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Bulletin of Indonesian Economic Studies
ISSN: 0007-4918 (Print) 1472-7234 (Online) Journal homepage: http://www.tandfonline.com/loi/cbie20
Indonesian Monetary Policy During the 1997–98
Crisis: A Monetarist Perspective
George Fane
To cite this article:
George Fane (2000) Indonesian Monetary Policy During the 1997–98 Crisis:
A Monetarist Perspective, Bulletin of Indonesian Economic Studies, 36:3, 49-64
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http://dx.doi.org/10.1080/00074910012331338953
Published online: 18 Aug 2006.
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INDONESIAN MONETARY POLICY DURING THE 1997–98
CRISIS: A MONETARIST PERSPECTIVE
George Fane*
Australian National University
This paper defends the IMF’s strategy of targeting base money (M0) in 1997–98 against the criticism by Grenville (2000) that it was destined to fail because M0 is mainly demand determined and the demand for it was increased by a large and unpredictable amount by the banking panic. Grenville contends that Indonesian monetary policy should have aimed at domestic price stability. It is argued here that the growth of M0 far exceeded what could be justified by last resort lending to accommodate the banking panic, and that rapid inflation could only have been avoided by preventing most of the expansion of the public’s cash holding that actually occurred. Achieving a modest target for domestic inflation would not therefore have been very different in practice from setting tight limits on the growth of M0. In contrast, both these policies would have been very different from the loss of control over M0 that actually occurred.
INTRODUCTION
Different economists have drawn different lessons from the Asian crisis on how monetary policy should be set during currency and financial crises in emerging market economies. The present paper defends the IMF-endorsed strategy of targeting base money against criticisms levelled at it by Stephen Grenville (2000).
successful floating exchange rate system, no such target was announced until 31 October 1997, when a letter of intent from the Indonesian government to the IMF set out a new IMF-endorsed monetary strategy. The main element of the new strategy was to set targets for the slow growth of base money and its components—net domestic credit and net foreign assets. By controlling base money, the IMF and the government hoped that they would restore confidence in the rupiah and cause a reversal of the depreciation which, even at the end of October 1997, already far exceeded any plausible estimate of the amount needed to restore competitiveness, and instead reflected the fear, soon to be realised, that BI would lose control over the money supply.2
Grenville (2000) is highly critical of the IMF’s strategy. He argues that base money was not a useful guide for monetary policy because its main component—currency held by the public—is demand determined, and the demand for it was increased by a large but unknowable amount by the banking panic. He therefore claims that trying to control base money was ‘destined to fail’. He also asserts that ‘the exchange rate was driven by forces that could not be offset by higher interest rates’ (p. 44). Instead of targeting base money, he argues, policy should have been aimed at domestic price stability, and the IMF should have been boosting confidence by saying that Indonesian monetary policy was doing just about all that could be expected of it, rather than eroding confidence by harping on its deficiencies (p. 55).
banks were to be allowed to fail at clearing. This implication, which I reject, is the basis for Grenville’s attack on the policy of targeting base money. He argues that BI should instead have targeted the price level. In the next section I argue that his support for targeting the price level is inconsistent with his explanation of why, in his opinion, it would have been infeasible to target base money. I argue that BI could only have avoided excessive inflation by preventing most of the expansion of the public’s cash holding that occurred during the crisis period. Setting and achieving a modest inflation target would not therefore have been very different in practice from implementing the base money targets agreed with the IMF. In contrast, both these policies would have been very different from the loss of control over the supply of base money that actually occurred.
The second issue involves interest rates and the exchange rate. In contrast to the impression created by Grenville, I argue that BI did not follow a high interest rate policy for at least six months after September 1997, and did not allow interest rates to rise by enough to prevent a rapid expansion in base money until July 1998. Almost as soon as it did bring base money under control in July and August 1998, by allowing the interest rate on its own certificates of deposit (SBI, Sertifikat Bank Indonesia) to rise to 70% per year, inflation was halted and the exchange rate appreciated. During the second half of 1998, confidence in BI’s commitment to its base money targets was gradually restored; as a result, the interest rate on one-month SBIs fell from 70% to 35% per year.
