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.