The spectre of inflation

Bank Indonesia's move on Monday to nearly double the interest rates on its benchmark instruments (SBI) to a range of 40 percent to 45 percent for papers of one week to two months should have been the best of the worst alternatives it has in addressing the threat of inflation and arresting the rupiah's fall. The immediate consequence, though, is that a lot more businesses may have to fold.

The SBI rate increase is obviously designed to soak up excess liquidity that is threatening to increase inflationary pressures. The central bank said M1 -- currency and demand deposits -- expanded by 12.15 percent last December, and by 18.45 percent in January, to reach Rp 92.8 trillion, before declining slightly to Rp 92.5 trillion in February. M2 (M1 plus savings, time deposits and other quasi money) also rose sharply by 7.6 percent in December and 26.73 percent in January to reach Rp 450.7 trillion, but decreased to Rp 430.2 trillion in February.

The anomaly here is that most national banks are cash strapped. The central bank's governor, Sjahril Sabirin, acknowledged Monday that Bank Indonesia had been forced to pump cash into banks. As many big depositors cashed out of private national banks immediately after the November closure of 16 ailing banks, most local banks would not have stayed afloat without liquidity injection from the central bank.

The problem now is that people are not spending. Nor are they putting money in many local banks, which they consider too risky. Many depositors have moved their savings to foreign banks in Jakarta or overseas, especially in the wake of anti-Chinese riots in January and February. A lot of money is not circulating, but is kept instead in safe-deposit boxes, tucked under mattresses and crammed into holes in the floor.

Bank Indonesia is indeed caught in a precarious dilemma because of the blanket guarantee it has provided for rupiah and foreign exchange claims on all locally chartered commercial banks since January. If it stops supporting the banks, most of them are likely to collapse, undermining further the already sagging confidence in the banking sector. If, however, it keeps injecting cash, it risks worsening inflation, projected at a range of 40 percent to 50 percent for this year -- inflation in the first two months already reaching almost 20 percent -- especially because the government's decision to continue food, fuel and electricity subsidies will require the central bank to print more money this year.

Pumping money into ailing banks, including grossly inefficient ones, is also against the banking reforms already agreed on with the International Monetary Fund (IMF).

Basically, Bank Indonesia is just buying time and delaying bankruptcies, which will only serve to hinder the progress of banking reforms. Which leaves us wondering what has been done by the Indonesian Bank Restructuring Agency (IBRA) whose former chief, Bambang Subianto -- known for his tough stance on ailing banks irrespective of the political backing of their shareholders -- was fired last month after less than two months in that post.

As local banks can now increase their deposit rates to as high as 65 percent (150 percent as high as the SBI rates), they hopefully will be able to lure back a hefty portion of the money now outside the banking industry. Foreign banks, currently awash in liquidity but averse to lending to national banks, may also be attracted to put their excess liquidity into SBIs.

Nonetheless, Bank Indonesia cannot maintain such prohibitively high interest rates for some time without crippling economic activities. This means the IBRA should speed up the implementation of banking reforms in order to restore public confidence in the national banking industry.