Burhanuddin Abdullah: Monetary and exchange rate policy in a global financial
integration - Indonesian experience
Paper by Mr Burhanuddin Abdullah, Governor of Bank Indonesia, presented at the South East Asia -
Latin America and Caribbean Countries (SEACEN-LAC) Governors Seminar, Kuala Lumpur,
15 September 2006.
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Introduction
First of all, let me thank BNM for hosting the first SEACEN-LAC Governors Seminar with an excellent
arrangement. I am both delighted and honored to be here before Fellow Governors from two regions
of separate hemisphere, to discuss important issues of common interest. Indeed, the theme of this
seminar "Monetary and Exchange Rate Policy and International Financial System" is timely and very
relevant for Asian and Latin American economies. We are all aware that over the past two decades,
these two regions have undergone daunting challenges in managing monetary and exchange rate, in
particular dealing with major external shocks. In spite of our improved resilience in addressing such
kind of shocks, thanks to major reforms we have conducted in the aftermath of the late 1990s crises,
the downside risks in the global economy could not be dismissed.
In fact, under the globalized and integrated financial market, central bankers all over the world, most
notably the emerging markets have been confronted with unprecedented potential challenges arising
from surges in short term capital flows. Currently, the low interest rates in the international market and
concerns over the sustainability of the US twin deficits have been driving factors in pushing capital to
flow to emerging markets. At the same time, the high yields on domestic currency-denominated
instruments in emerging markets have been the pull factor. As we are all aware, there are distinct
characteristics of capital flows during the pre- and post-crisis periods. Before the crisis, capital inflows
were mainly associated with efforts by domestic market actors to avail foreign sources of finance
through international bank loans and issuance of various global financial instruments. However, since
2003, foreign capital flows have mainly been driven by the flush global liquidity in search of optimum
rates of return. The differences between these types of capital inevitably entail different consequences
for emerging markets, and as a corollary in monetary and exchange rate policy, which I will briefly
elaborate further.
Policy on open capital account
Dating back to 1970, Indonesia began to seek liberalizing its capital account. Initially, the liberalization
started with the removal of compulsory surrender of export proceeds. By 1982, all types of capital
controls were dismantled leaving the capital account virtually open. Until the Asian crisis hit in 1997,
the existing restriction on capital inflows were only applied to foreign borrowings by banks and
companies with government-linked projects and net open foreign exchange position (NOP) on banks
as a prudential regulation.
Prior to the crisis, this system had contributed to sustained high economic growth, thereby promoting
our long term development program. Foreign capital inflows had also fostered the deepening of
domestic financial sector by expanding market liquidity. However, the benefits of capital inflows, in
particular in the early 1990s, were undermined by financial market imperfection stemming from lax
regulation and supervision and moral hazard due to implicit guarantees. These problems were
reflected in the inefficient allocation of capital, unhedged foreign liabilities, and inflated asset prices. As
market confidence in the prospect of the economy of the emerging market in Asia faltered, reversal of
capital outflows could not be arrested, thereby leading to capital account crisis.
With the hindsight of the Asian crisis, the Central Bank has sought to strengthen the monitoring on the
capital movement and minimize speculative transactions. To this end, in 2001 Bank Indonesia issued
a regulation on the non-internationalization of the rupiah. Subsequently, when a wave of capital
reversal and speculation against the rupiah triggered by rising world oil prices heightened in 2005, we
issued a series of micro policies addressing the imbalances in the demand and supply in the forex
market. Furthermore, prudential regulation in the banking sector was also strengthened through a
tighter ruling on the NOP and particular transactions in forex trading.
Indonesian floating exchange rate regime
Needless to say to Fellow Governors that the choice of an exchange rate system depends to a great
extent on the condition of a country at a given time. In the current context of Indonesia, under a free
capital mobility and limited amount of international reserves, we believe that our floating exchange rate
system adopted on August 14, 1997 is an optimal choice. The system, we believe, provides a built-in
discipline in a market whereby all other infrastructures are not sufficiently strong. This float will in part
create a break on imprudent overseas borrowing, because in doing so market participants will have to
factor in the cost of possible movements of rupiah.
We are fully aware that in the case of domestic financial markets with imperfections, such as the thin
forex market and limited availability of hedging instruments, a floating rate system often leads to high
volatility with adverse consequences on stability. Therefore, while in practice we adopt a floating rate
system, we are of the view that smoothing of exchange rate movements is necessary. In fact, our
measures to reduce volatility are not unique. As posited by Calvo and Reinhart, almost all countries
de jure
adopting free floating rate system do not rule out interventions to curb volatility in their
exchange rates. Such interventions are conducted both through direct intervention on the forex market
and through the use of interest rates.
