Loose monetary policy dragging rupiah down

Loose monetary policy dragging rupiah down

SINGAPORE (Dow Jones): Overly loose monetary policy in Indonesia is pushing up inflation and could very well drag the rupiah down through key psychological support at Rp 10,000 to the dollar.

Also weighing on the currency, say analysts, is the Southeast Asian nation's weak balance of payments position and Jakarta's unorthodox - and some say flawed - efforts to attract foreign capital.

In late December the dollar hit a 26-month high of Rp 9,800, which represented an 8.1 percent rise in the U.S. currency against the rupiah over the preceding two months. The dollar was traded at Rp 9,600 in the morning trade on Friday.

Ray Farris, analyst with ING Barings, says Bank Indonesia has fallen behind the curve on inflation and is now attempting to play catch up through interest rate increases. It is losing this battle, however, because inflation is in a sharp upward spiral.

The government aims to keep inflation below 7 percent, but prices rose 9.4 percent on year in December, accelerating from a 6.8 percent pace of increase in September. Inflation excluding volatile food prices was even worse, rising to an 11.3 percent rate in December.

Farris says excessive growth in the monetary base - otherwise known as M0 - of close to 20 percent year on year throughout most of the second and third quarters of last year is driving the trend. Instead of tightening supply in the fourth quarter, Bank Indonesia, the central bank, allowed M0 growth to accelerate to 23.4 percent growth on year in December.

"This (M0) growth seems very high even given the holiday period, and we expect this acceleration to push inflation up to 10 percent-11 percent in the first half of 2001," says Farris.

M0 comprises notes and coins in circulation and banks' operational balances with Bank Indonesia.

During this recent sharp increase in Indonesian prices, Farris says interest rate rises have failed to keep pace, causing monetary conditions to become overly easy. "With inflation accelerating, nominal SBI rates need to rise 100-200 basis points," he says in a research note titled "Losing Hope In Monetary Policy."

Since the end of September, the nominal one-month deposit rate has risen 40 basis points to 11.2 percent, while the one-month SBI, a short-term bill issued by the central bank, is up around 120 basis points.

Both increases are far less than the 260 basis point rise in inflation during the same three-month period.

Coordinating Minister for the Economy, Rizal Ramli, earlier this week said to achieve a government economic growth target of 5 percent-6 percent for 2001 means SBI rates cannot "be too high."

So with the government against sharply higher interest rates for fear of damping economic activity, and the administration still imposing its political will on Bank Indonesia, there seems little reason to expect monetary conditions will tighten any time soon.

With this is mind, Farris says ING Barings cuts its 2001-year end forecast for the rupiah to Rp 10,500 from Rp 9,000.

But there are risks to long dollar positions against the rupiah.

"The main risk we see to long dollar positions is that as pressure on the rupiah builds, and if tensions with the IMF escalate, the government may resort to some sort of capital controls," say Farris.

The expected slide in the rupiah will also be driven by balance of payments weakness, says Barclays Capital in a research note.

Soured relations between President Abdurrahman Wahid and the International Monetary Fund, which withheld a $400 million loan after Indonesia failed to meet attached conditions, and a spat between Abdurrahman and the central bank governor have caused capital inflows to slow.

"Indonesia's external liquidity position is fragile," it says.

"Only a fraction of the country's outstanding foreign debt with a face value of $152 billion, which exceeds gross domestic product, can be repaid," says Barclays Capital.

With government debt around $77 billion and net foreign exchange reserves a mere $29 billion, it says Indonesia faces the prospect of a succession of foreign debt rescheduling in coming years.

But rather than address the root cause of its external liquidity crisis by appeasing the IMF and Abdurrahman calling a truce with Bank Indonesia Governor Sjahril Sabirin, Jakarta is focusing on flawed and unusual methods of attracting foreign capital.

In this regard, Barclays cites government consideration of a $400 million bond issue - the same size as the delayed IMF loan - backed by liquefied natural gas assets.

Using energy assets to obtain much needed foreign capital inflows worked during the 1995 Mexico peso crisis, during which Mexico used oil receipts as security, or collateral, for a currency swap arrangement with the U.S. Treasury.

But using LNG assets to securitize a bond would be difficult for Indonesia because seizing assets in this country is difficult, and complicated by the granting Jan. 1 of greater autonomy for provinces.

The move new autonomy laws allow regions greater claim to revenue from oil, gas and mining projects.