During the period of 1978 – 1997 Indonesia was implementing a managed floating exchange rate system; Indonesian authority then change to the free-floating exchange rate system directly after the East Asia financial crisis of July 1997.
This implies that the Government totally gave up the exchange rate value of Indonesian Rupiah (IDR) against the US Dollar (USD) to the currency demand and supply mechanism. Furthermore, the new regime brings the Indonesian Rupiah (IDR) to a very volatile period.
At the same time, exports of industrial products which performance closely related to the exchange rate had become very effective and significant leverage of economic growth in developing countries over the past two decades. As a result, to improve the performance of foreign trade, particularly exports, Indonesia began to implement several policy regulations in its field. Among them are “Paket January 1982” and “Inpres No. 4 of 1985 “regarding the technical execution of foreign trade and management of foreign exchange, and ” 6 Mei 1986 policy “which was aiming to enhance the exports of non-oil commodities and increase foreign direct investment.
This situation promotes question about the relationship between two important economic variables relating to currency exchange rates. There are two problems that have been discussed for years in the literature regarding the effect of the exchange rate level on a country’s foreign trade performance.
The first one is volatility and the second one is the misalignment of the exchange rate from its equilibrium. Exchange rate misalignment generally defined as a persistent departure of the real exchange rate value from its steady-state level; either it is undervalued or overvalued. Whereas exchange rate volatility is generally understood as the impermanent variability of the exchange rate which is nowadays commonly derived from the conditional variance of the exchange rate. Kaminsky, Lizondo, & Reinhart (1998) mentioned that the real exchange rate misalignment has a substantial contribution upon the sustainability of the current account.
Jongwanich (2009) further states that economic equilibrium could be strongly affected by the real exchange rate misalignment. Therefore, involving real exchange rate volatility and misalignment could help us to gain a better insight into foreign trade behaviour.
The issue regarding the influence of exchange rate on trade performance has been widely discussed theoretically and investigated empirically in a large number of papers. In the case of Indonesia, the devaluation of Rupiah against the US dollar in 1983 was followed by the increasing of non-oil exports in the same year.
This was not the case in the previous year when Indonesian non-oil experienced a contraction. Another example of the rupiah devaluation positive effect on exports occurred on September 1986 when a 31 percent devaluation was followed by 11 percent and 30 percent rise in non-oil exports in two consecutive years.
This clearly shows the existence of the exchange rate both volatility and irregularities in Indonesia’s foreign trade. In addition, the fact that compared to other East Asian countries, Indonesia experienced the highest exchange rate volatility during the financial crisis certainly help us to clearly identify the impact of exchange rate volatility on foreign trade.
From the evolving data and theory, exchange rate volatility significantly influences export volumes even if only a few commodities in the short term and their effects last longer on smaller quantities of commodities. As for real exchange rate misalignment, it turns out to have a positive effect both in the short and long term. This condition reminds us again of the importance of Bank Indonesia as an institution that has authority and responsibility for the value of rupiah in maintaining the exchange rate to be stable and conducive in the economy.
Author: M. Khoerul Mubin
Detail information from this research can be seen in our writing at: https://ier.ut.ac.ir/article_71780.html
