Weakening fundamentals worsen rupiah free fall

Riyadi Suparno, The Jakarta Post, Jakarta

The rupiah's plunge over the past few weeks may not have spoiled last weekend's wedding party for President Susilo Bambang Yudhoyono's son, but it could eventually undermine his government.

For most people, especially those in the middle class, the rupiah's fall to over Rp 9,800 a dollar -- its lowest level since March 2002 -- will likely serve as one more visible sign, after the fuel shortages, of the government's failure to meet their needs.

Although the responsibility for guarding the rupiah lies more with Bank Indonesia, the government also shares responsibility for maintaining the stability of the rupiah.

According to a special report on the rupiah by Standard Chartered Bank, the recent fall of the rupiah is not just a matter of an imbalance in the supply and demand of the dollar and rupiah, but rather is the result of the country's weakening fundamentals.

This includes the deteriorating current account due to rising imports as a result of increased domestic demand. The current account surplus is expected to drop to about US$2 billion this year from almost $2.9 billion last year and $8.1 billion in 2003.

Another fundamental factor weighing on the rupiah is the government's suspension of the privatization program for state- owned companies. Whereas president Megawati Soekarnoputri was quick to sell state companies, President Susilo is taking a more cautious approach to privatization. So far, very few dollars have been raised from the privatization program under Susilo.

As a result, the supply of dollars from trade and privatization has declined, thus providing little support for the rupiah.

The government seems to have expected this decline, and hopes to compensate for it by increasing official capital flows as a result of multibillion foreign grants and loan commitments from donors to help rebuild Aceh following the tsunami.

Foreign money for Aceh has indeed begun to trickle in, but less than expected because of perceived problems of governance in Indonesia.

Despite the weak official capital flows, the government and the private sector had hoped for better private capital inflows this year following the $5 billion acquisition of the country's second largest cigarette producer, HM Sampoerna, by Philip Morris of the United States.

Looking into the details of the acquisition, however, the expected dollars will not enter Indonesia any time soon.

According to Standard Chartered Bank's report, the Sampoerna family, who received $2 billion for its 40 percent stake in the cigarette company, has not reinvested the money in Indonesia. Also, more than 70 percent of public investors who sold their stake through a tender offer were foreigners, who may not hold on to their rupiah. Last, Philip Morris funded the purchase partly by borrowing rupiah onshore.

Thus, the expected private flows have not yet materialized, and consequently, no additional support is coming for the rupiah.

This delicate situation has been worsened by rising crude oil prices in the international market. As Indonesia becomes a net oil importer as a result of a lack of private investment in the oil sector, the government -- through state oil and gas company Pertamina -- has to fork out more dollars to import fuel to meet a quarter of the country's demand.

While dollar support for the rupiah is slim, the dollar has suddenly strengthened globally as a result of rising interest rates in the United States.

On the other hand, the adjustment of local interest rates has been too slow, compared to the rate increases in the United States. The U.S. Federal Reserve has raised its benchmark rate by 225 points to 3.25 percent per annum, while Bank Indonesia has only raised its benchmark rate by 90 points to 8.25 percent.

As a result, people with excess liquidity have been dumping their rupiah and rushing to the greenback.

Given the situation, where the weakening of the rupiah has been driven by both global factors -- the strengthening of the dollar -- as well as weakening local fundamentals, the government and Bank Indonesia must strengthen their cooperation to defend the rupiah.

Bank Indonesia should continue to do its part by adjusting its interest rates so real interest rates -- interest rates adjusted to inflation -- are positive, and by smartly intervening in the market.

To make the measures more effective, the government needs to do its part to help increase the supply of dollars in the market.

The government should be commended for instructing state and state-owned companies to repatriate their dollars from offshore to onshore banks. However, it is a challenge to persuade private exporters to bring their dollar earnings back to the domestic market.

The government also needs to improve its governance to help expedite the disbursement of money for Aceh, and thus increase the dollar supply in the domestic market.

But most importantly, both the government and the central banks need to take longer term measures to bring the rupiah to the desired level of Rp 9,000 per dollar by improving economic fundamentals; especially better inflation management by the central bank and sound fiscal policies by the government.