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.