RI should return to fixed exchange rate

Indonesia's monetary crisis, which has led to a combination of stagnancy in economic growth and high inflation (stagflation), is still dragging on in spite of an over US$40-billion bailout package from the International Monetary Fund (IMF). Economist Kwik Kian Gie proposes a solution to the crisis.

JAKARTA (JP): The stagflation has been going on for 21 months now, and several parties want to see it ended to allow the economy to recover.

The stagflation has been caused by many interdependent factors, of which the sharp depreciation of the rupiah's value against the U.S. dollar is the most conspicuous.

Since the rupiah's value started deteriorating in the middle of 1997, prices of goods and services have been skyrocketing and supplies of a great variety of products become scarce, due to the heavy dependence of the country's economy on imports. Many companies have gone bankrupt because they failed to finance the increase of their working capital and sell their more expensive products.

Following the rupiah's depreciation -- from Rp 2,400 to the dollar in July 1997 to more than Rp 10,000 in early 1998 -- the government announced a plan to peg the rupiah at Rp 5,000 to the dollar through the introduction of a currency board system (CBS), but many Indonesian economists and IMF officials opposed the plan.

However, instead of CBS, the government can reintroduce a fixed exchange rate system, which was once adopted in Indonesia before the implementation of a managed float system using an intervention band. The fixed exchange rate system was then regarded as problematic, because the government was forced to devalue the rupiah whenever the ever-increasing current account deficit to savings investment gap resulted in overinvestment.

Now that sharp depreciation has caused the rupiah to be substantially undervalued, we look forward to when the currency's exchange rate is fixed at a level which reflects purchasing power parity, even though devaluation is needed from time to time.

Suppose that the government, instead of abolishing the intervention band, had devalued the rupiah by 45 percent to Rp 3,500 per dollar in August 1997, the conversion rate would have remained at that level and capital flight could have been arrested. Unfortunately, the government, which had expanded the intervention band eight times in response to a continued rush on the dollar, abolished the managed float system and introduced a totally free exchange rate system.

With the rupiah significantly undervalued at around Rp 8,700 per dollar at the moment, economic activity cannot be reinvigorated and only industrial companies which can sell their products to a thin layer of consumers with high purchasing power can survive.

Many believe that after a successful general election in June and the establishment of a legitimate government able to sustain social and political stability, economic activity will resume with the investment that is expected to flow into the country again, raising the purchasing power of the people and increasing demand for goods.

However, the expected increase in demand for goods will never reach a level sufficient to encourage industrial companies, whose sales depend very much on the few consumers with money to spend, to increase production to a level that will allow economics of scale.

Such companies, whose operations usually depend largely on imported materials, can only operate in a sustainable way if the rupiah's value stabilizes at about Rp 5,000 per dollar.

If the government fixes the conversion rate at Rp 5,000 per dollar, some traders will surely rush to the dollar, but they will be few as the majority of currency speculators have already converted their funds into foreign currencies. Furthermore, those with rupiah deposits will have enjoyed high interest rates as well as the appreciation of the rupiah. Therefore, the government does not need too high a level of foreign exchange reserves to cope with a possible rush on the dollar.

To generate funds to build up its foreign exchange reserves, the government can apply for financial assistance from the international community.

This proposal is certainly not for the current government, which evidently cannot create stability, but for the government resulting from the coming general election. (riz)