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.