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To cite this article: George Fane (2005) Post-crisis monetary and exchange rate policies in Indonesia, Malaysia and
Thailands, Bulletin of Indonesian Economic Studies, 41:2, 175-195, DOI: 10.1080/00074910500117024
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BIESAug05 29/6/05 4:18 PM Page 175
George Fane ∗ a
This paper surveys the post-crisis monetary and exchange rate policies of Indo-
nesia, Thailand and Malaysia. Malaysia has pegged the ringgit while Indonesia and
Thailand have adopted heavily managed exchange rates. Under their IMF pro-
grams, Thailand and Indonesia set base money targets, but Thailand has moved,
and Indonesia is now moving, to inflation targeting, using interest rates as the
short-term instrument. Malaysia also sets interest rates. The ability of the three cen-
tral banks to set interest rates and also pursue an exchange rate target with an inter-
est rate target has been bolstered by restrictions on the internationalisation of the
domestic currency. The three central banks have also had to sterilise the monetary
effects of their foreign exchange interventions. It is argued that inflation targeting
is now a good policy choice, but that a more freely floating exchange rate would be
better than sterilisation of balance of payments surpluses or deficits.
INTRODUCTION
The monetary and exchange rate responses of Indonesia, Thailand and Malaysia
to the dramatic speculative attacks on their currencies in 1997 were very differ-
ent. Having sought and obtained the help of the IMF, Indonesia and Thailand
abandoned long-standing policies of pegging their currencies to baskets that
were overwhelmingly dominated by the dollar, and announced the adoption of
floating exchange rate regimes and restrictive monetary policies based on targets
for restraining the rate of growth of base money (M0).
In the first nine months of the 1997–98 crisis, Bank Indonesia (BI) completely
failed to meet the monetary targets announced in the Indonesian government’s
letters of intent (LOIs) to the IMF. This happened as a result of last-resort lending
to weak banks that was far in excess of the amount needed to meet the public’s
demand to convert deposits into cash (Fane and McLeod 1999: tables 2, 3 and 4;
Kenward forthcoming; McLeod 2003: 305–6; Djiwandono 2004: 65–6). In the sec-
ond half of 1998, BI did achieve its base money targets. As a result, interest rates
∗ I am grateful for help from officials of the central banks of Indonesia, Malaysia and Thai-
α
land. I have also received many helpful comments from Stephen Grenville, Lloyd Ken-
ward and Stephen Marks. The opinions expressed and any remaining errors are of course
my responsibility alone.
and inflation both fell rapidly and the exchange rate appreciated.1 During the
remainder of the IMF program, the M0 targets were not always met, but they
were never again missed as badly as they had been before mid-1998.
Under Thailand’s Standby Agreement with the IMF, the Bank of Thailand
(BOT) allowed the exchange rate to float, and from 1997 until 2000 it targeted base
money for periods that ranged from three months to one year ahead. On a day-
to-day basis, the BOT adjusted its net supply of liquidity to the interbank money
market with the aim of minimising fluctuations in short-term interest rates. The
BOT’s policy was to put upward pressure on interest rates if base money was run-
ning ahead of the medium-term targets and downward pressure on interest rates
if base money was below them. Although there were some substantial deviations
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between the actual and targeted values of base money, the deviations mainly
involved base money being below the announced targets.
Malaysian policy makers initially hoped that they would avoid the crises that
overtook Thailand and Indonesia in the second half of 1997, and did not seek assis-
tance from the IMF. In December 1997, the Malaysian finance minister, Dr Anwar
Ibrahim, introduced policies of fiscal and monetary restraint that were described
as ‘IMF policy without the IMF’; however, it seems that Prime Minister Mahathir
did not support these policies, and they were reversed over the next eight months
(Athukorala 2001: 65–6). A complete break with the IMF’s prescription for dealing
with the Asian crisis occurred in September 1998, when Malaysia adopted mildly
expansionary monetary and fiscal policies, pegged the currency at Rgt 3.80/$ and
severely tightened its capital account controls (Athukorala 2001: chapter 6).
