BI urged to use exchange rate to contain inflation

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)