Managing exchange risk amid volatility

Winarno Zain ,  Jakarta   |  Tue, 03/25/2008 12:43 PM  |  Opinion

Iran's President Mahmoud Ahmadinejad once decried the dollar as a" worthless piece of paper". Of course the value of the greenback is nowhere near that point yet. But the precipitous fall of the U.S. dollar last week has pushed its level to below 100 yen -- at one point it reached 96 yen -- and to below one Swiss franc, a level not seen since the mid 1990s.

The extreme volatility in the currency market resulting from the credit crisis in the U.S. is being reflected in the wild swing of U.S. dollar exchange rates against other major currencies. Those who are exposed to exchange risk, whether in the form of assets or liabilities, are facing intricate problems of how to better manage this risk to avoid losses. These risks are not specific to corporate sectors.

As the aftermath of the credit crisis in the U.S. is still unfolding, uncertainties hang over the direction of the currency market, and the risk of foreign exchange exposure all of a sudden weighs heavily on central banks all over the world. They together have accumulated almost $6 trillion in reserves.

The Central Bank of China, which is sitting on a $1.4 trillion reserve, must be facing an acute dilemma. It can sit idly by and watch its dollar assets crumble, or it can dump its dollar holdings immediately, pushing the dollar into a tailspin. If this happens, it would be a disaster of unprecedented scale for the world economy.

How would this turmoil in the currency market affect the Indonesian economy? The effects would come in three ways: through trade, the government budget and the central bank reserve. The U.S. only supplies 9 percent of Indonesian imports. But around one third of Indonesian imports come from strong currency countries like the EU and Japan.

China, whose currency, the yuan, is posed to appreciate, is becoming a major supplier of Indonesian imports with its 15 percent share. With this pattern of trade, it is clear raw materials imported from these countries would be more expensive for Indonesian manufacturing industries.

The wild fluctuation in currency exchange rates would also adversely affect the Indonesian government budget if not handled properly. Already beset by mounting fuel subsidies, the 2008 budget would bear more burden from the government's external debts denominated in strong currencies that have been appreciating against the U.S. dollar. A higher debt service burden could not be avoided because a sizable part of government debts are denominated in these currencies.

The Indonesian government's external debt stood at US$81.2 billion at the end of 2007. But out of this amount, only 52 percent was denominated in U.S. dollar. The rest is denominated in strong currencies like the euro and yen. Last week, these currencies appreciated around 5-6 percent against the dollar.

This means that in only one week, the government debt in euro and yen rose by $2 billion, or the equivalent of Rp 18 trillion. This is not an insignificant amount for a budget whose viability is being threatened by ballooning oil subsidies. To cover the widening deficit in its budget, the government could cut spending on routine expenditures, education, health and infrastructure. But it cannot cut debt service payments that fall due.

In preparing the budget draft every year the government only makes assumption on the rupiah exchange rate against U.S. dollar, and does not specifically make assumptions on U.S. dollar exchange rates against other major currencies. This is a bit of a mistake since rates among major world currencies are bound to fluctuate -- sometimes wildly -- which could heavily influence the budget.

Therefore it is important for the government to make specific assumptions on U.S. dollar exchange rates against major currencies in the budget to make the budgeted figures more realistic.

The demise of the U.S. dollar will also impact on the central bank (BI)'s foreign exchange reserve. BI is currently sitting on a $55 billion reserve, a record amount. Most of this, or around 70 percent, is invested in U.S. Treasury notes.

The dollar's plunge and continuing cut in Federal Reserve discount rates have resulted in a decline in the value of the BI reserve. Valued against currencies such as the Japanese yen or euro, the BI reserve is currently worth $2 billion less than a week ago.

These losses occur at the time when BI is struggling to reduce interest burden it pays to Bank Indonesian certificate (SBI) holders. The outstanding SBI stood at Rp 268 trillion at the end of 2007, a 30 percent rise over the same period last year. The SBI is still one of the favorite investments for investors who are having difficulty in finding attractive returns for their funds. Rapid accumulation of SBI is a by-product of BI policies in the past.

In order to protect exporters from too much rupiah appreciation, BI since 2005 has frequently conducted interventions in the money market by purchasing U.S. dollar. Between September 2005 and August 2007, these purchases amounted to $21 billion. But because these actions could be inflationary, BI had to sterilize the rupiah it pumped into the market by issuing more SBIs with attractive rates.

Even though the spread between SBI rates and the yield of U.S. Treasury notes has narrowed because of several cuts in BI rates, with a 4 percent yield on U.S. Treasury notes -- and still declining -- the negative spread still incurs high costs for BI.

BI still maintains a small fraction of its reserve in gold. This is unfortunate since the price of this metal has soared from $500 per troy ounce three months ago to $1,015 last week. BI might regret that gold is a mere 3.5 percent of its portfolio, too small to function as a buffer against the declining value of its dollar reserve.

Developments in the currency market are moving rapidly, and because it is difficult to predict the direction of the market, a new paradigm in reserve management is called for. The first instinct of a central bank in managing its currency reserve is to take a conservative stance and avoid risk.

But this approach is only appropriate in normal conditions. But in times of turmoil, where normal relationships among market forces are crumbling, the conventional way of managing exchange risk could result in the lost opportunity of making gains.

Managing exchange risk needs foresight, better forecasting and a willingness to undertake calculated risk. Unless both BI and the government realize this, they will be unable to avoid suffering losses from their foreign exchange exposures.

The writer is an economic analyst.

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