Defending the rupiah

The joint concerted efforts of Bank Indonesia and the government to defend the rupiah exchange rate, which fell to a three-year low of nearly Rp 9,800 against the U.S. dollar on Tuesday, should have come as early as March, after the fuel price increase set off stronger inflationary pressure and the U.S. Federal Reserve further tightened its monetary policy.

Bank Indonesia's open-market ammunition alone would not have been powerful enough to address the combined impact of the stronger inflationary pressure and the steady rise in the U.S. Fed funds rate to as high as 2.75 percent at present.

Hence, the government directive that such state companies as oil and gas company Pertamina -- which need large sums of foreign exchange for their daily operations -- must coordinate with the central bank to buy dollars, is a rational move to prevent a shock in the market.

Such coordination is essential because the foreign exchange market volume is quite small, ranging from only $250 million to $400 million a day. Since Pertamina needs some $80 million a day for financing its oil imports, its purchase alone could cause the dollar rate to rise steeply on the spot market.

Hence, allowing the oil monopoly to buy dollars directly from Bank Indonesia, instead of going to the spot market, could help prevent a market shock.

The latest developments in economic fundamentals and the level of the country's foreign reserves, which remained at a comfortable level (equivalent to six months' imports), did by no means warrant the more than 5 percent depreciation of the rupiah from its January level.

Speculative attacks have played a part in the downfall, and the central bank should be blamed for allowing the speculation to run almost freely for a few days, before moving firmly to deploy its open-market weapon to eradicate negative sentiments against the rupiah.

The central bank should have been fully aware that the condition is highly vulnerable to currency speculation, given the large sum of excess liquidity at banks that can instantly be used to attack the rupiah and the recent redemption of around Rp 30 trillion in mutual funds, due to deep concern over the declining returns on government bonds.

Bank Indonesia succeeded in curbing the rupiah's decline in mid-2004, after it acted firmly and quickly to soak up excess liquidity by introducing a new instrument -- a seven-day intervention rate to supplement the overnight facility -- increasing the compulsory bank reserve requirements and reducing the net open position of assets and liabilities in foreign exchange to 20 percent.

The central bank should be more than a reactive institution. It must anticipate any speculative attacks on the rupiah -- however light they might be. Allowing the rupiah to depreciate beyond its ordinary range was surely a positive signal for currency speculators to step up their attacks.

Bank Indonesia said it would resume the weekly auction of its promissory notes (SBI) to soak up liquidity from the banks, but that apparently is not enough because the U.S. Fed has signaled a further increase in its Fed funds rate.

A higher interest rate differential between dollar and rupiah deposits would surely prompt the shifting of more financial assets from rupiah to dollars and this would trigger another wave of speculative attacks on the rupiah.

The central bank should also consider issuing six-month promissory notes soon to supplement the one-month and three-month notes. Better still, the government could speed up its plan to float treasury bills.

These new instruments, in addition to Bank Indonesia's open- market operations, will further diversify investment vehicles to commercial banks with excess liquidity.

Quick and firm action to cope with speculative attacks on the rupiah are the key to maintaining macroeconomic stability because sharp rupiah depreciation always sets off a vicious circle within the economy by way of high inflation (import price inflation) and a high interest rate. The central bank, therefore, should be on guard to stamp out any sign of speculation, however small it may be.

Unless the market can be assured of the government's ability to cope with inflationary pressure from the sharp fuel price increase, the rupiah will remain extremely vulnerable to wild fluctuations, especially since more than 80 percent of third- party savings in banks are invested in one-month deposits.

In the long run, however, the best defense of the rupiah exchange rate against wild fluctuations are strong economic fundamentals, which can be built up only if the general business climate is conducive enough to stimulate a robust wave of domestic and foreign investments.