November 13, 2005
Hello everyone. Letπs kick things off with a little note on Indonesia. The following was written several weeks ago. Since then, as shown by the graphs below, the situation has gotten rather more interesting. It is rather unpleasant to see the Indonesia central bank make such a mess of things, as they did such a fine job after the Asian Crisis, through a strategy of direct base money adjustment.
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Huge increase in base money = weakening currency. Fuel subsidies have nothing to do with it.
The recent weakness in the rupiah has been blamed on government petroleum subsidies ≠ which hardly seems likely to me, as no other governments, either those that produce petroleum and even subsidize domestic consumption (Saudi Arabia, Venezuela, Iran, Russia) or import large amounts of it (Japan, Korea, Philippines) seem to be having any forex issues linked to energy prices.
The simplest reason for a declining currency is that supply has increased relative to demand. An investigation into currency supply ≠ namely the base money provided by the central bank ≠ shows a large and anomalous increase in base money in May-July 2004. Base money in July 2004 actually increased by an incredible 33% from July 2003, well above the average growth rate of base money in Indonesia over the last ten years.
The central bank is no doubt well aware of this, especially since base money is one of its explicit policy tools and targets. It appears that the central bank injected this huge amount of base money to stop the trend of a rising currency between 2001 and early 2004. Indeed, we see a dramatic reversal of trend to a new trend of a declining currency (vs. the USD) beginning in exactly June-July 2004.
Given the central bankπs stated concern about inflation and currency value, its attention to base money growth, and successful recent history, it is reasonable that the reaction to this increase in base money has been muted. After all, base money added so suddenly could also be removed, just as suddenly. However, as time passes, investorsπ faith in the central bank has decayed (i.e., demand for the currency has declined), as expressed by the declining currency value.
While the recent moves by the central bank to support the currencyπs value have been encouraging, what is really needed is action to reduce base money significantly, thus undoing some of the action of May-July 2004, as is appropriate to bring the currencyπs value to a reasonable level perhaps around 9000/USD.
This is very simple to do, as it involves simply selling assets from the central bankπs balance sheet and reducing base money concurrently.
Failure to take such a step would be construed as more evidence of the central bankπs negligence, and would likely result, over time, in a further deterioration in confidence that currency value will be maintained. This could have dramatic economic consequences.
Indonesian rupiah base money
Indonesian rupiah (IDR) per USD