During the course of the Asian crisis, all three central banks tightened the
measures designed to prevent the use of their currencies in international financial
markets. These measures involve making it illegal for residents to make domes-
tic currency-denominated loans to non-residents.
In May 2000, the BOT moved away from targeting base money and began to
set short-term interest rates so as to achieve a medium-term inflation goal. Even
though its Standby Agreement with the IMF has now ended, BI continues to have
annual targets for M0. However, these targets are now merely one of a checklist
of variables that BI monitors when deciding how to set short-term interest rates.
BI has announced that it will adopt a similar inflation targeting regime to that of
Thailand and has taken some steps in this direction (Alamsyah et al. 2001).
Despite nominally operating floating exchange rate policies, both BOT and BI
intervene heavily in the foreign exchange market and have to sterilise the effects
of these interventions in the domestic money market in order to keep short-term
interest rates at their set levels.
Bank Negara Malaysia (BNM) has now removed its exchange controls, other
than those designed to prevent the use of the ringgit in offshore financial centres.
So far, it has continued to keep the ringgit pegged to the dollar, but it neverthe-
1 The30-day interest rate on SBI (Sertifikat BI, certificates of deposit at BI) peaked at 70.4%
in August 1998 before falling to 35.5% in December 1998; by August 1999 it was down to
13.1% (CEIC Asia Database). Inflation fell rapidly and the exchange rate appreciated from
Rp 15,000 to Rp 7,500/$ in just over three months (McLeod 2003: 305–6).
BIESAug05 29/6/05 4:18 PM Page 177
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 177
less also sets short-term interest rates and it too therefore has to sterilise the mon-
etary effects of its exchange market interventions.
In the aftermath of the crisis, there has therefore been a considerable conver-
gence in the policies of the three central banks. If BNM were to allow the ringgit
to float, while still intervening heavily in the foreign exchange market, and if both
BI and BNM were to set firm medium-term inflation goals, the remaining differ-
ences would be trivial.
The next section begins with a statistical summary of real growth, monetary
growth, inflation and interest rates in the three countries and then discusses infla-
tion targeting. This policy, which has become increasingly popular with central
banks in both developed and developing countries, has been adopted by the BOT
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and is in the course of being adopted by BI.2 The third section begins with a dis-
cussion of the decision by all three central banks to intervene actively in the for-
eign exchange market and to sterilise the monetary effects of such intervention in
the short-term money market. The ability of central banks to do this is bolstered
by restrictions on the internationalisation of the domestic currency. These restric-
tions are the focus of the remainder of the section. The fourth section deals with
the technical aspects of monetary policy in the three countries, and the final sec-
tion summarises the similarities and differences among the policies of the three
central banks and suggests tentative appraisals of these policies.
Indonesia
Base money (M0) 100 119 139 153 171 205
CPI 100 104 116 129 138 146
Real GDP 100 105 109 114 119 125
Nominal GDP 100 126 153 173 190 211
Velocity of M0 100 106 110 113 111 103
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Thailand
Base money (M0) 100 104 112 122 135 150
CPI 100 102 103 104 106 109
Real GDP 100 105 107 113 120 128
Nominal GDP 100 106 111 117 128 142
Velocity of M0 100 102 99 96 95 94
Malaysia
Base money (M0) 100 104 108 113 121 131
CPI 100 102 103 105 106 108
Real GDP 100 109 109 114 120 128
Nominal GDP 100 114 111 120 131 150
Velocity of M0 100 109 103 107 108 115
a Datafor base money (M0) are averages of the monthly figures; velocity of M0 is defined
as nominal GDP divided by M0.
and 2004, whereas in Thailand it fell by 6% over the same period.3 As a result,
although base money grew more rapidly in Thailand than in Malaysia, inflation
was faster in Malaysia than in Thailand.
Base money can be expressed as the sum of the net foreign assets (NFA) and
net domestic assets (NDA) of the central bank. This identity is used in figures 1,
2 and 3 to analyse the proximate sources of changes in the supply of base money
in the three countries. One striking feature of these charts is the strong upward
trend in NFA in all three countries. Whatever the central banks of Thailand and
Indonesia may say about floating their currencies, figures 1 and 2 show that they
have actually intervened heavily and systematically in the foreign exchange
market.
