Indonesia and a Currency Board -- Another Bad Idea

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The word is out:

President Suharto

is going to set up a currency board to peg the rupiah to the dollar. Is there any end to the financial mismanagement of poor

Indonesia

?

The story in yesterday's

Wall Street Journal

makes interesting reading. Basically, Suharto's children went around the old man's ministers and brought in Professor Steven Hanke. Hanke is the

Johns Hopkins

professor who goes around the world telling everyone that fixed-exchange regimes are best and the way to go is a full-blown currency board.

A currency board is kind of a doomsday machine. Here's how it works: The board becomes the issuer and backer of the national currency. It pledges to hold an amount of "hard" foreign currency equal to the amount of national currency in circulation. At all times, the board is supposed to stand ready to buy or sell the national currency in exchange for hard currency reserves at the established, pegged exchange rate. People like Hanke, and apparently also Suharto, think this is a bulletproof fixed foreign exchange system.

But wait a minute. The currency board is the issuer of the nation's money supply. Hence, anytime the board buys back the national currency, here the rupiah, the country's money supply drops. One other factor worth noting: This means that if there is ever a run on the national currency, the currency board in effect has to stand there and reabsorb the national money supply. Hmmm. That is what is called a unsterilized foreign exchange intervention -- and it will lead to immediately higher interest rates and quite likely a ruinous recession.

You know what else it will do? If my instincts as a trader are right, two things will happen. First, a lot of Indonesians who want out of the whole damn mess are going to use the board to convert their rupiahs to dollars. Right now it is not clear that they are permitted to do so, as I have pointed out before. Second, the existence of a currency peg at this time is going to effectively hang a three-concentric ring target on the rupiah. And there is nothing that the foreign exchange world loves more than the declaration of a target. Target practice, everyone!

J.P. Morgan Gets Stiffed in Korea

Here is a little creative bailout finance, Korean style.

Bloomberg

reports today that a Seoul court has blocked a $180 million payment to

J.P. Morgan

from

Boram Bank

on losses from currency swaps. The Boram swap with Morgan was back-to-back with a deal that Boram did with its customer

SK Securities

. The court seems to agree that Morgan should have done more to warn of the risk of investing in derivative securities. Some of this doesn't make sense -- the ultimate customer, SK Securities, here has successfully sued to prevent its counterparty, Boram, from paying Morgan -- not that that didn't stop the Korean court. I am reminded of an old Arabic saying here, "me against my brother; my brother and me against a foreigner." Meanwhile the whole episode points to yet another way that the Korean financial nightmare can spread through the financial system. Swaps, by the way, are off-balance sheet items and as such may not be covered by the agreement between the Korean government and creditor banks to restructure bank debt.

Quotes of the Day

"You'd throw the whole damn country out of work." -- Mark Malloch Brown, chief spokesman for the

World Bank

, on the consequences of the Indonesian currency board. (Feb. 10

WSJ

)

"First,

Suharto went to the IMF doctor, who prescribed a bitter pill and told him to wait for it to work. But he thinks it's not working, so he goes to a dukun (traditional healer) for a quick fix." -- senior economic official of Suharto government. (Feb. 10

WSJ

; Professor Hanke is supposedly the dukun)

David DeRosa heads a trading research firm and is an adjunct professor at the Yale School of Management. His column on international finance and trading appears Mondays, Wednesdays and Fridays. He welcomes your feedback at

derosa@derosa-research.com.