RI should return to fixed exchange rate

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)