A second striking feature of figures 1, 2 and 3 is the extent to which, in each
case, NDA and NFA are mirror images of each other. This results from the cen-
3 The rise in velocity in Malaysia can be explained, at least in part, by the reduction in statu-
tory reserve requirements. Likewise, the fall of velocity in Indonesia in 2004 is associated
with an increase in statutory reserve requirements in that year. The (modest) fall in veloc-
ity in Thailand does not have any equally simple explanation.
BIESAug05 29/6/05 4:18 PM Page 179
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 179
300
200 NFA
100 NDA
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-100
-200
-300
Jun–99 Jun–00 Jun–01 Jun–02 Jun–03 Jun–04
Source: CEIC Asia Database.
2,000 NFA
1,500 NDA
1,000
500
-500
-1,000
-1,500
Jun–99 Jun–00 Jun–01 Jun–02 Jun–03 Jun–04
Source: CEIC Asia Database.
tral banks setting exogenous targets for both the exchange rate and the short-
term interest rate. Of course, BOT and BI have not pegged their currencies
rigidly to the dollar in the way that BNM has, but all three central banks have
regularly intervened in the foreign exchange market, and these interventions
BIESAug05 29/6/05 4:18 PM Page 180
300
NFA
200
NDA
100
0
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-100
-200
-300
Jun–99 Jun–00 Jun–01 Jun–02 Jun–03 Jun–04
4 In the absence of any other changes, an exchange rate fluctuation causes equal and oppo-
site changes in NDA and NFA, leaving M0 unchanged. The reason for the change in the
domestic currency value of NFA is obvious; the equal and opposite change in NDA arises
because one of its negative components is the net wealth of the central bank in domestic
currency, which is directly affected by capital gains, or losses, on NFA. For this reason,
exchange rate fluctuations cause the charts to exaggerate the extent to which the central
banks have actually sterilised NFA. Without knowing the composition of NFA between
dollars, yen, euro and so forth, it is impossible to make accurate allowances for this effect.
BIESAug05 29/6/05 4:18 PM Page 181
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 181
20
16
12
Indonesia: SBI 30 days
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0
Jun–00 Jun–01 Jun–02 Jun–03 Jun–04
5 Forexample, the average rate of core inflation in the last quarter of 2004 is defined as the
average of the rates of core inflation for October, November and December 2004, relative
to the same months in 2003. Since the monthly increases were 0.6% in each case, the aver-
age core inflation rate for the quarter was also 0.6%.
BIESAug05 29/6/05 4:18 PM Page 182
The MPC meets about once per month to set the 14-day repurchase (‘repo’)
rate.6 Under a 14-day repo contract, one party sells a high quality security, such
as a treasury bill, to another party, but makes a commitment to buy it back at a
slightly higher price after 14 days. In effect, the first party borrows from the sec-
ond party using the high quality security as collateral. The interest rate on the
loan is determined by the difference between the sale and the repurchase price.
The MPC uses the repo rate to influence inflation, raising the interest rate to
choke off inflation if it appears to be too rapid and lowering the interest rate if
inflation would otherwise be negative. Because of the width of the target zone,
the MPC can also devote some attention to other factors, such as the strength of
real growth. So far, the MPC has been able to keep core inflation within the target
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zone; admittedly, the zone is quite wide, but the MPC deserves credit for keeping
inflation low and for anticipating how inflation is likely to respond to its actions
and to other internal and external developments.
The reason given for the switch from targeting base money to targeting infla-
tion was the claim that the relationship between base money and output growth
had become weaker than it used to be (Bank of Thailand 2004: 3). In fact, the case
for targeting M0 rests on there being a stable relationship between it and the level
of nominal GDP, or perhaps between it and the price level, rather than on there
being a stable relationship between it and output growth. Given this and given
that the BOT has not tried to demonstrate that there is a stable relationship
between core inflation and output growth, it seems likely that the reason for the
switch probably had more to do with changing fashions, in Thailand and else-
where, on how best to operate monetary policy. The relative merits of the two
alternative nominal targets—inflation and M0—are discussed below. The new
policy has strong similarities with the approach pioneered by the Reserve Bank
of New Zealand (RBNZ), and explanations of the new policy on the BOT’s web-
site explicitly compare it to that of the RBNZ.
