A Magic Bullet For Indonesia?

But pegging the rupiah to the dollar probably won't work

Is the answer to Indonesia's economic problems a currency board? That's what embattled President Suharto suggests. By permanently linking the exchange rate of the rupiah to the U.S. dollar, currency volatility could be reduced, indebted Indonesian corporations could begin to repay loans, and politics would be removed from setting monetary policy--a big reason that Indonesia is in the current mess to begin with.

Suharto first raised the possibility on Feb. 9 that the country might adopt an independent currency board. A day later, Finance Minister Mar'ie Muhammad confirmed that the government already was working on regulations to do so. The news pushed the rupiah, which had lost two-thirds of its value over the past six months, up 32%. Indeed, given their recent successes in countries as diverse as Argentina, Hong Kong, Estonia, and Bosnia, currency boards have their merits. Even Thailand is considering adopting one. "Currency boards are ideally suited for crisis situations, and we have a crisis," says Johns Hopkins University professor Steven Hanke, who has met with Suharto to discuss foreign exchange strategy.

NO CREDIBILITY. Hanke adds that a currency board could help provide the stability necessary for Indonesia to move ahead with controversial reforms such as those the International Monetary Fund is pushing. Says Hanke: "You can't do economic reforms in the middle of a hot crisis because everyone's worried about where they're going to get their next pound of rice."

Despite Hanke's optimism, the chances of making a currency board work in Indonesia are slim. The country is financially hamstrung, and its political leadership lacks credibility and is notoriously interventionist. Some analysts even think that Suharto has no intention of freeing the rupiah from government control. "Lots of people are skeptical that this is just a game to manipulate the exchange rate and breathe life into a handful of ailing companies," says Paribas chief currency strategist Nick Parsons.

If the government talks up the value of the rupiah, skeptics contend, politically connected businesses and banks will be able to buy dollars at better rates than they could when the rupiah, on a spike, was at a record low of 20,000 to the dollar. Suharto, charges one Hong Kong-based hedge-fund manager, "is grasping for a fix-it solution that favors his family." Some Indonesia-based analysts fear that once these companies pay off some of their foreign debts, any commitment to a currency board will evaporate and the rupiah will plunge anew.

On the surface, a currency board seems to do little more than formalize what most of Southeast Asia was already doing before the crash--keeping exchange rates closely aligned to the greenback. These artificially pegged exchange rates created too much confidence in the strength of Asian currencies. Private borrowers, who normally might have hedged their foreign currency exposure, felt no need to do so. "As current-account deficits grew wider and currencies became overvalued, that confidence collapsed," says Robert D. Hormats, vice-chairman of Goldman Sachs (International).

But a currency board is a fixed-rate regime with a difference (table). Unlike the system that existed in many Asian countries, a currency board puts a country's monetary policy on autopilot, giving local politicians and central bankers no say over monetary policy. Linking local monetary policy to that of the U.S., as Argentina has done, basically means that Federal Reserve Board Chairman Alan Greenspan runs the show and determines local interest rates.

Under a currency board, all of a country's coins and notes are convertible into dollars or other hard currencies at a fixed exchange rate. The board must hold reserves equal to 100% of the cash in circulation. New currency can be created only through balance-of-payments surpluses. If inflation or political turmoil rises and investors lose faith in the local currency, a currency board system allows them to withdraw bank deposits and cash them in. That, in turn, would pummel demand for the local currency and send interest rates through the roof. If they go high enough, investors might be persuaded to come back.

But the cost to the economy could be enormous. Indonesia already is facing severe social unrest, with 12-month interest rates at 61%. If rates went into triple digits, as some economists think possible under a currency board regime, that would send the economy into an even worse tailspin than it's experiencing now. Unemployment and inflation would rise, asset prices would collapse, and locals would hoard food. A currency board is an "incredibly austere mechanism," says Walter Molano, director for economic and financial research at SBC Warburg Dillon Read. "It's akin to going on a diet by wiring your mouth shut."

A currency board for Indonesia could face other problems. True, it would help stabilize the currency in the short term. But by linking the rupiah to the dollar, Indonesia risks desynchronizing its monetary policy from those of its local trading partners. Since Indonesia's economy is not big enough to allow it to operate on its own as a global player, it must align itself with other regional economies. Indonesia's biggest trading partner is Japan, not the U.S., notes Jim O'Neill, London-based chief currency economist for Goldman, Sachs & Co., who believes Suharto should peg the rupiah to a trade-weighted basket of yen and dollars.

Another obstacle is choosing a fair exchange rate for the rupiah. At the start of the crisis in July, the rupiah fetched 2,400 to the dollar. By the end of January, the buck was worth 18,000. It's now around 7,250. So which rate, if any, is right? If the currency board sets the rupiah's value too high, demand for dollars would grow astronomically, and local interest rates would have to soar as everyone cashed out. Too low an exchange rate would fuel inflation--already estimated at 50%--and make it even more unlikely that Indonesia would be able to repay its $137 billion foreign debt.

Market rumors now suggest that Suharto is considering an exchange rate of 5,500 to 6,000 rupiah to the dollar--a substantial strengthening from its current value. But many analysts feel this rate is unrealistic. "I don't know how many countries could sustain the kind of oppressively high real interest rates that a currency board at those levels would mean," says a Hong Kong-based money manager.

MANY SKEPTICS. With $19 billion in currency reserves left in Indonesia's coffers, such a rate would only be enough to cover the rupiah in circulation. The remainder--$55 billion to $60 billion--would not be covered, estimates Joyce Chang, managing director of international emerging markets fixed income at Merrill Lynch & Co. Thus, if speculators were to attack the rupiah or there was a massive flight of capital overseas, Indonesia's money supply would shrink. Until the country earned more dollar reserves, it wouldn't be able to print new money to refloat the economy. For the same reason, a currency board would prevent Suharto from trying to rescue troubled banks by printing money.

For a currency board to succeed in Indonesia, it also would have to have the backing of official creditors. At the World Bank, officials are privately skeptical. They fear that a currency board could exacerbate capital flight if it's improperly structured. IMF Managing Director Michel Camdessus is also wary. "It's a useful instrument, but it has limitations, " he says. "It is a strong medicine. You must be sure the body will be in appropriate shape each time you use a strong drug."

That's the key. A currency board alone will not buy Indonesia credibility--a commodity in short supply in this resource-rich nation. Suharto's government needs to show it is committed to economic and political reforms. And Indonesian consumers have to be willing to undergo the pain of monetary shock therapy. But these are big ifs, and at least a currency board will buy time. Lately, that's all Indonesia can afford.

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