Currency reserves: The new balance of power
Calvin Michel Sidjaja
The latest economic report showed that Indonesia enjoyed 6.4 percent economic growth in the second quarter of 2012. This development is positive as the situation in other markets remains gloomy.
The unemployment rate in the US has not shown any improvement, the eurozone is plagued by sovereign debt problems and recession, the latest economic data shows Italy’s economy has contracted 0.7 percent and Japan has been hit by the appreciation of the yen which has caused its exports to become uncompetitive.
However the good news was overshadowed by bad news from the trade sector. In June 2012, Indonesia posted a trade deficit of US$1.5 billion even though it had narrowed to $180 million by July. The rupiah has been one of the worst performers among Asian currencies this year. Currency reserves have depleted alarmingly. Indonesia’s offical reserves declined to $106 billion by June, despite them posting a high of about $116 billion in April.
Bank Indonesia has taken a stance against attacks on the rupiah. On Aug. 6, several foreign lenders were forbidden to withdraw US dollars. They are likely to be followed by others.
Other countries, such as Argentina, have made similar efforts. In August, Argentina imposed stricter regulations to control dollar flight. Under the new policy, travelers are barred from purchasing dollars unless the dollar is the currency of their destination.
The cases of Argentina and Indonesia remind us of an issue that has long plagued the international economy and emerging markets: Dollar dominance.
Despite the rising influence and role of emerging markets, the US dollar is still the de facto global reserve currency.
Numerous attempts to establish an international currency have been made throughout history without success. From 1870-1914, the world adopted the gold standard, where currencies of the major economies were pegged to the amount of gold stored in their vaults, and people could exchange their money for gold. Gold served as collateral to ensure central bankers did not abuse their power and print money excessively. This system was dropped following World War I.
After World War II, major economies tried to establish another international currency and adopted the Bretton Woods System, where the dollar served as the international currency and was exchangeable with gold. This system collapsed in 1970s. However, the dollar remains the de facto global currency, backed by nothing but an empty promise.
The negative effects of dollarization were highlighted in 1998 when Asian economies collapsed due to currency devaluation.
It started with an attack on the Thai baht, which was followed by massive devaluation of other countries’ currencies such as the rupiah and South Korea’s won. The crisis was devastating because many corporations issued bonds in dollars. The currency devaluations left businesses unable to pay their dollar liabilities and many went under.
This caused ripple effects. Indonesia’s economy contracted by about 16 percent in 1998, and the rupiah plunged to an all-time low of Rp16,800 to the dollar. Interest rates spiked to 20 percent to ensure people did not sell rupiah and buy dollars.
Years later, in 2009 and 2010, emerging markets enjoyed currency appreciation due to the effects of the Federal Reserve’s quantitative easing (QE).
Regarded as printing money, quantitative easing is a policy of central banks buying bad debts from financial institutions to increase liquidity in the system. In theory, these purchases should reduce interest rates, increase credit and loan disbursement and gear up the economy.
However, even after QE1 and QE2, the US economy has not recovered much. Instead, the financial institutions placed their money into the safe havens, such as US treasury bonds.
Furthermore the effect of this money printing was the devaluation of the dollar during the period from 2009 to 2011, causing emerging markets to enjoy a degree of appreciation. While a strong currency is desirable for emerging markets, rapid appreciation disrupts exports and reduces profits in export-based economies, and possibly causes de-industrialization as people prefer to import instead of producing.
By 2012, the effect had worn off. The hot money has gone as eurozone sovereign debt has exploded. Dollars flew from emerging markets as fast as they had entered. The currencies of Asian countries are weakening, stock market rallies have stalled.
Theoretically, pumping money into the system will reduce confidence in the currency and cause hyperinflation as exemplified by Zimbabwe. This has not actually arisen mainly due to the absence of another currency that could replace the dollar.
The US has run a trade deficit for years with China. There is not much the US can do to combat China’s cheap currency. Quantitative easing is a powerful tool to devalue a currency and make exports more competitive. The US has nothing to lose as it still has the most trusted currency in the world.
It is impossible to escape the dollar, therefore there should be strategic planning to “de-dollarize” the Indonesian economy, for example by formulating incentives for corporations and the private sector to reduce dollar usage by using bilateral swap agreements with their biggest trading partners.
The balance of currency reserves is the new balance of power. As long as countries continue trusting the dollar, their economies will remain dependant on the United States.
It is important to reduce this dependency before emerging markets become entangled in a currency war.
The writer is a research associate at Royston Advisory Indonesia. The views expressed are his own
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