Regarding the central bank's money policy: It's already too tight

Purbaya Yudhi Sadewa ,  Analyst   |  Thu, 09/11/2008 11:03 AM  |  Business

As a result of double-digit inflation, the central bank has hiked its benchmark interest rate steadily since May. However, there are now indications that liquidity in the Indonesian financial system is very tight.

This poses a major question: does the central bank need to tighten its monetary policy further?

Looking back, high oil prices in the first semester threatened the sustainability of the state budget, forcing the government to raise fuel prices. Thus, on the back of rising transportation and other operational costs, many producers took the step of raising prices for their products -- leading to a sharply higher rate of inflation.

BI then started tightening its monetary policy in May. And by early September, the BI rate stood at 9.25 percent after a series of hikes, from 8.0 percent in April.

The hikes in the BI rate might give the impression the central bank is indeed tightening its monetary policy. A more careful analysis, however, suggests the opposite is true.

This is because, despite the hikes in the BI rate, central bank certificates (SBI) outstanding have actually fallen. When the banking system reduces its SBI holdings, it receives cash from the central bank commensurate to the size of the reduction in SBI holdings.

Thus, rather than absorb excess liquidity from the financial system, the central bank has actually pumped money into the system. By the end of June 2008, SBI outstanding had fallen to Rp 158 trillion, from Rp 272 trillion at the start of the year.

In the meantime, open market operations (OMO) -- which include SBIs, FASBI and other instruments -- had fallen from Rp 281 trillion in December 2007 to Rp 191 trillion in June 2008. The fall suggests BI pumped money through the OMO amounting to around Rp 90 trillion in the first six months of 2008.

Although BI has been injecting money, the financial system is currently experiencing tighter liquidity. This condition has forced some banks to offer time deposits at a much higher rate than the BI rate.

In addition, some banks have started to slow down the process of loan disbursements. Some have even started to renegotiate loans that had previously been approved.

So if the financial system is experiencing tighter liquidity, where is all the money that was injected by the central bank since the beginning of the year?

Some believe the money in the financial system was absorbed by the rapid growth in loans. By June 2008, total bank loans had grown 33 percent year-on-year.

However, the brisk loan growth does not sufficiently account for the tight liquidity in the financial system.

Note that companies which borrow from banks put some of the borrowed funds in the bank from which they borrow. At the same time, some of the borrowed funds are also paid to the company's suppliers or contractors. The suppliers and contractors then deposit the money in banks. Hence, loan activities should not lead to a drying up of liquidity in the system.

One possible culprit for the tight liquidity could be the government's account with the central bank. The government account is not accessible to the banking system. As such, a significant rise in the account means more money is being taken out of the system, which results in less liquidity in the market.

Usually, the total funds in the government account remain at a low level at the beginning of the year. The amount typically grows gradually as government income from taxes and other sources begins to build up.

Then in April, the growth in the government account tends to slow significantly. This is because various projects -- including infrastructure and development projects -- start to be implemented. In the April-November 2007 period, for instance, the government account in the central bank was stable at around Rp 80 trillion.

In 2008, however, the account is displaying a different pattern from previous years. Funds in the account are significantly higher than usual. In the April-June period, the amount of funds in the government account hovered at around Rp 140 trillion. And they even rose to Rp 170 trillion by the third week of July.

This is around Rp 90 trillion higher than the average level in the same period of 2007.

As such, most of the money injected by BI into the system through its open market operations has been absorbed by the government, which, in turn, has then deposited the money back in the central bank. In other words, the government, which usually prefers a more lax monetary policy to spur growth, has unintentionally helped the central bank tighten monetary policy.

At the same time, liquidity has also dried up as a result of significant increases in the overnight rate. In the December 2007-July 2008 period, the average overnight rate rose 5 percent. The increase was due to BI's new policy of using the BI rate as the target for the overnight rate.

So why has the government account with the central bank increased so much? Basically because of low absorption in the state budget, with many government development projects still to be implemented as of July 2008.

And the very low rate of government expenditure in the second quarter of the year (only 2.2 percent) only confirms the low level of absorption in the state budget.

In summary, there are indications that liquidity in the financial system is getting very tight.

So unless the government can find a way to accelerate the implementation of its development projects, a further tightening in monetary policy could dry up liquidity even more, thus putting the current economic expansion at risk.

The writer is the chief economist at Danareksa Research Institute

Copyright © 2008 The Jakarta Post - PT Bina Media Tenggara. All Rights Reserved.