Skepticism looms over RI's CBS plan

Skepticism looms over RI's CBS plan

HONG KONG (Reuters): Asian fund managers have expressed a high degree of skepticism over proposals by Indonesia to introduce a currency board mechanism.

They said Indonesia needed confidence rather than a new monetary system to shore up the rupiah, which Friday was closed at 8,000 to the U.S. dollar after hitting a record low of 17,000 last month.

"Re-establishing confidence is of critical importance," said Marshall Mays, chief strategist at Nikko Securities.

Tough action to clean up rotten banks, proof that nepotism and corruption were things of the past and concrete steps to solve Indonesia's huge private sector debt problem were the only possible routes to a return in confidence, fund managers said.

"The real issue in Indonesia is how do we really progress, move forward on these issues, and I don't think they can be solved just by a different exchange rate mechanism," said Eugene Chung, chief Asian investment strategist at SBC Warburg.

Politics remained the key, the strategists said.

President Soeharto appears to be backing a currency board as a quicker method of raising the value of the rupiah currency in a bid to bring down prices and help resolve the debt issue.

Some critics say vested interests in Indonesia see a pegged rupiah as a way of protecting their assets.

"It's hugely popular with the crowd in charge right now because they have a hope they can hold onto their goodies, where if they have to give up monopolies, do the right thing and restructure the system, they would suffer," said Mays.

A currency board would fix the rupiah to an external currency such as the U.S. dollar or Japanese yen, with full cash-backing for the amount of rupiah in circulation.

In theory, the Indonesian central bank would then forfeit control over monetary policy to the United States or Japan, implying lower rates along with a stable rupiah.

In practice, Asia's experience with fixed exchange rates has demonstrated investors' insistence on country risk premiums over and above the rates applied to the external currency.

"In Hong Kong, we know from experience that interest rates are a function of the risk premium," said Chung.

Those premiums made a substantial contribution to the Asian crisis. Huge and volatile U.S. dollar inflows seeking high interest and no currency risk ramped inflation throughout Asia, swelling credit and building unsustainable asset price bubbles.

Those asset bubbles collapsed like dominoes after Thailand devalued the baht last July 2, sparking rapid capital flight.

If Indonesia fixes its currency again, those inflows could return and repeat a process clearly identified as dangerous.

"The risk that people will borrow U.S. dollars again, assuming its guaranteed, is not inconsiderable," said Mays.

Foreign investors were also skeptical of Indonesia's political will to allow the currency board to work independently -- and independence would be key to its successful operation.

"We're not even sure we have that political will here in Hong Kong," said Chung. "In theory, things can work out beautifully but in practice, politics does matter unfortunately. Politics is everything in Asia."

Hong Kong has faced criticism for acting to ease the interest rate burden during speculative attacks on the Hong Kong dollar, pegged at a rate of HK$7.80 to the U.S. dollar.

Although most commentators supported the Hong Kong intervention, others argued the currency board should be allowed to work in total isolation from interference, with rates moving only according to market demand for the domestic currency.

The fear among foreign investors is that Indonesia will refuse to abide by the currency board when rates shoot high enough to damage corporate activity.

Instead of allowing higher rates to force economic adjustment -- bankruptcies or bank failures -- Indonesia could instead resort to printing money to maintain the status quo, the fund managers said.