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.