In 1970, US$1 was equal to ¥360, and it was equal to Rp 363. Today $1 is equal to Rp 13,455, while it is equal to just ¥123.8. In June 1997, $1 was equal to Rp 2,380, and it was equal to 2.5 ringgit and 25 baht. In July 1998, one dollar was equal to Rp 14,150, and it was equal to 41 baht and to 4.1 ringgit. What a difference, what a nightmare.
In almost three years between June 2012 and May 2015, the rupiah depreciated 38 percent, while the Indian rupee depreciated 12.4 percent. We are also haunted by a current account and trade deficit. Why? In this article we argue that the exchange rate should not be based only on a short term horizon, but rather a longer one.
Indonesia is rich in natural resources. Japan is not. Does the so called “curse of natural resources” apply to Indonesia? We first visit the case of the US economy, which is now the champion of trade and the current account deficit.
The US economy has suffered a trade deficit since 1971. Initially it was one that was quite small. It then grew bigger and in 2014, it was $508.3 billion dollars. In spite of its very advanced scientific and technological achievements, the country has a big trade and current account deficit.
Before 1971 the US was always in net trade surplus where the net export of goods was much higher than net service imports.
In 1973, Daniel Bell predicted the coming of a post-industrial society dominated by services and the decline of manufacturing.
The idea seemed to permeate the general economic thought and policy circles at the time, and the service sectors became US prima donnas. One of the most vital activities following this was finance closely related to the real estate business.
The new trend was preceded by several related events, such as the collapse of the Bretton Woods fixed exchange rate, the Yom Kippur war and the quadrupling of oil prices, and the financial invention of Black and Scholes that revolutionized the financial sector.
By digging deeper into the economic structure of the US, it appears that the dominant activities in the economy are in the FIRE (Finance, Insurance, and Real-Estate) sectors.
The largest sector is real estate, where its cashflow in the form of EBITDA (earnings before interest, taxes, depreciation, amortization) accounts for over one quarter of national income.
In addition, mortgages account for 70 percent of the US economy’s interest payments. Real estate is the financial system’s major customer.
Behind this fact there is the American Dream, which states that every family should have their own home.
But its financial consequences tell a different story. Housing represents the biggest form of wealth for most families in the US.
In line with that, the US economy’s largest asset is real estate, the source of the largest capital gains.
Real estate is part of the non-tradable sector. The economy is divided into the tradable and the non-tradable sectors. This brings us to the domain of the real exchange rate, which is understood as the ratio of prices of non-tradables with the world price of the tradables in a national economy.
The most popular meaning of an exchange rate is the price of one currency in terms of another currency. There are two methods of determining a real exchange rate, namely the purchasing power parity (PPP) and the above ratio of tradables to non-tradables.
An additional approach is through the market, the equilibrium price of the supply and demand on a certain currency, namely for US dollars in Jakarta.
In this section, we will discuss the tradables and the non-tradables approach, because it should be one of the important policy issues on the exchange rate policy.
In the US, the trade deficit, as one important part of the current account balance, is closely related to the tradables and the non-tradables issue.
Manufacturing, as an important part of the tradables, has been less favorable to the US economy compared to services.
The trade deficit has been put under scrutiny, where recently the net trade surplus in services is just one seventh of the value of imports in merchandize.
In the case of Indonesia, we refer to the sector composition of GDP from 2005 to 2013, showing the result that non-tradables were growing higher than tradables.
Analogically to the US, the non-tradables comprise of the housing sector, local trade, hotel, transport, communication, and so on.
The tradables declined between the years 2005-2013, while the non-tradables rose. This means that the non-tradables are more attractive than the tradables.
One of the spectacular facts about housing is that it has a backlog of more than 10 million units. This is a seller’s market, potentially giving them economic rent.
Theoretically we can calculate the change in the real exchange rate (RER) or the internal exchange rate.
Roughly, we get a decline in the RER of 25 percent within the period, approaching the market fall of the rupiah to the US dollar.
In Indonesia, there is a close connection between the financial sector and the non-tradables, namely in the financing of car and motorcycle loans, in real estate and so on.
The previous finance minister, Chatib Basri, once stated that financial institutions received big profits, but tax revenues were very low.
In the US, tax on capital gains is very low or nonexistent, where it is found mostly in the capital markets and the property sector.
In Indonesia, it is quite similar, which could be the factor behind the attractiveness of non-tradables. The taxation system could achieve better results by reforming or improving its collection system.
A good management of the exchange rate should be the result of cooperation and coordination between the central bank and the finance ministry.
From the publications from the Bank Indonesia (BI) regarding the exchange rate, we may conclude that the BI is mostly studying the exchange rate issue through the analysis of market transactions.
And the central bank relies on the inflation targeting instrument for setting the inflation policy, which is also used as a background to evaluate the exchange rate.
Both represent a short-term horizon, and the role of economic fundamentals in the interplay of the tradables and the nontradables issues will not be accommodated.
The hidden state of the economic fundamentals will be superseded by the everyday market forces in currency trading.
But at an opportune time it will come up to show its force, such as we have today. A good policy should not allow this to happen.
There is no curse of natural resources. There is only the curse of bad policy.