CENTRAL BANKING REFORM IN INDONESIA

By : J. Soedradjad Djiwandono
Gurubesar tetap Ilmu Ekonomi, Universitas Indonesia


To be presented in a panel on "Regional Central Banking Reforms in the Context of World Reform" sponsored by Adam Smith Institute and Fiduciary Trust International, Hong Kong, November 9-10, 1999


INTRODUCTION

Among the many factors causing or contributing to the Indonesian crisis, in fact Asian crisis, there are two problem areas that seem to be accepted as the major problems facing the national economies in the region. They are the weak banking systems and unsustainable corporate debts in foreign currencies. Very close to the center of issues related to these problems is the absence of a robust financial infrastructure, including the lack of independence in central banking.

Of course the absence of an independent central bank is not the sole problem that leads to the financial and banking crisis in Indonesia or elsewhere. However, an independent central bank is definitely an important issue on its own for the well functioning of banking systems, and not just an article of faith that central banks should be independent in their role as monetary authorities. Independence of central banking has been considered as part and partial of the requirement for improved corporate governance and transparency in the conduct of business of national economies that have increasingly integrated into a borderless economy.

This paper will discuss issues of central bank independence and its relevance to macroeconomic management in Indonesia during the recent crisis that could have important bearing to central banking in the region. This paper discusses issues related to the role of Bank Indonesia as a central bank in the macroeconomic management that was facing daunting challenges during the crisis that has been inflicting Indonesia for well over two years now. Based on some lessons learned from the crisis, an independent Bank Indonesia is definitely a necessity. However, the discussion on the need for independent central banking has to be put in the context of a backdrop that a sound-banking sector supported by a robust financial infrastructure is needed for sustainable financial and monetary management in the national economy.


A CALL FOR INDEPENDENT CENTRAL BANKS

In May 1998 Indonesia adopted a system of independent central banking when President Habibie announced his decision to put the Governor of Bank Indonesia outside the Cabinet that he formed several days after assuming his presidency. The decision was actually putting the status of Bank Indonesia back to its position before 1983. With the President's decision the Governor of Bank Indonesia, the central bank, no longer has a ministerial rank. This means that the governor of the central bank is no longer part of the government headed by the President. The legal basis for an independent Bank Indonesia was made official with the enactment of the new bill on Bank Indonesia a year after. It is explicitly mentioned in the new law that Bank Indonesia is an independent state institution, free from government or other parties' intervention, except on matters specifically mentioned in the law.

Discussions on the need to have an independent central bank in the country had actually been going on for quite some time before the decision by the new government. But, they were limited to seminars or Parliament Hearings with the Governor of Bank Indonesia. The issue became more pressing when Indonesia faced financial and economic crisis in mid 1997. In fact, the issue was raised during the negotiation for the IMF stand-by loan in late October 1997. It became a required step to be taken within the IMF-supported program as mentioned in the second letter of intent to the IMF in January 1998.

But, why does an economy need an independent central bank in the first place? For sure, independent central banking has become a new trend. Is has been an accepted practice by most countries since the end of the eighties, when more countries were adopting market economies after discarding economic planning. In industrial economies, independent central banking has become an article of faith. In the Maastricht Treaty, independent central banking was mentioned as one of the requirements for countries before joining the European Union. One by one the industrial reformed their central banks into independent ones.

However, as Professor Blinder wrote "the term (independence) itself is somewhat vague and has occasionally been misused". I completely agree with his assertion that the term independence should be interpreted as to mean that the central bank has freedom to decide on how to pursue its goals, and that its decisions are very hard for any other branch of the government to reverse. Basically what it meant here is that once the goals for the central bank have been decided, the government cannot intervene on how the institution would endeavour to achieve them. Stanley Fischer described this as the condition that the central bank should have instrument independence. But not necessarily goal independence. This is to say that the goal itself does not have to be decided by the central bank. In fact, the goal should not be decided by the central bank itself. It is usually determined by the government, for example certain level of inflation rate. But, once it is determined no other institutions could intervene the central bank's policy to achieve it.