MONETARY TARGETING
In industrialised countries with long-established reputations for avoiding rapid inflation, an explicit commitment to a nominal target is often not necessary for the maintenance of confidence in the currency. But even in these countries, an explicit commitment to a nominal target probably helps to maintain confidence, if it can be made credible. However, since developing countries are much more prone to excessive inflation, a firm and explicit commitment to a nominal target is correspondingly more important for them than for industrialised countries. Whether the commitment is to the exchange rate, the rate of inflation, nominal GDP, or some measure of the volume of money is less important than the making of a credible commitment to some nominal target.
The correct choice of the variable to target need not be the same everywhere. In his appendix, Grenville explains why the USA moved away from targeting base money. In a country with a long-established reputation for no more than moderate inflation, this may well be a sensible choice. There is, as he argues, a case for targeting one of the variables that policy makers seek ultimately to control, such as prices or nominal GDP. On the other hand, there is also a case for targeting a variable that policy makers can directly control, such as base money. Which is better depends partly on how accurately the central bank can predict the lagged responses of the variables in which it is ultimately interested to the things that it directly controls, such as open market operations or the prices of its own securities. Trying to target a variable that is not directly under the control of the monetary authorities, and which responds to these direct instruments in complex ways, runs the risk of generating excessive oscillations for reasons that can be easily appreciated by watching a novice trying to reverse a car and trailer.
The choice of target also depends on how important it is for the authorities to enhance their credibility. If they initially lack credibility but genuinely mean to keep to their targets, base money has two important advantages over other targets. First, the monetary authorities can directly control it if they choose to do so, and if they allow both interest rates and the exchange rate to be market determined. Second, market participants can quickly see if the authorities are hitting their target. For these reasons, the IMF was probably right to encourage the Asian crisis countries to target base money rather than the price level.
crisis in which the central bank is suspected of being about to inflate the money supply, vagueness undermines credibility. While conceding that SBI sales might have been ‘more vigorous ... in the latter months of 1997 and early months of 1998’ (p. 47), Grenville argues that most of the expansion of base money during the crisis was inevitable. If so, then most of the inflation that occurred was also inevitable, and an inflation target would have been pointless because it would have had no chance of being fulfilled.
At the end of his article, Grenville suggests that BI should have tried to maintain the stability of non-traded goods prices and wages. ‘It would still have been necessary to have quite tight monetary policy (in practice, probably somewhere near the settings that were achieved going into the middle part of 1998, i.e. somewhat higher than the end 1997 period)’ (p. 55). Since tight control of base money is the lever that BI would have to have used if it had tried to maintain the stability of non-traded goods prices and wages, this suggested strategy appears to be much closer to the IMF-endorsed strategy of tight base money targets—which Grenville strongly criticises—than to the very rapid expansion of base money that BI allowed to occur. What BI actually did in early and mid 1998 was, first, to allow the interest rate on one-month SBIs to rise from 22% to 45% per year in late March, and then to halt the growth of base money in July and August by allowing this rate to rise to 70% per year. Grenville’s approval of monetary policy ‘settings’ when they involved selling SBIs on the scale needed to halt the growth of base money is inconsistent with his view that it was not feasible to prevent most of the growth of base money that actually occurred.
There are three reasons for preferring Grenville’s relatively optimistic view that BI could and should have targeted domestic prices—which I take to mean that it should have used whatever SBI sales were necessary to restrict inflation to, say, 20% in 1998—to his pessimistic and contradictory assertion that the bulk of the growth of base money during the crisis ‘had to be met’, because it was due to the growth of the public’s cash holding.
plausible view that the rapid, but less extreme, inflation that occurred in Indonesia in 1997–98 was due to the rapid, but less extreme, growth of its monetary base.
Second, if the Indonesian authorities were merely expanding base money in line with an exogenous rise in the demand for it, there would have been no reason for prices to rise at all. What then caused Indonesian prices to rise by 78% during 1998? The flaw in Grenville’s analysis is to refer to the ‘public’s demand for cash’, without distinguishing between its demand for cash at given prices, and its demand for cash at rapidly rising prices, and without acknowledging that rapidly rising prices are the result of increasing the supply of base money faster than the growth in demand for it at given prices.
