Monetary reform could pay divident

By Peter Duncan

JAKARTA (JP): Indonesia is about to embark on the most far- reaching monetary reform of its half century of existence as an independent nation. It is being discouraged from taking this step by an impressive array of conventional banking and business authority and wisdom from the IMF, the World Bank and national leaders down through economists and analysts to the ever- articulate brokers and fund managers.

This reform, the establishment of a Currency Board System (CBS), will have the following benefits: First, it holds out the prospect of basically sound businesses being able to meet their debt payments. Second, it will eliminate Bank Indonesia's central banking function of lender of last resort to government, other banks, state enterprises, commodity boards, national business projects, and well connected businesses. Third, it will leave two rump components of Bank Indonesia -- one to deal with bank supervision reporting and statistics, and the other to manage whatever is left of BI's assets after it has handed over a clear US$12-15 billion to the new Indonesian Monetary Authority. These assets could become part of the assets of the Indonesian Bank Rehabilitation Authority. All of these benefits are in line with the intentions of the GOI/IMF agreement.

Doubters of the CBS should put their fears behind them and back establishing a strong and orthodox CBS with the sole functions of exchanging rupiah currency for U.S. dollars at a fixed rate and managing the CBS reserves in conservative U.S. dollar denominated securities.

The proposed Currency Board System (CBS), provided it is an orthodox one, is a simple mechanism for converting the existing and future Indonesian currency stock into greenback rupiah -- yes, U.S. dollars -- but just the currency, not the rest of M1 and M2. The question most troubling those who fear adoption of the CBS is will it work? That is can it survive? They fear that holders of rupiah (notes and coins) and claims on rupiah (deposits) will decide that this is their last, best chance to get real U.S. dollars at a good price, say Rp5,000 if that is the agreed strike price. That is twice what a dollar cost in rupiah less than six months ago but much less than the cost in rupiah only a few weeks ago.

If there is such a flight to the U.S. dollar, rupiah currency will soon command a premium. Notes will come from wherever they are hiding and migrate to the CBS until there are few rupiah left in the system for day to day business. We would then have to conduct our daily business in greenbacks and barter or pay a premium to get hold of rupiah currency.

But why should such flight occur? There are three main groups of holders of rupiah and claims on rupiah. First, the business elite, bankers, foreign debt holders, corporates and business groups. Second, the business middle class, traders, owners of small enterprises, operators of schools, households, and other institutions. Third, the bewildered masses who receive a pittance of salary or wages and spend most of it within days of receiving it.

The first and second groups have done most of what they can already to get out of rupiah and claims on rupiah, but they still may lead another wave of flight from the rupiah. This would contract the currency available and thereby tighten money supply across the banking system. The third group has no choice but to accept that what little cash savings they have are at least halved in value and that they will have to live on maybe half or less of what they have survived on before -- until such time as the economy gets back to business as usual.

The government has two major problems of communication to face. First, convincing the elite and middle business groups that Rp5,000 to the U.S. dollars is fixed, come what may. Second, convincing the bewildered masses that rioting, looting and shop burning will only delay the process of recovery to real living standards comparable with those of less than a year ago.

The only way to convince the elite and middle business groups that the CBS will work and will be here to stay is to commit to it irrevocably with ironclad safeguards.

Convincing the masses to suffer peacefully will not be such an easy task. But surely that is what part of the US$39 billion of the IMF Plus Package should be used for -- to ease the transition from subsidized prices held in check in spite of much too rapid growth in money supply (permitted by Bank Indonesia as a central bank) to market determined prices in line with international prices -- as well as to finance the recovery and back the debt repayment of banks and corporates.

Why are the IMF, WB and other interested parties not backing this necessary and tough decision? Perhaps because they fear the loss of power, authority and prestige that comes with pulling down the walls of the temple of central banking. Or because they fear the contagion effect of giving up sovereignty over monetary management to the U.S. Federal Reserve Board.

Or because they are worried that a fixed link to the U.S. dollar will tie the rupiah to shifts in the U.S. dollar against the currencies of other countries, most notably Japan and China, and thereby distort development of trade and investment with these countries. Surely, the prospect of a fixed exchange rate for the rupiah instead of the present chaos should outweigh these concerns.

The writer is chief economist of the Castle Group.