Defending the rupiah

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.