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Why Indonesia must consider abolishing Rupiah JAKARTA - The crisis of confidence that has come back to haunt the rupiah for the second time in eight years is making some analysts wonder if Indonesia would be better off without a central bank. After all, what's the good of having a monetary authority when it can't protect the purchasing power of the currency it issues?

If Indonesian President Susilo Bambang Yudhoyono can get people to swallow nationalist pride, he should close down the central bank and dollarize. He would be doing the country's 239 million people -- not to mention investors -- a big favor. Having tumbled to a four-year low of 11,800 to the U.S. dollar on Aug. 30, the rupiah rose to 10,300 yesterday after the central bank raised interest rates to stem the decline.

The monetary tightening should have been taken place much earlier. Even if the currency doesn't fall much further, the damage has been done: The rupiah has lost 10 percent of its value against the dollar this year, the most of any Asian currency.

Those who say that the Southeast Asian nation was unlucky to get hit by high global oil prices miss the point that Indonesia doesn't have much of a balance-of-payments problem.

Sure, investors are concerned about the impact of higher energy costs on the budget deficit of the Indonesian government, which heavily subsidizes retail fuel prices.

Fuel subsidy

The subsidy cost will almost double this year's deficit to 48.3 trillion rupiah ($4.7 billion), President Yudhoyono said in a speech yesterday, vowing to reduce the support after October. Still, the ballooning budget deficit is only part of the reason for the loss of confidence in the rupiah.

A major chunk of the blame for the rupiah's woes must be laid on the central bank's doorstep. It has kept money far too cheap far too long. The central bank has had ample time to act to control inflation that has, even with subsidized oil prices, hovered between 7 percent and 9 percent this year.

As early as September 2004, when most Asian currencies were holding steady against the U.S. dollar in the face of the U.S. Federal Reserve's interest rate increases, the rupiah was down 8.2 percent for the year.

Clear mandate

"Bank Indonesia," Adam Le Mesurier, a Goldman Sachs Group Inc. economist in Singapore, wrote at the time, "needs to be clearer on its mandate. The recent refusal to raise interest rates in the face of a weaker rupiah and higher inflation illustrates the confusion in policy."

The central bank's first increase in the interest rate for rupiah deposited by lenders came in April this year, when it was raised by a quarter percentage point to 7.25 percent. Two subsequent increases, both in the final eight days of August, boosted the seven-day rate to 8.5 percent.

Interest rates may have to keep rising to stabilize the rupiah. As credit suddenly becomes expensive, the economy may slow, further weakening the currency.

Kurt Schuler, an economist in the U.S. Treasury's Office of International Affairs, had anticipated such a turn of events in 1999 in a paper he wrote advocating dollarization.

Just a year earlier, in 1998, the International Monetary Fund and Treasury came down hard on another American economist, Steven Hanke of Johns Hopkins University, for recommending a currency board to General Suharto, whose three-decade-long dictatorship came to an end because he couldn't save the rupiah and the economy from collapsing.

Argentina 2001

Dollarization, or replacement of the national currency with the U.S. dollar, euro, the British pound, the Japanese yen, or even gold, is slightly different from a currency board in which the central bank issues local notes convertible on demand into a foreign anchor currency at a fixed rate.

The currency board idea has become harder to sell since Argentina's debt default in 2001. Hanke says Argentina didn't really have an orthodox currency board, so his recommendation for Indonesia remains, he said in a telephone interview from Baltimore.

"The only way Indonesia can stabilize the currency is to take all discretion away from the Bank Indonesia," Hanke said. "It has no credibility whatsoever." Politically, dollarization may be untenable in Indonesia, a nation with a Muslim majority that opposes the U.S. war in Iraq. Politicians would be wary to canvass public support for adopting the dollar or the pound as the national currency.

From a pure economics standpoint, however, it can be done. Indonesia's $32 billion foreign reserves are 73 percent higher than its rupiah-denominated base money: local currency in circulation and bank deposits at the central bank.

Pride and prejudice

Informal dollarization already exists in Indonesia. Foreigners living in Indonesia often pay housing rents and school fees in dollars; travel agents quote prices in the U.S. currency.

"Indonesia would not be going through this turmoil if it didn't have its own central bank and its own currency," says Ross McLeod, an economist at the Australian National University and an Indonesia researcher since 1978.

No matter, Indonesia won't find it easy to dollarize. "The central bank," McLeod says, "would fight strenuously against a policy that would see it disappear." If only it would fight half as hard to establish credibility.

Posted in Economy @ 01 September 2005 by Jeroen · 'Blog' RSS feed · permalink

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