Political uncertainty is taking its toll again on the rupiah. The Indonesian currency slid above the 9,000 level against the US dollar yesterday, notwithstanding the improvement seen in IndonesiaÆs economic fundamentals in recent months and the fact that the rupiah is currently deeply undervalued. Bank Indonesia, for instance, estimates fair value of the rupiah to be about 6,500 against the dollar. However, taking into account US-Indonesian inflation differentials since the last maxi-devaluation in 1986, the fair value of the rupiah in purchasing-power parity (PPP) terms could even be as low as 5,000 per US dollar, barring the usual measurement errors.
By all measures, the rupiah is heavily undervalued: how long will it remain so?
History shows that the rupiah eventually reverts back towards its fair value as investor confidence in IndonesiaÆs fundamentals is restored, either through a pick-up in inflation or through a renewed appreciation in the rupiah. Until then, there is little that Bank Indonesia (BI) can do to engineer a recovery in the rupiah. Following brief foreign exchange interventions in support of the currency, BI deputy governor Gultom stated yesterday that BI would not defend the rupiah anymore by means of interventions or a sharp increase in interest rates. (Foreign exchange interventions may, of course, be employed to slow down the pace of any further slide in the rupiah.)
We believe that this is the most appropriate strategy. Firstly, event risk is at the heart of the rupiahÆs current weakness. A resurgence of domestic unrest in the Moluccas and Aceh has been followed by political developments, which cast doubts about the resolve of the current government to tackle IndonesiaÆs huge problems. The detention of BI governor Sabirin may have unnecessarily compromised the autonomy of Bank Indonesia û one of the countryÆs few technocratic institutions û while president WahidÆs stand-off with parliament suggests that the political power struggle is far from over. Finally, only patchy progress has been made in achieving the structural reform targets agreed with the International Monetary Fund (IMF) on, for example, the reform of the Indonesian Bank Restructuring Agency, public enterprise audits and asset disposals ahead of another IMF review at end-July.
Secondly, BI has little reason to raise interest rates in response to the weakness of the rupiah. Money market rates of 10% to 12% are high in nominal and real terms in view of year-on-year inflation of just 2.14% in June. Inflationary pressures are also not likely to pick up in any major way as the economy is still operating at significant excess capacity, which should limit the pass-through of import price inflation into headline inflation.
Financial conditions, in any case, remain very tight as bank prime lending rates are at a crippling 32%, owing to a dysfunctional banking system burdened by a high stock of non-performing loans. A rise in interest rates may, in this respect, add to the banking systemÆs woes by raising its funding costs û in turn increasing its negative cost of carry. Moreover, with current high bank lending rates unlikely to result in a resumption of bank credit growth, monetary reflation may even prove to be desirable in future in order to avoid a debt-deflation spiral in case money supply growth turns negative.
High real deposit rates of approximately 10%, in any case, may not have prevented a recurrence of capital flight. Although data on external debt repayments remain sketchy, IndonesiaÆs foreign exchange reserves are still under strain from sudden, unexplained, step-up in capital flight. Notwithstanding recurring monthly current account surpluses of roughly $500 million, foreign exchange reserves dropped by $2.25 billion in May, while in June foreign exchange reserves increased by only $200 million in spite of a $370 million IMF loan and likely higher oil export receipts. (The idea of an imposition of capital controls is, however, a non-starter given the negative impact this would give on the repatriation of flight capital and export earnings).
Finally, implied forward rates of around 14% have failed to provide much protection to the rupiah. In a similar vein, we believe that the creation of an offshore forward market a la Thailand would also do little to support the rupiah as informal credit limit restrictions on Indonesian banks among foreign banks have already created a de facto two-tiered forward currency market.
Given the lack of a significant forward premium on the rupiah, long positions on the currency should be avoided until the political situation settles down. Of note, in this respect, would be the outcome of the IMFÆs July review and, in particular, president WahidÆs accountability speech to the PeopleÆs Consultative Assembly in August. We believe, moreover, that the Indonesia 2006 sovereign should be trading at least 150bp wider over T-bonds (T+750-800) and 200bp to 250bp wider over the Philippine sovereign in view of ongoing event risks.
Pieter van der Schaft is an Economist at Barclays Capital in Hong Kong.