At the outset it should be noted that in general central banks' responsibilities include monetary management, payment systems and occasionally banking supervision. The actual system adopted by each economy varies with respect to what are the overall responsibilities.

With respect to monetary management, the central bank usually has the authority over supplying base money and the responsibility over managing money supply and credits and thus, interest rates determination. There are cases that the government determines the level of the rate of interest but it is the responsibility of the central bank to maintain its stability.

The central bank may have the sole responsibility or together with other institutions, to manage the exchange rate for certain objectives. In addition it may have the responsibility to manage international reserves. With respect to exchange rate determination, the central bank may have the responsibility to determine the system of foreign exchange to adopt or to implement the foreign exchange system which is predetermined by the government.

A central bank determines, and sometime holds the reserve s of commercial banks. With the banking system in place the central bank is also usually overseeing the national payment system.

A central bank is usually responsible for maintaining the stability of the financial system through conducting banking supervision and acting as lender of last resort for the banking system. However, recent developments in different economies have been for entrusting banking supervision together with other financial institutions to a separate agency outside the central bank. Bank of Japan and Bank of England have been released from conducting banking supervision precisely after they were granted independence. In fact, presently the Fed is one of the few major central banks that is still responsible for bank supervision.

A central bank may also function as the government bank. In fact, central bank's original task was not to conduct monetary policy or support the banking system, but to finance government spending. This was what happened with the Bank of Sweden, the world's oldest central bank, during its early development as well as many other central banks.

In a system that imposes exchange control, the central bank is usually responsible for administering the control mechanism. A central bank may also manage government debt. In some countries central banks also provide economic and financial advice to their respective governments.

What is then the objective of a central bank? And if we know its objective, what would be its function? To be independent a central bank has to have well defined objectives. And to exercise its independence the central bank should also have clearly defined functions of what is expected to do. An established reference of central bank functions could be found in the Maastricht Treaty on European Union. The Treaty stipulates that the primary objective of a central bank should be to maintain price stability. And four basic tasks of a central bank are then set out: (i) defining and implementing monetary policy; (ii) conducting foreign exchange operations; (iii) holding and managing the official foreign reserves; and (iv) promoting the operation of payment systems. It is to be noted here that in the European Union there is no reference to responsibility for bank supervision. A consensus concerning the locus of banking supervision has so far not emerged.

In the early development of most emerging market economies the central bank was functioning more as a government bank than a central bank. A central bank was often used as the major source of financing government budget deficits. However, together with financial sector development there has been distinct transformation of central banking towards a more clearly defined function as to include the three core responsibilities, the monetary management, payment system and banking supervision. This development was influenced by a new approach in financial sector role, in development originated from seminal works in this matter by Shaw and McKinnon in the early seventies. Their works showed that most developing countries suffered from a condition of repressed finance whereby the financial sector including the central bank was put under control of the government in the name of economic development. As a result the banking sector was underdeveloped to serve the economy as financial intermediary. The economy was usually dominated by the government sector. And the government usually suffered from running budget deficits that had to be financed by the central bank.

The two works had inspired argument that economic development would be served better by a liberalized financial sector or financial deepening. By arguing that financial deepening would support the development process better, these works gave theoretical basis for financial liberalization to be done in these countries. The drive for liberalization of all sectors in the national economies was strengthened in the so called 'Washington consensus' in the eighties.

Some started a process of financial liberalization or financial deepening, as it was known then, in the early seventies and eighties while others in the nineties.

Indonesia started the process of financial deepening as early as in the late sixties with deposit rate liberalization, and in the early seventies through freeing foreign exchange control. But only in the eighties did liberalization really take its steady course, from freeing banks to determine deposit rates, lending rates and gradual reduction of direct lending by the central bank to easing requirements for bank licensing.

In this context macroeconomic management of a national economy is basically conducted through fiscal and monetary policy. In the early part of emerging market economies when the state sector is still playing a dominant role, macro-economic management is usually conducted to achieve growth and stability. With a tendency for the fiscal side to be more expansionary, monetary policy is aimed at supporting the achievement of economic growth while at the same time to check inflationary pressures such that growth and stability could be achieved simultaneously.

