ECONOMICS: Indonesia and currency peg
Far Eastern Economic Review
Feb 19, 1998

 Hanke Panky?
  * By Salil Tripathi
    475 Words

Indonesia appears set to take a dangerous leap of faith now that
Finance Minister Mar'ie Muhammad has said the government would establish
a currency board. It would set a fixed exchange rate for the rupiah
against a foreign currency, presumably the U.S. dollar. Under such a
plan, Indonesia's foreign reserves must be large enough to back all the
rupiah in circulation at the predetermined rate. No peg was announced
immediately, but some economists believe Jakarta will opt for a rate of
5,500 rupiah to the greenback.
   The move comes amid growing frustration in Indonesia that the
International Monetary Fund's programme of fiscal austerity and
financial reform is not showing results in stabilizing the rupiah. At a
meeting with Johns Hopkins University economist Steve Hanke, a
currency-board proponent, President Suharto warmed to the idea of a
fixed rate, lured by the prospect of quickly stabilizing the currency.
But others were aghast: Finance Ministry sources told the REVIEW that
technocrats are solidly opposed to the currency board proposal.
 Countries typically establish a currency board to set a floor for a
currency, keep inflation under control and boost confidence to encourage
foreign and local capital to return, according to analysts at Jardine
Fleming in Singapore. Under current circumstances, an Indonesian board
will achieve none of these goals. Boards work best for well-managed
economies that run large current-account surpluses to replenish their
foreign-exchange reserves. Though at the moment Indonesia seems to have
enough reserves to back the rupiah at 5,500 to the dollar, that pile
could easily evaporate if Jakarta does make good on its vague pledge to
guarantee some private-sector debt.
   On February 11, Indonesia's foreign reserves stood at $19 billion.
Its narrow money, or M1 (currency and demand deposits) at 5,500 rupiah
to a dollar was $14.2 billion.
   David Carbon, partner at Pacific Asset Management in Singapore, sees
a grim future ahead: "This is a drastic move for drastic times, and the
only way they can support it is by imposing draconian capital controls,
and that's not what currency boards are about. They are about inspiring
confidence, but this will instill fear. People will run for the door as
soon as it is in place."
   Christa Marti, economist at UBS Securities in Singapore, says if the
peg is established at 5,500 rupiah, traders and investors will
immediately switch to U.S. dollars even at the current rate of about
7,000 rupiah. In effect, they would be betting that the government won't
be able to keep the rupiah at what they see as an overvalued level
(particularly if the currency comes under attack from traders, as seems
likely). To stem the flight from rupiah, inter-bank rates will have to
go much higher. That in turn will make it even more difficult for
companies to repay debts and will exacerbate the already critical
problem of nonperforming loans at Indonesian banks.