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)