ECONOMICS: Indonesia and currency peg
Far Eastern Economic Review
Feb 26, 1998

Hankering for a Peg:
 Indonesia forges ahead with its currency-board plan
  * By Salil Tripathi in Jakarta
    1029 Words

It was more of a classroom lecture on monetary policy than a press
conference. Although a roomful of reporters fired a barrage of questions
at him, Steve Hanke deftly picked the few he wanted to answer and evaded
the rest. For the most part, he talked in his slow, purposeful manner,
spectacles perched on the bridge of his nose, about the economic
rightness of a currency peg for Indonesia in these troubled times. It's
an idea championed by Hanke, who has emerged as President Suharto's
economic guru in recent weeks. And it is creating much heartburn for the
country's economic policymakers.
   The president's insistence on taking Hanke's advice to peg the
floundering rupiah has led to a stand-off with the International
Monetary Fund, which has threatened to withdraw a $33 billion bailout
package if he goes ahead with plans to set up a currency board to
implement such a link, presumably to the U.S. dollar. The IMF believes
such a radical measure cannot work in Indonesia under the present
circumstances: The country's reserves are low, banks are weak, and
corporate debt is high. Reserves are needed to back the peg, and banks
need to be strong to withstand high interest rates. High corporate debt
means the government's coffers could be drained of foreign currency as
companies pay off foreign loans.
 Hanke refuses to define the preconditions necessary to establish a
board. Neither does he accept that there could be a run on U.S. dollars
as soon as a currency board is set up. The Johns Hopkins University
professor -- who comes across as a preacher with a missionary zeal that
sometimes borders on the arrogant -- argues that nothing in the
IMF-Indonesia memorandum prevents a currency board. Dismissing his
critics as inaccurate and ignorant, he says: "My plan is not a
substitute to IMF; it complements the programme."
   The rupiah initially rose to 7,000-levels against the dollar on news
of the currency-board plan, but it later tumbled to about 10,000 as the
plan met criticism from the IMF and world leaders. Australian economist
Michael Backman says: "The world is on the verge of deserting Suharto
and the markets certainly have. The rupiah is now an accurate messenger,
and by attempting to fix it, Suharto is simply trying to shoot the
   Worse, he is destabilizing the region. Other currencies such as the
baht and the ringgit, which had been strengthening before the feud broke
out, declined in tandem with the rupiah, although they have since
recovered somewhat. With uncertainty growing over Indonesia's economic
future, the region may have to deal with even more turbulence -- Thai
Prime Minister Chuan Leekpai told the REVIEW that the world views the
region as a single unit.
   Jakarta's challenge to the IMF's prescription of austerity and reform
also comes at a time when many are questioning some elements of its
severe prescription for Thailand and South Korea. The U.S.-supported IMF
programmes will bring unemployment and bankruptcies in the short term as
they try to rid those countries of economic deadweight and make them
more efficient. That makes the fight over how to fix the Indonesian
economy a defining moment in the seven-month old Asian crisis.
   To be sure, the IMF's opposition to a currency board is not
doctrinaire. In fact, the multilateral agency in the past has
recommended just such a system for troubled economies in Bosnia, Estonia
and hyperinflationary Argentina. Indeed, Hanke's main success has been
in Argentina, where an autonomous currency board is constitutionally
mandated. Says an economist familiar with Hanke's work: "He is a highly
successful salesman who sells his device to all countries, whether small
ones like Estonia, where it is probably appropriate, or large ones such
as Russia, where it is not."
   Critics say it isn't appropriate for Indonesia either. The country's
reserves are a mere $19 billion, compared with the $30 billion-40
billion that economists believe would be needed to back a currency
board. In addition, about $30 billion of private foreign debt falls due
this year. Once dollars are affordable at a pegged rate, companies may
decide to buy huge amounts to pay off their debt, thus reducing
reserves. In addition, many economists question whether Indonesia could
weather the extremely high interest rates -- by some reckoning as high as
200% -- that a currency board might require if people shift money en
masse from rupiah into dollars. (Rates of 300% were seen in Hong Kong's
interbank market in October when exactly such a move happened; they have
since fallen as depositors return to local currency.)
   Hanke dismisses this scenario, holding up the examples of Bulgaria
and Argentina, where interest rates actually fell after currency boards
were set up. But Neil Saker, head of economic research at SocGen-Crosby,
points out that such a turnaround would happen only in economies reduced
to a rubble, where any credible, austere step like a currency board
inspires confidence. Indonesia hasn't experienced such severe
hyperinflation and isn't yet in such dire economic straits.
   Some economists argue that much of Indonesia's problem with the IMF
package has to do with Jakarta's failure to implement its conditions
faithfully. The first deal struck in mid-November flopped when, among
other things, Indonesia backtracked on cancelling certain infrastructure
projects. Implementation of a revised package in mid-January has been
equally half-hearted: A plywood monopoly meant for the axe survives, and
monopolies continue to grow -- an exclusive new water-supply contract
was recently given to Suharto's grandson, Ari Sigit.
   Not surprisingly, local business people who want cheap dollars
believe the president should be allowed to try the option of a currency
board, since the IMF in their view has clearly failed to stabilize the
rupiah. Argues James Riady, deputy chairman of the Lippo group: "The
system has the potential to provide a stable currency and manufacturers
can start planning to do business."
   For the moment, though, it seems the currency board can take off only
with IMF support. And that won't happen unless Indonesia implements
promised banking and debt-repayment reforms. Faced with global
opposition to his plan, Suharto may buy time by delaying implementation,
perhaps until August, by which time domestic banks should have begun
restructuring in earnest.