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Indonesia Monetary and Exchange Rate Policy
In the early 1990s, Bank Indonesia, the central bank of
Indonesia, was formally under the guidance of the central
government through the Monetary Board. This board was
composed of
the minister of finance, several other cabinet members,
and the
governor of Bank Indonesia. New Order monetary policy
reflected the
resolve of the government to maintain stable prices and a
balanced
central budget to prevent the high inflation of the
previous
decades. This priority was stated in 1991 by the governor
of Bank
Indonesia, who announced a departure from the central
bank's goal
to inflationary rates below 20 percent a year. Henceforth,
the goal
would be to reduce inflation to a maximum of 6 percent a
year.
High inflation had been a major problem since the
mid-1960s.
During the Sukarno regime's final years, the increasing
government
deficit was financed by Bank Indonesia in compliance with
instructions from the Monetary Board--a practice that
violated Bank
Indonesia's own charter, which limited central bank credit
to 20
percent of gold and foreign exchange reserves. Although
this lack
of financial discipline was a major cause of severe
inflation
during the mid-1960s, the New Order regime was unwilling
to
dismantle the time-tested Monetary Board.
Whereas, during the 1970s and 1980s, the central bank
contained
inflation below 20 percent per year with few exceptions,
in 1991
the governor of Bank Indonesia pledged to reduce inflation
by
limiting the amount of bank credit available in the
economy. After
the 1983 reforms, Bank Indonesia faced the problem of
controlling
bank credit while permitting all banks, including the
then-dominant
state banks, to operate on a commercial basis. In many
industrialized countries, indirect control of bank credit
is
achieved by central bank transactions in government
securities that
expand or contract the supply of reserves available to
banks to
meet required reserves on bank liabilities. Because the
Indonesian
government maintained a balanced budget, no government
securities
were issued. Instead, Bank Indonesia began to issue its
own debt in
the form of Sertifikat Bank Indonesia (SBI), beginning in
1984. The
intent was to encourage banks to invest their short-term
funds in
SBIs, and, as the market deepened, permit Bank Indonesia
to buy and
sell SBIs to influence the quantity of bank reserves. Bank
Indonesia also encouraged the development of other
privately issued
short-term debt instruments. A sophisticated market in
short-term
securities offered banks more flexible management of their
total
assets and encouraged them to hold short-term funds in
rupiah
rather than in overseas dollar deposits, which had become
a common
practice.
In the 1990s, Bank Indonesia also managed the exchange
rate
between the rupiah and foreign currencies, a
responsibility that
sometimes conflicted with the objective of controlling the
amount
of bank credit. Following a period of floating the rupiah
from 1966
to 1971 to permit the market to set its value in foreign
currency,
Bank Indonesia pegged the exchange rate at Rp415 per US$1,
and
lifted most restrictions on international transactions
that were
heavily regulated during the Sukarno era. To maintain the
exchange
rate, the central bank was obliged to buy or sell as much
foreign
currency as was demanded at the predetermined rate.
When oil revenues surged in 1974, the bank found itself
in
essence printing rupiah currency in exchange for the
oil-generated
dollar revenues. Bank credit rose precipitously once the
currency
was deposited in domestic banks. Inflation surged to over
40
percent that same year, the highest rate experienced in
the New
Order era as of 1992. Bank Indonesia responded
aggressively by
imposing direct controls on the amount of credit issued by
individual banks, a policy that also contributed to the
lack of
competition with the favored state banks
(see Financial Reform
, this ch.). By 1978 inflation was reduced to less than 10
percent
per year, but four years of double-digit inflation had
seriously
undermined Indonesia's exporters, whose costs rose with
inflation
even though revenues still translated into rupiah at the
rate of
Rp415 per US$1.
To address the eroding profits of exporters, Bank
Indonesia was
compelled to devalue the rupiah by 50 percent in 1978,
bringing the
exchange rate to Rp625 per US$1. Bank Indonesia announced
its
intent to permit more gradual adjustments in the exchange
rate in
line with the industrial world's abandonment of fixed
exchange rate
regimes in the mid-1970s. However, inflation in Indonesia
continued
at an average of 14 percent per year, which was low by the
standards of many developing countries but above that in
many of
Indonesia's industrialized trade partners. In 1983 a
second major
devaluation brought the rupiah exchange rate to Rp970 per
US$1.
This devaluation was accompanied by a major financial
reform that
eliminated the direct controls Bank Indonesia had relied
on in the
past to manage the growth in bank credit.
Although these markets began to develop gradually, Bank
Indonesia continued to confront periodic financial crises
that
required a more drastic response. The third major
devaluation since
1971 was undertaken in September 1986, primarily in
response to the
decline in foreign exchange earnings through oil exports.
The
exchange rate rose from Rp1,134 per US$1 to Rp1,641 per
US$1.
Moreover, the uncertain oil market, together with the
history of
major devaluations, combined to make financial markets
highly
susceptible to rumors of further devaluations. Once
anticipation of
a possible devaluation spread, the response by banks and
businesses
alike was to borrow rupiah funds to acquire dollars to
profit from
the anticipated devaluation, thereby depleting the dollar
reserves
of Bank Indonesia. Ideally, such runs could be discouraged
by
paying a high rate of interest on SBIs, but occasionally
the crisis
was so severe that banks were unwilling to purchase SBIs.
On two
occasions, in late 1987 and February 1991, Bank Indonesia
instead
required state-owned corporations to withdraw large sums
from their
bank deposits (around Rp800 million in 1987 and Rp8
trillion in
1991) to purchase SBIs, which deprived banks of a major
source of
rupiah funds to use for speculation, thwarting the outflow
of
dollar funds.
The efforts to manage inflation and contain speculation
against
the rupiah resulted in high interest rates on bank credit
following
1983 interest rate deregulations. In 1991 interest rates
on
commercial loans soared to 28 percent per year from 20
percent in
1990, whereas inflation was around 9 percent per year. One
Indonesian economist from the private Institute for
Economic and
Financial Research observed that many businesses would be
unable to
find investment projects that could generate such a high
rate of
return. The Asian Wall Street Journal noted in
February 1991
that the high interest rates on bank deposits were partly
responsible for the substantial decline in the average
stock share
prices listed on the Jakarta Stock Exchange in 1991, which
dropped
over 50 percent from the previous year as financial
investors found
bank deposits a more lucrative investment. In spite of
these
adverse consequences, the government remained steadfast in
its
efforts to control inflation in the hope that improvements
in bank
efficiency and increased economic growth would help lower
interest
rates. In addition, Bank Indonesia permitted a more
gradual rate of
rupiah depreciation (about 5 percent per year) from 1987
through
1992 to avoid further major devaluations.
Data as of November 1992
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