Third, as figure 1 shows, the variations in the ratio of broad money to base money and the velocity of circulation of base money in 1997 and 1998 were negligible compared to the increase in the volume of base money.4 The measured velocity of circulation of base money and the measured ratio of broad to base money both rose in August 1997 and then both fell during the last quarter of 1997. Part of these measured changes was genuine and part was spurious. The spurious part was that in late 1997 BI allowed the banks to run overdrafts that played the role of reserves, but were not counted as part of the monetary base until the end of December. The genuine component of the changes was due partly to the banking panic in late 1997 and the restoration of confidence after the announcement of the government’s blanket guarantee of depositors in January 1998. It was also due partly to the relaxation in September 1997 of the August credit squeeze. This relaxation brought the interest rate on one-month SBIs down from 40% at the beginning of September 1997 to 21% at the end of the month.
Between the end of September 1997 and the end of June 1998, only a small part of the Indonesian public’s increased demand for cash can be attributed to its loss of confidence in the banks. The great bulk of it was due to rapidly rising prices and expanding bank lending to the private sector, which were only possible because of BI’s massive unsterilised expansion of last resort lending. Far from declining, the public’s holdings of rupiah deposits grew during this period at an annual rate of 79%. The shift from deposits to currency, which caused the ratio of broad to base money to fall from 9.6% in September 1997 to 9.0% in June 1998, was dwarfed by the expansion of base money, which was growing at an annual rate of 138% over the same period.
from the weakest private banks, together with the deposit-creating effects of BI’s credit expansion, allowed the state banks and the private banks that did not fail—or at least not immediately—to expand their total assets and liabilities. For all commercial banks, this expansion was from Rp 484 trillion at the end of September 1997 to Rp 1,014 trillion at the end of June 1998. The implied annualised growth rate is 168%. The corresponding annual growth rate for the assets and liabilities of state banks alone was 231%. It is not possible to estimate exactly how much of this rapid growth was due to new lending, how much to the rise in the book value of outstanding foreign currency denominated loans because of the rupiah’s FIGURE 1 Base Money, Velocity of Base Money and Ratio of Broad to Base Moneya
(1996 = 100)
aM0 is base money; M2 is broad money; V0 is the velocity of circulation of base
money (nominal GDP/M0). Monthly nominal GDP is obtained by interpolating quarterly nominal GDP; the estimate for the middle month in each quarter is esti-mated as the GDP for that quarter, the estimate for the first and last months for each quarter is two-thirds of the GDP for that quarter plus one-third of GDP in the nearest adjacent quarter.
Source: Asian Database of CEIC Ltd (Hong Kong).
0 50 100 150 200 250 300
Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99
depreciation, and how much to the accumulation of interest on existing rupiah denominated loans. However, there are three reasons for thinking that, during the period in which Grenville claims that BI was obliged to expand base money very rapidly because the public was draining liquidity from weak banks, some of them were in fact extending substantial amounts of new loans.
First, there is evidence relating to individual banks. The Texmaco affair provides direct evidence of large new lending by a state bank.5 Balance sheet data for Bank Central Asia (BCA), the largest private bank, strongly suggest that it too was making new loans during the crisis. Before it was taken over and nationalised by the Indonesian Bank Restructuring Agency (IBRA) at the end of May 1998, BCA received Rp 21.3 trillion in liquidity support from BI. Subsequently, bad and doubtful loans with a face value of Rp 73.3 trillion were transferred from BCA to IBRA, and BCA was left with loans of Rp 4.1 trillion (Bahana Securities 2000: 14–15). Since its total loans in 1996 had been only Rp 23.0 trillion, it appears that during 1997 and early 1998 BCA was able to expand its lending by Rp 54.4 trillion, or 237%. It is hard to believe that all this growth occurred before the crisis began, or that it was due just to rolling over existing loans.
A report presented to parliament in August 2000 by the Supreme Audit Agency (BPK) asserted that more than 95% of BI’s last resort loans to 48 private banks that borrowed from it during the crisis were wrongly used. These alleged uses included financing foreign exchange speculation, illegal lending to related businesses, repaying subsidiaries’ loans, the expansion of branches, and the acquisition of fixed assets. The report claimed that more than two-thirds of the loans went to support five banks with close links to former President Soeharto, and that some banks disguised their true position to conceal the fact that their assets were less than their borrowing from BI.6 If these claims are correct, they provide case-by-case confirmation of the implication in the aggregate data that BI’s last resort lending exceeded what was needed merely to accommodate the public’s wish to raise the ratio of cash holdings to deposits. They also offer a simple motive for BI’s seemingly irresponsible and excessive last resort lending: some of its officials were corrupt and others were reluctant to refuse the corrupt demands of Soeharto’s cronies. The accuracy of the report will be tested if the investigations promised by the Attorney General lead to prosecutions.
