Rupiah free float

Rupiah free float

Bank Indonesia's decision on Thursday to float the rupiah has
dramatically changed the currency market as speculators no longer
have a particular zone (trading band) to aim at.

Previously, the central bank, like a target in a shooting
gallery, was fully exposed to the bright lights while the
speculators (shooters) were hidden in the dark. Now the game has
been reversed.

The central bank's move was taken after several weeks of
persistent, speculative assaults on the rupiah amid the regional
contagion of the currency crisis which began early last month. It
is now up to the central bank to decide when to hit the
speculators.

The already tumultuous foreign exchange market was predictably
shocked by the move as, until Wednesday, the central bank was
still determined to defend the trading band it set last month.
Speculators, now deprived of the parameters for the central
bank's intervention to defend the rupiah rate, panicked and the
rupiah fell to a new historic low of 2,800 to the U.S. dollar
during morning trade.

Most analysts, including the International Monetary Fund,
welcomed the move. Further widening the rupiah trading band, from
the 2,378-2,682 range set on July 12, would provide the jittery
market with another target to shoot at. This would force the
monetary authorities to remain preoccupied with short-term
measures which could eventually affect the long-term state of the
economy.

Bank Indonesia's Governor Soedradjad Djiwandono said the
measure was not actually free float in the purest sense because
the central bank would intervene to keep developments on course.
The only difference now is that the central bank no longer sets
an intervention band.

It will instead keep to itself the most appropriate range for
the rupiah exchange rate as seen from the macroeconomic
objectives of encouraging private savings, bolstering exports and
wooing capital flows.

This means that despite the free float the rupiah market will
not be allowed to behave like, for example, the grocery market
where the prices are determined entirely by the supply and demand
equation. True, under the free float system, market forces will
be the main determinant of the rupiah equilibrium rate but the
central bank still commands several instruments. The interest
rate mechanism to steer the rate toward the range desired to
support the broader economic objectives, is one example.

The market players will have to bear all the risks of exchange
rate fluctuations as they are now in the dark about the threshold
rate for central bank intervention. Speculators will not know
when the central bank plans to beat them at their own game.

The biggest problem in the currency market now is that the
short-term rates are influenced not by economic fundamentals and
supply and demand equation but mostly by expectations of
appreciation or depreciation of the currency.

The commercial demand from companies for a foreign currency,
for example, for paying imports and servicing foreign debts, very
rarely causes wild volatility in exchange rates.

It is the demand from portfolio investors (speculators) that
usually is most responsible for a currency fiasco. This is
because they use a currency not as a bill of exchange but as a
commodity to be traded (hedged against expectations of
appreciation or depreciation).

Since the funds they control are huge they could easily drive
up or depress a currency and central banks which try to fight
against these speculations do so at great costs, not only to
their foreign reserves but also to economic stability. Moreover,
speculative attacks may force central banks to resort to ad hoc
measures at the expense of their long-term economic fundamentals.

What has been irking monetary authorities, especially in the
current era of globalized financial market, is that the
speculators' expectations are often irrational and influenced by
wild rumors irrelevant to the economic fundamentals on which the
rate of a currency is founded.

But now as the rupiah is on a free, managed float, it becomes
even more imperative than ever for the monetary authorities to
see to it that the rupiah market operates as efficiently as
possible. This requires timely, credible information on the key
economic indicators such as balance of payments position (notably
current account deficit), inflation and interest rate policy to
allow for a fairly efficient market based on rational
expectations.

The immediate domestic agenda is to prevent the general public
from panicking as businesspeople have yet to become accustomed to
a free floating rate. The rupiah rate will predictably fluctuate
widely during the next few weeks until the market forces fully
absorb all the information available and set the equilibrium rate
for the rupiah.