BI urged to use exchange rate to contain inflation

JAKARTA (JP): Bank Indonesia, the central bank, should use its exchange rate policy more to contain inflation, Australian economist Ross M. McLeod has said.

McLeod said in his "Survey of Recent Developments" paper, published in Bulletin of Indonesian Economic Studies' April edition, that the central bank used exchange rates to maintain the Indonesia's export competitiveness rather than to control inflation.

Instead of exchange rates, the central bank had been using monetary aggregate targeting to control inflation, but this policy had been far less successful in managing monetary aggregates, he said.

"An alternative approach is to focus instead on the exchange rate as the 'nominal anchor' for inflation control," McLeod said.

Using the exchange rate to control inflation was an appropriate way for countries with balance of payment surpluses like Indonesia, he said.

Because of the surpluses, Bank Indonesia had to intervene in the foreign exchange market as a net buyer to keep the rupiah going down to maintain the competitiveness of Indonesia's exports, he said.

But this in turn meant the central bank was constantly injecting money into the economy, which was inflationary, Mcleod said.

This would cost the central bank more when it tried to cut inflation by sterilizing the monetary impact of the payment surplus by issuing Bank Indonesia Certificates, he said.

To reduce losses, the central bank abandoned the steady depreciation of the rupiah against the U.S. dollar -- which was set at 3 percent to 6 percent a year -- from February to September last year, with the spot rate virtually unchanged.

But this policy change appeared to have little support from the finance minister who insisted the government's aim of depreciating the rupiah against the dollar remained at 5 percent a year.

The central bank then relaxed its intervention in exchange rates by widening the intervention band from 3 percent to 5 percent last September.

This might help explain the apparent low inflation of 5.17 percent for the last fiscal year, the lowest since the 1985/1986 fiscal year.

Equal

McLeod said that using the exchange rate Indonesia's inflation would be roughly equal to the U.S. rate of about 3 percent a year plus the rate of the rupiah's depreciation.

"If the new policy (of reducing or eliminating depreciation) could have been sustained, the authorities should have been able to hold inflation well below the official target ceiling," McLeod said.

But the central bank depreciated the rupiah a bit faster over the last few months. Toward the end of the year it entered the foreign exchange market as an active buyer, forcing the rupiah to depreciate more rapidly.

"It seems clear that Indonesia is approaching a watershed in its exchange rate policy, with Bank Indonesia preferring a more market-oriented stance but, for the time being, yielding to the view of other arms of government that continued depreciation is required to maintain Indonesia's competitiveness," McLeod said.

He also criticized Bank Indonesia's contractionary measures to contain inflation by increasing reserve requirements for commercial banks from 2 percent to 3 percent effective February 1992 and to 5 percent effective on April 1.

The reserve requirement increase aimed to assist the achievement of target growth rates for bank lending and money supply both in narrow and broad terms.

Despite the ratio increase, broad-term money supply and bank credits grew at annualized rates of 30 percent and 24 percent respectively between February and November 1996, far above their the respective targets of 17 percent and 16 percent.

"Manipulating the reserve ratio is not, therefore, the solution to the problem of chronic rapid growth of the monetary aggregates, and the foreshadowed increase in April can be expected to meet a similar fate," McLeod said.

He said controlling inflation by limiting credit expansion was inappropriate because the source of inflation was not in the banking sector but was base money, which the central bank keeps supplying to absorb balance of payment surpluses. (rid)