Monetary Policy Running off the Rails October 16, 2008
Posted by Ross McLeod in Essays and Comments.Tags: Bank Indonesia, inflation, interest rates, recession
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Along with the monetary authorities in many other countries, Bank Indonesia and the government are now acting to increase liquidity in the Indonesian economy, in the hope that this will protect against the possibility of a recession.
It would be possible to increase liquidity simply by reducing the quantity of SBIs (central bank certificates) outstanding. Although BI signalled this as a possibility last week (i.e. increasing liquidity through open market operations), more recently it has announced an alternative policy of reducing the minimum reserve requirement, which determines the amount of funds the commercial banks need to place at the central bank. Until now, calculation of minimum reserves has been absurdly complex, depending on both the size of the bank (four different categories) and its loan to deposit ratio (LDR) (six different categories). Theoretically, the ratio of reserves to deposits could be anywhere in the range 5 to 13%. The average level is currently about 9.1%, and BI has announced that the new reserve ratio will be a flat 7.5%, with no adjustment for bank size or LDRs.
The simplification of the reserve requirement is to be welcomed. But the impact of this on liquidity is likely to be counter-productive. The change will have the effect of freeing up almost Rp 23 trillion, the effect of which in turn is equivalent to increasing the supply of base money (M0) by about 6.6%. But base money has already been growing far too rapidly to be consistent with the current target level of about 5% inflation, which has risen from about 6% in the middle of 2007 to more than 12% in September this year. The new policy is therefore a worrying development. It seems almost certain to generate even higher inflation and more rapid depreciation of the currency. At the same time, the ability of this policy to prevent the emergence of recession is by no means obvious.
Almost everybody who talks about this issue focuses only on the demand side, forgetting about supply. With increased liquidity, individuals and firms have a greater capacity to spend. But firms also have a greater capacity to withhold goods and services from the market in anticipation of being able to push up their prices. If supply curves move upward at about the same rates as demand curves, the result is higher prices with no change in output. The experience of 1998, when inflation surged to over 80% at the same time that output was falling by 13%, provides clear evidence of the wishful thinking that underlies the push for increased liquidity in current circumstances.
Senior deputy governor of BI, Miranda Goeltom, is well aware of the problem, and has announced that BI does not intend to decrease its policy interest rate, which has only recently been increased to 9.5%. But there is an air of unreality about this. How could nominal interest rates possibly be maintained at current levels with liquidity being increased so significantly? Liquidity and interest rates are directly linked. Indeed, if BI were to choose to reduce interest rates, it is precisely by increasing liquidity that this would be achieved. It would simply reduce the quantity of SBIs it issues relative to the quantity maturing, which means that it would be paying out more on maturing SBIs than it would be receiving for issuing new ones.
With liquidity suddenly increasing by a large amount as a result of the change in reserve requirements, the demand for SBIs at current interest rates will increase. If BI issues enough to satisfy this demand, liquidity will return to roughly what it had been previously. If it does not satisfy this demand, it will either need to allow SBI rates to fall, or it will have to ration the demand for SBIs at the auction. In this latter case, a wedge will be driven between money market rates and the official rate, which will only serve to demonstrate that the policy rate no longer bears any relevance to what is going on in the market. BI will be able to pretend that it is still fighting inflation, but the reality is that by adding to system liquidity so significantly, it is encouraging inflation to accelerate even further.
In the near future, expect inflation to accelerate and money market interest rates to decline. But don’t bet on Indonesia avoiding an economic downturn.
I am also confused as to why they are acting to increase liquidity via reducing bank’s GVM. I can understand foreign reserve GVM holdings, but why they are reducing rupiah denominated minimum requirements when bank lending growth is around 30% is confusing.
It definitely sends mixed signals in that they are raising rates to constrain aggregate demand and cool lending growth, but at the same time are putting measures in place to increase the amount of loanable funds for banks, which should increase lending growth. On top of all this BI is selling dollars to halt the slide of the rupiah which should also increase liquidity as well. It’s a bit like the different branches of the central bank are all pursuing their own agendas.
Bob, I’m guessing by ‘GVM’ you actually mean ‘GWM’ (Giro Wajib Minimum: Minimum Required Deposits)?
Just one other point: when BI sells dollars it reduces liquidity, rather than increasing it. People are paying for the dollars by handing over rupiah, thereby taking rupiah out of circulation. This FX market intervention therefore works in the opposite direction from reducing the GWM.
Correct completely about GWM and liquidity.
It really seems like the central bank is trying to do many things with monetary policy all at once, reducing minimum reserve requirements (easing) while raising interest rates (tightening). On top of all this excess liquidity is being blamed for rupiah weakness and the central bank is selling dollars to boost the rupiah (as you point out reducing liquidity).
This seems like its a circular problem regarding the rupiah: decrease GWM->increase liquidity -> rupiah weakening -> dollar selling _> decrease liquidity -> rupiah strengthening.
Unfortunately it seems like BI has differing priorities that make it hard for them to achieve all their policy goals at once. Maybe they should prioritize what their main objective is and be prepared for higher bank lending rates than normal and a stronger stable rupiah or normalised bank lending rates and a weaker rupiah. It certainly seems like the approach undertaken currently (trying to achieve interest rate and rupiah stability simultaneously by moving interest rates and reserve requirement ratios in different directions) isn’t working. Selling dollars and running down reserves isn’t sustainable. Your thoughts?
[...] It is not easy to know the true stance of monetary policy in Indonesia these days. In September it was announced that system liquidity was to be increased, in line with what was going on in many other countries in response to the emerging global financial crisis. Yet it was also stated that the central bank policy rate was not going to be reduced, notwithstanding the fact that liquidity and interest rates are opposite sides of the same coin. [...]