What awaits the erratic rupuah?

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.