Tight money still required

Tight money still required

One may be inclined to see chief economics minister Rizal
Ramli's call on Bank Indonesia not to be overzealous in raising
interest rate as an attempt to intervene in the beleaguered
central bank's monetary management. After all, one of the biggest
controversies over the last few weeks has been the political
battle between the government and the House of Representatives
for control of the supposedly politically-independent central
bank.

However, as the leader of the Cabinet's economic team, Rizal
has a legitimate argument for a relaxed monetary policy: to
inject more liquidity into the economy in order to fuel stronger
economic activities.

Buoyed by year-on-year economic growth of more than 5 percent
in the third quarter, the government seems to think that now is
the right time for priming financial outlets to strengthen the
recovery, especially while there is still idle capacity for
increased production in the manufacturing industry.

Given the depressed condition of the Jakarta stock market,
credit remains the only feasible source of liquidity to lubricate
the economy, especially now after the banking industry is in a
better condition to resume lending.

However, an environment of high interest rates not only
increases credit risks, thereby threatening to further swell the
already huge pool of bad loans in the banking industry, but may
also cause further wounds at banks, because their interest margin
(difference between the cost of funds and loan interest income)
may again become negative, as it was between 1998 and the first
quarter of 2000.

It is true that a more relaxed monetary policy -- meaning
lower interest rates -- will theoretically stimulate the economy
through a number of different mechanisms. Consumers tend to spend
more when the interest rates are lower, which has taken place
since early this year. Bond yield and stock prices will tend to
increase, thereby further bolstering consumer confidence. Higher
stock prices will in turn fuel business confidence as borrowings
are made cheaper and the capital costs of businesses lower.

But this theory does not entirely fit Indonesia's current
economic environment, given the lingering political uncertainty,
the persistently weak rupiah, and the security and legal risks
associated with the introduction of what is now seen as
inadequately-prepared political and fiscal decentralization in
provinces and districts.

No wonder then, that the central bank has been tightening its
monetary policy, as can be seen in the steady rise in its short-
term benchmark interest rate (Bank Indonesia promissory notes)
since the height of the political uncertainty in May.

In fact, Bank Indonesia again raised its interest rate from
14.42 percent to 14.53 percent on Wednesday, only two days after
Rizal's appeal for easier money.

Rizal was correct in estimating that a credit crunch would not
help beef up the rupiah, as its steady depreciation over the last
six months has been caused mainly by the unfavorable political
condition, compounded by security problems in several provinces.
There is always a link between the exchange rate and the interest
rate through the capital market, and the government cannot have
an interest rate policy or monetary policy completely independent
from an exchange rate policy.

However, defending the rupiah is not actually the main
objective of Bank Indonesia in making steady rises in the short-
term interest rate, from 11 percent in May to 14.53 percent
today.

It has been the strong inflationary pressures generated by the
weakening rupiah (imported inflation) and the fuel price rise in
October, as well as the large budget deficit which forced the
central bank to tighten its monetary policy.

As inflation throughout this year may exceed 8 percent, higher
than the earlier projection of 5-7 percent, letting the interest
rate remain low would not only upset macroeconomic stability but
would also widen the interest rate differential between rupiah
and dollar deposits, consequently further battering the rupiah
which has depreciated by more than 21 percent since January.

The tricky question though, is whether the interest rate
should react to actual or forecast inflation. In most countries
the calculation of real interest rates normally takes into
account inflation expectations, rather than simply considering
the latest inflation figure.

Since inflationary pressures are expected to persist next
year, with the government scheduled to raise fuel prices by
another 20 percent in April, as well as increasing the cigarette
excise tax and civil servant salaries, the central bank will have
to carefully manage the base money and broad money supply. Hence,
will have to live much longer with a relatively tight monetary
environment, though not as tight as last year and 1998.