When BI adopts inflation targeting, this will not mark a sharp break with what
has gone before, since the setting of base money targets was always intended to
be a means to controlling inflation, rather than an end in itself. Besides, tentative
versions of inflation targeting formed part of several of Indonesia’s LOIs to the
IMF. The January 1998 LOI dropped the base money target that had been part of
the original IMF package and announced that inflation would be kept to less than
20% in 1998. In the event, the CPI rose by 21% in just the first two months of 1998.
The LOI of April 1998 reinstated base money as the proximate target of monetary
policy; it discussed the likely future rate of inflation, without making it a target.
The LOI of July 1998 stated that ‘inflation is to be reduced to a single-digit annual
rate within no more than two years’. The LOI of January 2000 set base money tar-
gets that were designed to keep annual inflation below 5%. The actual CPI
increase between December 1999 and December 2000 was 9.3%. Following a fur-
ther increase in inflation to 12.5% for the 12 months ending in December 2001, the
LOI of 13 December 2001 announced that the ‘strategic goal’ of monetary policy
6 Before May 2001, the BOT’s lending rate was set by the Monetary Policy Board. Other
minor changes occurred at the same time as the change in the title from ‘Board’ to ‘Com-
mittee’.
BIESAug05 29/6/05 4:18 PM Page 183
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 183
was to restore single-digit inflation by the end of 2002. The actual CPI increase
between December 2001 and December 2002 was 9.9%. In September 2004, the
governor of BI announced a policy of ‘low and stable inflation’ for the period
2005–08. He stated that senior staff at BI were working on the details of how this
is to be achieved, but at the time of writing (February 2005) these details have yet
to be announced (Bank Indonesia 2004).
the domestic interest rate will not fall and the final inflow will be the initially
planned $100 million, not some lesser amount. Further, the whole of the $100 mil-
lion will now go into increased non-resident holdings of official short-term bills
and real investment will not rise. Sterilisation therefore switches off the stabilis-
ing effects of a capital inflow on interest rates and investment. If the central bank
matches its short-term domestic currency-denominated liabilities with short-term
foreign currency-denominated assets, the reversal of the inflow would not be a
problem, provided that the authorities were willing to run down their foreign
currency-denominated assets in defence of the domestic currency, and provided
that a sudden capital outflow did not generate speculation against the domestic
currency. But since these conditions may not hold, managing the exchange rate
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Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 185
A foreign exchange swap has two parts. In the first part, the two parties to the con-
tract exchange amounts of two currencies that have the same value in the spot mar-
ket; in the second part, the initial exchange is reversed at a rate that reflects the
originally expected change in the spot exchange rate. As an illustration, consider a
swap between rupiah and dollars, on 1 January when the exchange rate in the spot
market is Rp 8,000/$. In the first part, the two contracting parties exchange amounts
of rupiah and dollars that have the same value in the spot market, for example Rp 8
billion and $1 million. In the second part, which might occur three months later, on
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1 April, the initial swap is reversed, but at an exchange rate that reflects the differ-
ence between rupiah and dollar interest rates. If the interest rate for borrowing and
lending in rupiah is 12% per year, and therefore roughly 3% for three months, and
the interest rate for borrowing and lending in dollars is 4% per year, and therefore
roughly 1% for three months, the exchange rate for the second part of the transac-
tion, the reversal of the original swap, will be about Rp 8,160/$, that is the initial
exchange rate scaled up by the 2% difference between the three-month interest rates
on rupiah and dollars. ‘Roughly’ and ‘about’ have been used because this numeri-
cal example uses simple interest and ignores the minor complications of compound
interest. The party that handed over Rp 8 billion in exchange for $1 million on 1 Jan-
uary will be returned about Rp 8.16 billion in exchange for $1 million on 1 April.