Monetary policy in a market economy is the major responsibility of the central bank. Conceptually the more independent the central bank, the more effectively it can achieve its monetary stability goal. Studies had shown that countries with independent central banks did indeed tend to have lower inflation rates. And low inflation did not appear to come at the cost of slower growth. But, correlation, of course, does not prove causation. The Economist reminded us that Germany's Reichsbank was statutorily independent when the country suffered hyperinflation in 1923. Despite this note, it is generally agreed that the more independent the central bank, the more effective would monetary policy be in achieving monetary stability. Thus more central bank independence or less government intervention is warranted for effective macro-economic management.

Granting the central bank its independence in conducting monetary management is basically liberalizing the central bank from government intervention. Thus, granting central bank independence is part and parcel of liberalization which has been accepted as a credo for the market economy to function efficiently. The consensus has been that a central bank should be granted independence in the conduct of monetary policy for monetary stability as determined by the government.

Unfortunately monetary stability is not just having a low rate of inflation, which is usually measured in some index of prices of goods and services. Recent developments showed that with a record low rates of inflation in the industrial economies, the world was still experiencing monetary instability in the form of financial crisis. With the enjoyment of central bank independence in advanced countries lately, financial systems still had to confront new challenges, namely assets inflation or economic bubble on the one hand and economic deflation on the other. At the time when inflation is very much under control, the US seems to face a financial asset bubble, while Japan, a deflationary economy. This development may raise some challenge to the present day conventional wisdom that the monetary objective of a central bank is stable inflation measured in consumer price index.

Problems facing macro-economic management have recently been much more complicated and making central banks responsibilities more challenging. As The Economist's World Economy Survey stated, "the role of central banks has traditionally been defined in terms of banks, money and inflation. Thus at the pinnacle of their power it is disconcerting that they still have to ask three questions. What is a bank? What is money? And what is inflation?" With new innovations in financial instrument and new techniques of financial intermediation in a global finance, the concept of bank and the instruments banks are dealing with, and thus their function as financial intermediary, is changing. The concept of independent central banking may also need to be redefined as well. As if answering to this issue, the IMF in the recent Interim Committee meeting produced a document that specifically listed definitions of central bank, financial agencies, financial policies and government.


INDEPENDENCE OF CENTRAL BANKING IN PRACTICE

After presenting arguments for independence of central banking in monetary policy for stabilization and observing the general pattern of central bank responsibilities, let me briefly discuss the implementation of these functions in practice. This is important to get a good grasp on what is actually meant by independence in central banking.

With respect to managing its national payment system, the central bank in a market economy is responsible for the development of national payment system to facilitate the national economy such that consumption, production, investment and trade activities could run effectively and efficiently. In money supply creation through fractional banking system, the central bank is commonly in charge of determining reserve requirement policy, the development of payment system techniques, and the regulation and infrastructure development of the clearing system.

With respect to banking supervision, despite a recent development to put its responsibility outside central banking, it had been common in the past to put banking supervision under central bank responsibilities. Some studies showed that banking supervision in most countries was executed by central banks. In other words it is common to include banking supervision as part of central bank responsibilities. However, as Stanley Fischer argued, this has nothing to do with the basic principle of central banking. As it was cited before, the new tendency has been to put banking supervision together with supervision of other financial institution under a separate autonomous body.

The Indonesian experience taught us that putting supervision of different financial institutions under separate supervisory bodies could raise problems. First, putting different but closely related financial institutions under different supervisory authorities could cause overlapping of supervision for some institutions and no supervision for others. In other words inefficient supervision. In the modern world of new innovations and global finance, the actual distinction between one type of financial instrument and another could be so obscure that separating them under different supervision could lead to ineffective supervision. Second, it was a general practice for owners of companies in Indonesia to have cross ownership in different financial institutions that may not be easily traceable under separate supervision authorities. Separate bodies of supervision would open more chances for overlapping of supervision over these institutions or the reverse. Some institutions may be under-supervised, while others are over-supervised. Both are unwarranted. It is crucial that these closely related financial institutions are put under the same supervisory body. In the condition of less clear cut separation among financial institutions and instruments, supervision would be more effectively enforced if it is entrusted to a strong and autonomous supervisory authority.

