Perry Warjiyo: US monetary policy normalization and EME policy mix -
the Indonesian experience
Speech by Mr Perry Warjiyo, Deputy Governor of Bank Indonesia, at the NBER 25th Annual
East Asian Seminar on Economics, Tokyo, 20-21 June 2014.
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I. Introduction
Indonesia is weathering relatively well this year the spillovers from the US monetary policy
normalization process. In fact, over the past two months portfolio inflows are increasing,
equity prices are rebounding, bond yield is decreasing, and exchange rate is appreciating
(Graph 1-4). This is evidence that strengthening domestic macroeconomic fundamentals and
financial system stability plays crucial role for minimizing the spillovers. The aggressive and
bold measures of monetary and macroprudential policy mix since June 2013 have resulted in
streams of positive news of benign inflation, faster than expected decline in current account
deficit, and better than expected GDP growth to the markets.
This note draws Indonesian experience on the transmission mechanism and policy
responses to global monetary factors, with a focus on the recent episode following the Fed
announcement of planned tapering in May 2013. In particular, three main issues will be
discussed. First, the setting of interest rate supported by exchange rate flexibility and capital
flows management in responding to policy trilema arises from global monetary factors.
Second, the efficacy of macroprudential measures in reinforcing lending channel of monetary
transmission mechanism at the back of volatile capital flows and underdeveloped financial
market. And third, the important of financial market deepening in smoothing out the
transmission of global monetary factors to domestic monetary and financial system stability.
II. Making possible the policy trilemma
The UMP and its normalization process give rise to policy trilemma of the optimal setting on
interest rate response, exchange rate flexibility, and some forms of capital flows
management. Interest rate policy needs to be geared toward maintaining price stability,
taking into account the impacts of global interest rate and some rooms of exchange rate
flexibility as shock absorber. But market over-reaction and structural rigidities may cause
unnecessary exchange rate overshooting and volatility that may hamper growth as well as
overall monetary and financial system stability. Volatility in the capital flows is also
complicating the optimal monetary policy response for achieving domestic economic
objectives.
For Indonesian case, we cope with this policy trilemma through a monetary and
macroprudential policy mix, consisting of interest rate response complemented by some
exchange rate flexibility, capital flow management, and macroprudential measures. Clear
communication, policy coordination with the government on inflation, fiscal and structural
reforms, as well as central bank cooperation on strengthening regional financial
arrangements also play crucial role. The interest rate policy, as in other inflation targeting
countries, is the main instrument to anchor inflation expectation and forecast going forward to
fall within the targeted range. Exchange rate policy is geared toward maintaining the stability
along its fundamental path. Some forms of capital flows management are implemented to
dampen its short-term excessive volatility. Macroprudential measures are targeted to
manage procyclicality and excessive lending in some specific sectors. Overall, the policy mix
is intended to reinforce the effectiveness of all monetary transmission channels (interest rate,
exchange rate, money and lending, asset prices, as well as expectation channels) to better
withstand the spillover impacts of global monetary factors.
Interest rate policy
Indonesia is among the first central bank that ahead of the curve raised its policy rate in the
aftermath of Fed announcement on planned tapering in May 2013. We started to raise the
BI policy rate by 25 bps in June 2013. We then aggressively raised the policy rate by 50 bps
in July, another 50 bps in August, and 25 bps in September 2013. After pausing in October,
we raised again the policy rate by 25 bps in November 2013. In total, the policy rate was
increased by 175 bps to 7.50% within six months. We hold the policy rate since then and
maintain our tight monetary policy stance.
The primary objective of this aggressive interest rate policy is to preemptively anchor inflation
expectation that initially arose from food price shocks. Subsequently, the increase in policy
rate is to contain the second round impact of fuel price hike that caused CPI inflation to reach
its peak at 9.0% in July 2013. The large increase in policy rate is also to help in slowing down
the domestic demand to dampen the current account deficit that rose to a peak of 4.4% of
GDP in Q2-2013. The timing of the aggressive increases in policy rate is also important as
they help in responding to the capital reversals and increasing interest rate and risks in the
global financial market following the Fed announcement of planned tapering. We believe bold
and aggressive response in interest rate is a key to send a strong and clear signal to the
market in our monetary policy deliberation. Higher consideration is given to domestic factors,
even though global monetary conditions and trends are always taken into account.
