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ndonesia and other emerging economies with flexible exchange rates are the main victims and are carrying a double burden from the ongoing currency wars and Quantitative Easing (QE) in advanced economies.

Indonesia and other ASEAN countries suffer disproportionately from the (Renmimbi) RMB undervaluation as under ACFTA (ASEAN-China FTA) they had begun to reduce both tariff rates and non-tariff barriers (NTB) in 2005. Full implementation of the ACFTA started on Jan. 1, 2010.

But the weak RMB is now replacing tariffs and NTB as an instrument of trade protection as currency undervaluation subsidizes Chinese exports and taxes her imports. Export of agriculture manufacturing products from Indonesia and other ASEAN countries cannot compete with similar products from China in weak global markets. The drop in export of these products has been partly compensated by the rise in exports of primary goods, including energy, mainly due to the rapid economic growth, industrialization and mechanization in both China and India.

Indonesia and other emerging economies are also suffering from QE in advanced economies that print fresh money to buy long-term government bonds. Such monetary policy preserves interest rate disparity between Indonesia and international markets that encourages surges of short-term capital inflows into emerging economies, in search of higher yields.

The combination of the boom in export of primary products and the surges of short-term capital inflows has caused overheating in our asset markets including the relatively small bond and capital markets. The surplus in balance of payments also appreciated our Rupiah both in nominal as well as in real terms to cause the Dutch disease to our economy. There are four costs of the Dutch disease to the economy.

First, the rupiah appreciation erodes competitiveness of our economy in international markets. The currency appreciation is like a tax to our exports and subsidy to our import that makes our export more expensive and import cheaper. Second, it reduces the efficiency of the economy, as the stronger rupiah provides incentive for the mobility of resources from the more productive traded sector of the economy to the less productive non-traded sector. The shift ignites a bubble of assets including land and property markets. A traditional monetary policy instrument, such as the interest rate, may dampen the bubble but exacerbates the imbalance and capital inflows.

Third, it creates regional disparity as the booming natural resources are mainly produced off Java while the affected agriculture and manufacturing sectors are primarily located on the labor surplus island of Java. The fourth cost of the surges in capital inflows is making our financial system less efficient as their sources of funding are more relied on foreign borrowings.

Unlike China, Indonesia has no strong bureaucracy to implement tight capital control. BI also has a limited capacity to absorb the capital inflows and accumulate foreign exchange reserve to prevent appreciation of the rupiah. This is partly because our shallow and narrow money and capital markets are less integrated with global markets. Moreover, the financial costs sterilization operations are very expensive for BI and the opportunity costs for the economy are also very high.

At present, monetary policy instruments at BI’s disposal are only limited to SBI, its certificates, FASBI (its facility to absorb excess liquidity) and standing facility. The Finance Ministry has issued a small amount of Treasury bills. To buy foreign currency, BI issues SBI that carries an interest rate of 6.9 percent while its investment in the US dollar only earns less than 3 percent. BI pays interest rates for FASBI and sells foreign currencies at lower rates. Depreciation of the US dollar further reduces yields from a portfolio in that currency. The larger financial losses from holding bigger foreign assets will negatively affect the liquidity position of BI and erodes its equity capital. Recapitalization will tarnish reputation and independency of the central bank.

Under the IMF Program in 1997-2003, Indonesia shifted to an independent floating exchange rate system, supported by inflation targeting. This means that an exchange rate target is no longer used as an anchor of monetary policy. In theory, a flexible exchange rate requires a smaller war chest of foreign reserves as the system reduces the need for market intervention.

In reality, however, during the past 10 years, the nominal value of the reserve position of Indonesia has tripled from US$29 billion in 2000 to more than $90 billion today, although the percentage share of GDP has gone down from 15 percent of GDP in 2003 to 13 percent in the third quarter of 2010.

There are four reasons why Indonesia needs to accumulate foreign exchange reserves. First, they could serve as a tool for intervention to avoid a large exchange rate fluctuation and prevent an adverse impact on the economy. BI needs reserves to cover the potential capital flow reversal particularly because the shares of foreigners in government bond and SBI markets are quite dominant, close to 30 percent. On the positive side, the presence of foreign capital stabilizes our nascent securities markets and makes them more liquid. Our own institutional investors, such as pension funds and insurance companies are still undeveloped.

The second reason for accumulating foreign exchange reserves is to prepare for a defense against speculative attack and foreign exchange instability due to shortfalls in export and capital flow reversal. Because Asian countries were treated badly during the crisis in 1997, they are quite reluctant to turn to the IMF.

Third, the less volatile exchange rate minimize currency risks and provides incentive for overseas borrowing, particularly when international exchange rates are lower than domestic interest rates. The fourth reason is to provide for a fiscal space when facing economic crisis.