Pricey credit and oil

Businesses in Indonesia may have to wait a while for a significant decline in interest rates as Bank Indonesia, concerned by strong inflationary pressure from the weakening rupiah, or rather the strengthening U.S. dollar, and the steep rise in international oil prices, is delaying easing its monetary stance.

The appreciation of the greenback against most currencies in Asia due to the imminent tightening of the money supply in the United States, and oil prices that have soared to a 13-year high of US$40 per barrel (unadjusted for inflation), have again raised the specter of high inflation. This is particularly frightening for Indonesia, where spending for the legislative and presidential elections is expected to increase the base money supply way above the aggregate monetary target.

It is now much more difficult for Bank Indonesia to maintain the rupiah within the band it considers conducive for exports, and yet not too low as to induce imported inflation. Since the Rp 8,200 to Rp 8,700 band set by the central bank as the target range is no longer feasible after the appreciation of the dollar since early this month, a new exchange rate target band has to be set to prevent excessive speculation. Like it or not, the U.S. dollar is the world's reserve currency, widely held by the central bank, and disruption of the dollar disrupts the entire world economy.

The rupiah is highly vulnerable to speculative attacks because banks, with the high risks involved in corporate lending, are still awash with excess liquidity. Moreover, most of the Rp 890 trillion in third-party funds at banks consists of deposits that can easily be shifted to dollar assets at the expense of the rupiah.

Bank Indonesia gave the signal for pricier money last month when it jacked up the ceiling interest rates on time deposits eligible for reimbursement under the government blanket guarantee scheme. Many midsize commercial banks immediately responded by slightly raising their deposit rates.

The steep rise in international oil prices is stoking inflationary pressure that may also force tighter monetary policies in Europe and Japan, which would slow the global economic rebound.

For Indonesia, soaring oil prices will cause problems rather than windfall profits, because, despite its daily output of almost 1.2 million barrels per day, the country is now a net oil importer.

The weakening rupiah and soaring oil prices are creating a dilemma for the government. Certainly, it would be political suicide for the government to raise domestic fuel prices ahead of the upcoming presidential elections. But maintaining fuel prices at their current levels will increase fuel subsidies, adding to the inflationary pressure because much of the oil revenue now belongs to local administrations (as a result of local autonomy), while subsidies are borne by the central government. All of this will further force much tighter monetary measures, dampening economic growth.

Most analysts agree that the period of cheap oil has ended, with world oil production already at or close to full capacity while demand continues to rise.

The Paris-based International Energy Agency estimates world oil demand will rise by four million barrels per day between now and the upcoming winter. The problem is that output in non-OPEC countries will likely remain flat, while OPEC can pump at most an additional 2.5 million barrels per day, as Saudi Arabia seems to be the only member country still with spare capacity. In addition, production in Iraq continues to be held up by security disturbances.

The tightening of credit in China to prevent its economy from a hard landing may decrease the growth in oil demand and take the pressure off oil prices, as China, which consumes more than six million barrels of oil per day, accounted for almost 35 percent of the world economic growth over the past three years.

However, the credit restraints in China are already having negative repercussions in most major exporting-countries in East Asia, which have become increasingly dependent on China's thirst for imported capital goods and industrial materials.

It is now most imperative that Bank Indonesia provide the market with a strong and clear direction by coping with inflationary pressure and curbing speculative attacks on the rupiah.