interest. Given the banking panic, they would have grown more slowly than this, or declined, in the absence of net new lending. In fact, whereas total assets grew by Rp 530 trillion between the end of September 1997 and the end of June 1998, total commercial bank capital rose by only Rp 10 trillion over this period and, as noted above, rupiah deposits were actually growing at an annual rate of 79%.7
Finally, according to BI’s data on non-compliance with its prudential regulations, the number of banks in violation of the legal lending limits rose from 56 at the end of 1997 to 137 at the end of 1998 (Bank Indonesia 1999: 93). This rise is at least consistent with the view that many banks were extending loans to related firms during the crisis.
The increase in the demand for cash was not an inevitable consequence of the banking crisis that forced BI to expand base money. It could not have occurred in the absence of extensive money creation by the commercial banks and of the price inflation that this produced. In turn, the rapid creation of money by the commercial banks could not have occurred if last resort lending had merely accommodated the non-bank private sector’s desire to hold a higher proportion of cash relative to deposits, thereby forcing banks to reduce lending.
Given the relative stability of the velocity of circulation of base money, targeting the domestic price level and targeting base money would have involved similar policies. Under an effective inflation strategy, base money would have had to grow at rates similar to those announced in the various letters of intent to the IMF. In both cases, the immediate instrument of policy would have been SBI sales, and in both cases BI would have had to allow the interest rate on SBIs to rise to the kinds of levels that were not accepted until July and August 1998.
At one point in the crisis, BI did in fact state that it was targeting inflation. The government’s letter of intent to the IMF on 15 January 1998 dropped the base money targets that had been announced in October 1997 and announced a price level target: inflation was to be held to about 20% during 1998. According to the letter of intent, the inflation target was to be achieved by restricting the growth of broad money to about 16% in 1998. The trouble was that BI was not willing to allow interest rates to rise to the extent that would have been necessary to keep to the monetary target in the first quarter: in January 1998 alone, the growth of broad money exceeded the target for the whole of 1998, and the resulting inflation was so rapid that the CPI (consumer price index) had already exceeded its targeted annual growth by the end of February 1998. Like the base money targets of October 1997, the inflation and broad money targets of January 1998 were never implemented and never referred to again.
When Thailand began its IMF program in August 1997 it announced base money targets for the 12 months beginning in September 1997. When Korea began its IMF program in December 1997 it initially announced base money targets for only the next three months, but it extended the target horizon to 12 months in early February 1998 (Fane and McLeod 1999: 402, tables 3 and 4). Both Thailand and Korea kept to their targets and the baht and won appreciated strongly over these periods. In both Thailand and Korea, consumer prices rose by only 7% between September 1997 and September 1998, whereas they rose by 83% over the same period in Indonesia. Since targeting base money was successful in Korea and Thailand, it is hard to see why it was ‘destined to fail’ in Indonesia.
Although Grenville does not mention BI’s reversal of its previously expansionary monetary policy in July and August 1998, the results of its new-found determination to keep to its announced base money targets were impressive: from the end of July 1998, base money was held constant for more than a year, the dollar value of the rupiah roughly doubled during the next five months, and the consumer price index rose by only 1% in the year from September 1998. If this policy could succeed in July– August 1998, why was it inappropriate and ‘destined to fail’ in October 1997?
HIGH INTEREST RATES AND THE DEFENCE OF THE RUPIAH
and interest rates were the instrument’ (p. 44). This description reflects how the IMF wanted BI’s policy to be set, rather than how it was actually set. At the insistence of former President Soeharto, BI in fact reduced the SBI interest rate in September 1997 from 30% to 21%, and kept it close to 20% for the next six months.8 Rather than control base money, BI followed a low interest rate strategy during the first six months of the crisis, and did not bring base money under control until July–August 1998, when it allowed the SBI interest rate to rise to 70%. By demonstrating that it—or Soeharto—preferred to allow a massive increase in base money rather than to keep the SBI rate above 20%, BI destroyed the credibility of the monetary strategy agreed with the IMF. What was needed in the first half of 1998 to restore BI’s credibility was not an assertion that monetary policy was doing about all that could be expected of it, but a detailed explanation of why it had failed to meet its previously announced targets and why it would henceforth keep to its new ones.
