Hanke on Proposed Indonesian Currency Board
By Steve Hanke
By the first week of February, Indonesia's President Suharto knew
that he would be finished if he failed to stabilise the rupiah at
a reasonable level. Now President Habibie faces the very same
dilemma.
As Suharto saw it, the IMF, by its own admission, had botched the
closing of 16 banks in November. This aggravated Indonesia's
economic troubles by setting off a financial panic and capital
flight. In an attempt to stabilise the rupiah, Indonesia signed a
second IMF agreement on January 15. That agreement failed to
address the rupiah's problems.
Consequently, the markets promptly jumped all over the rupiah and
put it into a free-fall. Loaded with external debt, Indonesia's
private sector was bankrupt. Workers were losing their jobs. And
if that wasn't bad enough, prices were rising as a result of the
rupiah's devaluation and the Bank of Indonesia's (BI)
November-January explosion of credit.
What antidote could counteract this deadly cocktail? As Suharto's
special counsellor, I proposed a comprehensive rupiah
stabilisation program. Its linchpin was a currency board system
(CBS), an idea endorsed by Nobelist Milton Friedman and Margaret
Thatcher's economic guru, Sir Alan Walters, among others.
My program also included proposals for external debt
restructuring, bank restructuring and recapitalisation,
privatisation, a bankruptcy code overhaul and the break-up of
crony capitalism.
The CBS proposal, however, created a firestorm of controversy.
Why? After all, the CBS would have required the rupiah and US
dollar to freely trade at a reasonable fixed rate and required
the rupiah liabilities of the BI to be fully covered by dollar
reserves.
This would have tied the hands of the BI and Suharto, something
Suharto was willing to live with because it would have
permanently shut the BI's credit spigot, put an end to
Indonesia's currency crisis and kept Suharto in the saddle.
A variety of objections to the CBS proposal were raised. Most
were so well worn that an entire chapter of my 1994 book,
Currency Boards for Developing Countries, was devoted to refuting
them. But Indonesian-specific objections were also raised. One
concerned setting the exchange-rate at an "overvalued" level so
that Suharto and his family and friends could get their money out
of the country at a favourable rate.
The most disturbing aspect of this objection was the assertion
that I had recommended to "artificially" fix the rupiah-dollar
rate at 5,500. Such an artificial rate-setting recommendation
would have, among other things, contradicted all of my previous
technical work on the CBS. Never mind.
This assertion got legs when The Wall Street Journalÿ of February
10 quoted from a working paper that I had allegedly written for
the Indonesian Government. But I had never written any such
report or made any exchange-rate recommendations. One of the
article's authors subsequently acknowledged this error in
correspondence of February 12 and the Journalÿ finally fessed up
in a belated and muddled correction on February 19.
It was then that I realised that I would not only have to argue
the case for a CBS in the intellectual arena, which was my job,
but that I would also have to deal with certain elements of the
press that were intent on condemning the CBS idea by concocting
stories and letting their imaginations run amok. I set the record
straight on the exchange-rate objection at every opportunity,
most notably in a question-and-answer interview that appeared in
the International Herald Tribuneÿ on March 20. But this was to be
a Sisyphian task.
Indeed, the June 1 issue of Business Weekÿ was still peddling the
same old phony exchange-rate story. Without interviewing me or
bothering to read my IHTÿ interview, BWÿ claimed that I had
recommended a rate of 5,000, the rate for budget planning which
was contained in the January 15 IMF agreement.
Many critics argued that interest rates would increase sharply if
a CBS was installed. Indeed, no less than Michael Camdessus,
managing director of the IMF, made this claim in a letter he
addressed to President Suharto on February 11. But history
doesn't support this argument. The introduction of every CBS
since Hong Kong's in 1983 has resulted in a reduction in interest
rates.
The markets indicated that this would also happen in Indonesia.
Each time the markets anticipated the introduction of a CBS, swap
rates in the rupiah forward markets would fall, indicating that
the markets thought a CBS was viable and viable at lower, not
higher, interest rates.
In the meantime, the clock was ticking and by mid-March, the bean
counters in Jakarta were getting nervous. They informed me that
the BI's useable foreign reserves were running low. And without
adequate reserves, they claimed a CBS wouldn't be feasible.
I responded to that practical objection in a paper to the Credit
Suisse First Boston Investment Conference in Hong Kong (March
27). Under my new proposal, Indonesia would adopt a parallel
currency system, something that has worked well in other
countries. The existing stock of rupiahs would remain on the
books of the BI and in the pockets of Indonesians. But no more
old rupiah (OIR) base money would be created by the BI. The OIR
printing presses would literally shut down. Available reserves
would be used to establish a CBS that would issue a new rupiah
(NIR). The NIR would be linked to the US dollar via an absolutely
fixed exchange rate and the OIR would float against the NIR.
My last proposal was too late. Suharto had finally caved in and
waved off the CBS. On April 10, a third IMF agreement was signed.
It included all the elements in my proposal of February 26,
except the CBS linchpin.
And as I wrote in the Financial Timesÿ (April 22): "This is why
the third IMF agreement has little chance of success." Little did
I know that in only a few short weeks I would say in a Reuters
television interview from Geneva that "the whole thing is going
to blow up . . ."
Although some of the names have changed, Indonesia's problem
remains the same: it's the rupiah, stupid. As President Habibie
charts the course for Indonesia, he would do well to ponder on
the experiences of his predecessor.
The lesson to be learnt is clear: without a CBS and a stable
rupiah, everything is nothing.
Steve H. Hanke is a professor of Applied Economics at the Johns Hopkins University in Baltimore, Maryland. He was a special counsellor to former president Suharto in the early months of this year.
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