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.