The ‘high interest rate’ strategy for defending an exchange rate has come in for much criticism recently. The basic empirical finding of the studies that supposedly cast doubt on the effectiveness of this strategy is merely that high interest rates are at least as likely to be followed by a large depreciation of the exchange rate as by its maintenance (see, for example, Kraay 1999; Basurto and Ghosh 2000). This empirical finding is entirely consistent with the view that a country with a floating exchange rate should set a credible nominal target. Indeed, if high interest rates were not usually accompanied by rapid exchange rate depreciation, buying apparently weak currencies would, on average, provide a free lunch. The obvious explanation for the observed correlation between high nominal interest rates and exchange rate depreciation is that high interest rates are often an indication that the central bank has not made a credible commitment to monetary restraint. It would be nice if one could test whether making a credible commitment to slow monetary growth usually produces moderate interest rates and exchange rate stability, but it is obviously hard to measure the credibility of a commitment to monetary restraint without begging the question by using the outcome to measure the credibility of the announcement. The other side of this econometric problem is the policy problem of how to make an announced target credible.
implementing its monetary targets and allowing interest rates to rise in the period July to September 1998, BI convinced investors of its new-found determination to keep to its monetary targets in the future.
Although it is hard to achieve complete credibility, the studies by Cukierman (1992) and Cukierman et al. (1993) show that, on average, central bank independence is associated with low inflation. One plausible rationalisation for this finding is that the best way to make a commitment to a nominal target credible is to use legislation to set the target as the central bank’s primary, or sole, objective, and give the central bank the policy instruments and the political independence to achieve it. This provides strong justification for the new act, Law No. 23 of 1999, that has greatly increased BI’s independence (McLeod 1999). The fact that BI was dominated by Soeharto appears to have been a major factor in its failure to keep to its monetary targets. For example, as summarised in note 5, it appears that Soeharto intervened personally to pressure BI to facilitate the provision of large subsidised loans to the Texmaco group.
LAST RESORT LENDING AND THE COST OF BAILING OUT THE BANKS
The Price of Last Resort Loans: Penalty Rate or Subsidy?
It has been argued above that BI’s expansion of base money in late 1997 and early 1998 far exceeded what was needed to accommodate the banking panic. BI should instead have chosen between the following two more responsible options. The first was to adopt a policy of accommodative last resort lending. This would have involved selling enough SBIs to offset the effects on broad money of BI’s loans to banks that were losing deposits. The interest rate on SBIs would have had to rise by enough to ensure that the banks to which deposits were being transferred wished to buy SBIs, rather than to extend new loans. The second option was to close down or take over the weak banks that were losing deposits and transfer the remaining deposits to surviving banks, in accordance with the blanket guarantee given to depositors and other creditors of Indonesian banks in January 1998.
most of which subsequently fail, and at interest rates that are highly subsidised relative to the true risk of default. Benston and Kaufman (1997: 148–9) cite a US Congressional study which showed that 90% of the banks that received extended credit from the Federal Reserve in the savings and loan crisis of the late 1980s subsequently failed.9
The difficulties of preventing last resort loans from being used to prop up failing banks are much greater in Indonesia than in the USA. Any good defence of accommodative last resort lending—’option 1’ above— would have to explain how BI could have offered a high enough rate on its SBIs to absorb excess liquidity while propping up the weak banks, and yet have avoided making large losses by lending to insolvent ones. In my view, this would have been an impossible task, since the true risk of default of many of the banks borrowing from BI was so high that loans at these rates would have been of little use. BI should therefore have followed the second option and closed down or taken over the weak banks as quickly as possible.