Restrictions on the ability of onshore banks to enter into swaps with non-
residents in which the onshore bank initially provides domestic currency in
exchange for foreign currency are an essential part of an exchange control system
that is designed to prevent the internationalisation of the domestic currency. The
reason is that such swaps effectively involve the onshore bank making a domestic
currency-denominated loan to the non-resident, matched by a foreign currency-
denominated loan from the non-resident to the domestic bank.
they would also have to restrict indirect rupiah lending via the swap market. As
explained below, all three central banks have responded to the Asian crisis by
imposing and tightening such restrictions.
7 Therupiah weakened from Rp 8,661/$ in April 2004 to Rp 9,415/$ in June 2004 (CEIC
Asia Database).
BIESAug05 29/6/05 4:18 PM Page 186
each bank’s foreign currency assets and liabilities, relative to their capital—that
has had the effect of further restricting their access to the swap market. Previ-
ously, each bank’s overall NOP had to be less than 20% of its capital, and this
requirement was monitored at the end of each day. Under the new regulations,
both the on-balance sheet NOP and the overall NOP, that is, the sum of the on-
balance sheet NOP and the off-balance sheet NOP, must be less than 20% of cap-
ital, and this condition must be met at midday, as well as at the end of the day.
The new regulation has substantially hindered banks’ ability to trade in the
swap market. The reason follows from the fact that, as explained in box 1, a for-
eign exchange swap has two parts: in the first, currencies are swapped, in the sec-
ond the original swap is reversed. Because of this reversal, the swap does not
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Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 187
banks; improving bankruptcy laws (since the financial system cannot work effi-
ciently if sanctions against defaulters are ineffective); and raising the capital ade-
quacy ratios of banks and other financial institutions. Since it would be hard to
guarantee that even these policies would be completely effective, and since the
costs of the financial crisis of 1997–98 proved to be very high, it is not surprising
that all three countries maintain tight restrictions on the internationalisation of
their currency. While this safety first approach can be defended, the three govern-
ments can be criticised for not also moving much more vigorously to implement
the first best policies, listed above, for reducing financial sector vulnerability.
dated SBI. However, whereas SBI are issued at monthly auctions, the FASBI
facility is permanently open and banks can deposit as much or as little as they
wish at the rate set by BI, which at the time of writing is 7%. Because the banks
are not rationed at the SBI auctions, or in deciding how much FASBI to hold, the
two rates are never far apart. The one-month SBI rate is generally about 20 to 50
basis points (0.20 to 0.50 percentage points per year) above the FASBI rate, in
compensation for the greater liquidity of FASBI, but the exact difference depends
on expectations about changes in short-term interest rates.
The regulations that introduced FASBI provided for the possibility of BI offer-
ing to accept deposits for terms of up to 14 days. In the event, BI has never
accepted FASBI deposits for terms of more than seven days. It has usually offered
seven-day deposits, and initially it also offered one-day deposits, with rates that
varied according to whether the deposits were made in the morning or afternoon
trading sessions. Before June 2004, the overnight FASBI rate set a floor on the
overnight rate in the interbank money market, since banks would never lend to
each other at a lower rate than that offered by BI. However, in June 2004, BI began
to ration the amount of overnight FASBI that it would accept. The reason seems
to have been its reluctance to pay interest on deposits whose maturities are so
short that they do little to reduce the liquidity of the banking system. In January
2005, BI took this reasoning a step further and stopped accepting overnight FASBI
altogether. The situation at the time of writing was that only seven-day FASBI
were available, and there was no rationing of banks at the 7% rate set by BI.
If there were a deep secondary market in SBI, BI could trade in it to set one-
week interest rates. In practice this market is thin, and BI therefore sets this inter-
est rate directly using FASBI, which offers some extra flexibility that the SBI
system does not possess. Of course the fact that BI operates in this way exacer-
bates the thinness of the SBI secondary market.
