Problem with monetary evangelicals

By Bondan Winarno

JAKARTA (JP): Indonesians did not like what they saw on television. President Soeharto signing an agreement with the International Monetary Fund (IMF), as its director, Michel Camdessus, looked sternly on with crossed arms.

Former Jakarta governor turned dissident, Ali Sadikin, said "Soeharto is bad all right, but he is my president. Camdessus was treating my president like he was his colonial master."

Then came Steve Hanke peddling the virtues of a currency board system (CBS) to the government of Indonesia. He took center stage at President Soeharto's residence, where Camdessus had been just a few days before, when he briefed Soeharto on the wonderful world of currency boards. "A CBS is the only way to end Indonesia's crisis", Hanke later remarked to the press.

Smooth talking, wearing academic looking spectacles, he later gave a lecture on currency boards to a hoard of Jakarta journalists, with convincing credibility. Momentarily, the journalists forgot that Hanke moonlights as a currency trader.

Indeed, Hanke did not even correct Jakarta newspapers which hailing him as the "father of CBS", when in fact it is a concept dating back to the British Empire. The first currency board was established in Mauritius in 1849 and the system reached its peak in the late 1940s.

Currency boards were abandoned in favor of central banks as colonial empires receded. However, when central banks became susceptible to government pressure to finance excessive deficits, currency boards were revived. Approximately seventy countries now subscribe to CBS in its modern form.

Hanke wrote his first book on currency boards with Kurt Schuler in 1991. Milton Friedman is among contemporary economists who view CBS as a possible monetary system for Eastern Europe and the Third World. Many even believe that fixed exchange rates might become the way of the future.

To me, Hanke sounds like an apocalyptic preacher. He came promising heaven to those who for too long have been staring at the gate to hell. Choose CBS now, lest Armageddon come in four months.

To worsen the appearance of hell, Hanke forecast inflation running at 1000 percent this year, but he did not substantiate this claim.

Peter F. Gontha, a business associate of one of President Soeharto's sons, quickly denied any role in arranging the meeting between Hanke and President Soeharto. People now believe that it was Mohamad (Bob) Hasan, a timber tycoon closely linked to Soeharto, who rang Hanke when the latter was on holiday in Istanbul.

Hasan has a reputation for this sort of covert operation. Whatever the truth, Hanke won Soeharto's ear. Hanke believes a currency board can do no wrong. "There has been no history of a bad currency board system anywhere in this whole world", he said during an interview with TVRI, the government-owned television station.

In the same interview, Hanke strongly stated that there is no technical conflict between CBS and the IMF. "A CBS... complements the IMF package," he said.

However, moments later he said that the "IMF sets preconditions for Indonesia to achieve stability... But, the rupiah will collapse before stability is attained", in blatant contradiction to his earlier statement.

In the interview, Hanke also questioned why conditionality attached to an IMF loan to Bulgaria required the recipient country to adopt a currency board, while the IMF strongly opposed a currency board in Indonesia. Perhaps Hanke was correct to make this reference, but it is nevertheless misleading.

In an article in Kontan, Jakarta's weekly economic newspaper, Prof. Emil Salim pointed out that Bulgaria is a case apart from Indonesia. When a currency board was introduced in Bulgaria, the banking system was in good order. "We can have a CBS in Indonesia, but with the banking system in its present state, we will all sink," Salim said.

That a CBS does not contradict IMF reforms is not quite accurate. In fact, the IMF just reaffirmed that it will cancel the aid package if Indonesia introduces a currency board. The G-7 meeting in London also called on Indonesia to delay a CBS.

Behind the dogmatism, Hanke's logic, when discussing CBS, must be treated with care. He stated that with CBS "interest rates would fall because of increased credibility". There are two flaws in that statement.

There is no evidence to suggest that interest rates fall in response to improved credibility. Furthermore, there is the matter of credibility itself. Hypothetically, a currency board will improve credibility, but if the government hold insufficient currency reserves to manage a currency board, then credibility would quickly disintegrate.

Hanke's rhetoric makes it sound like no brain is required to run the system. "It is very restrictive and disciplined. It runs on an automatic mechanism," he said. So can one fall asleep at the wheel?

A currency board will, according to supporters, give Indonesia a credible mechanism with which to defend a fixed exchange rate. The cost will be loss of control over monetary policy. There is also confusion over the specifics of the proposed system.

Many people fail to distinguish between a fixed exchange rate and a pegged exchange rate, which are different entities. Holding the exchange rate constant is the top priority in a fixed exchange rate regime. Under a pegged system, other policy tools such as the interest rate are also considered and the term 'peg' alludes to a certain mobility in exchange rates -- a fixed but adjustable exchange rate system.

The currency board system being touted for Indonesia is definitely a fixed exchange rate regime with very restrictive rules. But a fixed exchange rate can be achieved without a currency board. Indonesia has used a fixed exchange rate regime for two decades without a currency board.

A currency board can also come under different guises. Singapore's Board of Commissioners of Currency is a currency board which does not fix the exchange rate -- Singapore uses a managed float regime.

For Indonesia, the question is whether to fix or to peg the rupiah. A return to a free floating currency is almost certainly out of the question.

Popular argument has recently favored fixing the rupiah to a dollar rate of exchange conducive to production and trading. This would be complemented by limiting the use of foreign currency to those with legitimate business needs to do so.

Informed people in Indonesia now believe that Soeharto is reconsidering his plan to introduce a currency board, but amid all the speculation, one question still remains unanswered. Will an Indonesian currency board lead to the demise of Bank Indonesia?

In Singapore, the central bank coexists with the Board of Commissioners of Currency. One institution does not make the other obsolete.

In Hong Kong, the Exchange Fund (currency board) was introduced in 1985 after serious speculative attacks on the Hong Kong dollar. The exchange fund cooperated with the Banking Commission, which had a mandate to supervise banking and financial institutions in the territory, until 1993, when the two were merged to form the Hong Kong Monetary Authority (HKMA). The HKMA is technically a central bank which performs extra currency board functions.

There is no need to dissolve Bank Indonesia if it is capable of taking on the extra functions required to run a currency board. In fact, if Indonesia opts for a fixed exchange rate regime without a currency board, the role of the central bank will be vital.

CBS, just like any other monetary system, has advantages and disadvantages. Suitability depends on a country's fundamentals. A currency board may be appropriate for Indonesia, but for this to be true, certain prerequisites for success must be met. That all these prerequisites are present in Indonesian society is debatable. Furthermore, since Hanke is not the sole authority on currency boards, Indonesia should take the time to listen to other supporters and opponents of this controversial exchange rate regime.

The writer is a business consultant based in Jakarta.

Window A: Popular argument has recently favored fixing the rupiah to a dollar rate of exchange conducive to production and trading. This would be complemented by limiting the use of foreign currency to those with legitimate business needs to do so.

Window B: Informed people in Indonesia now believe that Soeharto is reconsidering his plan to introduce a currency board, but amid all the speculation, one question still remains unanswered. Will an Indonesian currency board lead to the demise of Bank Indonesia?