The strengthening rupiah

The strengthening rupiah and moderating the volatility of its exchange rate since last year have created a virtuous cycle within the economy, further bolstering macroeconomic stability.

The steady appreciation of the local unit against the American dollar from as low as Rp 10,420 in January 2002 to as high as Rp 8,100 this week has allowed the central bank to continuously ease its monetary policy by bringing down its benchmark short-term interest rate to below 11 percent from as high as 17 percent in January 2002.

The stronger rupiah will, first of all, reduce government spending on servicing its foreign debts in the current fiscal year that assumes the rupiah's exchange rate at a range of Rp 8,500 to Rp 9,500 to the U.S. dollar and bolster the export competitiveness of manufacturing companies, which depend on imported materials and components.

The local unit's appreciation will significantly cut down the production costs of electricity, thereby enabling state electricity company PLN to cancel the quarterly increase of 6 percent in its power rates already mandated for the whole year. Likewise, government spending on fuel subsidies will most likely be less.

Further down the line, a stronger rupiah will decrease pressures of imported inflation and help check cumulative inflation this year to less than the 9 percent to 9.5 percent range envisaged for the fiscal year. In fact, cumulative inflation in the first four months was less than 1 percent, compared to 3.26 percent in the same period last year.

This development in turn will give more leeway for the central bank to further lower its benchmark interest rate, and this will decrease government spending on servicing its domestic debts.

It has officially been estimated that a decline of each percentage point in the interest rate will decrease the government's service burden on its domestic debts by almost Rp 2 trillion (US$242 million). The central bank's interest rate has declined steadily from 12.84 percent in January to less than 11 percent this week, compared to the average 13 percent assumed for the whole fiscal year.

It is also comforting to learn that the positive developments have been generated largely by domestic factors. A weakening dollar did contribute to the rupiah's appreciation, but the improving fundamentals of the economy have been the biggest source of the rupiah's strength.

Analysts attribute the rupiah's strength mainly to the solidifying political stability, steady increase in gross foreign reserves to as much as $34 billion now and the significant inflow of portfolio capital to the stock and bond market. The significant progress in the restructuring of corporate foreign debts has reduced the demand for dollars as the repayment period of most debts has been rescheduled.

Critics of the International Monetary Fund program in Indonesia need to be reminded that more than $10 billion of the international reserves was derived from IMF balance of payments assistance. Even though these loans cannot be used for the state budget, they have contributed significantly to increasing the country's foreign reserves to such a level that is greatly effective to bolster market confidence in the rupiah and deter speculative trading on the currency market.

The concern that further appreciation of the rupiah would hurt exports seems premature because the rupiah is still far from what analysts and the central bank consider overvalued.

Moreover, experience has shown that rupiah depreciation has never been a major influence on export competitiveness. Security, smooth transportation, easier port handling, efficient customs clearance and low interest on working capital loans have instead been the strongest boosters of export competitiveness. Without these preconditions, exports would remain depressed even if the rupiah were to fall to as low as Rp 10,000, as it did in 2000 and early 2001.

The question now is whether the steady rupiah appreciation will be sustainable.

Most analysts are confident the virtuous cycle will continue if the government remains firmly committed to its structural reform agenda. The rupiah will appreciate at an even faster rate if the next few months see more positive developments that increase business confidence.

A smooth initial public offering by Bank Mandiri, the country's largest bank, and the strategic sale of Bank Lippo within the next few weeks will contribute further to the virtuous cycle. A higher pace of asset disposal by the Indonesian Bank Restructuring Agency will provide another building block for market confidence.

Credible preparations for exiting the IMF program later this year will further strengthen market confidence and enable the economy to weather the political turbulence expected in the 2004 election year.