The currency board system

The currency board system

President Soeharto's fast, bold move on a fixed exchange rate
system under currency board arrangements, to arrest the wild
volatility and downward spiral of the rupiah, is founded strongly
on both economic and political rationale.

Without a stable currency, nothing else will stabilize and
improve the economy. Instead, a shattered rupiah will drive most
companies into bankruptcy, increasing the unemployment ranks to
an explosive level, raising prices beyond the purchasing power of
the people and triggering social and political instability.

A fixed exchange rate, if the experiences of other countries
such as Argentina, Hong Kong, Brunei, Bosnia, Estonia and
Lithuania are any guidance, could quickly solve almost all the
problems caused by a wildly fluctuating currency.

A currency board system (CBS) creates a stable exchange rate
because every unit of local currency is backed by the equivalent
in the chosen anchor currency. Any increase in the domestic
currency in circulation should be matched with foreign reserves.

However, whether a CBS is the best way for Indonesia to get
out of the present crisis is still highly debatable, given the
wide differences between our circumstances and the countries
which have successfully implemented the system.

Not many technical details were immediately available as to
how the government would organize and structure its CBS for the
rupiah. But, given the short time available to prepare all the
legal and technical frameworks, we reckon that the CBS would
likely be established as a division within the central bank (Bank
Indonesia).

Setting up a separate monetary institution outside Bank
Indonesia would require amendments to the Central Bank Law, a
process that may take a few weeks even though the House of
Representatives is dominated by the ruling Golkar organization.

The consequence of the introduction of CBS is that the
government will have to surrender virtually all its monetary
policy autonomy.

The government would no longer be free to set interest rates
and inject liquidity into the economy at will. Asset markets,
output, employment and other economic aggregates must adjust to
whatever levels are required to maintain the specified exchange
rate. If companies or banks go bankrupt they can not be bailed
out.

Given the rigid market discipline CBS requires, the biggest
question -- or rather the greatest doubt -- is whether such a
system could be credible and sustainable for a long time under a
political leadership, notoriously known for its high
vulnerability to cronyism, nepotism and corruption.

The advocates of CBS see this fixed-rate system as the
quickest way of getting out of the currency turmoil, arguing that
the country's official foreign reserves are more than enough to
back up such a system.

Critics and skeptics, however, argue that while the US$17
billion in official foreign reserves might be adequate to support
CBS -- depending on which level the rate would be fixed and which
money category would be covered -- two key fundamentals for a CBS
success do not yet exist in the country: a sound banking system
and strong public confidence in the political leadership's
capability and willingness to consistently take painful reform
measures to cope with the economic crisis.

CBS is only as good as the intentions of the people who create
and operate it. Doubts about the motives behind introducing CBS
would remain until the government is seen to act firmly on its
previous commitments. The people should be convinced that the
government does not fiddle with the system.

The question is how the government could convince the people
that CBS would really be free from political interference, unlike
the central bank, which has so far been highly vulnerable to
political intervention and politically well-connected vested
interests.

Confidence is a precious commodity. Once lost, it is difficult
to regain.

The value of the currency and financial intermediation process
in particular are built on confidence, the trust that deposits
are safe, bonds are redeemable, contracts are binding and
enforceable.

Take this vital pillar away, and the entire structure
collapses with devastating consequences for the economy.

If the people do not fully believe in CBS there might be a
massive scramble for dollars to cash out of rupiah as quickly as
possible. This would worsen the credit crunch, leading more
companies into bankruptcy, as rupiah interest rates would
skyrocket to several hundred percent.

In anticipation of such a scramble for dollars the CBS should
be backed up by reserves equivalent to the broad money supply
(estimated at Rp 378 trillion) to make it credible. Obviously,
our foreign reserves would not be sufficient to support it.

IMF endorsement is also vital for gaining the international
market confidence in CBS but as IMF First Managing Director
Stanley Fischer stated in Washington on Thursday, CBS was not
viable for Indonesia at this juncture in time.

The government is faced with extremely difficult choices. It
could accelerate the process of stabilizing the rupiah by acting
more firmly and speedily on the IMF-arranged reforms and
strengthen this effort with equally bold political reforms to
regain confidence.

Or the government could push ahead with its plan on CBS at
great risks because the new system will not only require
wholesale renegotiation of the IMF rescue package of Jan. 15 but
also may delay the next disbursement of the second $3 billion
fund from IMF, scheduled in the middle of next month.

But the sheer renegotiation of the Jan. 15 package, after the
bad image and low credibility already incurred by the
government's backtracking on the Nov. 1 package, would not help
the process of confidence building.