Bank Indonesia's control of money supply must end

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.