Commentary: Indonesia: A Currency Board Is No Magic Bullet

Is the answer to Indonesia's economic woes 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 cut, Indonesian corporations could begin to repay loans, and politics would be removed from monetary policy--a big reason Indonesia is in the mess it's in.

Since Suharto first raised the possibility on Feb. 9 that the country might adopt an independent currency board, the rupiah, which lost two-thirds of its value in the past six months, rose 32%. Boards have been so successful in places as diverse as Argentina, Hong Kong, and Bosnia, that even Thailand is considering one. Proponents say a currency board will provide the stability necessary for Indonesia to move ahead with controversial reforms such as those advocated by the International Monetary Fund. "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.

A DIVE? But the long-term success of a currency board in Indonesia is dubious. The country is financially hamstrung, and its political leadership lacks credibility and is notoriously interventionist. The word among foreign investors is that Suharto's real motive is to protect the financial interests of his family and friends. If the government talks up the rupiah, skeptics say, favored businesses and banks will be able to buy dollars at better than market rates. The fear is that once these companies pay off some foreign debts, any commitment to a currency board will evaporate and the rupiah will plunge anew.

At first glance, a currency board could be a panacea. It puts a country's monetary policy on autopilot, giving local politicians and central bankers no say. Linking local monetary policy to that of the U.S., as Argentina has done, basically means Federal Reserve Board Chairman Alan Greenspan sets interest rates. All of a country's cash is convertible into dollars or other hard currency 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.

But the cost to an economy can be enormous. Indonesia already faces severe social unrest, with 12-month interest rates at 61%. If rates went into triple digits, as some economists expect, 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."

Then there's the exchange rate dilemma: No one has the faintest idea of what a fair rate for the rupiah should be. If the currency board sets the rupiah's value too high, demand for dollars would grow astronomically, and local interest rates would soar as everyone cashed out. Too low a 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. Yet Paribas chief currency strategist Nick Parsons contends that's unrealistic. With $19 billion in currency reserves left in Indonesia's coffers, such a rate would only be enough to cover the rupiah in circulation. A remaining $55 billion to $60 billion would be exposed, says Joyce Chang, managing director of international emerging markets fixed income at Merrill Lynch & Co. If speculators were to attack the rupiah or there was a massive flight of capital overseas, Indonesia's money supply would shrink.

TOO SMALL. By fixing 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.

A currency board alone would 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. These days, that's about all Indonesians can afford.

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