The crisis in Indonesia also taught us that with the central bank holding the responsibility of banking supervision and lender of last resort, the function of monetary management for stability and banking rescue was sometime compromised. Monetary tightening which was required for stabilizing the currency, could be compromised because of the complicating effects the step may impose on the rescued banks. With less independent central banking like what Indonesia had before, its effectiveness in either function was even reduced further. This would lead to the argument for separating bank supervision from the central bank and putting it under a separate body or together with supervision of other financial institutions. Ultimately the choice would be between a comprehensive single financial supervision and separate supervision for different institutions with close coordination. In any case, supervisory authority has to have independence.

Conceptually, the argument for independent central banking must be in reference to monetary management function. And the independent status is referring to the choice of instruments and the policy execution. In monetary management, the goal for stability may be predetermined by the government, like certain rates of inflation or the stability of the exchange rate. The central bank in turn has the freedom to determine on the steps it is taking to achieve the objective. Of course conceptually there is some constraint that would limit the authorities in making the choice in policy objectives as well as instruments as reminded by Krugman in his 'eternal triangle'.

In reality, the power to manage money supply and bank credits gives a huge leverage to the central bank. In particular, in the context of developing economies whereby the role of banking is usually very dominant in the financial sector. In this context, for economies in which the central bank has the authority to control the rate of interest, the objective of the interest rate policy is usually predetermined. The following are policy goal formulations in different systems that were mentioned by Fischer in the writing that was cited before:

  • Bundesbank is given the responsibility in monetary management to maintain the value of the currency. It is also required to support general economic policy of the government in so far as this is consistent with the objective for maintaining the value of the currency.

  • Banque de France in the 1993 law is responsible for maintaining price stability within the framework of general economic policy of the government.

  • The Central Bank of New Zealand is responsible for price stability

  • The Federal Reserve Banks have a more general objective, i.e. to safeguard long -term growth of money supply and credits which are in line with long term growth of production, maximum employment, price stability and normal rate of interest in the long run.

From all of the examples mentioned above, it is in general the case that the status of an independent central bank is related to its function of conducting monetary policy for price stability and (or) the stability of the national currency. Generally, the independence status of the central bank is specifically determined in an act of the state. In other words, for a central bank to be independent, its objective and function are clearly specified in the law. The Fed is probably the only exception, whereby it has responsibilities that are formulated in wide ranging areas and yet it is considered as one of the most independent central banks. If independence is not considered to be important, it is also unimportant to formulate the central bank function very specifically. In other words, very detailed formulation would not make any difference. This was the case with the Bank of England before the adoption of the new act, which becomes the legal base of its current operation.

By observing practices of central banks in 72 developing countries Cukierman et al in their study showed the followings:

  • There are 2 countries whose central banks are responsible only in maintaining price stability with rights to deviate from the policy of their respective governments

  • 17 countries whose central banks are responsible for maintaining price stability and other responsibilities in line with it

  • 22 countries whose central banks are responsible for price stability and other responsibilities not necessarily in line with price stability

  • 10 countries whose central banks are not given specified responsibilities, and

  • 15 countries whose central banks are responsible for specific areas outside price stability.

It is to be noted that in most economies, maintaining price stability has always been specified to be the major responsibility of the central bank. Even in cases of multiple objectives of central banking, monetary management for price stability is well accepted as the main responsibility of the central bank in a national economy. And if more independence or less intervention is accepted as a condition for a market economy to function more efficiently, it should follow that for the central bank to function more effectively in achieving monetary stability it has to be given a more independent status.

For exercising its independence, the objective and function of the central bank has to be explicitly specified in a solid legal base. The central bank should have an autonomous authority in determining monetary instruments for pursuing its objective. In turn, the central bank has to exercise its independence in a transparent and accountable manner. In the new international financial architecture, transparency and governance have been identified prominently as crucial factors for the strengthening of the financial system.


