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.