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Indonesia Monetary and Exchange Rate Policy
http://www.photius.com/countries/indonesia/economy/indonesia_economy_monetary_and_exchang~14.html
Sources: The Library of Congress Country Studies; CIA World Factbook
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    In the early 1990s, Bank Indonesia, the central bank of Indonesia, was formally under the guidance of the central government through the Monetary Board. This board was composed of the minister of finance, several other cabinet members, and the governor of Bank Indonesia. New Order monetary policy reflected the resolve of the government to maintain stable prices and a balanced central budget to prevent the high inflation of the previous decades. This priority was stated in 1991 by the governor of Bank Indonesia, who announced a departure from the central bank's goal to inflationary rates below 20 percent a year. Henceforth, the goal would be to reduce inflation to a maximum of 6 percent a year.

    High inflation had been a major problem since the mid-1960s. During the Sukarno regime's final years, the increasing government deficit was financed by Bank Indonesia in compliance with instructions from the Monetary Board--a practice that violated Bank Indonesia's own charter, which limited central bank credit to 20 percent of gold and foreign exchange reserves. Although this lack of financial discipline was a major cause of severe inflation during the mid-1960s, the New Order regime was unwilling to dismantle the time-tested Monetary Board.

    Whereas, during the 1970s and 1980s, the central bank contained inflation below 20 percent per year with few exceptions, in 1991 the governor of Bank Indonesia pledged to reduce inflation by limiting the amount of bank credit available in the economy. After the 1983 reforms, Bank Indonesia faced the problem of controlling bank credit while permitting all banks, including the then-dominant state banks, to operate on a commercial basis. In many industrialized countries, indirect control of bank credit is achieved by central bank transactions in government securities that expand or contract the supply of reserves available to banks to meet required reserves on bank liabilities. Because the Indonesian government maintained a balanced budget, no government securities were issued. Instead, Bank Indonesia began to issue its own debt in the form of Sertifikat Bank Indonesia (SBI), beginning in 1984. The intent was to encourage banks to invest their short-term funds in SBIs, and, as the market deepened, permit Bank Indonesia to buy and sell SBIs to influence the quantity of bank reserves. Bank Indonesia also encouraged the development of other privately issued short-term debt instruments. A sophisticated market in short-term securities offered banks more flexible management of their total assets and encouraged them to hold short-term funds in rupiah rather than in overseas dollar deposits, which had become a common practice.

    In the 1990s, Bank Indonesia also managed the exchange rate between the rupiah and foreign currencies, a responsibility that sometimes conflicted with the objective of controlling the amount of bank credit. Following a period of floating the rupiah from 1966 to 1971 to permit the market to set its value in foreign currency, Bank Indonesia pegged the exchange rate at Rp415 per US$1, and lifted most restrictions on international transactions that were heavily regulated during the Sukarno era. To maintain the exchange rate, the central bank was obliged to buy or sell as much foreign currency as was demanded at the predetermined rate.

    When oil revenues surged in 1974, the bank found itself in essence printing rupiah currency in exchange for the oil-generated dollar revenues. Bank credit rose precipitously once the currency was deposited in domestic banks. Inflation surged to over 40 percent that same year, the highest rate experienced in the New Order era as of 1992. Bank Indonesia responded aggressively by imposing direct controls on the amount of credit issued by individual banks, a policy that also contributed to the lack of competition with the favored state banks (see Financial Reform , this ch.). By 1978 inflation was reduced to less than 10 percent per year, but four years of double-digit inflation had seriously undermined Indonesia's exporters, whose costs rose with inflation even though revenues still translated into rupiah at the rate of Rp415 per US$1.

    To address the eroding profits of exporters, Bank Indonesia was compelled to devalue the rupiah by 50 percent in 1978, bringing the exchange rate to Rp625 per US$1. Bank Indonesia announced its intent to permit more gradual adjustments in the exchange rate in line with the industrial world's abandonment of fixed exchange rate regimes in the mid-1970s. However, inflation in Indonesia continued at an average of 14 percent per year, which was low by the standards of many developing countries but above that in many of Indonesia's industrialized trade partners. In 1983 a second major devaluation brought the rupiah exchange rate to Rp970 per US$1. This devaluation was accompanied by a major financial reform that eliminated the direct controls Bank Indonesia had relied on in the past to manage the growth in bank credit.

    Although these markets began to develop gradually, Bank Indonesia continued to confront periodic financial crises that required a more drastic response. The third major devaluation since 1971 was undertaken in September 1986, primarily in response to the decline in foreign exchange earnings through oil exports. The exchange rate rose from Rp1,134 per US$1 to Rp1,641 per US$1. Moreover, the uncertain oil market, together with the history of major devaluations, combined to make financial markets highly susceptible to rumors of further devaluations. Once anticipation of a possible devaluation spread, the response by banks and businesses alike was to borrow rupiah funds to acquire dollars to profit from the anticipated devaluation, thereby depleting the dollar reserves of Bank Indonesia. Ideally, such runs could be discouraged by paying a high rate of interest on SBIs, but occasionally the crisis was so severe that banks were unwilling to purchase SBIs. On two occasions, in late 1987 and February 1991, Bank Indonesia instead required state-owned corporations to withdraw large sums from their bank deposits (around Rp800 million in 1987 and Rp8 trillion in 1991) to purchase SBIs, which deprived banks of a major source of rupiah funds to use for speculation, thwarting the outflow of dollar funds.

    The efforts to manage inflation and contain speculation against the rupiah resulted in high interest rates on bank credit following 1983 interest rate deregulations. In 1991 interest rates on commercial loans soared to 28 percent per year from 20 percent in 1990, whereas inflation was around 9 percent per year. One Indonesian economist from the private Institute for Economic and Financial Research observed that many businesses would be unable to find investment projects that could generate such a high rate of return. The Asian Wall Street Journal noted in February 1991 that the high interest rates on bank deposits were partly responsible for the substantial decline in the average stock share prices listed on the Jakarta Stock Exchange in 1991, which dropped over 50 percent from the previous year as financial investors found bank deposits a more lucrative investment. In spite of these adverse consequences, the government remained steadfast in its efforts to control inflation in the hope that improvements in bank efficiency and increased economic growth would help lower interest rates. In addition, Bank Indonesia permitted a more gradual rate of rupiah depreciation (about 5 percent per year) from 1987 through 1992 to avoid further major devaluations.

    Data as of November 1992


    NOTE: The information regarding Indonesia on this page is re-published from The Library of Congress Country Studies and the CIA World Factbook. No claims are made regarding the accuracy of Indonesia Monetary and Exchange Rate Policy information contained here. All suggestions for corrections of any errors about Indonesia Monetary and Exchange Rate Policy should be addressed to the Library of Congress and the CIA.

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Revised 10-Nov-04
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