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 189
ket. Trading in the bilateral market is usually conducted once or twice per fort-
night. This trading involves the sale by the BOT, under repurchase agreements, of
government securities to nine authorised dealers. The BOT indicates the amount
of liquidity that it intends to absorb and invites tenders from these dealers at var-
ious maturities, ranging from one day to one month. Recently, about half of the
volume traded has been for one day and the next most important maturity is 14
days. Some trading takes place at seven days, but only very little is traded for one
month. The BOT does not make a commitment on the total volume to be ten-
dered. Rather, it adjusts this in the light of the bids to ensure that the average
accepted rates are very close to the policy rate. In the case of the 14-day tenders,
all bids must be at the policy rate, but bidders do not necessarily receive the full
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amount for which they bid. The BOT decides how much to accept and apportions
the total among the dealers in proportion to their bids.
The BOT-operated repo market is open for one hour on each trading day.
Between 40 and 50 institutions are eligible to bid in this market. These eligible
institutions include large state-owned enterprises as well as banks and other
financial institutions. Buy and sell bids are submitted to the BOT, which matches
them and charges a small commission. As well as operating this market, the BOT
trades in it on its own account, using it to absorb or inject whatever liquidity is
needed to keep the 14-day rate close to the policy rate. The authorised dealers
use the BOT-operated market to adjust the positions taken up in the bilateral
market.
At the end of the day, banks with a shortage of liquidity can borrow from the
BOT at the policy rate plus 1.5%, using government securities as collateral. Those
with surplus liquidity can only leave it in their current accounts at the BOT. Since
these accounts do not bear interest, banks try to operate on a very small margin
of excess liquidity, and the bulk of the funds in their current accounts is there to
satisfy statutory reserve requirements. The BOT does have provisions for allow-
ing banks with current account deposits in excess of their statutory requirements
to obtain a ‘credit’ against their future statutory requirements; that is, if they held
more than the required amount of reserves in one month, they can hold less than
the required amount in the next. Currently, the statutory reserve requirement is
1% of customers’ deposits. There is also a requirement that banks keep liquid
assets of at least 6% of customers’ deposits. Liquid assets are defined to include
current accounts at the BOT (although the required reserves are not really liquid),
vault cash and government securities. At the time of writing, banks have large
holdings of government securities and the demand for bank loans is low. As a
result, the liquid assets requirement is not binding and banks hold well in excess
of the 6% minimum.
Since lending to a central bank in its own currency is essentially risk-free, the
BOT does not really need to provide collateral for its borrowings from the finan-
cial system. Its reason for borrowing via repos, rather than employing a ‘pure
borrowing’ facility like BI’s FASBI, is that the collateral that it provides to the
institutions that lend to it can be used by these lenders as collateral for their own
borrowing, if the need arises. This deepens the market in government paper and
gives the lending institutions more flexibility than they would have if their lend-
ing was in the form of a non-transferable term deposit at the BOT. This has the
advantage for the BOT that financial institutions are willing to accept slightly
BIESAug05 29/6/05 4:18 PM Page 190
lower interest rates than the BOT would have to pay if it simply offered term
deposit facilities.
Although the bulk of the BOT’s open market operations are done in the repo
market, it does sometimes purchase government securities outright. Since one of
its long-term goals is to build up its portfolio of government securities, it does not
generally engage in outright sales of them, and since most of its monetary oper-
ations are intended to absorb liquidity rather than inject it, its outright purchases
are infrequent and generally small. It can also use the swap market to affect
domestic monetary conditions. For example, it can absorb domestic liquidity by
swapping the foreign currency-denominated assets that it holds in international
financial centres for baht.
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9 BNM’s total holding of Malaysian government securities is less than 0.1% of its total
assets.
BIESAug05 29/6/05 4:18 PM Page 191
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 191
• BNM would make more active use of repo operations in short-term monetary
management. Since BNM does not have large holdings of MGTB and other
government paper, its repo operations are normally done using securities that
it first borrows from institutions such as the EPF and then sells, subject to
repurchase agreements, to banks and other financial institutions.
• Short-term monetary management would focus on the overnight interbank
interest rate, though BNM might also intervene at other maturities from time
to time.
