New opportunity exists for the central bank

Kahlil Rowter, Lecturer, School of Economics University of Indonesia, Jakarta

Only once in the last three years did Bank Indonesia meet its monetary policy targets. Its record in bank supervision is spotty -- while its handling of the national payments system has been exemplary. The work of the next governor is clearly cut out for him. But the government and the legislature are not off the hook either.

The 1999 central bank law was a watershed for the financial structure. It separated BI from the rest of the government, in the same way most central banks are. Under the old regime, BI was essentially a branch of the government, taking orders from a monetary board including the BI chief and the finance minister.

The task of the "new" central bank is to maintain the value of the currency both in purchasing power (inflation) and against other currencies (exchange rate), maintain the national payments system and supervise the banking system.

How has it fared? Given the fundamental change with the new law, we will focus on BI's performance from 2000 forward.

The first task, inflation, has been stated as the ultimate target against which the credibility of a central bank is to be measured. The intermediate goal would be money supply growth -- reserve money that the central bank has direct control over. Reserve money is currency in circulation plus the deposits that banks place at the central bank.

In 2000 BI's inflation target was set at 5 percent to 7 percent, in 2001 at 7 percent to 9 percent and in 2002 at 9 percent to 10 percent. The realization for each year was 9.35 percent, 12.55 percent and 10.03 percent. Not very successful!

Meanwhile, reserve money growth was targeted at 8.3 percent in 2000, 11 percent to 12 percent in 2001 and 12 percent to 14 percent in 2002. The outcomes were 18.9 percent, 17.44 percent and 9.69 percent. Again not very impressive.

But why did BI fail to contain inflation in 2000 and 2001 but was "successful" in 2002? Inflation, like any price, is the result of the interaction between supply and demand. Aggregate supply and aggregate demand in this case. If inflation goes up it is due to aggregate demand rising faster than aggregate supply. Note that the central bank mainly operates only on the demand side. Therefore, BI must have failed to suppress demand.

Suppressing demand can be done by decreasing money supply growth, along with hiking interest rates. But then economic growth will suffer. But do not forget the aggregate supply curve. BI would certainly explain the rise in inflation as being the result of the government's hikes in administered prices. If BI were to suppress demand to attain its inflationary goal, economic growth would suffer a double blow.

Herein lies the policy dilemma. Although the 1999 central bank law did refer to economic growth as the bank's target, getting away from this politically sensitive issue is not easy. Nevertheless, if the law is to be interpreted strictly then in anticipation of the hike in administered prices BI should have slammed the brakes of money growth. This would increase interest rates and reduce economic growth significantly.

The main driver of inflation here is the currency rather than other policy variables. Therefore, stabilizing, and even strengthening the currency, are more vital to reducing inflation. However, stabilizing currencies has proven most difficult even for central banks in industrial countries. Sentiments may play more important roles than any actual change in policy levers.

It may be asking too much for BI alone to be responsible for the strength and stability of the rupiah; witness the strengthening of the rupiah in 2002. This probably had more to do with the global retreat of the U.S. dollar than anything done inside Indonesia. Even after the Bali bombing, the rupiah did not budge a lot. And the strengthening of the rupiah was arguably the reason inflation was so tame in 2002.

What about the other two tasks?

BI has improved the national payments system by introducing the Real Time Gross Settlement System (RTGS). Where before one needed two days before knowing if money transfers had reached their destination, now this takes a few hours.

As regards bank supervision, recently BI delayed the deadline for banks to reach a 5 percent maximum level of non-performing loans, and it has not made up its mind whether it will stick with the end of 2003 deadline for the 12 percent minimum capital adequacy ratio. Again the policy dilemma.

BI fears that if it is strict with these deadlines many banks will close, leading to another banking crisis. But it risks credibility by giving in to popular pressure.

The central bank's credibility is also not helped by having a disclaimer on its financial accounts. Following the agreement with the government regarding the sharing of the highly contentious Rp 144.5 trillion in liquidity support funds (BLBI), the government has agreed to accept most of the expenditure, amounting to Rp 120 trillion. BI has also accepted the bill of Rp 24.5 trillion stemming from unverifiable liquidity support expenditure, an arrangement yet to be approved by the House of Representatives (DPR).

The government and the DPR now have a good opportunity to create a central bank with a clean break from the past, by proposing and appointing a new governor untainted by past mistakes or a history of bowing to political or popular pressure. This would signal both institutions' commitment to keeping the central bank independent.

The government and the DPR must also resolve the issue of what to do with the liquidity support bonds that the government issued to Bank Indonesia. These pay 3 percent in interest while the principal is increased every year by the amount of inflation. The interest is capitalized so the government does not actually pay interest in cash. Plans are now afoot to replace the bonds with a "Capital Maintenance Note".

The main objective here is to alleviate the refinancing burden once the bonds mature, which requires the approval of the Supreme Audit Agency (BPK). An earlier plan to replace the BLBI bonds with perpetual zero coupon bonds was rejected as this would amount to a donation from the central bank to the government, and would have to be recognized as a loss.

Second, and more structurally, until now BI had paid from its own pocket the cost of monetary policy. This is because BI pays interest on the main monetary policy instruments: The BI Certificates (SBIs). BI even pays interest to commercial banks which place their money in the central bank. This creates a conflict when interest rates need to be raised but the central bank's income is not sufficient.

Do we need to see the bank's capital shrink below Rp 2 trillion? This is the threshold when the government is compelled by the 1999 law to recapitalize the central bank. A steady supply of short-term government bills is needed to replace the outstanding SBIs.

It is now up to the government and the DPR to map out a comprehensive plan to revamp the central bank. That is if we want to have a credible and functioning central bank any time soon.