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 I watch with great concern the proposal to adopt a currency board to solve the unfolding financial crisis in Indonesia and the IMF's strong objections to the idea.

 Should Indonesia adopt a currency board arrangement (CBA)? Well, if I may use the twin categories of "efficiency risk" and "systemic risk" again (Tsang 1998), the answer is related to two key issues.

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Efficiency Risk

 1. What kind of CBA is Indonesia going to adopt? The classical currency board based on specie-flow and cash arbitrage? Hong Kong's idiosyncratic version of "linked exchange rate"? Or the AEL model of cashless/electronic arbitrage? In other words, can the Indonesian CBA even keep the spot exchange rate firmly in line? This is the first defense. If it is not secured, the following, second, question would be irrelevant.

The classical currency board based on cash arbitrage is doomed to become history soon, at least for modern economies of non-negligible sizes. Despite the lack of efficient arbitrage, Hong Kong has been able to defend its half-baked "currency board" regime because of huge reserves (40% of total HK$ deposits) and "sound" economic fundamentals. Indonesia does not possess those "strengths". Hence the country should adopt right away the AEL model of convertible reserves, which binds the whole banking system through electronic arbitrage to quote narrowly around the fixed exchange rate. But is the Indonesian banking system ready for the model, in terms of hardware and software, as well as its financial viability at the pegged rate eventually chosen?

Systemic Risk

2. Granted that the Indonesian CBA, whatever form it takes, can hold the spot exchange rate of the rupiah firmly through an efficient arbitrage mechanism, hence eliminating the "efficiency risk", how could it inspire confidence in market participants that the CBA (especially regarding the specific fixed rate of the rupiah against the designated anchor currency---the US dollar?) would not be abandoned in the future, out of economic or political considerations?

In other words, even a "perfect system" to fix an exchange rate could still be sacrificed not because of its own technical faults, but as a result of exogenous and environmental factors. This constitutes a "systemic risk" which must be carefully addressed, with a view to balancing short-term stability concern and long-term exit cost calculation (Tsang 1998).

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So.....

My feeling is that the AEL model would go a long way in helping Indonesia to reduce the efficiency risk of the rupiah, barring disastrous cracks in the banking system. As to systemic risk, it is everyone's guess. The IMF seems to be pre-occupied with such a risk.

The choice of the peg is very important: while banks are forced to quote around the official rate because of efficient arbitrage, they would also be the first victims, if non-confidence degenerates into massive capital flight---or "currency substitution" (Tsang 1984). But remember what happened in Argentina in 1995: 20% of peso deposits lost within a few months; and sixty banks went under. Still the system survived! In any case, the IMF is rightly wary of a systemic failure. A CBA is one of the most "rigid" fixed exchange rate regimes that can be designed in the modern context. Think twice when you have to use your last ammunition.

Another successful CBA in East Asia would certainly help the Hong Kong link to exile its sceptics. If the AEL model is adopted, it might also serve as an enlightening "tutorial" for Hong Kong. But what about the backlash of a failed attempt? Indonesia should think carefully whether the country can manage the two types of currency board risks and ensure economic peace for itself. Its decision would have repercussions far beyond its national boundary in the current "crisis atmosphere". My best wishes!

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References

Tsang, Shu-ki (1984), "On the Cash-based Fixed Exchange Rate System", in The Pearl in the Mouth of the Dragon: Collected Essays (in Chinese), Hong Kong: Wide Angle Press, 179-201.

Tsang, Shu-ki (1998), "Currency Board Complications: The AEL Model for Hong Kong?", 9 February, http://www.sktsang.com/ArchiveI/web982.html.

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Epilogue (17 February 1998)

On second thought, Indonesia may enhance the chance of successfully using the AEL model to fix its problems through a "dual track " approach:

1. The government could announce that some time in the future, say six months or one year from now, a currency board system that would fix the exchange rate at a realistic level would be adopted.

2. Within the period, the government should do its best to implement measures and reforms that address the most crucial problems in the economy.

Such an approach could help to stabilize or even anchor future expectations, and buy time for the government. Of course, at the end of the day, the perception of systemic risk would only be alleviated through effective measures and reforms, as well as the return of political stability.

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