BANK INDONESIA LACK OF INDEPENDENCE AND THE CRISIS

Independent central banking as discussed above follows a normative concept of a central bank's role in a market economy and what has been practiced in different economies. Now let me briefly discuss what has been practiced in Indonesia in the recent past, prior to the enactment of the new law on Bank Indonesia.

At the outset I would like to reiterate that before the enactment of the new law on Bank Indonesia, the stipulation of the central bank's responsibilities was very broad, including the three major functions of monetary management, payment system and bank supervision. From the previous discussion, the issue of independent central banking should focus on the first function, the monetary management.

In Indonesia, the monetary policy objective as specified in the law on Bank Indonesia of 1968 was to safeguard the value of Rupiah, the national currency. This implied that the central bank was responsible for safeguarding the rupiah value in terms of prices of goods and services (price stability) and foreign currencies (exchange rates stability).

With respect to a central bank's role as the government bank, Indonesia developed a balanced budget policy concept, which was controversial, but was to a certain extent effective in containing fiscal impacts on inflation for many years.

But, even in the monetary management, Bank Indonesia prior to the new law, was not independent. Two points should be mentioned here to explain this position. First, the responsibility for monetary policy formulation was placed in a Monetary Board, chaired by the Minister of Finance. The Governor of Bank Indonesia was only a member together with several economic ministers, even though he/she had the right to deviate from the board's views. Secondly, since 1983 the Governor of the central bank was given a status of a Cabinet Minister. So, the central bank became part of the government and as a consequence the governor was legally, as well as structurally, not independent from the government.

Bank licensing was the responsibility of the Minister of Finance. But the Minister of Finance could only issue a bank license upon receiving a recommendation from Bank Indonesia. In other words, the central bank had the responsibility to review new proposals for bank licenses whether or not requirements had been fulfilled, but not to a issue bank license. Banking supervision was the responsibility of the central bank, while supervision for other financial institutions was under the Department of Finance.

With respect to the payment system, there were no substantive problems that Indonesia had to face. With an exception for the fact that with rapid growth of economic activities the volume of transactions and thus fund flows had also been growing tremendously. Together with new development of finance towards global finance, monetary authorities faced new challenges. The volume of daily transactions of dollars in the money market increased from a little over USD 2 billion at the beginning of the nineties to more than USD 8 billion just before the crisis. At the same time the daily volume of transactions in the capital market also increased tremendously. Meanwhile, the rate of growth of the national economy of more than seven per cent annually for years had caused similar growth of transactions, and thus flows of fund for payments. All of these resulted in tremendous increases in the volume of daily payments for financing transactions. The volume of payments that the central bank clearing system had to clear increased from IDR 5 trillion per day at the beginning of the nineties to more than IDR 20 trillion in 1996. These would require all the necessary institutional developments of a payment system that would serve payments for financing transactions efficiently, promptly and safely.

The lack of Bank Indonesia's independence both in the determination of its goal as well as in the choice of instruments in the monetary management had definitely constrained its effectiveness in the conduct of monetary management during the crisis. Prior to the crisis, Bank Indonesia had so much difficulty in convincing the Monetary Board to raise compulsory reserve requirements for banks. Bank Indonesia did not enjoy the freedom of determining exchange rate depreciation or appreciation since there was always some controversy between increasing the rate of depreciation for export purpose and the reverse for inflation control.

During the crisis, Bank Indonesia under the instruction of the Monetary Board was reluctantly resorting to an administrative intervention by instructing some state enterprises and semi government foundations to transform their deposits with different banks to central bank certificates. This was done in August 1997 as a part of liquidity tightening. The reverse problem arose when the President in October and November 1997 gave instructions to reduce the tightness of liquidity by allocating bank credits to small and medium scale enterprises. These examples showed us that Bank Indonesia did not enjoy its independence status in the conduct of monetary management whether conceptually or legally. During the crisis some direct interventions were made by the President in the form of issuing instructions in monetary operation.

In the conduct of banking supervision, Bank Indonesia faced problems that came out internally from the structural weaknesses of Indonesia's banking system and also externally due to interventions by the government. With the benefit of hindsight I would argue that the intervention in Bank Indonesia's banking supervision authority was the trigger point of the drastic loss of confidence in the Indonesian banking sector in the wake of the recent crisis. In particular, the government intervention in the process of bank closures.

