funds
are not only a possible high appreciation of the rupiah but also
a possibly sudden reverse flow -- a trend which may be set off by
wild rumors or jitters about policy inconsistency. Diminished
confidence in economic prospects may also trigger capital flight,
and thereby upset monetary stability.

A wider intervention band is therefore not in itself adequate
to maintain monetary stability, or reduce pressure on the
external balance. Of equal importance is a higher degree of
policy consistency and a more concerted effort to bolster
exports.

Policy consistency is crucial to stimulate direct foreign
investment, which, unlike short-term funds and portfolio capital,
is resistant to speculation. Reinvigorating exports is also
pivotal in preventing the current account deficit, already
estimated to be as high as 4 percent of the gross domestic
product this year, from worsening and to enable the central bank
to maintain the equivalent of three months' imports as the
minimum foreign reserve holding.