What awaits the erratic rupuah?

By Seamus McElroy

JAKARTA (JP): After hitting Rp 16,000 to the U.S. dollar in mid-June in the aftermath of the May riots, the rupiah staged a gradual comeback to hit Rp 7,000 in early November. Since then the rupiah to dollar rate has weakened again, this time by nearly 30 percent, to Rp 9,000 to the dollar last Friday. The question now on everyone's mind is "Where to now, my rupiah?"

In the rush to dump the currency in late May and June, the rupiah had been heavily oversold. Its recovery was encouraged by the return of a sense of political and social normalcy coupled with a tightening monetary policy to reign in the vast sums of money in circulation by offering high short term interest rates, initially at an annual rate of 70 percent falling to 50 percent by mid-November.

During that period, the appreciation of the rupiah relative to the dollar was supported by a host of both external and internal factors.

The yen came off its floor of 146 yen to the dollar after August, gradually appreciating to 112 yen to the dollar by last Friday, pulling with it the battered currencies of the region. Japan's banking system was not going to implode just yet. And Korea, Thailand and Indonesia were seen to be serious in addressing their own banking and bad debt problems.

Internally, the Indonesian government also seemed to have the International Monetary Fund (IMF) on side with its economic recovery policies. Bank depositors had the government's assurance that both principal and interest payments would be guaranteed.

This, coupled with the high profile billion dollar monthly loan payments to the country by the IMF, the trade current account in hefty surplus to the tune of $2.5 billion per month, plus the government's active support of the appreciation of the currency through its large dollar purchases of rupiah, all served to put a floor under the rupiah and signaled the government's determination to defend the currency's appreciation against attack.

Riots, looting of property and racial and religious attacks on people flared up in different parts of the country, but were quickly brought under control.

The downside risks of the currency again spiraling out of control were seen as becoming increasingly unlikely in the short- term.

The turning point was the Black Friday shootings on the night of Nov. 13 as the House of Representatives/People's Consultative Assembly session was drawing to a close and the subsequent looting the same night and the following day in Chinatown.

In the two months since, the rupiah has gradually weakened against the yen and dollar, hitting Rp 8,000 to the dollar in the last week of 1998, and sliding to Rp 9,000 in the first two weeks of January.

There are two questions to answer.

First, why has the rupiah weakened since early November?

Second, where is the rupiah heading from here in the short- (one month) to medium- (three to six month) term.

In other words, what forces are likely to be driving the currency in the next 3 to 6 months?

I have already given part of the reason for the fall in the rupiah since early November. The Black Friday shootings and subsequent looting were a small replay of the May riots six months earlier. It brought into focus that the seven months leading up to the election and possibly beyond was likely to see a continuation of the student demonstrations of the previous nine months together with the risk of a spread in racial and religious violence.

This increase in country risk requires either an increase in interest rates or a weakening of the currency, relative to where either would otherwise be.

In the period from mid-November to mid-December, interest rates came down from 56 percent to 36 percent -- by too much too quickly. While perhaps justified in terms of the rapid fall in inflation, as the election process approaches it will be necessary to slow the decrease in -- or increase -- short-term interest rates gradually to defend the currency.

Since the start of 1999, four new factors have come into play, causing the rupiah to slide: 1. the government's macro-economic position has become clearer, but its ability to finance it is currently a lot less certain; 2. the sum of the budget and the capital refinancing of the banking sector is expansionary, requiring debt financing of the order of $40 billion to $50 billion over the next year and, taken together with the refinancing of other parts of the corporate sector, is likely to stoke up inflation well above the government's target of 17 percent; 3. the new draft rules on the reporting of foreign exchange transactions include reporting the origin of the money and the possibility of Bank Indonesia arbitrarily imposing a rate of exchange different to that in the spot market, thereby increasing the risk of holders of the currency and those holding funds in Indonesia, possibly leading to some capital flight taking place, and; 4. in the last few days, fall-out from the devaluation and subsequent floating of the Brazilian real has hit confidence in most other weak currencies, such as the Indonesian rupiah.

Given the above, in the absence of raising short-term interest rates, the rupiah has started to slide.

Second, where is the rupiah heading in the short to medium- term?

That, as always, is anyone's guess, because it depends upon a number of factors, only some of which are currently in the market.

On the international front, the first issue is the appetite for taking on risk in emerging markets. This has been severely dented three times in the past 18 months, first with the Asian crisis, next with Russia and now with Brazil.

Assuming no major external shocks over the next six months such as no significant devaluation of the Chinese yuan, it will then depend upon the assessment of relative risk-reward by the pool of investors interested in Indonesia compared to other emerging markets.

The current perception is that the crisis in Asia is bottoming out, thereby limiting the downside risk, added to which there are a significant number of assets which can be bought at good prices.

Within Indonesia, the government has a difficult call to make. While it can finance its own budget deficit from loans secured at prime rates from the World Bank and Asian Development Bank, for the recapitalization of the banking sector it is taking on commercial risks.

It will want to obtain the best rates it can on this commercial debt. But to determine the appropriate rate, it will have to offer at least some of this paper on the international and domestic bond markets. But the huge increase in government debt burden taken on will increase the premium on government debt in the international bond market, reducing the government's capacity to finance this debt and, if too much paper is issued, putting the country at risk of another speculative attack on the currency.

Clearly, it is a delicate balance in which the flow in time and volume of calls on the capital market, from both government and the private sector, will be as critical as the total amounts called for. Also, not all of this new paper will find a home.

The key advantage of going to the market over the next one to 12 months is that, with interest rates at historic lows in the major economies, the prospect of achieving reasonably priced financing could not be better -- provided you offer very low credit risk.

Add to this the timetable for the election in June, and the next six months could see Indonesia through the worst.

Putting all this together suggests that on the short to medium-term view, the exchange rate of the rupiah to the dollar is likely to become increasingly volatile and, in the absence of a rise in interest rates, will tend to weaken i) first until the government's macro-economic financing is clarified, and ii) from April until the election process is over and the composition and orientation of the new government and president is clear.

Provided there are no major external or internal shocks to greatly affect confidence, the rupiah could gradually weaken (or interest rates be hiked) until mid-June, after which, provided the markets and Indonesian people like the composition of the new administration, the country risk premium should lessen, the rupiah could strengthen (or interest rates come down) gradually and exchange rates could become less volatile during the second half of 1999.

The writer is an economist based in Jakarta.