Tracking foreign exchange

Tracking foreign exchange

Market speculation of possible foreign exchange controls and a
new exchange rate system will hopefully be laid to rest after
last week's legal assurance from the House of Representatives.
The bill on foreign exchange flows and exchange rate system,
approved by the House on April 20, does not stipulate any changes
in the open capital account and the free float of the rupiah
currently in force. The foreign exchange regime remains free and
open without any restrictions.

The new legislation, which is scheduled to come into force in
June, reaffirms that every individual and legal entity is free to
own and use foreign exchange. No restrictions whatsoever are
imposed on the amount of money transferred in and out of the
country or on the mode of transfer. As regards to the exchange
rate system, the law merely stipulates the system shall be
determined by the government after consultations with Bank
Indonesia.

It is encouraging that the government consistently sticks to
the principle of an open capital account at a time when several
countries, including Malaysia which imposed foreign exchange
controls, seemed more successful in maintaining their currency
stability during the peak of the currency crisis in Southeast
Asia last year. At current meetings of the International Monetary
Fund and World Bank in Washington, more economists are revisiting
the merits of restrictions on capital flows, notably the short-
term, volatile ones.

In view of the current economic crisis and virtual absence of
foreign investor confidence in the economy, Indonesia would be
ill-advised to tinker with its open capital account regime. This
system has become the most valuable asset and biggest advantage
the economy can still offer to international investors and
creditors. Without this free foreign exchange regime, not a
single foreign investor would be likely to enter the country to
help fuel an economic recovery, even after the election of a
credible government later this year.

Indonesia has learned valuable lessons that jarring, short-
term, volatile capital flows could wreak on the economy.

When the Indonesian government freely floated the rupiah,
abandoning the fixed trading band of the currency in mid-August
1997 in response to the fallout from the collapse of Thailand's
baht, it was caught off-guard in coping with market reaction.

The fact was that Bank Indonesia, the guardian of the
monetary system, was not adequately advised of foreign exchange
inflows, and was therefore completely in the dark about how
widely the country had been exposed to shocks of capital
outflows. Only in the first quarter of 1998 did the central bank
acquire a clearer, and indeed shocking, picture of the magnitude
of the private sector's foreign indebtedness -- more than US$80
billion, most of which was short-term and unhedged.

But instead of imposing outright controls, the new law focuses
on the establishment of an effective monitoring system to keep
the central bank adequately posted of foreign exchange flows,
ensuring it is well-informed to prepare and execute monetary
policies.

The legislation requires individuals, banks, companies and
other institutions to report to Bank Indonesia, or other agencies
to be appointed by the central bank, of transfers above a certain
amount in rupiah and foreign currencies into or out of the
country. The central bank is yet to set the amount above which
transfers must be reported.

An effective monitoring system, however, is only one of
several instruments needed for the effective management of
foreign exchange and external balance to maintain the rupiah's
exchange rate stability.

Apart from prudent macroeconomic policy, an adequately
supervised and regulated banking industry is quite crucial
because foreign capital flows primarily through the banking
system. In fact, the financial crisis has clearly shown how
disastrous is the combination of free capital flows and badly
regulated banks.

The new legislation on foreign exchange flows should be
welcomed as another instrument, which, together with the new
central bank bill being deliberated by the House and the massive
bank restructuring program, will greatly assist the government to
establish better management of foreign exchange and external
balance.