The beleaguered rupiah

The beleaguered rupiah

Remember early January 1998 when the rupiah crashed through
the 10,000-to-the-dollar barrier two days after then president
Soeharto unveiled his draft 1998-1999 budget? The four-fold fall
of the rupiah was then precipitated by what the market perceived
to be unrealistic budget proposals, which defied the urgent
imperatives for drastic reform and belt-tightening measures.

What happened on Monday was by and large a similar phenomenon,
though on a much smaller scale. The rupiah depreciated from Rp
9,985 on Friday to Rp 10,030 -- its lowest level in the past 41
months -- and the stock market fell 1.1 percent.

However, the development here bucked the regional trend as
most currencies and stock prices in other Asian markets firmed
up. The main cause of the bearish sentiment in Jakarta is the
market distrust in the draft 2006 budget that President Susilo
Bambang Yudhoyono proposed to the House of Representatives last
Tuesday as well as the uncertainty over policy direction.

Chief economics minister Aburizal Bakrie has tended to
downplay the rupiah decline, as he considers it simply the work
of market mechanisms. Since the rupiah is floated against a
basket of currencies it is supposed to fluctuate.

However, such a laid-back attitude is damaging the credibility
of the government because this negative sentiment, if allowed to
escalate, could turn into a self-fulfilling prophecy.

Worse still, the new set of measures launched last month to
prevent speculative attacks on the rupiah has seemingly been
unable to beef up the rupiah. The government and Bank Indonesia
last month launched joint arrangements whereby the central bank
directly supplies the foreign exchange needs of state oil and gas
company Pertamina for importing crude oil and oil products and
other state-owned companies to purchase dollars from designated
state banks.

But the rupiah has declined steadily this month even though
foreign exchange derivative transactions with foreign
counterparts against the rupiah have been limited to a maximum
US$1 million, down from a previous $3 million and dollar
purchases in outright forward transactions, swaps have been
capped at $1 million and a three-month minimum investment hedging
period has been imposed on foreign exchange transactions.

The key assumptions used by the government to construct its
2006 budget plan have been seen by most analysts and market
players as utterly unrealistic, causing market distrust in the
government's fiscal management.

The government's assumption of $40/barrel as the average price
of oil for the whole of next year, compared to at least $55 as
foreseen by most analysts, has put the national budget at the
mercy of international oil-price volatility, thereby causing
uncertainty about the budget's fiscal sustainability and the
prospect of the country's balance of payments.

The market is nervous that the government does not have much
leeway in managing its budget deficit, which will most likely be
much larger than the Rp 19.8 trillion envisaged in the draft
budget, because the fuel subsidy expenditures will be much larger
than the Rp 68.5 trillion as budgeted for next year.

Even with such a low oil price projected for next year, the
budget plan already requires the government to dip into its
savings balance at Bank Indonesia, currently estimated at Rp 22
trillion, and to raise another Rp 60 trillion through new bond
issues, divestment and asset sales. Where else can the government
get additional revenues to plug the big budget hole?

The market is apprehensive that another bout of fuel-price
increases is only a matter of time and stronger inflationary
pressures will further push down the rupiah and force the central
bank to tighten the credit crunch. This is a lethal combination
for the manufacturing industry as most factories still rely on
imported materials and components. But businesspeople are in the
dark about when and how these painful measures should be taken.

This vicious cycle will surely increase the government's
burdens of servicing its foreign and domestic debts and this, in
turn, could cause the fiscal deficit to explode to an
unsustainable level, thereby raising the sovereign risks. Higher
sovereign risks would consequently increase the government bond
yields as investors, instead of buying new bond issues, would
decrease their government bond portfolio.

The government could be correct in its conclusion that the
current rupiah rate developments were not truly reflective of the
economic fundamentals. But it is entirely misguided for the
government not to act immediately and firmly to address the
market apprehension because the steady fall in the rupiah rate
and its negative repercussions are affecting macroeconomic
stability and will eventually damage the economic fundamentals.