• BNM introduced the OPR, which was set at 2.7% and has so far remained
unchanged. No trading actually takes place at this rate, but it does have two
important functions. First, BNM announced that its day-to-day money market
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operations would aim to leave the overnight rate as close as possible to the
OPR, which therefore provides a useful signal to market participants of the
central bank’s intentions. Second, BNM stands ready to accept deposits at the
end of each day’s trading at the OPR minus 25 basis points from banks with
surplus liquidity, and to lend against collateral, in the form of Malaysian gov-
ernment securities or Bank Negara paper, at the OPR plus 25 basis points to
banks that end up short of funds at the end of the day.10 With the OPR at 2.7%,
the overnight interbank rate is therefore sure to end up within a 50 basis point
‘overnight operating corridor’, centred on the OPR, with a floor at 2.45% and
a ceiling at 2.95%.
Since the introduction of the New Interest Rate Framework, the weighted aver-
age interest rate in overnight interbank trading has always been close to the OPR
and has never reached either end of the operating corridor, though individual
banks have occasionally made use of the facilities. In practice, monetary policy
was not radically altered by the new framework, which mainly involves tidying
up and formalising existing procedures. Some borrowing by BNM using repos
has occurred, but it is still only a minor part of BNM’s total monetary operations,
most of which still take the form of banks tendering for deposits in the way
described earlier.
• the technical operating procedures of the central bank in the short-term money
market; and
• the nominal variable to be targeted—base money, inflation or the exchange rate.
10 This overnight collateralised lending by BNM to a bank with a small deficit at the end
of the day is quite different from last-resort lending to a bank in real financial difficulty.
Last-resort lending would be made at much higher rates through a different facility.
BIESAug05 29/6/05 4:18 PM Page 192
This final section summarises and attempts to appraise the various aspects of
monetary and exchange rate policy of the three central banks. The appraisal
inevitably rests on judgments that are somewhat subjective.
The ability of such a small country as New Zealand to weather the Asian crisis
suggests that these policies can work, even in a world of high capital mobility. But
they seem unlikely to be implemented in the foreseeable future in Indonesia,
Thailand or Malaysia.
Similarly, the uniformity of the approaches to active intervention in the foreign
exchange market, combined with sterilisation of the balance of payments effects
on the domestic money supply, is evidence that this policy too is not likely to
change soon. The sterilisation of balance of payments flows is much harder to jus-
tify, since it is a major potential source of monetary instability. Thailand, in par-
ticular, would probably have had a much less severe crisis in 1997 if the BOT had
floated the currency much earlier, or if it had kept to the textbook rules of a fixed
exchange rate system by holding NDA constant, or even contracting it, in the 12
months preceding July 1997, thus allowing the speculative pressure on the baht
to trigger automatic stabilisers such as interest rate increases (Fane and McLeod
1999: 397–99). The sterilisation of the balance of payments outflow in this period
meant that the BOT suddenly ran out of reserves before any of the automatic sta-
bilisers had begun to operate.
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 193
therefore in a more liquid position than would be the case if they had placed term
deposits at the central bank. This explains why BNM is trying to expand its use
of repo operations, relative to its borrowing by attracting term deposits.
This survey has not been able to offer any explanation for the thinness of the
secondary market for SBI, or for why BI does not encourage this market by con-
ducting repo operations in SBI. Greater reliance on such repo operations would
seem to be a sensible strategy for BI to pursue.
as illustrated by table 1, inflation and monetary growth are usually strongly cor-
related. As a result of this correlation, there will often not be much difference
between setting short-term interest rates so as to keep the rate of inflation within
some medium-term target zone and setting them so as to keep the rate of growth
of base money within a target zone that is obtained by adding the estimated rate
of long-run GDP growth to the target zone for inflation.
The most obvious illustration of the similarity between targeting base money
and targeting inflation is provided by the most dramatic monetary policy failure
covered in this survey—BI’s failure to meet its base money targets in late 1997
and early 1998. To keep to its base money targets, BI obviously needed to sell SBI
very much more aggressively than it actually did. If it had been following an
inflation target, exactly the same response would have been called for.
