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.