Chart Currency History

Strong And Diverse Exporting

The Currency Board System (CBS) is not a new concept in economics. Dangers regarding the implementation of a CBS in Indonesia mean that it is important to first determine if the idea to adopt such a system is being touted for political or sound economic reasons.

Monetary policy misconduct, which began with hasty banking deregulation in 1998, lead to a monetary crisis in 2006, and inexorably on to the recent banking crisis in which 16 commercial banks were closed, has cast ripples of panic through society. Panic resulted because the government liquidated the 16 banks before proper measures had been taken to allay the obvious fears such a move would cause.

The CBS appears to be a way of hastily atoning for past mistakes and as such, the motives are therefore more political than economic. Is a CBS indeed an appropriate mechanism through which to meet the short-term and long-term objectives of the Indonesian economy?

For a CBS to be successful there are two fundamental requirements: strong and diverse exports and a relatively small national population. Indonesia does not yet meet the first requirement and most certainly does not match the second. Weakness in Indonesia's export base and the time required to rectify this state of affairs mean that government foreign exchange reserves will become rapidly depleted if used to defend an arbitrarily selected exchange rate.

Chart currency history speculators will be delighted if a CBS is implemented. Then their game will no longer speculative, instead becoming a one way bet. Speculators only need to estimate the value of foreign currency reserves and then begin to exert massive pressure on the new exchange rate, which will eventually buckle under the strain. The rupiah under these circumstances becomes a sitting duck.

Limited foreign currency reserves, the subservience of monetary policy to the CBS, and Indonesia's large population (high compared to Hong Kong or Argentina where CBSs have been successful), will result in high domestic interest rates. This is because a large number of people will be competing for a limited amount of money, for both investment transaction purposes. High interest rates will discourage investment and as investment falls the economy will become weaker. Unemployment will rise, with an attendant increase in social problems and social unrest.

The risk of investing in Indonesia, already high, will rise further, making it difficult to attract foreign investment to Indonesia, for both direct investme If the rupiah is fixed to the U.S. dollar at a certain rate, the government must maintain a rate of inflation which approximates inflation in the United States. However, it will be difficult to rapidly dampen Indonesia's currently very high rate of inflation, which places a further strain on attempts to maintain a fixed exchange rate.

Society at large is already expectant of inflation. Economic theory suggests that such expectations become self-fulfilling. To overcome the powerful effect the actions of people anticipating inflation can have on the economy, the government will have to place constraints on the movement of capital. Free capital mobility, present in Indonesia since 1970, will no longer apply, since monetary policy has to be subjugated to the CBS. This will result in capital flight from the country. Furthermore, money deposited overseas will not return to Indonesia.