New opportunity exists for the central bank<\/p>\n
Kahlil Rowter, Lecturer, School of Economics University of Indonesia,
\nJakarta<\/p>\n
Only once in the last three years did Bank Indonesia meet its
\nmonetary policy targets. Its record in bank supervision is spotty
\n-- while its handling of the national payments system has been
\nexemplary. The work of the next governor is clearly cut out for
\nhim. But the government and the legislature are not off the hook
\neither.<\/p>\n
The 1999 central bank law was a watershed for the financial
\nstructure. It separated BI from the rest of the government, in
\nthe same way most central banks are. Under the old regime, BI was
\nessentially a branch of the government, taking orders from a
\nmonetary board including the BI chief and the finance minister.<\/p>\n
The task of the "new" central bank is to maintain the value of
\nthe currency both in purchasing power (inflation) and against
\nother currencies (exchange rate), maintain the national payments
\nsystem and supervise the banking system.<\/p>\n
How has it fared? Given the fundamental change with the new
\nlaw, we will focus on BI's performance from 2000 forward.<\/p>\n
The first task, inflation, has been stated as the ultimate
\ntarget against which the credibility of a central bank is to be
\nmeasured. The intermediate goal would be money supply growth --
\nreserve money that the central bank has direct control over.
\nReserve money is currency in circulation plus the deposits that
\nbanks place at the central bank.<\/p>\n
In 2000 BI's inflation target was set at 5 percent to 7
\npercent, in 2001 at 7 percent to 9 percent and in 2002 at 9
\npercent to 10 percent. The realization for each year was 9.35
\npercent, 12.55 percent and 10.03 percent. Not very successful!<\/p>\n
Meanwhile, reserve money growth was targeted at 8.3 percent in
\n2000, 11 percent to 12 percent in 2001 and 12 percent to 14
\npercent in 2002. The outcomes were 18.9 percent, 17.44 percent
\nand 9.69 percent. Again not very impressive.<\/p>\n
But why did BI fail to contain inflation in 2000 and 2001 but
\nwas "successful" in 2002? Inflation, like any price, is the
\nresult of the interaction between supply and demand. Aggregate
\nsupply and aggregate demand in this case. If inflation goes up it
\nis due to aggregate demand rising faster than aggregate supply.
\nNote that the central bank mainly operates only on the demand
\nside. Therefore, BI must have failed to suppress demand.<\/p>\n
Suppressing demand can be done by decreasing money supply
\ngrowth, along with hiking interest rates. But then economic
\ngrowth will suffer. But do not forget the aggregate supply curve.
\nBI would certainly explain the rise in inflation as being the
\nresult of the government's hikes in administered prices. If BI
\nwere to suppress demand to attain its inflationary goal, economic
\ngrowth would suffer a double blow.<\/p>\n
Herein lies the policy dilemma. Although the 1999 central bank
\nlaw did refer to economic growth as the bank's target, getting
\naway from this politically sensitive issue is not easy.
\nNevertheless, if the law is to be interpreted strictly then in
\nanticipation of the hike in administered prices BI should have
\nslammed the brakes of money growth. This would increase interest
\nrates and reduce economic growth significantly.<\/p>\n
The main driver of inflation here is the currency rather than
\nother policy variables. Therefore, stabilizing, and even
\nstrengthening the currency, are more vital to reducing inflation.
\nHowever, stabilizing currencies has proven most difficult even
\nfor central banks in industrial countries. Sentiments may play
\nmore important roles than any actual change in policy levers.<\/p>\n
It may be asking too much for BI alone to be responsible for
\nthe strength and stability of the rupiah; witness the
\nstrengthening of the rupiah in 2002. This probably had more to do
\nwith the global retreat of the U.S. dollar than anything done
\ninside Indonesia. Even after the Bali bombing, the rupiah did not
\nbudge a lot. And the strengthening of the rupiah was arguably the
\nreason inflation was so tame in 2002.<\/p>\n
What about the other two tasks?<\/p>\n
BI has improved the national payments system by introducing
\nthe Real Time Gross Settlement System (RTGS). Where before one
\nneeded two days before knowing if money transfers had reached
\ntheir destination, now this takes a few hours.<\/p>\n
As regards bank supervision, recently BI delayed the deadline
\nfor banks to reach a 5 percent maximum level of non-performing
\nloans, and it has not made up its mind whether it will stick with
\nthe end of 2003 deadline for the 12 percent minimum capital
\nadequacy ratio. Again the policy dilemma.<\/p>\n
BI fears that if it is strict with these deadlines many banks
\nwill close, leading to another banking crisis. But it risks
\ncredibility by giving in to popular pressure.<\/p>\n
The central bank's credibility is also not helped by having a
\ndisclaimer on its financial accounts. Following the agreement
\nwith the government regarding the sharing of the highly
\ncontentious Rp 144.5 trillion in liquidity support funds (BLBI),
\nthe government has agreed to accept most of the expenditure,
\namounting to Rp 120 trillion. BI has also accepted the bill of Rp
\n24.5 trillion stemming from unverifiable liquidity support
\nexpenditure, an arrangement yet to be approved by the House of
\nRepresentatives (DPR).<\/p>\n
The government and the DPR now have a good opportunity to
\ncreate a central bank with a clean break from the past, by
\nproposing and appointing a new governor untainted by past
\nmistakes or a history of bowing to political or popular pressure.
\nThis would signal both institutions' commitment to keeping the
\ncentral bank independent.<\/p>\n
The government and the DPR must also resolve the issue of what
\nto do with the liquidity support bonds that the government issued
\nto Bank Indonesia. These pay 3 percent in interest while the
\nprincipal is increased every year by the amount of inflation. The
\ninterest is capitalized so the government does not actually pay
\ninterest in cash. Plans are now afoot to replace the bonds with a
\n"Capital Maintenance Note".<\/p>\n
The main objective here is to alleviate the refinancing burden
\nonce the bonds mature, which requires the approval of the Supreme
\nAudit Agency (BPK). An earlier plan to replace the BLBI bonds
\nwith perpetual zero coupon bonds was rejected as this would
\namount to a donation from the central bank to the government, and
\nwould have to be recognized as a loss.<\/p>\n
Second, and more structurally, until now BI had paid from its
\nown pocket the cost of monetary policy. This is because BI pays
\ninterest on the main monetary policy instruments: The BI
\nCertificates (SBIs). BI even pays interest to commercial banks
\nwhich place their money in the central bank. This creates a
\nconflict when interest rates need to be raised but the central
\nbank's income is not sufficient.<\/p>\n
Do we need to see the bank's capital shrink below Rp 2
\ntrillion? This is the threshold when the government is compelled
\nby the 1999 law to recapitalize the central bank. A steady supply
\nof short-term government bills is needed to replace the
\noutstanding SBIs.<\/p>\n
It is now up to the government and the DPR to map out a
\ncomprehensive plan to revamp the central bank. That is if we want
\nto have a credible and functioning central bank any time soon.<\/p>",
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