Similarly, the long-run effects of targeting inflation or base money will gener-
ally not be very different from those of pegging the currency to that of a country
that targets inflation. By pegging the ringgit to the dollar, Malaysia is assured of
having the same medium-run rate of inflation of traded goods prices as the
United States. While the US Federal Reserve does not have a formal, numerical
inflation target, its deputy chairman has been quoted as saying that its policy in
recent years has been to lean against disinflation when core inflation threatens to
fall much below 1%, and, similarly, against inflation when the core rate threatens
to rise above 2–2.5% (Berry 2004). This means that while its peg to the dollar
remains in place, Malaysia’s medium-term inflation rate can only move outside
the range of about 1–2.5% per year if its real exchange rate appreciates or depre-
ciates substantially relative to that of the US.
Real exchange rate changes are of course possible, and the expectation of a
nominal appreciation of the ringgit is, at the time of writing, generating capital
inflows that could cause real appreciation. To date, however, the pegged exchange
rate has given Malaysia low and stable inflation. Since August 1999, Malaysian
inflation has remained between 1% and 2.5%, and since January 2000, it has
remained between 1% and 2.1%.11 If BNM had actually announced a policy of tar-
geting inflation, it could not have been criticised for failing to meet its target.
11 When the ringgit was initially pegged in September 1998, Malaysia’s annual inflation
was running at about 5.6% (month on 12 months earlier), and it took just under a year for
the rate to fall below 2.5%. This lag in reducing inflation was presumably due to the grad-
ual flow-through to non-traded prices of the large depreciation of the ringgit that had
occurred in the year preceding September 1998.
BIESAug05 29/6/05 4:18 PM Page 194
Similarly, over the six-year period covered in table 1, Malaysia managed to pursue
a relatively tight monetary policy despite not targeting base money, while Indo-
nesia failed to do so, despite its stated commitment to base money targeting.
In the short run, the choice of nominal target is important. The advantage of
allowing the exchange rate to float is that the induced movements in response to
exogenous shifts in capital inflows and outflows help the economy adjust to these
shifts without the need for large movements in domestic prices and nominal
wages. That this is an important advantage in a world of volatile capital was con-
firmed by the ability of Australia and New Zealand to survive the Asian crisis
without any major calamity.
The choice between targeting inflation and targeting base money is less clear
Downloaded by [George Washington University] at 19:31 31 December 2014
cut. The advantage of targeting base money is that it is something that the central
bank can influence directly if it chooses to do so, whereas its ability to control
inflation is much less direct and immediate. Targeting M0 therefore provides a
way of sending a clear signal of the central bank’s determination—or lack of
determination—to keep to its stated policy.12 For this reason, the IMF was proba-
bly right to focus on M0 in designing monetary policies to restore confidence after
the onset of the Asian crisis, and Indonesia paid the price for failing to follow
these policies.
Targeting inflation is probably a better option if the central bank’s credibility is
not at stake. If market participants are confident that long-run inflation will be
kept within a narrow low range, a rise in interest rates becomes a clear signal of
monetary tightening and not, as in Indonesia in late 1997 and early 1998, a sign
that the central bank has lost control of the money supply and is in danger of
lapsing into hyperinflation. Provided that the central bank’s credibility is not at
stake, the advantage of targeting inflation, rather than base money, is that a slow
steady growth in base money is at best a means to low and stable inflation, rather
than an end in itself. Further, targeting base money will only be an effective
means for achieving low and stable inflation if its velocity of circulation does not
fluctuate in unpredictable ways. By targeting inflation, the central bank will auto-
matically accommodate unexpected fluctuations in the velocity of circulation of
base money. For this reason, the BOT’s decision to shift to inflation targeting, now
that its credibility has largely been restored, was probably correct.
Whether it targets base money or inflation, the test for BI will continue to be
whether it is willing and able to resist the political pressures to hold down inter-
est rates even when the chosen variable is growing faster than the targeted rate.
So far, BI’s record on sticking to temporarily unpopular strategies has not been as
good as those of BNM and BOT.
12 The relative merits of targeting base money and inflation have been debated in this jour-
nal by Grenville (2000a, 2000b) and Fane (2000a, 2000b).
BIESAug05 29/6/05 4:18 PM Page 195
Monetary and Exchange Rate Policies in Indonesia, Malaysia and Thailand 195
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