New monetary and exchange rate policy

JAKARTA (JP): The Letter of Intent on reinforced and strengthened reform measures agreed with the IMF which was signed by President Soeharto yesterday was supplemented with a 13-page appendix which contains a Memorandum on Economic and Financial Policies.

The following is a condensed version of the chapter on monetary and exchange rate policy excerpted from the Memorandum:

Since the crisis began, Bank Indonesia's monetary strategy has been to support the rupiah exchange rate, and limit any increase in inflation, by maintaining a firm monetary stance. The execution of his policy, however, has been hampered by problems in the banking system.

Following the closure of 16 insolvent banks in November last year, customers concerned about the safety of private banks have been shifting sizable amounts of deposits to state and foreign bank, while some have been withdrawing funds from the banking system entirely.

These movements in deposits have greatly complicated the task of monetary policy, because they have led to a bifurcation of the banking system. By mid-November, a large number of banks were facing growing liquidity shortages, and were unable to obtain sufficient funds in the interbank market to cover this gap, even after paying interest rates ranging up to 75 percent.

At the same time, another smaller group of banks were becoming increasingly liquid, and were trading among themselves at a relatively low JIBOR (Jakarta Interbank Offer Rate) of about 15 percent. As this segmentation continued to increase, while the stress on the banking system intensified, Bank Indonesia was compelled to act. It provided banks in distress with liquidity support, while withdrawing funds from banks with excess liquidity, thereby raising JIBOR to over 30 percent in early December, where it has since remained.

From early December to early January, the exchange rate lost a further 53 percent of its external value, falling from around Rp 3,700 per U.S. dollar to around Rp 8,000 per U.S. dollar.

With the overall policy package that has recently been adopted, and set out in this Memorandum, the government is now convinced that confidence in the economic direction of the country will be speedily restored.

However, during the transitional period, in which confidence is taking hold, lingering concerns about exchange rate depreciation are likely to keep market interest rates at high levels. Bank Indonesia recognizes that, in these circumstances, it will need to keep its own interest rates high, as well.

This tight monetary stance will inevitably mean that, at least for the time being, the amount of credit available for lending to the corporate sector will remain constrained and the cost of credit will remain very high.

To alleviate this burden, the government has introduced a temporary program under which credit will be provided to small- scale enterprises through the state banks at subsidized interest rates. The cost of the subsidy will be borne not by the state banks, but rather by the central government budget.

Bank Indonesia has established, in consultation with the Fund, a financial program for 1998, to ensure that monetary policy continues to operate within a well-defined framework, with a clear inflation objective.

This program aims to contain inflation to less than 20 percent, implying that policy will ensure that there is only a limited pass through of the very substantial depreciation onto the prices of imports, and only a muted impact of the drought on food prices.

To achieve this ambitious objective, Bank Indonesia plans to limit the growth of broad money to 16 percent in 1998.

This monetary strategy will be complemented by judicious foreign exchange intervention to stabilize and support the exchange rate. The scale of this intervention will be determined in close consultation with IMF staff, and will also be subject to Bank Indonesia maintaining net international reserves above the monthly and quarterly floors specified in the program.

Bank Indonesia will immediately be given autonomy in formulating and implementing monetary policy. To ensure that the central bank remains accountable, the inflation objective will continue to be decided by the government as a whole, but the policies for achieving this objective, such as changes in official interest rates, will be determined solely by the central bank.