Defending a stable rate: The central bank steps in to avoid rapid currency fluctuations

While government spending has not been a key driver of growth thus far, monetary policy has remained the key instrument of macro-economic management. Affected by balance-of-payments crises exacerbated by currency volatility, the central bank has maintained a watchful eye on the rupiah, which rose 14.4% against the dollar in 2010 and stands as the fastest-rising currency after the Singapore dollar in 2011.

The international carry trade from low-interest-yielding economies towards high-yielding ones explains some of the rise, as do inward investment levels. Compared to ballooning budget deficits, exponential debt burdens, stagnating growth rates and looming ratings downgrades for many Western economies, Indonesia makes a convincing case for investment. Bank Indonesia (BI) has taken long strides in establishing its credibility for prudent macro-economic management. The authorities are eager to avoid a repeat of the 1997-98 crisis when BI used its foreign reserves to defend a currency target; the aim remains to avoid rapid movements in the currency but not to change its direction.

BRINGING STABILITY: The rupiah has long been vulnerable to rapid swings in sentiment. Its upward trend in early 2011 dampened some inflationary pressure but then fell below the Rp9000-per-dollar mark over late summer 2011 in the face of large foreign portfolio outflows. Although by no means as large as in 2008, when the rupiah dropped to Rp12,000 per dollar, the central bank has intervened to reduce the swing. To do this, BI has used central bank certificates (SBIs), relatively costly at 6.75%, government bonds and, mainly, buying and selling foreign exchange on the open market.

The central bank has historically shied away from using more than $1bn in a short period in such ways, fearing a depletion of its foreign currency reserves. Yet with over $123bn in backing as of September 2011 it has increasingly moved to prove its ability to reduce rapid swings. It used more than $2bn in open-market operations in a single week in September, for instance. The government has also tabled measures to allow state-owned enterprise and budgetary funds to buy rupiah government bonds should capital flows reverse sharply.

These moves have been welcomed by investors.

NEW MEASURES: BI introduced new earnings repatriation measures that will be mandatory by January 2012 requiring companies to store export revenues and the proceeds of foreign loans in Indonesian financial institutions. But whereas countries such as Thailand and Malaysia mandate a minimum onshore stay period for such funds, Indonesia allows them to move offshore again after only one day, meaning the measures are more meant as a monitoring instrument for real export earnings rather than to bolster foreign currency reserves in-country per se. “These earnings repatriation measures are not capital controls since the law passed under the IMF programme of the late 1990s expressly forbids such controls,” Fauzi Ichsan, senior economist and head of government relations at Standard Chartered Bank, told OBG. According to BI, around $110bn of Indonesia’s $140bn in yearly export earnings are repatriated onshore, while $30bn remains offshore. If even 10% of this repatriated revenue remained in Indonesian banks, this would come to an extra $3bn-5bn in foreign currency in the domestic economy.

The central bank has imposed restrictions on the trading of SBIs to control potential large capital outflows. It placed a one-month minimum holding period for SBIs in June 2010, further raising the period to six months in May 2011. In the first quarter of 2011 a limit of 30% of bank’s capital was imposed on short-term foreign loans to cap excessively speculative carry trades.

BI also introduced a term-deposit facility for banks to reduce dependency on SBIs, raised requirements for foreign currency deposits, and increased its supervision of foreign exchange transactions and capital flows.

Large flows still have the potential to cause excessive swings in sentiment on the markets as in mid-2011, yet strong FDI inflows and the central bank’s keen vigilance are likely to ensure any wider macro-economic impact through the current account is rapidly addressed.