There had been criticisms on the decision to close the 16 insolvent banks as a first step in the Indonesian banking restructuring on the eve of an IMF stand-by arrangement for Indonesia on November 5, 1997. The criticisms were generally faulting bank closures as causing bank runs, which led to a banking crisis afterwards. It was indeed ironical that, the closing of these insolvent banks which was aimed at boosting market confidence was in effect eroding completely the much-needed confidence. Indonesian banking sector was suffering from a loss of confidence both from their clients as well as correspondences after the bank closures. Confidence was shaken even among banks as inter-bank money market was compartmentalized.

Despite the actual truth of what did happen, could one argue with confidence that bank closure was indeed the cause of the banking crisis in Indonesia? I have written in a different paper on this issue. Suffice it here to say that I do believe in closing insolvent banks as a part of banking restructuring. But, the crucial issues are on the execution of bank closure. In other words, the problem is related to the how and when to do it.

The Indonesian experience in bank closure has some bearing in the issue of central bank independence due to the fact that Bank Indonesia also has the responsibility of banking supervision. The lack of Bank Indonesia's independence in its conduct as bank supervision authority was clearly demonstrated in the problems related to the closing of the 16 banks. Judging from what happened with the rupiah, it was positive for a very short period, but very soon the pressure on rupiah was even stronger. And the short-lived strengthening of the currency was of course being helped by a joint intervention in the foreign exchange market by Bank Indonesia and the Monetary Authority of Singapore and the Bank of Japan. Within a couple of days in the first half of November 1997 the rupiah was strengthening from IDR 3900 per USD 1 to IDR 3200. But, after that, the rupiah was returning to weaken.

The market reaction to bank closures was in fact strange. The foreign market was, in the beginning, reacting positively to the closures. The fact the 16 closed banks included three banks that were partly owned by the President's family members was read by foreign market players to be positive. This was interpreted that the government was evenhanded and serious in addressing bank problems. However, when one of the President's children and the former owner (even though actually just a minor owner) of one of the closed bank was known publicly to be allowed to takeover a small bank almost immediately after the bank closure, then the foreign market's reaction changed to negative, and the pressure on the rupiah resumed. The domestic market reaction was completely different. It should be noted that for some time there was some concern about the weaknesses of some private banks, even though the public was never sure about the exact number of the weak banks, nor did they know exactly which ones were actually problem banks. But, when the public learned the fact that even banks known to be owned by the President's family members were liquidated, many people did believe that other banks would follow. As a result, depositors started to move out their funds and put them into safer banks, the well-known process of flight to safety.

Here, the lack of independence of Bank Indonesia as supervision authority turned out to be too costly. The government intervention in the process of bank closure and bank acquisition as the market was led to believe, ultimately resulted in a negative reaction that negated the positive impact of a policy that basically was sound and proper in resolving problem banks within a framework of bank restructuring.

The erosion of public confidence in the banking system was further enhanced by the reaction of some of the President's family members in the form of suing both the Minister of Finance and the Governor of Bank Indonesia in court, to show their feeling of contempt against the decision to close their banks. In the current social and political condition, the action put hard pressure on Bank Indonesia's credibility. The pressure continued when the President dismissed four of the seven Managing Directors of the central bank in December 1997 and replaced them with his appointees. This was followed in less than two months by sacking the Governor, a couple of weeks before finishing his term of office.

In addition, there seemed to be natural conflict of interests in central bank operation, both with the managers of monetary policy and the bank supervisors that were associated with the function of lender of last resort. The conflict of interests could have easily emerged during the period of distress in banking or banking crisis. In a distress or crisis period, when a number of banks faced with a liquidity problem that could in a short term, turn into an insolvency problem due to the general worsening of the economic environment, monetary tightening for exchange rate stability can run at the crossroads with implementation of policy for rescuing banks.

