BI's policy on stabilizing the value of the rupiah

This is the second of two articles on the rupiah by Achjar Iljas, the Deputy Governor of Bank Indonesia.

JAKARTA (JP): As the weak and volatile rupiah continues to pressure inflation, it has limited the ability of a monetary policy to create a more conducive investment climate. In fact, the exchange rate pass-through effects to inflation have been one among other factors significantly contributing to the Indonesian inflation rate. These pass-through effects of the weakening rupiah have been largely due to a significant share of imports in the Indonesian economy.

Furthermore, over time, price adjustments will be even faster -- less than one month in the recent period -- reflecting partly producers' markup price setting mechanism. The government's price and income policies, for instance in April 2001 -- when a number of policies were issued regarding the retail price of cigarettes, drinking water, fees and fuels for industries and shipping -- will weigh heavily on inflation.

Given the above situation, with increasingly expected depreciation and government plans to adjust tariffs on public utilities such as telephone, expectations of inflation may rise even higher.

Accordingly, prices for the first five months of 2001 have been on the upward trend, and the strong inflationary pressure is expected to continue throughout the year. In May 2001, the monthly inflation rate was recorded at 1.13 percent. On a year-to-date (y.t.d.) basis, the cumulative inflation reached 3.73 percent while on an annual basis the consumer price index (CPI) reached a double digit figure of 10.82 percent -- the highest rate in the last 22 months.

Among goods and services in the CPI basket, clothing, followed by food and health products have been the main contributors of the May inflation.

From a different perspective, the impact of the weakening rupiah exchange rate is reflected in the traded goods inflation (4.07 percent y.t.d), which was higher than that of nontraded goods (3.15 percent y.t.d).

It is quite clear that current monetary developments point to an increasing inflationary pressure on the economy. As a conservative central bank, Bank Indonesia (BI) has no choice other than to direct monetary policy toward containing and maintaining a relatively low inflation rate as a prerequisite to sustainable economic development.

This is not an easy task, especially when the short-term prospect of the economy is also at stake. After factoring in all relevant indicators and information, it is not surprising that stabilization of the exchange rate is paramount for controlling inflation.

In efforts to stabilize the monetary conditions, Bank Indonesia has taken a number of measures, which include:

* First, as monetary stability is instrumental to stabilizing the exchange rate, BI's monetary policy has been geared to regain control of the monetary base expansion.

Therefore, a tight bias monetary policy was implemented since May 2000. In carrying out its monetary policy, BI mainly uses open market operations in the form of BI Certificate (SBI) auctions and rupiah interventions in the money market to squeeze excess liquidity out of the market.

This tighter strategy will be executed through the achievement of base money target while constantly optimizing policy mix instruments.

An ensuing interest rate increase will then be inevitable and as such monetary control operations will be carried out while the adverse impact of such increase to economic activities are minimized. Due to higher expectations on depreciation and inflation in the first half of 2001, BI tends to apply a front loaded tight bias monetary policy, as reflected in the increasing one-month SBI rate around 185 basis points, from 14.53 percent at the end of December 2000 to 16.38 percent on June 6, 2001.

* Second, BI has also undertaken foreign exchange sterilization by selling foreign exchange in a timely manner in line with the adequacy of foreign exchange reserves. This policy is directed at smoothing out movements in the exchange rate. Under the present floating exchange rate regime, the central bank will not necessarily intervene in the market to direct the movement of exchange rate.

The bank has, however, at discretion, on its free will, intervened in the market at times when it considered the movements of the exchange rate could disrupt the orderly working of the market, and/or could have great impacts on inflation.

* Third, improvement continues in the foreign exchange monitoring system, which has been developed to better understand the nature and magnitude of foreign exchange transactions. Such improvements are aimed to increase the accuracy of information reported by foreign exchange banks.

* Fourth, Bank Indonesia has also conducted direct monitoring at a number of banks to enhance compliance with prudential regulations that relate to foreign exchange transactions, and monitoring of vostro accounts.

* Fifth, Bank Indonesia has restricted rupiah transactions between banks in Indonesia and nonresidents as part of the policy of noninternationalization of the rupiah. This is a prudential measure aimed at reducing rupiah fluctuations by minimizing the opportunity for nonresidents to speculate on the rupiah, e.g. through limiting their access to the rupiah.

These measures will not cure all factors affecting monetary conditions, especially the stability of the rupiah exchange rate, but it will certainly help ease somewhat the burden of the monetary policy in regaining control over inflation.

A final note: The road to sustained recovery may still be long and bumpy, but the fight against inflation will go on.