Currency board the wrong way forward

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.