In a non-transparent environment with weak governance, the problems became more complex. Lack of independence of bank supervision authority could open a variety of government intervention for whatever reasons that ultimately constrained the central bank in pursuing its monetary policy's objective. In the worst case both banking supervision and monetary management became ineffective. The possible conflict of interests between monetary management for stability and banking supervision for financial sector stability may strengthen the argument for putting supervision authority outside the central bank.

On the other hand the recent Asian crisis had served as a wake-up call for monetary authorities, on the issue of the close relation between effective monetary policy and a sound banking system. The latter would include stringent and effective banking supervision. These two areas of policy objective, even though in the past usually were put under central bank jurisdiction of authority, were not fully recognized as closely interconnected. Issues of policy coordination between monetary policy and banking soundness received more serious attention from monetary authorities as well as pundits and international institutions only since the mid-nineties. Now, with the benefit of hindsight from the recent crisis, it has certainly been popular to say that effective monetary policy requires a robust banking system or that sound banking system is a conditio sine qua non for effective monetary policy. Also that financial liberalization should be accompanied or even preceded by strengthening banking supervision. All these are newly found religion, which were not very transparent prior to the Asian crisis.

The Indonesian experience taught us that indeed monetary policy for stability is a macroeconomic issue that deals with basically short-term variables. Tight or loose monetary policy and low or high rates of interest policy are in general short-term issues. On the other hand, policies to produce sound banking systems, deal with issues like banking efficiency, bank soundness as minimally measured in bank condition with respect to its capital, assets quality, management performance, earnings and liquidity are all micro issues. Likewise prudential regulation, banking supervision, and other financial infrastructures. These are all micro issues. In addition they are in general medium term or even long term issues.

While it seems to be correct to say that a sound banking system is required for effective monetary policy or macroeconomic management, it is less certain to argue that an economy could make a doable program that could strengthen the financial sector and make effective monetary policy at the same time. Because, this implies for the government to run a program that could produce a solution for both micro and long term problems in a combination with macro and short-term problems. This is a daunting task facing monetary authorities of crisis-ridden economies like Indonesia. This I think is a new challenge for both theoretical construct as well as policy formulation that would ultimately show a package of policies for a sustainable solution for the recent crisis.

Coming back to the issue of central bank independence, the Indonesian experience would definitely attest the argument for central bank independence for effective monetary management. But, the experience also showed that there are new challenges facing the monetary as well as the supervision authority. This is because of the well established experience of the close, and may be, functional relation between monetary management which should be the sole responsibility of an independent central bank, at least with respect to the choice of instrument, and the soundness of banking system which requires independent and robust supervision authority.

For Bank Indonesia to exercise its authority as an independent institution, it is imperative that its function as the central bank is clearly specified and the independent status is specifically stipulated in the central bank act. In turn, Bank Indonesia should exercise its independence in a transparent and accountable manner. And to have sound credibility of its operation, Bank Indonesia should exude itself as an institution that is run fully by professionals with high standing of integrity from the Governor down to the lowest level of officials. Adherence to good governance and transparency are the keywords for Bank Indonesia to become an independent central bank.


AN INDEPENDENT BANK INDONESIA: SOME NOTES

At the start of the Habibie government in May 1998, by declaring the status of Bank Indonesia's Governor as no longer a Cabinet Minister, the President rendered Bank Indonesia a status of an independent central bank. But, legally Bank Indonesia became independent only after the new law on Bank Indonesia was enacted in May 1999. A brief look at details of the law confirms that all the necessary requirements for an independent central bank are clearly stipulated, including a clear specification of its objective and function, the meaning of independence, transparency and accountability. This is definitely most welcome for the strengthening of Indonesia's banking system.

In contrast to the 1968 law which defined Bank Indonesia's objectives very broadly, the new law very specifically stated that the central bank has a single objective in its operation, i.e. to achieve and maintain the stability of the value of Rupiah. In the explanatory notes of the new law it is stated that the rupiah value is measured both in the rate of inflation and the rate of exchange. Thus, maintaining stable rate of inflation and rate of exchange are the two objectives that should be achieved by Bank Indonesia in exercising its function as an independent central bank.

