Turbulence in financial markets
The turbulence in the foreign exchange and stock markets in Indonesia and other Asian countries will continue until the Federal Reserve finally decides on how much it will increase its funds rate and businesses have made reasonable assessments of the impact of monetary tightening in China, the world's fourth largest trading nation. In Indonesia, however, the financial markets will encounter intermittent bouts of tumult until the completion of its presidential elections later in September.
For the past few months the markets have been expecting a hike of at least 0.25 of a percentage point in the U.S. funds rate, which currently stands at 1 percent, but most analysts now see this happening some time in June or in August at the latest.
Widespread concern over the impact of monetary tightening in the world's two largest economies were mainly responsible for the steep falls in both the rupiah and stock prices last week. Certainly, the wait for the Fed's final decision has produced uncertainty that caused the market to overreact and sent the rupiah off on a roller-coaster ride to lows of Rp 9,000 to the American dollar at times compared to a range of between Rp 8,300 and 8,500 previously, before the national unit finally strengthened again. The Jakarta stock exchange index also declined markedly as many investors made a bee-line for dollar assets.
Fortunately, the country's internal factors have remained largely positive, thereby helping prevent panic in the markets.
The positive review of Indonesia's economy by the International Monetary Fund's Executive Board was a positive new factor that helped prevent bearish market sentiment from spinning out of control. The review, based on the IMF's surveillance of Indonesia's economic policies for 2004, commended the government for making significant progress in its macroeconomic policies and key areas of structural reform.
Standard & Poor's upgrading of the outlook on the long-term credit rating of the Indonesian state last Wednesday further contributed to warding off excessive speculative attacks on the rupiah. Standard & Poor's revised the outlook from stable to positive, reflecting continuing progress in establishing macroeconomic stability, as evident from falling inflation, a relatively stable exchange rate and lower interest rates.
However, both the IMF and the rating agency tempered their praise with strong recommendations for a quicker pace of structural reform, especially in the financial services, judicial, legal and labor sectors. The IMF particularly warned that Indonesia would continue to lag behind other countries in Asia with regard to growth, investment and exports if it did not adequately address its remaining structural weaknesses.
The IMF urged the government to maintain tight oversight of state banks to ensure that their lending practices are in line with sound banking standards. Apparently concerned over the particular vulnerability of state banks to fraud and corruption, the IMF Board also urged the government to increase private- investor participation in these state banks.
The multilateral agency called for special attention to be paid to addressing weaknesses in the area of tax administration and recommended that emphasis be placed on avoiding arbitrary tax assessments, illegal fees, burdensome customs procedures and inefficiencies in the refund system for value added tax and income tax.
Consistent implementation of the reform agenda is more important than ever now to maintain relative stability in the foreign exchange market and sustain market confidence in the outlook for the economy in view of the two uncertainties currently affecting it -- one related to the upcoming Fed monetary measure and the other one connected with the presidential election on July 5.
The next six months will present great challenges. While the government is preoccupied with the national political scene, it will also have to weather potential bouts of heavy turbulence in the financial markets stemming from both external and internal factors.
However, policy consistency on the part of the government could reduce the duration and impact of such turbulence. Tight monitoring by Bank Indonesia of foreign exchange transactions in the wholesale interbank market would help prevent excessive speculative attacks on the rupiah. In this context, the plan by the central bank to tighten its rules on banks' net foreign- exchange positions should be welcomed as this move will restrict the net differences between banks' off-balance sheet assets and liabilities.
The rupiah should be protected from wild volatility as too steep a fall in the rupiah could set off a massive panic in the market and stoke strong inflationary pressures, thereby severely threatening macroeconomic stability.
It would also be a major help if presidential candidates and their running mates refrained from making confusing, controversial statements or anti-market and anti-foreign investor declarations during the upcoming campaign.
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