BI’s discount rate was kept at 20% from November 1997 to February 1998, when it was raised to 22%. The rate was raised again to 27.75% in March, to 46.4% in April and then to 58% in May 1998. Over these months, the interest rates on interbank loans to the strongest banks were usually between 40% and 50%, but the weakest banks—to which BI was lending— had to pay around 150% or more if they wished to borrow in the interbank market (Bank Indonesia 1999: 62). Since interbank lenders to the weakest banks must have known about the loans that the latter were receiving from BI, the 150% rates demanded probably reflected a fair estimate of the premium needed to compensate lenders for the risk that such banks would default, even given BI’s heavily subsidised support. In the event, the high default rate on BI’s last resort loans meant that taxpayers had to bail out BI by issuing it with Rp 164.5 trillion of government bonds. In addition, BI’s last resort loans gave weak banks the time and the funds to gamble on resurrection.
Last Resort Lending or Prompt Corrective Action?
The incentive provided by government and central bank safety nets for conglomerates to gamble with depositors’ funds was a major contributor to Indonesia’s economic debacle, and second in importance only to the chaos created by the failure of the bankruptcy system to force debtors to negotiate a restructuring of their debts or forfeit their assets.
hazard, are only apparent later. Probably the least inefficient way of containing this moral hazard is to institute a system of formal deposit insurance in which banks with high capital adequacy ratios are charged low premiums, and subjected to few additional regulatory constraints, whereas those with low capital adequacy ratios are charged high premiums and subjected to tight regulatory constraints.
A system with some elements of this approach was introduced in the US by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991, although Congress was strongly criticised by some commentators for having watered down the provisions of the original bill. The most important element of the FDICIA is ‘prompt corrective action’, which means that regulators are obliged promptly to apply increasingly severe corrective provisions on banks as their capital adequacy declines from safe levels to levels at which they are deemed to be critically undercapitalised, and therefore to have very strong incentives to use taxpayers’ funds to gamble on resurrection. The great danger of last resort lending is that it involves the opposite of prompt corrective action: it enables banks that are in the process of failing to obtain the funds to finance one last throw of the dice.
While implicit deposit guarantees or explicit deposit insurance appear to be politically unavoidable, there does not seem to be any good reason why weak banks should be supported with last resort loans, rather than quickly closed down or taken over. If the Indonesian banks that eventually failed had been closed down more quickly there would have been a huge saving to taxpayers. At the end of December 1997, just before the government issued its blanket guarantee, the total liabilities of the commercial banks were Rp 529 trillion. Six months later these liabilities had grown to Rp 1,014 trillion, an annual growth rate of 267%. The gross cost of government bonds needed to bail out the banks is now estimated to be at least Rp 639 trillion, which is well in excess of the total assets and liabilities of all banks shortly before the guarantee was issued. The eventual cost may well end up being much higher than the current estimates. As recently as early 1999, this cost was expected to be ‘only’ Rp 166 trillion (Cameron 1999: 21).
NOTES
* I am grateful to Peter Rosner for many very helpful suggestions.
2 By October 1997 the rupiah price of dollars, deflated by the consumer price index, had risen by 44% relative to the average for 1996.
3 All data on monetary and banking aggregates reported in this paper are taken from the Asian Database of CEIC Ltd (Hong Kong); the ultimate source is Bank Indonesia.
4 Figure 1 omits the data for end December 1999, when the supply of base money was temporarily increased to accommodate the increased demand for it due to the Y2K scare.
5 Loans were channelled from BI to the textile conglomerate Texmaco via the state-owned Bank BNI. The total loan package to Texmaco, which was negotiated between November 1997 and February 1998, was for about $1 billion, in the form of $754 million in foreign exchange and Rp 1.9 trillion in domestic currency. The latter component amounted to about $500 million at the November 1997 exchange rate, but only $180 million at the February 1998 rate (Fane 2000: 29–30).
6 The summary of the report given here is taken from The Financial Times, 7/8/00. 7 The growth of rupiah deposits is much too fast to be attributed just to the accumulation of interest: between the end of September 1997 and the end of June 1998, the average annual interest rates on one-year and one-month deposits were 17% and 35% respectively.
8 Since the risk of default on SBIs is negligible, the spread of the SBI interest rate over dollar interest rates reflects market perceptions of the risk of depreciation of the rupiah relative to the dollar. In contrast, the much higher interest rates in the Jakarta interbank market during the crisis, particularly for the weakest banks, reflected default risk.
9 ‘Extended credit’ excludes the short-term discount facilities provided by the Fed on a regular basis to facilitate interbank clearing without large fluctuations in interest rates.
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