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.