To pursue the specified objective, Bank Indonesia could independently exercise the three functions usually accorded to a central bank; i.e. formulating and implementing monetary policies, managing the payment system and supervising banks. In the explanatory notes of the law it is mentioned that in order for the central bank to achieve effectively and efficiently the stability objective, the three areas of its function should be integrated. It is not very clear as to what is actually meant by integrating these activities. In a way this is somehow not in tune with the single objective of the central bank.

On inflation rate as a target for monetary stability concern about the measurement or the specific definition of inflation, is in order. As discussed previously using price index of goods and services exclusively for measuring inflation rate may not be sufficient. As Indonesia had been exposed to some economic bubbles in the past, assets inflation is certainly an issue that should be addressed. The fact that asset inflation from property and financial assets could trigger monetary instability through the transmission mechanism of distress in banking and other financial institutions cannot be ignored. In other words inflation target has to be defined and measured carefully.

Reading the law and its explanatory notes in terms of inflation target, Bank Indonesia's independence seems to include not just instrument independence but something more. It is stipulated that the central bank determines on its own, the annual rate of inflation in the calendar year which may be different from the figure assumed by the government in the budget. It still has to be seen what if indeed there is a difference between the two, which one should prevail. Certainly the two cannot be both right for the same year. If the fiscal year stands as it is - April to March- there will also be a difficulty in interpreting the two figures.

With respect to determination on targeted exchange rate, the law gives a clear statement. It is to be determined by the government on the base of the central bank proposal. The central bank has the freedom to determine the instrument to choose in pursuing the exchange rate target. However, there is no mentioning about the exchange rate regime to be adopted. This issue has to be addressed carefully in the near future.

Discussion on which exchange rate regime to adopt will certainly be crucial in the near future. As the current state of development in this matter, the agreement seems to be in the form of accepting the reality that the choice of exchange rate regime reflects both economic and political factors. The Managing Director of IMF in his report to the last Interim Committee Meeting showed that :

  • No single exchange rate regime is appropriate for all countries in all circumstances, and the choice of exchange rate regime reflect both economic and political factors

  • The existing system of flexible exchange rates among three major currencies seems likely to continue, with their monetary policies predominantly focused on domestic stability

  • Pegged exchange rate may continue to be the preferred choice of many countries. However, other things equal, an increase in openness to capital flows will raise the requirements -- in terms of policies and institutional readiness -- for sustaining a peg

  • For mid-size industrial and emerging market economies, pressure arising from extreme fluidity of capital flows are tending to push countries either toward floating exchange rates or toward more rigid arrangements such as currency boards

  • Exchange rate flexibility needs to be accompanied by a credible alternative anchor for monetary policy. Inflation targeting is one option.

Conceptually there are some points that need clarification. It is stipulated that Bank Indonesia is granted an autonomous authority of supervising banks. But, by December 2002 Bank Indonesia is to hand over this authority to an independent financial supervisory body, which will be created on a later date. As a matter of expediency it is well understood that Bank Indonesia is keeping this task now. However, keeping it for good with other financial institutions remaining under a separate supervisory body, would invite problems that I mentioned before. In addition a specific drawback for putting both monetary management for stability and the task as supervisor cum lender of last resort as mentioned before would not be resolved by integrating these two tasks.

It may not be as crucial, however, a note on the task for managing the national payment system is in order here. I trust that among the three tasks, the clearing of payments does not conceptually have the characteristics of a public good. In the future, the more advance the private sector the more recent for the central bank to hand this task over to the private sector.

My final point is to reiterate that no matter how important is the legal base for central bank independence, it does not guarantee to make the central bank an effective institution in achieving its objective of monetary stability and serving as a solid foundation of financial infrastructure for robust banking system in the national economy. Bank Indonesia still has to earn its reputation as an independent central bank. In the wake of rampant bank scandals this is becoming a tough challenge to meet. As mentioned before, there is only one way to meet the challenge effectively , i.e. by solidifying the institution with professionalism and credibility. Good governance and transparency should be the iron rules guiding everyone from the Governor down to the lowest level of Bank Indonesia personnel, lest the legal status does not mean much.

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