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.