Bank Indonesia's control of money supply must end
The rupiah has fallen well beyond the "psychological" limit of Rp 10,000, in what has been called a repetition of the September 1997 scene. An economist at the Australian National University, Ross H. McLeod, talked with The Jakarta Post contributor A'an Suryana. The following is an excerpt of an interview in Canberra with the professor, who is editor of Bulletin of Indonesian Economic Studies -- Indonesian Project, at the university's Research School of Pacific and Asian Studies.
Question: The rupiah exchange rate has fallen since 1997, and it has yet to recover from its initial rate Rp 2,500 per U.S. dollar. What do you see as the main causes?
Answer: The fundamental cause of the tumble of rupiah is the policy of the central bank, Bank Indonesia (BI). BI creates money, and money is like everything else. If you increase the supply of the money into the market, then its value will decrease.
We are back into the beginning of the crisis in September 1997. Suddenly, the amount of money increased very rapidly by 80 percent in less than one year, exceeding its normal increase (of) 10 percent a year. (This) created inflation.
The other aspect of the deteriorating value of money is the depreciation of local currency against the dollar, in which Indonesia's rupiah, trading at Rp 2,400 per dollar in mid-1997, plunged to Rp 15,000 in 1998.
Other countries had similar problems with Indonesia, like Thailand and South Korea. Their currency lost their value too, but none of them had high inflation, and it occurred because none of them allowed their money supply (to become) out of control.
The devaluation of the rupiah is much bigger than other countries, and I don't know why the central bank let the supply of money grow rapidly. Perhaps they were not confident, or they just ignored the International Monetary Fund (IMF), which sets target on the money supply.
If you allow the money supply growth, it will create inflation. People would not be happy, and they would demand the rise of interest rates as the value of the currency drops. They demand higher interest rates to gain profit from their savings.
The political situation had something to do with inflation. The (current) situation has turned crazy, Gus Dur (President Abdurrahman Wahid) could be pushed out at any time, violence has occurred in Aceh, Maluku and Kalimantan.
People, then, prefer to put their money offshore, and they are waiting for a favorable political situation to avoid losing their assets. If you want to (place money offshore), you must buy foreign exchange from the central bank, and it will push up the price of foreign exchange.
How will different economic activities be affected?
Anybody who exports should be better off with the plunge of rupiah, and so should people who import substitutes. They will obtain benefits from the difference between the rupiah rate earlier and the rupiah rate today traded against the U.S dollar rate.
On the other hand, anybody in nontradable sectors such as real estate and transportation services will suffer from the rupiah plunge. You don't trade with the rest of the world, you can only sell your products in the local market and you will receive revenues in weak local currency.
You will get trouble if you have borrowed in foreign exchange, since your debt value in rupiah will grow up. If you are producing nontradable goods and services, even if you don't have any debts, you will still have problems since the increase of profitability of import and export substitute activities means that all resources including labor and natural resources will flow into those activities.
So, tradable sectors will be better off, and nontradable sectors will be worse off ...
Despite strong pressure from the market, the central bank has pledged to keep pouring dollars into the market to guard the rupiah. What is going to be the limit of its capability in doing this?
The government will not be able to keep the rupiah at a favorable rate by selling dollars continuously into the market. The central bank might have US$25 billion to US$30 billion in its reserves ... The more you sell, the less you get, until eventually you run out of your reserves.
This was why Thailand and Indonesia floated their exchange rate in 1997.
The government has urged state enterprises to sell dollars to help the rupiah. What do you see as the impact of this directive?
This simply shows that the government, BI in particular, continues to want to shift the blame for the falling rupiah to other parties, rather than accepting the blame for poor economic (and political) management itself.
It is absurd to suggest that business enterprises have any responsibility at all in managing monetary policy (even if they are state owned). That is the job of the central bank, nobody else.
BI can no longer blame Soeharto for forcing it to implement poor monetary policy. It has its independence; it is time it showed Indonesians that it is competent to use its independence wisely.
What would you suggest the central bank do to stabilize the rupiah?
There are three options. The government announces that it will float the exchange rate, like in 1997. In practice, they have never done that. It was a good policy, but as the government always tried to stabilize the currency by pouring dollars into the market, it means they don't have a floating exchange rate policy anyway. The government had it for few months only in 1998.
The second option is the fixed exchange rate policy, as also recommended by Steve Hanke. The policy requires a currency board which will determine that you will have rigid exchange rate target.
Once you have it, you have to stop trying to control the money supply. For example, you set the currency rate at Rp 7,500 per dollar. Suppose that a lot of people want to buy dollars at Rp 7,500, then they have to hand over rupiah to the central bank.
It means the money supply goes down because people are passing money back to the central bank out of the population. You have to allow money supply to decrease automatically if people start circulating money. The effect is the interest rate will go up in the short term.
The third option is to dollarize the rupiah. It means the country adopts foreign exchange, let's say the U.S. dollar, as its currency. Indonesia has done it to a certain extent because a lot of people have dollar deposits, a lot of firms have dollar loans from banks. What we are talking about is do it all the way.
Two countries have adopted this way: El Salvador and Equador, and the formula has done well there. Indonesia would not have any problems with a depreciation of currency.
But the government has taken the first option since August 1997. Whatever interventions BI occasionally makes are aimed at curbing wild volatility caused by speculative trading. The second option is impossible as the IMF is strongly against such a policy. The condition now is unfit for the third option.
In reality, although the government announced that it would follow a floating rate policy from August 1997, it has not done so. A genuinely floating rate policy implies very little intervention in the foreign exchange market.
We can tell whether this has been the case by looking at the level of BI's foreign assets, valued in dollars at contemporary exchange rates.
From memory, there have been big changes in this level from time to time, which shows that BI's intervention has been extensive -- far more than that which would be necessary to smooth out some fluctuations because of short-term trading.
Rather, BI has been trying to stand up against a strong long- term tendency for the rupiah to depreciate, not to iron out volatility.
I'm not sure that it is true that the IMF is strongly against a fixed rate policy -- after all, the IMF was founded precisely for the purpose of helping countries to maintain fixed rates -- although it was certainly against the currency board proposal of Steve Hanke. Why, I don't know.
The damage that was done by the inconsistent policies of BI in the first half of 1998 was far more than could have been expected under Hanke's proposal, if any. Indeed, in retrospect, implementing Hanke's proposal might well have saved the Indonesian people from having to shoulder the huge cost of bailing out the banking system.
If dollarization is ruled out by economic nationalism, the choice is between a floating or a fixed rate. What is not usually appreciated is that monetary policy has to be quite different, depending on which is chosen.
The floating rate policy will work well (as it did in late 1998 and most of 1999) if BI has a clear money growth target and sticks to it; the fixed rate policy will work well (as it does in Hong Kong), if BI does not try to manage the money supply, but leaves it to be determined by what happens in the foreign exchange market.
My preference is for the floating rate policy, which has been shown to work very well. The only problem is that BI can't seem to meet its money growth targets; it doesn't seem to realize how successful it was in late 1998 and 1999.