The bold response in interest rate has succeeded in containing the inflation pressures and
helped in reducing current account deficit faster than initially forecasted. The CPI inflation
returned to its normal path since September and downed to 8.3% in December 2013, much
lower than our earlier forecast of 9.0%-9.8% (Graph 5). The inflation decelerated further to
7.3% in May 2014 and we believe it will down to 5.3% at the end of 2014, and thus falls
within our targeted range of 4.5%±1% (Graph 6). Trade balance turns into surplus and
current account deficit is falling much faster than expected from 4.4% of GDP in Q2-2013 to
1.9% of GDP in Q4-2013 and 2.0% of GDP in Q1-2014 (Graph 7-8). We are aiming to lower
the current account deficit from 3.3% of GDP in 2013 to below 3% of GDP in 2014 and
around 2% of GDP in 2015. We believe this level of current account deficit is more
sustainable in the longer term for Indonesia. The good news is that these price and external
stability can be achieved with better than expected economic growth. GDP growth recorded
at 5.8% in 2013 and it is forecasted to moderate to 5.1%-5.5% in 2014 following the
stabilization policies (Graph 9).
The interest rate transmission mechanism is working even though it is yet to complete.
Following the 175 bps increase in policy rate, bank deposit rate rose by 240 bps as liquidity
is tightened and competition among banks in raising funds is increasing (Graph 10). But
interest rate on lending increased only by less than 50 bps due to a combination of factors,
e.g. time lag in interest rate setting, excess liquidity and aggressive lending in some banks,
and shallowness of domestic financial market. Aggregate liquidity and monetary aggregates
have already declined substantially, e.g. M1 growth downed from around 22% in January
2013 to 9% in April 2014 (Graph 11), even though liquidity is not evenly distributed among
banks. Bank lending growth declined more gradually from 23.5% to 19.0% during the same
period even though it accounts for 16.1% if excludes exchange rate depreciation (Graph 12).
Going forward, even though the policy rate is held constant, continuous monetary tightening
will bring about further decline in lending growth to about 15-17% at end of 2014.
Exchange rate policy
Even though increases in policy rate have succeeded in anchoring inflation expectation and
helped in slowing down the domestic demand, it could not left alone to play all the burdens of
economic adjustments, including in further reducing current account deficit and mitigating the
spillover effects from the UMP normalization process. It would need excessive increases in
policy interest rate to do all the adjustments. Some room for exchange rate flexibility helps in
facilitating the reduction of current account deficit and the transmission of global monetary
normalization.
For Indonesia, exchange rate policy is geared toward maintaining the stability of exchange
rate movements that is consistent with its fundamental path. The path is calibrated through
some methodology of determining the fundamental exchange rate and then inputted to be
consistent with macroeconomic forecasting and simulation when determining the policy
interest rate. Real Effective Exchange Rate (REER) is one approach to check the
consistency of exchange rate movements to the fundamental (Graph 13). To achieve this
objective, symmetric intervention in the foreign exchange market is conducted to smooth out
the short-term volatility of day to day exchange rate movements in the market with the path
that is consistent with the fundamental equilibrium exercises. The objective is not to achieve
a certain level or range of exchange rates, but merely to avoid too excessive volatility that
may give rise to panics and disruptions in the smooth functioning of foreign exchange
market.
Introducing greater exchange rate flexibility is not always easy when facing shallow domestic
foreign exchange market, however. This is what we are facing in Indonesia in the aftermath
of Fed announcement on planned tapering last year. The markets were not ready to adjust to
our new policy of greater exchange rate flexibility to facilitate the spillover impacts of Fed
tapering and the adjustments on current account deficit, especially during the period of June
to August 2013. There was large divergence of exchange rate determination among the
banks that accompanied increasing volatility and depreciation of exchange rate movements
during this period (Graph 14). Frequent and close communication with market participants is
important to adjust their behavior to the new policy direction. The smooth functioning of
domestic foreign exchange market has resumed since September 2013.
Capital flows management
Volatile capital flows, especially those of short-term and speculative natures, increase the
risks of instability to both monetary and financial system stability. The carry trade flows often
give rise to excessive volatility in the exchange rate movements beyond implied by
fundamentals. Dual intervention is one of strategy to smooth out volatility. But in some cases,
measures of capital flows management are needed.
For Indonesia, the policy on capital flows management is guided with three principles. First,
the objective is to help mitigate the negative impacts of short-term volatility in capital flows to
instability in exchange rate as well as overall monetary and financial system. Second, they
are targeted to short-term and speculative capital flows since we welcome those flows that
are medium-longer term that benefits the economy. And third, the measures are consistent
with our broad principle of maintaining free foreign exchange system. They are temporary,
i.e. the measures are strengthened when too much capital inflows and relaxed when too
much capital outflows, and do not differentiated to both domestic and international investors.
