Rupiah's fall: Who's responsible?<\/p>\n
By Ross H. McLeod<\/p>\n
CANBERRA (JP): President Abdurrahman Wahid is blamed by many
\nfor Indonesia's deteriorating economic performance, which is
\nalready significantly worse than was expected when the current
\nbudget was formulated.<\/p>\n
The growth rate for 2001 has been revised down from 5 percent
\nto about 3.5 percent. The average exchange rate has been revised
\nupward from Rp 7,800 to Rp 9,600 per dollar, and the annual
\ninflation rate from 7.2 percent to about 9.3 percent.<\/p>\n
The last two of these performance indicators concern monetary
\nmanagement, however, which suggests that although the President
\nmakes a convenient scapegoat for this deterioration, we should
\nnot overlook the role played by Bank Indonesia (BI), the central
\nbank.<\/p>\n
Maintaining the value of the rupiah is the responsibility of
\nBI, as stated in its own law (Law No. 23 1999). This same law
\nguarantees BI's independence: it cannot be told what to do by the
\ngovernment or any other party. If inflation and depreciation get
\nout of hand, therefore, the central bank must bear the blame.<\/p>\n
It is significant that the law provides only this single
\nobjective for BI. In other words, the central bank is not
\nresponsible for other aspects of macroeconomic management, which
\nare left to the government. In reality, however, BI's board of
\ngovernors has ignored the law and expanded the central bank's
\nrange of responsibilities. The result has been highly adverse for
\nmacroeconomic performance.<\/p>\n
Specifically, BI has chosen to concern itself with two
\nadditional macroeconomic policy issues: first, encouraging
\neconomic growth; and second, holding down the government's budget
\ndeficit. Its chosen strategy for achieving both objectives is to
\nhold interest rates down, by which it hopes to gain on at least
\nthree fronts.<\/p>\n
First, businesses will not be discouraged by higher interest
\nrates from undertaking the new investment on which continued
\neconomic growth depends.<\/p>\n
Second, the budget deficit will not expand by virtue of higher
\ninterest payments on floating interest rate government bonds used
\nto recapitalize the banks.<\/p>\n
Third, banks will not suffer the reduction in their capital
\nadequacy that would result from falls in the market value of
\ntheir holdings of fixed interest rate government bonds if
\ninterest rates rose; this would require additional bonds to be
\nissued, further increasing debt service costs in future budgets.<\/p>\n
But BI appears to see a conflict between holding interest
\nrates down and the fulfillment one of its key commitments to the
\nIMF: namely, to ensure a low rate of growth of the supply of base
\nmoney (i.e. BI's monetary liabilities).<\/p>\n
Faced with this perceived conflict, it has chosen to ignore
\nits money growth commitment. Specifically, the government's most
\nrecent Letters of Intent to the IMF set a base money growth rate
\nof 7 percent for 2000.<\/p>\n
Extrapolating this into 2001 the target becomes Rp 94.2
\ntrillion at the end of March, whereas the actual figure recorded
\nwas Rp 106.2 trillion -- about 13 percent higher.<\/p>\n
Yet the very reason for having this commitment is to ensure
\nthat BI meets its own legal responsibility to maintain the value
\nof the rupiah: accordingly, BI's failure to meet it provides the
\nmain explanation for the steady increase in inflation over the
\nlast year or so.<\/p>\n
In turn, rising inflation, together with the perception that
\nBI has no clear idea of what it should be doing, has been causing
\nyet another loss of confidence in the rupiah. This is resulting
\nin currency speculation -- over and above that caused by
\npolitical uncertainty and poor leadership -- hence the continuing
\nweakness of the currency.<\/p>\n
If BI chose now to abide by its commitment and bring base
\nmoney back to where it should be, it would need to issue
\nadditional Bank Indonesia Certificates (SBI). This would require
\nan increase in SBI interest rates, which is where the apparent
\nconflict between its legislated responsibility and its self-
\nchosen responsibilities arises.<\/p>\n
What a pity BI's institutional memory is so short! It needs
\nonly to look back to mid 1998, when output was falling and
\ninterbank interest rates and inflation were both running at
\naround 70 percent to 80 percent, to see that its concern is
\nmisplaced.<\/p>\n
From July 1998 BI suddenly began to control base money,
\nreducing it by about 5 percent at first, and keeping its growth
\ndown to just 6 percent over the following 12 months.<\/p>\n
Interest rates rose a little at first, but then fell
\ndramatically to around 12 percent a year later. Growth did not
\nfall. On the contrary, the economy bottomed out in the second
\nhalf of 1998 and then began growing quite strongly in 1999.<\/p>\n
Inflation declined to a monthly rate below zero within just
\nthree months, and the rupiah recovered from Rp 15,500 to Rp 7,500
\nper dollar in much the same period.<\/p>\n
If only BI had simply persevered with this highly successful
\nmonetary policy, inflation would not now be above the double
\ndigit level, and the rupiah would be far stronger against the
\ndollar.<\/p>\n
It is real, not nominal, interest rates that matter to
\nborrowers and depositors. Real interest rates are simply nominal
\ninterest rates adjusted for expected inflation. The general
\npublic have observed that inflation has been increasing steadily,
\nand that rather than tightening up on monetary conditions to get
\nback on track, BI simply adjusts its inflation target upward.<\/p>\n
Thus depositors demand higher nominal interest rates to
\ncompensate for expected increasing levels of inflation, while
\nborrowers are prepared to pay higher nominal rates, relying on
\ninflation to reduce the real burden of their debts.<\/p>\n
In short, BI's attempt to hold interest rates down by
\nincreasing the money supply is failing because the policy itself
\ngenerates expectations of inflation, pushing interest rates up,
\nnot down.<\/p>\n
Thus Gus Dur is not entirely to blame for rising inflation and
\nthe sagging rupiah.<\/p>\n
The writer is Editor of the Bulletin of Indonesian Economic
\nStudies, published by the Indonesia Project at the Australian
\nNational University in Canberra, Australia.<\/p>",
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