Amending the central bank law

Amending the central bank law

By Tony Hartono

WELLINGTON, New Zealand (JP): The Bank Indonesia Act was
finally passed two years ago in 1999. Some observers argue that
the law has technical weaknesses, while others believe that the
Act must be amended in order to become more operational.

In fact, the International Monetary Fund (IMF) has expressed
concern about the bank's independence in its response to the
proposed amendments. Bank Indonesia's senior deputy governor
Anwar Nasution has suggested some revisions to the amendments,
but he has not really described how they would be applied in
practice.

The House of Representatives will finalize the Act before the
Paris Club meeting in March determines the rescheduling of
Indonesia's debt. Failure to meet this deadline will cause a
delay in reviewing progress of implementation of the Letter of
Intent (LoI) agreed to with the IMF.

As the central bank, Bank Indonesia is responsible for the
operation of monetary policy, issuing currency and other related
functions.

The main monetary policy tool that the bank has to influence
saving, spending and borrowing decisions, is its ability to move
interest rates up and down.

But the bank cannot correctly determine the direction of the
change in interest rates unless there is a clear goal. Section 58
of the Act does not specify that goal. It only obliges the bank
to prepare an annual report on monetary issues for the government
and the People's Consultative Assembly. The popular, single goal
for monetary policy is price stability.

What does price stability mean? Price stability, the goal for
monetary policy, aims at controlling inflation. This is because
high inflation distorts market prices causing unfavorable
conditions for investors, exporters and consequently economic
growth.

In New Zealand, price stability is defined in a Policy Targets
Agreement (PTA), signed by the governor of the Reserve Bank of
New Zealand and the treasurer. Under the PTA, the governor is
assigned to strictly maintain inflation within its target range
of 0-3 percent. Failure to remain within the 0-3 percent target
range will result in the governor's dismissal.

The concept of the PTA may be used as the basis for amending
the Bank Indonesia Act 1999. Under this concept, Coordinating
Minister for Economy Rizal Ramli and governor of Bank Indonesia
Syahril Sabirin must negotiate the inflation target to a range
of, say, 0 to 5 percent per annum.

The most widely used measure of inflation in Indonesia is the
Consumers Price Index (CPI), calculated by the Central Bureau of
Statistics. Adjustments to the inflation target may be made to
allow for changes in terms of trade, indirect taxes and
subsidies. This CPI adjusted inflation target is then used to
guide monetary policy.

This target, if agreed to by both parties, can be periodically
reviewed to reflect changes in the state of the economy.

As indicated, Bank Indonesia must look very closely at the CPI
adjusted inflation target. When inflation outcomes rise above the
top of the target Bank Indonesia must tighten monetary conditions
by raising interest rates.

If inflation does not rise above the target the bank can ease
monetary conditions by cutting interest rates. This measure
should eventually bring about the CPI adjusted inflation target
to remain within its 0 to 5 percent target range.

In pursuing price stability as the goal for monetary policy,
Bank Indonesia must have operational independence from the
government.

This means that, although the government participates in
approval of the inflation target, it cannot tell the bank how the
governor should determine monetary policy.

Section 56 of the 1999 Act, requiring that the bank give
financial assistance to the government, is inconsistent with the
concept of the bank's independence (section 4).

The House of Representatives (DPR) must amend section 56 to
revoke this requirement because it can jeopardize achievement of
the CPI adjusted inflation target by the bank.

With independence goes accountability.

The bank's accountability means that the governor's
performance must be judged against achievement of the CPI
adjusted inflation target, and the actions he or she has taken in
pursuit of that target.

The purpose of the bank's accountability is to ensure that the
governor and other bank officials do not abuse the bank's
operational autonomy as stipulated in section 4. Bank Indonesia
could be held accountable in three respects.

First, if the government and the DPR believe that the
governor's performance is inadequate in meeting the agreed CPI
adjusted inflation target then the governor must be dismissed.

Section 48, which protects the governor from being dismissed,
is not in line with the concept of accountability. This concept
also conflicts with section 41, which requires the governor to be
appointed from within Bank Indonesia.

This section must be amended because there is no reason to
believe that only candidates recruited from Bank Indonesia have
the ability to maintain price stability.

Second, the bank must issue a monetary policy statement at
least every six months (section 58). Each statement describes
clearly how monetary policy was implemented over the previous
period and explains the monetary policies to be used to achieve
the CPI adjusted inflation target in the future.

Third, the governor and other bank officials must regularly
appear in meetings set by the government and the DPR to answer
questions about the bank's monetary policy statement and
strategies for maintaining price stability.

The monetary policy statement published by the bank should be
forward looking, in the sense that it must contain the prospects
and inflation projections for the Indonesian economy.

This is very important because firms and households base their
decisions on expected inflation rather than on past inflation
outcomes.

To do this, the bank must hire highly professional staff with
a very good knowledge of economic modeling to cope with the new
goal of price stability.

Ultimately, the bank's performance will depend on them as well
as the quality of available data.

Dr. Tony Hartono is a former senior economic researcher with the
Secretariat of the Association of Southeast Asian Nations in
Jakarta. He is currently employed by The Open University,
Department of Economics in Wellington, New Zealand.