Monetary policy framework in a floating exchange rate regime
A logical consequence of a flexible exchange rate system is that the exchange rate can no longer
serve as a monetary policy anchor. During our stabilization period under the IMF program, Bank
Indonesia adopted base money as an anchor. Over the long run, however, we noticed a number of
shortcomings in the use of base money as the operating target, such as the difficulties in achieving its
target and the poor signal it transmits to the market. Such a poor signal of monetary policy direction
and targets obviously fails to meet the need to maintain market expectations on the future exchange
rate movement. In view of those factors, Bank Indonesia adopted a fully-fledged inflation targeting
framework in July 2005.
The framework at least consists of three primary characteristics. First, monetary policy is directed
towards achievement an inflation target explicitly announced to the public for a specified time horizon.
In this regard, under the new Central Bank Law the inflation target is set by the Government. Second,
monetary policy must be implemented on a forward-looking basis, responding to future developments
in inflation. On the operational level, Bank Indonesia uses the BI Rate as policy rate to respond to the
future trend in inflation. In formulating monetary policy, the Taylor-type rule is used as a benchmark.
Thus in essence, interest rates used as monetary policy instruments are adjusted in such manner so
as to respond to deviations in the inflation gap and output gap.
Obviously, rules like these are not to be applied mechanically. A balance between rule and discretion,
or constrained discretion, as I see it, is especially necessary when monetary policy must be pursued
within an increasingly globalized and complex financial environment. We must always be alert of
market developments, whether the money market or markets for goods, and a number of other signals
and indicators reflecting domestic and global economic developments. We should also keep in mind
that while inflation is the sole objective of a central bank, the public also pursues its own objectives,
such as job creation and improvement of incomes. For this reason, the inflation targeting framework
retains the fundamental monetary policy paradigm of striking the optimum balance between inflation
and output.
Apparently, when a central bank faces a dilemma of choosing between inflation and growth, inflation
remains the priority. An example of this can be seen in the problems we faced last year, when world oil
prices almost doubled. This disturbing trend became highly problematic for monetary policy because
not only did it boost inflationary pressure, but also inhibit economic growth. Many suggested that the
central bank did not need to respond to this temporary surge in inflation. However, our view at the time
was that despite the temporary nature of the disturbance, the inflationary impact emanating from the
higher oil prices through increased price for other goods and services, such as transport and wages,
would drive up core inflation. In this situation, the tight policy was necessary to prevent sustained
escalation in public inflation expectations.
The third characteristic of the ITF is that monetary policy is implemented on a transparent basis with
measured accountability. In my view, with elements like these, inflation targeting is more than a mere
framework for monetary policy. Inflation targeting promotes the good governance of a central bank. By
announcing the inflation target to the public, the central bank commits itself to its achievement.
Uncertainty over future inflation will ease because public inflation expectations have a point of
reference, and thus economic costs arising from uncertainty will also be reduced. Communication to
the public on the future monetary policy direction is also vital so that the public can anticipate the
central bank monetary policy and to avoid 'surprises' that could trigger volatility in the money market.
To strengthen policy effectiveness in this present age of disclosure, the central bank must also carry
out a process of educating the public on what the monetary policy objectives are, the strategy for
achieving these objectives, and what lies behind the decisions taken. One example involves the
communication of the monetary policy response to soaring oil prices and risks from global imbalances
at a time of weak conditions in the real sector and high unemployment. Communications between the
central bank and market players are also necessary, especially when financial markets are
experiencing turbulence. In financial markets fraught with asymmetric information, the wealth of
information held by the central bank is frequently of great benefit in mitigating this issue and thus
preventing panic and herding by investors. In this regard, the credibility of the central bank is crucial.
Concluding remarks
Under the environment of financial integration, the task of a central bank in maintaining both monetary
and financial system stability has become more challenging. To navigate under this changing
environment, in my view a central bank should have at least three critical tools at its discretion. First is
the flexible exchange rate system, which provides for autonomy of monetary policy. Second is a
monetary policy framework which is consistent, credible, and transparent so as to provide a monetary
policy anchor within the flexible exchange rate system. Third is a strong banking system capable of
absorbing the various risks created by financial globalization.
The mounting risks and uncertainties emerging within the financial globalization process also
underscore the importance of the central bank role in guiding public expectations. Within this context,
the credibility of the central bank is crucial. To this end, transparency, accountability, and effective
communication must be integral to the entire monetary management process. In short, communication
may serve as an additional "instrument" that a central bank should use at its disposal to complement
other monetary instruments for monetary policy to operate effectively.
Thank you.