How to gauge rupiah's performance against dollar

By Seamus McElroy

JAKARTA (JP): As an economist, I am regularly asked for my opinion on the value of the rupiah and its direction over one, three, six and 12 months. My answer is simple.

In the rupiah-dollar spot and forward swap markets, one month rupiah is trading at Rp 8,000 (48 percent annual discount to cash), three months is trading at Rp 8,500 (48 percent discount to cash) and one year is trading at Rp 10,400 (37 percent discount) relative to its level in the spot market of Rp 7,500 to 7,600. (These were the WM/Reuters Closing Spot and Forward Rates at the start and end of the week beginning Oct. 26, before the current market turmoil related to the People's Consultative Assembly).

These prices also reflect rupiah interest rates where short- term rates are substantially higher than one-year rates. To continue the jargon, the interest rate yield curve is sloping steeply downward. Such situations are typically very temporary and signify in this case a move toward staving off inflation and the strengthening of an oversold rupiah.

Ah, says my friendly speculator, "On a historic basis, with inflation of roughly 100 percent since the rupiah fell from its peg of Rp 2,400 just over a year ago, the rupiah should be below Rp 5,000. Even with a high political and social risk premium of say 30 percent, the rupiah should be moving toward a value of Rp 6,500 or better, no?", he asks.

Thus in one view, at Rp 7,500 against Rp 4,500, the rupiah is 67 percent weaker than it should be, while in the second, at Rp 10,400, it is being discounted relative to today's value by 37 percent one year out.

So how do we settle this apparent conundrum, where on a 12- month horizon, even with a small amount of inflation, we can expect the rupiah to strengthen from today's level, while the forward market prices is a substantial discount on today's exchange rate?

"Simple", I say to the would-be speculator.

A strengthening of the rupiah is your view of the market, with all its inherent risks, while an exchange rate of Rp 10,400 to the dollar is the rate the market guarantees to sell you dollars for rupiah one year from today.

If you abhor risk, you will take the certainty of the Rp 10,400 on your forward dollar income.

If you are a speculator with a moderate appetite for risk, you will exchange a part of your dollar portfolio into rupiah today and obtain the highest interest rate offered by the local banks on, I would suggest, a six-month deposit term. This way you get a high rate both today and in six months time when the election process is in full swing and the banks are again offering high short-term interest rates.

Of course, by then the rupiah could have collapsed to below Rp 10,400, when your capital gain would have been wiped out by the loss in the value of the rupiah. But, as we have seen above, the market's pricing of risk suggests this is unlikely.

So what should the wily investor/speculator do?

Well, it rather depends upon your attitude to risk and where you expect to be spending that money.

Certainly, interest rates close to 50 percent are juicy.

But the critical factor driving the currency's direction and value is the flow of funds into and out of Indonesia.

The government has shown it has a firm hand on the country's finances, and is keen to see the rupiah strengthen further. Its partial use of the IMF loan money of US$1 billion per month to support the appreciation of the rupiah over the past four months is testimony to this.

The trade current account has been showing a strong dollar surplus for months, with no sign of that deteriorating, while the capital account could benefit from a substantial sustained inflow of foreign investment as companies relocate some of their production capacity to Indonesia from more expensive areas. The partial privatization of some state companies in the months ahead will also help a little in this regard.

Thus the rupiah should strengthen, provided the political process of reform remains socially responsible and stability is maintained.

As to the wider issue of introducing exchange controls and targeting a particular exchange rate, I believe adopting such a strategy is doomed to failure. Its justification is to provide stability and to hinder currency speculation.

But all investment is speculation, whether it involves putting money into a country for one month or for 20 years.

And fixing the exchange rate provides one more unnecessary, artificial target to speculate against. Because whoever fixes the rate must then defend it with all the country's reserves (limited and known) against an army of speculators who can call upon an unknown and virtually unlimited amount of funds.

Though more volatile, it is better to let the market price the currency according to its perception of economic fundamentals and the actual and anticipated flow of funds, both into and out of the economy. The alternative is to put a brake on inward investment and so economic growth, a luxury Indonesia cannot really afford at the present time.

So on balance, with a slight risk of exchange controls of some form being introduced within the next 12 months, and of a temporary but not economically damaging election process, my bet is on a strengthening rupiah over the forthcoming 12 months. I would put the risk of the rupiah being above Rp 10,400 one year on at no more than one in five.

But a major riot on the scale of last May would change that perception dramatically. While the risk may be small, its impact could be far more long-lasting and damaging to the country's international credit standing.