Zig-zag theory can't be applied in RI: McLeod

Zig-zag theory can't be applied in RI: McLeod

JAKARTA (JP): Australian economist Ross H. McLeod yesterday
supported Indonesian economists' view that the zig-zag theory for
reducing lending rates, as suggested by State Minister of
Research and Technology B.J. Habibie, was unfeasible.

Speaking at a seminar here on Indonesia's chronic inflation,
McLeod, an economic researcher in the Indonesia Project at
Australian National University, said that applying the theory
under current local conditions would set off capital flight.

"The capital flight then will force the Indonesian government
to devalue its currency. As a result the prices of imported goods
will be higher and could end up with the increase of inflation,"
he said at the seminar, which was organized by the Centre for
Strategic and International Studies (CSIS).

McLeod, who is also a member of the editorial board of the
Bulletin of Indonesian Economic Studies, pointed out that the
inflation increase would in the longer term cause bank interest
rates to rise.

McLeod was commenting on Habibie's recent suggestion that
domestic interest rates, among the highest in the world, be
reduced in stages by applying what he called a zig-zag theory of
interest rate reduction.

Habibie said the Indonesian central bank, Bank Indonesia,
should intervene by cutting interest rates according to a
specified target zone.

The seminar was attended by a number of noted economists,
including Mari Pangestu and Hadi Soesastro of CSIS and government
officials.

"It seems to me Pak Habibie suggests that the Indonesian
monetary authorities adopt direct control and the market
operation like it did in 1993," McLeod noted.

"The 1993 experience had proved that such a monetary policy
was not effective. It raised the inflation to about 10 percent
from about 5 percent in the previous year," he said.

Indonesia's lending rates now average 20 percent a year,
compared to Singapore's 7 percent, the Philippines' 12 percent,
Thailand's 13 percent and Malaysia's 8 percent.

Habibie's suggestion was rejected by almost all domestic
economists. They argued that it was unworkable given the state of
the national economy which was suffering high-capital costs.

But McLeod said that he did not agree with the view of
Indonesia's most senior economist, Soemitro Djojohadikusumo, that
the country would go bankrupt if it applied the zig-zag theory.
"I think such a statement is a bit too strong," he asserted.

If applied, the zig-zag theory would only raise inflation,
cause some economic instability and in the longer term push up
bank interest rates, he said.

Inflation

McLeod said that Indonesia's persistent inability to keep
inflation within the government's 5 percent ceiling could be
explained in terms of its failure to sufficiently suppress the
growth of base money (currency) relative to its demand.

"This may be ascribed to the central bank's practice of
focusing instead on broader monetary aggregates for which
correlations with prices have been greatly disturbed and obscured
by the process of financial reform," he said.

He said that frustration with the stubborn tendency of
inflation to remain between 9 percent and 10 percent in the last
few years, combined with an unwillingness to acknowledge the
pivotal role of base money in determining inflation, was leading
to the introduction and reintroduction of policies which
threatened the remarkable achievements of banking deregulation in
the 1980s.

He said the central bank could control base money growth if it
stopped depreciating the rupiah against the U.S. dollar.

If the central bank continued to depreciate the rupiah, it had
to continue buying foreign exchange from the public, meaning that
it was pumping base money into the economy, he said.

"The inflation in Indonesia was caused more by depreciation,"
he said.

"If the central bank reduces the depreciation it cuts the
inflation," said McLeod, who believed that the inflation problem
was only a monetary problem.

He said there was no need for the central bank to depreciate
the rupiah because the country's balance of payments was always
in surplus.

From 1986 until March 1996, he said, the government had
allowed the rupiah to depreciate 4 percent a year, but from March
to October last year depreciation was very small.

He said that 6 percent inflation last year was very much the
product of less depreciation.

The seminar's participants questioned McLeod's view, saying
that it was narrow and broad money (M1 and M2) which mainly
influenced inflation and not base money.

A World Bank economist cited the conclusion of his
institution's study that inflation in Indonesia was mainly caused
by M1 and M2. (bnt)