Currency board the wrong way forward

By Akhmad Mukhtar

JAKARTA (JP): The Currency Board System (CBS) is not a new concept in economics. Dangers regarding the implementation of a CBS in Indonesia mean that it is important to first determine if the idea to adopt such a system is being touted for political or sound economic reasons.

Monetary policy misconduct, which began with hasty banking deregulation in 1988, lead to a monetary crisis in 1991, and inexorably on to the recent banking crisis in which 16 commercial banks were closed, has cast ripples of panic through society. Panic resulted because the government liquidated the 16 banks before proper measures had been taken to allay the obvious fears such a move would cause. The CBS appears to be a way of hastily atoning for past mistakes and as such, the motives are therefore more political than economic.

Is a CBS indeed an appropriate mechanism through which to meet the short-term and long-term objectives of the Indonesian economy?

For a CBS to be successful there are two fundamental requirements: strong and diverse exports and a relatively small national population.

Indonesia does not yet meet the first requirement and most certainly does not match the second.

Weakness in Indonesia's export base and the time required to rectify this state of affairs mean that government foreign exchange reserves will become rapidly depleted if used to defend an arbitrarily selected exchange rate.

Currency speculators will be delighted if a CBS is implemented. Then their game will no longer speculative, instead becoming a one way bet. Speculators only need to estimate the value of foreign currency reserves and then begin to exert massive pressure on the new exchange rate, which will eventually buckle under the strain. The rupiah under these circumstances becomes a sitting duck.

Limited foreign currency reserves, the subservience of monetary policy to the CBS, and Indonesia's large population (high compared to Hong Kong or Argentina where CBSs have been successful), will result in high domestic interest rates. This is because a large number of people will be competing for a limited amount of money, for both investment transaction purposes. High interest rates will discourage investment and as investment falls the economy will become weaker. Unemployment will rise, with an attendant increase in social problems and social unrest.

The risk of investing in Indonesia, already high, will rise further, making it difficult to attract foreign investment to Indonesia, for both direct investment and portfolio investment in the capital market. It is possible that the Composite Index of the Jakarta Stock Exchange will fall to levels lower than previously imagined possible.

CBS can work well if the government can present a balanced budget. However, official data indicates that the country has been consistently running a budget deficit, which has been covered by foreign borrowing and foreign aid. A CBS will force the government to increase foreign borrowing or to increase domestic borrowing, resulting in even higher domestic interest rates. A worst case scenario would be a bankrupt government. The budget deficit is surely the largest obstacle to a successful CBS.

If the rupiah is fixed to the U.S. dollar at a certain rate, the government must maintain a rate of inflation which approximates inflation in the United States. However, it will be difficult to rapidly dampen Indonesia's currently very high rate of inflation, which places a further strain on attempts to maintain a fixed exchange rate.

Society at large is already expectant of inflation. Economic theory suggests that such expectations become self-fulfilling. To overcome the powerful effect the actions of people anticipating inflation can have on the economy, the government will have to place constraints on the movement of capital. Free capital mobility, present in Indonesia since 1970, will no longer apply, since monetary policy has to be subjugated to the CBS. This will result in capital flight from the country. Furthermore, money deposited overseas will not return to Indonesia.

Is there an alternative to a CBS? A new regime could be introduced at Bank Indonesia. The central bank could act to maintain price and exchange rate stability -- as central banks usually do.

Bank Indonesia would have to be granted independence, with a strong legal underpinning. Staffed by intelligent, upstanding, disciplined individuals, it would be more than capable of undertaking this task. The Ministry of Finance could be left to supervise commercial banks. If staff at the finance ministry are allowed to approach their new tasks diligently and conscientiously this will go a long way toward restoring government credibility. The rupiah will then find a stable value.

This reasoning I have presented is, I hope, reasoning which is echoed in the corridors of power when the government comes to consider a CBS. The advice of Prof. Samuelson (MIT) is recalled to mind. He said that the "economy is like a soft flower in spring time, and you have to be careful when you touch it". Advice once received from Prof. Robert S. Lucas Jr (Chicago) also holds true. He said, referring to economists, that "as a giving advice profession we are in way over our heads". There is no exception to this rule, even for Messrs. Hanke and Schuler, who advocate a CBS for Indonesia.

The writer is an economist and international finance consultant in Jakarta.