Followings provide clear examples. During heavy capital inflows from the UMP easing, in
2010 we introduced six month holding period for transactions in the central bank bills and
imposed a maximum of 30% capital to the short-term off-shore borrowings of the banks. But
following the Fed announcement of planned tapering in 2013 we relaxed the holding period
for central bank bills to one month and expanded a number of transactions that are excluded
from the calculation on off-shore borrowing of the banks. We view that these measures help
in dampening the short-term and volatile capital flows, and thus are consistent with the
objective of managing financial stability.
III. Assessing the macroprudential measures
As underlined before, the interest rate transmission mechanism of monetary policy is not
always smooth and fully effective in a country where financial market is not yet developed
such as Indonesia. Other channels of monetary transmissions must be deployed, including
the lending channel. This is where macroprudential measures play key role, including in
smoothing out the procyclicality nature of bank lending behavior. Thus, both the objectives of
maintaining monetary and financial system stability are taken into account when we design
macroprudential measures.
In Indonesia, the formulation of macroprudential measures is done as follows. We develop
some methodologies to assess some sort of optimal lending growth of the banks, including
what we call non-accelerating inflation lending growth model. We apply the model to
aggregate lending growth as well as lending growth to each bank, certain types of lending
(consumption, working capital, and investment) and per economic sectors. By comparing
these optimal vs. actual lending growth, we have some idea where excessive lending occurs
and thus some instruments of macroprudential measures are justified and can be applied.
This is the approach that we applied when introducing loan-to-value (LTV) ratio to lending to
automotive and property sectors in 2012. We then strengthen the LTV ratio to lending to
property sectors in 2013, especially to mortgages for the second, third, and so on purchases
of certain types of housing and apartments. The measures are also complemented by
supervisory actions to banks that we viewed exhibit excessive lending behavior. We note that
the formulation and implementation of macroprudential measures require a much detail and
complex analysis and calibration, as well as the need for clear communication to the banks
and business community.
Our experience shows that the macroprudential measures and supervisory actions help in
reinforcing the effectiveness of monetary transmission mechanism and supporting the
financial system stability. Even though lending growths increased in the period prior the
implementation of these measures, probably banks and their customers wanted to utilize the
interim period, they declined substantially in relatively short-period in the subsequent
episode. The growth of mortgage on housing for less than 21 M2, for instance, declined from
more than 100% to the negative growth during the period of June to September 2012 (Graph
16). Likewise, the growth of mortgage on apartment less than 21 M2 dropped from more than
300% to less than 10% during the period of January to November 2013 (Graph 17). It should
be noted that the automotive and property sectors contain substantially large import content,
and thus managing lending growths to these two sectors help in reducing the current account
deficit.
IV. Financial market deepening
The stage and depth of domestic financial market influence the transmission mechanism and
policy response to global monetary factors, in both the UMP easing period as well as the
normalization process. Preceding discussions clearly show the challenges that we face in
Indonesia. Interest rate transmission is lagging in the absence of domestic money and fixed
income markets that provide efficient mechanism interest rate and term-structure
determination. The shallowness of domestic foreign exchange market often causes
excessive volatility and overshooting of exchange rate movements in responding to global
monetary and financial shocks.
This is the rationale for our focus and priority on financial market deepening, as an integral
part of our policy responses to the normalization process of the UMP in the advanced
countries. In addition to strengthening the economic fundamentals, sound macroeconomic
and financial system stability, the best defense for withstanding the spillover effects of such
global monetary and financial factors is to make our financial market more conducive and
resilience to swings in the international investor preferences.
We embark on a series of policy initiatives to deepen our financial market, especially
domestic money and foreign exchange markets. In the foreign exchange market, we
succeeded in establishing the Jakarta Interbank Spot Dollar Rate (JISDOR), reflecting the
actual transacted exchange rates, as a reliable reference for the market. Recently, the
Association Banks of Singapore (ABS) recommends their members to use JISDOR as
reference rate in fixing their NDF transactions. We also introduce FX swap transactions with
the banks both bilaterally and weekly auctions. Further relaxation on regulations regarding
underlying transactions for forward and swap as hedging instruments has been issued, and
we are now campaigning to the banks and corporates to use more hedging instruments in
managing their increasing exchange rate risks.
We also make significant progress in deepening domestic money market, especially those of
collateralized transactions. We use more reverse repo with government bonds in our
monetary operations. We have succeeded in developing interbank repo using government
bonds as underlying transactions. Within less than three months, the size of transactions
increases substantially from almost nonexistence to equivalent of USD3 billion. The number
of banks participate in this interbank repo enlarges from only 8 to 65 banks, and more will
follow. We believe this progress of financial deepening play important role in supporting our
policy mix of monetary and macroprudential measures in responding to the spillover effects
from the normalization process of the Fed monetary policy.
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