Back to basics in monetary policy

The Jakarta Post , Jakarta | Sat, 05/26/2001 12:00 AM

This is the second of two articles on monetary policy by Tubagus Feridhanusetyawan, senior economist and head of economic affairs at the Centre for Strategic and International Studies (CSIS) in Jakarta.

JAKARTA (JP): Those who are against tighter money policy may argue that a higher interest rate would not effectively reduce inflationary pressure because imported inflation continues to dominate. Under these circumstances, sharp increases in the interest rate could be costly for the real sector, and if the interest rate is too high, it may lead to possible contractions in the real sector, which could crowd out efforts reduce inflation.

When the interest rate is facing a glass ceiling, the effort to support the currency is through direct policy action in the currency market. One method is to increase capital inflow by demanding exporters put their foreign currency earnings in domestic banks.

This would not be effective because with the collapse of the domestic banking system, many exporters are using offshore trade-financing services. In addition, institutional and legal frameworks are not effective or solid enough to prevent the under-invoicing and over-invoicing of exports and imports.

In the absence of capital inflow, a desperate action to restrict the demand for foreign currency is to control capital outflow. In other words, if the supply of foreign reserves could not be increased, then the demand has to be restricted.

Here comes the controversial argument for capital control. The measure to control capital outflow is seen as the second-best, or even third-best, solution when the relationship between interest rates and exchange rates is less sensitive.

With some sort of capital control, domestic interest rates could be kept lower, relative to international rates without creating heavy pressure that would lead to rupiah depreciation. Those who believe in capital control argue that there are various types of controls that can be implemented, from strictly monitoring spot transactions, taxing currency transactions, to strictly banning the purchase of foreign currencies.

While capital control seem to be attractive on paper, it is still not the best solution. The best solution is to revive confidence in the economy and encourage capital inflow. Restricting outflow is definitely not a substitute for that. Some argue that what Indonesia needs are three conditions: stable politics, credible economic reforms and some sort of capital control.

Once we have the first two, we do not need the third one. While capital control may be able to put the trash under the carpet in the short-term, its implementation would not solve the problem without having stable political conditions and credible economic reforms.

The implementation of any form of capital control is another problematic issue. The biggest problem that Indonesia is facing today is the absence of legal and institutional frameworks to ensure that things are done correctly. Placing restrictions on transactions would not work because the market would find a way to get around them.

We have had some examples already. The ban of one forward currency market overseas led to the development of a domestic non-delivery forward market within only two weeks. Another example is the blunder performed by the government in setting different prices for diesel fuels in the market, which led to a shortage of diesel fuels at gas stations, the creation of a black market and other illegal transactions.

No-one could guarantee the absence of a black currency market with the implementation of capital control or restrictions on currency transactions. Therefore, the credibility of any capital control is really questionable.

Let's go back to basics.

While the daily movement of the rupiah could constantly feed daily political news, the short and medium-term movement of the rupiah still depends on monetary fundamentals. So the monetary authority should focus on the core monetary fundamentals, which is the growth of base money.

Furthermore, Bank Indonesia should focus only on inflation. The central bank's officials have said that they are more interested in targeting core inflation, which actually opens the possibility for blaming the government for higher inflation due to the increase in some administered prices.

Or perhaps the bank has prepared another excuse for its possible failure in maintaining single digit inflation this year. Again, Bank Indonesia should be responsible for the control of overall inflation, not core inflation, and in return it should be given total independence in implementing its monetary policies.

Bank Indonesia officials have done their job in monitoring the monetary targets, but again, the increases in the interest rate have been too small, too late. This is not a new phenomenon though, because it seems that they have been watching many other things rather than just the growth of base money.

It remains to be seen whether base money growth of around 10 percent this year can be achieved, and the answer depends on Bank Indonesia's independence.

Bank Indonesia has been constantly fighting for its independence, and a real test case for its independence now is whether the bank's officials can determine interest rates or money growth without any intervention. Consistency with the principal of independence in conducting monetary policy would lead the monetary authority to be the one to blame if the monetary indicator gets out of control.

Higher interest rates are surely not without their risks. Further bank closures, mergers and a second round of recapitalization are all possible, and these are not simple matters. Because of the weak legal system, the breakdown of institutional frameworks, ineffective banking restructuring and the large government budget deficit, further bank closures and recapitalization would be extremely complex.

If we could risk higher interest rates, of course there is still another policy option to sacrifice the money growth, to maintain a low rupiah, and to allow for higher inflation. But can anyone guarantee that higher inflation and a lower rupiah would not lead to another round of bank recapitalization next year?

The effectiveness of monetary policies would also depend upon the success of bank restructuring. Solid banks would sustain a high interest rate environment and an efficient banking operation would reduce monetary operation costs.

Because the domestic credit market has collapsed, commercial banks have been investing in large amounts of Bank Indonesia short-term promissory notes (SBIs) to survive, and, as a result, the increase in SBI rates may have to be high enough to give commercial banks an incentive to increase their deposit rates and absorb any excess liquidity in the market.

Therefore, as long as the domestic banking system is weak and the progress of bank restructuring is slow, monetary policy will always be constrained.

Today's underlying problem is a lack of confidence in the government, in economic reform, and in the country in general, which have led to continuing net capital outflows. Anything that can solve these problems, that can bring back capital inflows in any form, would be the best solution.

The temptation to put currency or capital controls in place remains high, especially when the current or even the future government fails to show credibility, to bring back confidence and to attract significant capital inflows. But one must remember that implementing capital controls would never be the best solution.

The lack of institutional and legal frameworks would require the policy action to be designed as simply as possible. From the monetary side, just focus on the growth of money, be consistent, and let the market adjust and find its own way.

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