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s in its programs for the nations hit by the Asian crisis in 1997, the IMF’s programs for the Eurozone periphery also include a wide range of structural reforms as a lending conditionality.

The programs may have long-term merit, but their intermediate impact in restoring confidence and promoting growth is limited.

As they cannot devalue their money, the only instrument to increase the international competitiveness of the Euro periphery countries is to adopt a difficult and costly policy of “internal devaluation”, that is to lower the prices of their goods and services relative to other countries.

This is difficult to implement in the eurozone because of limited labor mobility and price and wage flexibility.

The Asian countries hit by the crisis in 1997 have switched to a flexible exchange rate system and adopted inflation targeting in monetary policy.

In theory, a flexible exchange rate system requires a smaller amount of foreign exchange reserves, as the system reduces the need for market intervention.

The need to build up external reserves has been reduced with the relaxation of the IMF conditionality requirements and creation of a regional safety net, namely the Chiang Mai Initiative (CMI).

In reality, for a number of reasons, all Asian countries, including those hit by the crisis in 1997, have built up large external reserves. This was done for several reasons.

The first reason was to limit credit growth induced by capital inflows and export booms and thus temper excess leverage and asset price booms.

The second reason was to enable governments to avoid extreme fluctuations in their currencies in a relatively shallow foreign exchange market, and thus prevent the adverse impacts on the economy and the balance sheets of the banking system and the corporate sector.

Third, was to mitigate fear of inflation from exchange rate fluctuations by providing greater exchange rate flexibility, particularly given the limited technical and institutional capabilities of central banks to implement transparent
inflation targeting.

To achieve inflation targets, central banks could appreciate its currency to lower the prices of imports.

Fourth, building foreign reserves also allowed the undervaluation of exchange rates to be adopted as an instrument to promote an export-oriented development strategy.

Fifth, it acted as a hedge against speculation and foreign exchange instabilities resulting from a shortfall in exports and from capital flow reversals.

Sixth, the foreign reserves gave nations adequate fiscal space when facing a crisis.

However, holding large foreign exchange reserves incurs large fiscal costs from the negative carry and capital loss in case of appreciation.

In the case of Bank Indonesia (BI), the nation’s central bank, its capital is eroding as the interest expense used to buy the foreign exchange is much greater than the rate of returns to its investment.

At present, the annual interest rate for BI’s SBI certificates is 5.75 percent, while the return from its investment in US Treasury bills is close to zero.

The economic costs in term of foregoing domestic investment opportunities are also large.

Following the Asian crisis in 1997, Asia developed local and regional bond markets to reduce reliance on short-term capital for financing long-term investment projects and therefore avoid the double currency and maturity mismatches.

The emergence of local bond markets in the crisis-hit Asian countries started with the issuance of sovereign bonds to recapitalize ailing banks. Country like Indonesia devised new sovereign debt strategies.

During the administration of Soeharto from 1966 to 1998, budget deficits were entirely financed by official development aid from foreign donors.

After the Asian crisis, the budget deficit has been financed by the issuance of sovereign bonds in local and international markets.

The end of financial repression following the crisis has encouraged the corporate sector to raise fund either through capital market or bond market.

Development of regional bond markets are promoted by the Asian Bond Market Initiatives (ABMI), under the auspices of ASEAN+3, and Asian Bond Fund Initiatives, promoted by the Executive Meeting of East Asia-Pacific Central Bank (EMEAP), and managed by the Regional Office of Bank for International Settlement in Hong Kong.

The writer is a professor of monetary economics at University of Indonesia and a former senior deputy governor of Bank Indonesia.