The target is low inflation, not a specific exchange rate

The target is low inflation, not a specific exchange rate

Vincent Lingga, Jakarta

The inflationary pressures resulting from the 29 percent
increase in fuel prices in March seem to have receded, as can
be seen from the significant decline in the inflation rate last
month to 7.40 percent, on an annual basis, from 8.12 percent in
April.

However, the finance ministry apparently agrees with the
central bank (Bank Indonesia)'s analysis that the assumption for
the rupiah exchange rate for the current fiscal year should be
revised to a range of between Rp 9,000 and Rp 9,300 from the
original projection of Rp 8,900 made last August. Meanwhile, the
inflation assumption is to be revised upward to an average 8
percent.

The revised assumptions have been made necessary because the
average rupiah exchange rate in the first five months of this
year had depreciated to almost Rp 9,400. In fact, the local unit
fell to as low as Rp 9,800 against the American dollar late in
April.

This development raises two major questions.

Does it mean that the central bank will now target the rupiah
exchange rate at a specific level?

Then, why have rupiah exchange rate movements not matched the
significant improvements that have taken place in political and
macroeconomic stability, especially after the peaceful, clean and
fair legislative and presidential elections last year?

Bank Indonesia's Senior Deputy Governor Miranda Goeltom gave a
"definitive no" to the first question on Thursday.

"We cannot target our exchange rate. Our target or objective
is low inflation," said Miranda at business luncheon hosted
jointly by the Indonesian French Chamber of Commerce and
Industry, the Indonesia-Netherlands Association (INA) and
Eurocham.

That means that the rupiah will be allowed to move within a
market-determined mechanism whereby Bank Indonesia uses its
instruments to achieve low inflation by taking the exchange rate
into account.

Put another way, the central bank will manage the exchange
rate with the primary objective of ensuring low inflation as
exchange rate movements directly influence inflation through
higher import prices.

After all, it is virtually impossible to have a stable
exchange rate in a country with an open-capital account and
floating exchange-rate system.

But why has the rupiah not appreciated since January despite
the significant improvements in economic fundamentals and
political stability?

Miranda cited inflationary pressures and a lack of supply of
foreign exchange as the main reasons.

Lack of supply seemed to have been a common phenomenon,
especially after the sizable increase in new investment over the
last four months, as reflected in the almost 34 percent rise in
imports during the January-April period, notably imports of
capital goods.

This seems rather an unusual phenomenon. But this trend
indicates that investment expansion has been derived mainly from
domestic investors, not from foreign direct investment.

Inflationary pressures due mainly to the March increase in
fuel prices had prompted the central bank to soak up excess
liquidity in the market by steadily raising its short-term
interest rate to as high as 8 percent now, thereby curbing the
movement from rupiah to dollar assets.

Dollar assets have offered higher returns after the U.S.
Federal Reserves increased its Fed funds rate to 3 percent now.

However, managing the exchange rate through either direct
market intervention (increasing foreign exchange supply) or money
tightening appears to be a delicate balancing act for the central
bank.

"We don't want to go to the market just to meet the private
sector's demand (for foreign exchange)", Miranda said.

That means that Bank Indonesia will not intervene in the
market if it believes that the increase in demand was caused
mainly by "unexplained factors" (such as an increase in demand
not supported by underlying transactions, meaning speculative
trading).

"We are monitoring the market very closely and our capability
to analyze the supply and demand movements have much improved,"
she added .

Further down the line, it suggests that the central bank will
intervene only if it comes to the conclusion that there really is
a genuine gap between supply and demand that can be explained
based on structural factors, such as in case of state-owned oil
company Pertamina's need for foreign exchange to import oil.

The government and central bank agreed late in April that
Pertamina, which needs large quantities of foreign exchange for
its daily operations, and other major state companies should
coordinate their dollar purchases with the central bank to
prevent shocks in the market.

Bank Indonesia has been criticized or misperceived by analysts
and market players as often being caught on the hop or being too
late in defending the rupiah.

But as Miranda explained,"We don't want to let unexplained
factors in exchange rate movements pass into the inflation rate."

Unexplained factors include an increase in demand that is not
supported by underlying transactions.

In the long run, however, Miranda believes that the best way
to save the rupiah from wild volatility is to woo foreign direct
investment and increase exports.

This means that economic fundamentals should be strengthened
by improving the general business climate to stimulate robust
domestic and foreign investment.