T

he economic stabilization policy adopted after the financial crisis of 1997 replaced the one in place during the 32 years under Soeharto.

In the previous era, between 1966 and 1998, the budget deficit was financed by long-term and concessionary loans from official development sources, the IGGI (International Governmental Group on Indonesia). This was called the '€œbalanced budget rule'€.

The budget and debt rules replaced the inflationary financing during the administration of president Sukarno prior to 1966 that financed the budget deficit.

The change in budget financing reduced the high rate of inflation from over 650 percent in 1966 to 10 percent in 1969.

This in turn enabled the government to start the implementation of the First Five Year Development Plan on April 1, 1969.

On monetary policy, President Soeharto'€™s administration repressed the banking system by setting detailed ceilings on bank credit, keeping interest rates low '€” sometimes below inflation rates '€” and determined the selective allocation of credit by priority economic sectors, class of customers and individual credit recipients.

Bank governance at that time was bad with the widespread practice of corruption, collusion and nepotism.  The central bank provided liquidity credit to finance the credit programs while credit risks were assumed by the state-owned credit insurance company.

Under such a credit program, the state-owned banks were treated as government treasury while bank regulations and supervision were focused only on credit administration rather than risks.

There was no incentive for the corporate sector to raise funds in domestic bond and the capital market simply because of the availability of cheap credit and low risks from state-owned banks.

Through lending to commercial banks, Bank Indonesia (BI) controlled its domestic credit or the domestic component of the monetary base.

Indonesia adopted a fixed-exchange rate system prior to 1997.

This allowed BI to directly control the foreign component of the monetary base, as it was ready to buy and sell units of foreign exchange at a fixed price in exchange for domestic money.

To keep the monetary base unchanged, BI credited the surplus in the foreign exchange as reserves.

The other way to counter the effect of foreign exchange reserves on the monetary base was through sterilization of the surplus by selling its own certificates (SBI) and other securities to banks in order to absorb increasing reserves.

Following the move to a floating exchange-rate system in 1997, BI has lost control of monetary authority on the foreign component of the monetary base, as it does not sell and buy exchange rates at a certain prescribed level.

Because of this BI has shifted to inflation targeting and the use of interest rate as the operating target of monetary policy.

The soft inflation targeting began in 2000 and the Taylor type reference has been fully implemented since 2005. Inflation targeting is supported by new fiscal and debt rules.

Similar to the Maastricht criteria of the EU, Indonesia limits the budget deficit to 3 percent of GDP and debt to GDP ratio at 60 percent.

Starting from July 9, 2008, the operational target was changed from the interest rate on one month BI rate to that of the interest rate in the overnight interbank market.

The central bank sets the real interest rate level neutral if the monetary policy is neither expanding nor contracting.

The neutral or equilibrium interest rate depicts stable inflation with a closed output gap over the medium term. The central bank sets the real interest rate above the neutral rate to dampen economic growth.

The difference between actual policy rate and the neutral real interest rate is called the interest-rate gap, which can be used to evaluate the monetary policy stance to close output.

It is not clear, however, the similarity between BI'€™s estimated long-term equilibrium natural interest rate in Indonesia with that of the US. Parallel to the US, the coefficient for inflation gap is nearly two and for the output gap is 0.25.

Potential output is estimated based on the Dynamic Stochastic General Equilibrium model (DSGE), which links real growth and changes in employment according to Okun'€™s law.

Aside from labor employment, the DSGE model also contains CPI inflation and capacity utilization, which are both unavailable in Indonesia.

In addition, Okun'€™s law is handicapped in estimating potential output in Indonesia because of limited data on the labor market, financial market, capital stock and capacity utilization.

The input and products markets are fragmented because of a combination of geography, weak inter-island connectivity and the high cost of interregional transportation, as well as distorted government policies.

Because of the market fragmentation, Indonesia has yet to exploit its large geography and population advantages.

In a dual economy, the role of an informal sector with low productivity is still substantial.

Moreover, in a small, open economy like Indonesia, the exchange rate affects both the interest rate and core inflation and CPI, by means of pass through effect.
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... Indonesia has yet to exploit its large geography and population advantages.
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The writer is professor emeritus of economics at the University of Indonesia, Jakarta.