Turbulence in financial markets

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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