Rupiah's fall: Who's responsible?

Rupiah's fall: Who's responsible?

By Ross H. McLeod

CANBERRA (JP): President Abdurrahman Wahid is blamed by many
for Indonesia's deteriorating economic performance, which is
already significantly worse than was expected when the current
budget was formulated.

The growth rate for 2001 has been revised down from 5 percent
to about 3.5 percent. The average exchange rate has been revised
upward from Rp 7,800 to Rp 9,600 per dollar, and the annual
inflation rate from 7.2 percent to about 9.3 percent.

The last two of these performance indicators concern monetary
management, however, which suggests that although the President
makes a convenient scapegoat for this deterioration, we should
not overlook the role played by Bank Indonesia (BI), the central
bank.

Maintaining the value of the rupiah is the responsibility of
BI, as stated in its own law (Law No. 23 1999). This same law
guarantees BI's independence: it cannot be told what to do by the
government or any other party. If inflation and depreciation get
out of hand, therefore, the central bank must bear the blame.

It is significant that the law provides only this single
objective for BI. In other words, the central bank is not
responsible for other aspects of macroeconomic management, which
are left to the government. In reality, however, BI's board of
governors has ignored the law and expanded the central bank's
range of responsibilities. The result has been highly adverse for
macroeconomic performance.

Specifically, BI has chosen to concern itself with two
additional macroeconomic policy issues: first, encouraging
economic growth; and second, holding down the government's budget
deficit. Its chosen strategy for achieving both objectives is to
hold interest rates down, by which it hopes to gain on at least
three fronts.

First, businesses will not be discouraged by higher interest
rates from undertaking the new investment on which continued
economic growth depends.

Second, the budget deficit will not expand by virtue of higher
interest payments on floating interest rate government bonds used
to recapitalize the banks.

Third, banks will not suffer the reduction in their capital
adequacy that would result from falls in the market value of
their holdings of fixed interest rate government bonds if
interest rates rose; this would require additional bonds to be
issued, further increasing debt service costs in future budgets.

But BI appears to see a conflict between holding interest
rates down and the fulfillment one of its key commitments to the
IMF: namely, to ensure a low rate of growth of the supply of base
money (i.e. BI's monetary liabilities).

Faced with this perceived conflict, it has chosen to ignore
its money growth commitment. Specifically, the government's most
recent Letters of Intent to the IMF set a base money growth rate
of 7 percent for 2000.

Extrapolating this into 2001 the target becomes Rp 94.2
trillion at the end of March, whereas the actual figure recorded
was Rp 106.2 trillion -- about 13 percent higher.

Yet the very reason for having this commitment is to ensure
that BI meets its own legal responsibility to maintain the value
of the rupiah: accordingly, BI's failure to meet it provides the
main explanation for the steady increase in inflation over the
last year or so.

In turn, rising inflation, together with the perception that
BI has no clear idea of what it should be doing, has been causing
yet another loss of confidence in the rupiah. This is resulting
in currency speculation -- over and above that caused by
political uncertainty and poor leadership -- hence the continuing
weakness of the currency.

If BI chose now to abide by its commitment and bring base
money back to where it should be, it would need to issue
additional Bank Indonesia Certificates (SBI). This would require
an increase in SBI interest rates, which is where the apparent
conflict between its legislated responsibility and its self-
chosen responsibilities arises.

What a pity BI's institutional memory is so short! It needs
only to look back to mid 1998, when output was falling and
interbank interest rates and inflation were both running at
around 70 percent to 80 percent, to see that its concern is
misplaced.

From July 1998 BI suddenly began to control base money,
reducing it by about 5 percent at first, and keeping its growth
down to just 6 percent over the following 12 months.

Interest rates rose a little at first, but then fell
dramatically to around 12 percent a year later. Growth did not
fall. On the contrary, the economy bottomed out in the second
half of 1998 and then began growing quite strongly in 1999.

Inflation declined to a monthly rate below zero within just
three months, and the rupiah recovered from Rp 15,500 to Rp 7,500
per dollar in much the same period.

If only BI had simply persevered with this highly successful
monetary policy, inflation would not now be above the double
digit level, and the rupiah would be far stronger against the
dollar.

It is real, not nominal, interest rates that matter to
borrowers and depositors. Real interest rates are simply nominal
interest rates adjusted for expected inflation. The general
public have observed that inflation has been increasing steadily,
and that rather than tightening up on monetary conditions to get
back on track, BI simply adjusts its inflation target upward.

Thus depositors demand higher nominal interest rates to
compensate for expected increasing levels of inflation, while
borrowers are prepared to pay higher nominal rates, relying on
inflation to reduce the real burden of their debts.

In short, BI's attempt to hold interest rates down by
increasing the money supply is failing because the policy itself
generates expectations of inflation, pushing interest rates up,
not down.

Thus Gus Dur is not entirely to blame for rising inflation and
the sagging rupiah.

The writer is Editor of the Bulletin of Indonesian Economic
Studies, published by the Indonesia Project at the Australian
National University in Canberra, Australia.