New opportunity exists for the central bank

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.