The global crisis reveals many flaws in an economy based on capital financing mediated through the financial system. Prolonged low interest rates in a low-inflation environment could increase financial cycles and accumulate systemic risks, causing instability in the financial system and economy. For these reasons, central banks in EMEs adopt various capital flow management measures to support their interest rate and exchange rate policies in achieving price stability and promoting financial stability.
The already established monetary policy framework in the central banks provides a strong basis for this. In order to achieve price stability and support financial stability, the central banks must not only evaluate macroeconomic prospects, but also address macro-financial imbalances in the financial system. They commonly emerge in the procyclicality and build-up of systemic risks from asset (financial and housing) bubbles, credit booms, accumulation of external debt and volatility of capital flows.
They tend to precede and spread systemic risks in the financial system that can lead to a crisis (Claessens and Kose, 2013; . Reinhart and Rogoff, 2009)). Stability is destabilizing and therefore leads to 'booms' and 'booms' in financial cycles, causing the economy. Interconnection and networks in the financial system can also lead to the rise of systemic risks during economic growth along with the procyclicality of financial cycles discussed above.
The increased volatility of capital flows poses serious challenges for central banks in EMEs in maintaining monetary and financial stability.
INDONESIA’S EXPERIENCE Macroeconomic Setting
These three challenges of monetary policy, macroprudential policy and the CFM must be addressed in the central bank's policy mix. As discussed above, two issues are of particular importance to include financial stability issues in monetary policy under (flexible) inflation targeting, namely: (i) extending the scope of price stability to the assessment of asset prices (financial and housing prices), and (ii) addressing procyclicality and systemic risk build-up in the macro-financial links. From a financial stability perspective, we perform in-depth assessments suggested in the literature (Bisias, 2012) and applied to a number of central banks (e.g. EBA, 2015).
Third, capital flow management is carried out to support exchange rate policy, especially in the period of large capital inflows and heightened capital reversal risks, to achieve monetary and financial stability. In the second quadrant, where expected risks to price stability are low but risks to financial stability are high, macroprudential policy is clearly tight. In this case, monetary policy could help macroprudential policy counter the predicted risks to financial stability over the policy horizon.
This is the case in the US in the period leading up to the global crisis as discussed between Taylor (2010) and Bernanke (2010) as discussed above. In the third quadrant, where expected risks to price stability are high but risks to financial stability are low, monetary policy is clearly tight. In that case, macroprudential policy could help monetary policy to counter the predicted risks to price stability over the policy horizon.
The scope and choice of monetary and macroprudential measures will naturally depend on the relevant factors causing the predicted risks to price and financial stability in the countries concerned. In the following subsections, we discuss how we implement this approach and the choice of instruments in the central bank's policy mix in managing monetary and financial stability in Indonesia during periods of major global economic and financial turmoil since the global crisis. The central bank is intervening in the foreign exchange market to curb the surge in capital inflows and moderate the appreciation of the exchange rate.
Indonesia is among the first central banks to raise its interest rate ahead of the curve after the Fed's fury erupted. The central bank also intervened heavily in the immediate aftermath of the Fed's tantrum to stabilize the exchange rate before it resumed from September 2013. The intervention is supported by the central bank's purchases of government bonds in the secondary market, especially during periods of severe crisis. capital reversals, a tactic we call double intervention (Warjiyo, 2013c).
During a period of large capital inflows due to the Fed's breakout, we introduced CFM measures in 2010 in the form of a six-month holding period for central bank bill transactions and imposed a maximum of 30% capital on short-term non-bank debt. Better data and statistics are also important, including the development of financial stability indicators and statistics on balance sheet interconnections at national and subnational levels.
CONCLUSION
Although the central bank is independent, its policy mix forms an integral part of the macroeconomic policy mix of monetary, fiscal and structural reform at the national level (Warjiyo, 2013a). For the stability of the financial system, coordination is done through the Financial Stability Policy Coordination Committee (FSPCC) chaired by the Ministry of Finance with members from Bank Indonesia, the Financial Service Authority (IFSA) and the Deposit Insurance Institution (IDIC). A new law on the prevention and resolution of financial system stability has just been adopted, which provides a strong legal basis of the roles and responsibilities of each institution for financial stability, related to systemically important banks, as well as the mechanism of crisis prevention and resolution.
The central bank's macro-prudential policy is also closely coordinated with the FSA's micro-prudential regulation and supervision. At the same time, policy coordination on financial system stability, including macroprudential policy of the central bank, aims to manage financial cycles and mitigate systemic risks for the promotion of macrofinancial balances. These measures of national economic policy mix are very important for achieving sustainable economic growth with sound macroeconomic and financial stability.
Capital flows in Indonesia: its behaviour, role and optimality for the economy. First lessons from the crisis prepared by the Departments of Research, Monetary and Capital Markets, and Strategy, Policy and Assessment, February. The role of macroprudential policy to manage exchange rate volatility, excess bank liquidity and credit.
Keynote Speech at ESCAP High Level Policy Dialogue and Eleventh Bank Indonesia Annual International Seminar, Yogyakarta, May. Paper presented at the Asia Economic Policy Conference (AEPC), Federal Reserve Bank of San Francisco (FRBSF), November.
