There are two opposing sides regarding the issue of BI rate. The first group views that the BI rate has to be cut in order to stimulate people’s consumption in which could lead to a more sound and sustainable economic growth. On the other hand, the other group sees that the BI rate has to be maintained in its present condition or even leverage it in to a higher rate so that it could guard the Rupiah’s value since. Moreover, they also believe that the muscular value of Rupiah could have a positive contribution to the target of inflation in 2008. As for me, in a normal situation I would rather sided with the first party but upon seeing what has happened now in the global financial crisis, I prefer to team up with the later.
Two or three years ago, the first choice which is to cut the BI rate, seems to be a very rational choice to be made. With the impoverishment of people’s purchasing power as a consequence from a high level of inflation rate, cutting the BI rate was considered to be effective according to some pundits. But, at that time, the central bank was very eager to cut its rate in order to cope with the high level of inflation rate. A choice which then was proven to be wrong since it was only made things worse. It is true that the interest rate has functioned as a tool to control inflation, but it was important to be noted that the high level of inflation in 2005 was caused by the major shrinkage in the production capacity. In other word, the inflationary episode was caused by the cost push inflation characteristics.
On the other hand, the Inflation targeting framework from which the central bank holds on to, will only work in a situation in which the inflation is caused by the demand pull inflation characteristic. Thus, the result can be easily guessed, the people’s purchasing power was even more devastated while leaving the real economic sector into a major slump and near to death condition.
The collapse of the real economic sector at that time could be seen through the described data. Take a look at the data; the growth of manufacturing industries has only grown to 7.9 percents in 2004 and 5.9 percents in 2005 which was below the average target of 8.59 percents per year. Thus, the major concern came from the decreasing trend of growth. On the other hand, on the labor absorbency side, in the year of 2004, the manufacturing sector only absorbs 13 thousands worker, which was below the average target of 528 thousands worker per year.
Another example was the garment industries; this sector has a major decreasing trend as a consequence of the high energy cost, the selling price of the garment products was steadily decreasing around 5 up to 10 percents a year while the operational cost was also steadily increasing around 10 percents a year. Not to mention the companies that could not grasp the international market opportunities as a consequence of the lacking of working capital. Electronic industries could also be seen as another example; this sector could no longer stay in the business not only because of the decrease in the people’s purchasing power but also because it could not compete with the cheap imported products.
Alas, the condition in two or three years ago was very much different with the present. The option to cut the BI rate is no longer considered to be an effective choice. The central bank must not always go along with the fed policy. The massive cutting which was applied by the fed to its interest rate is considered to be an emergency policy coping with the global imbalance in the financial sector. To take the same procedure like the fed is very risky since the rupiah had a very grim history in coping with this kind of stuff. Amid the storm in the financial sector, the weak fundamental factors that constitute the Rupiah’s value have to be taken into account.
There will be a basic problem arising from the policy to raise the BI rate which is the target of economic growth. A problem that is objectively raised since the high level of interest rate could impede the consumption rate which would only hamper the phase of economic growth. Employing the global financial crises variable, I made a simulation that try to seek the relationship between the interest rate, the exchange rate and also the economic growth. This simulation used a vector auto regression technique which was developed by Christopher Sims in 1980.
In this simulation I found that every policy attempting to increase the interest rate was proved to have a negative impact to the economic growth. But this impact would not prolong, it only took one quarter of a year. For the forthcoming periods, the Rupiah’s appreciation, as an output from the rise in interest rate, would give positive contribution to the economic growth. This contribution eventually could be more than just to offset the negative impact which was initially taken place in the first period since it has bigger coefficient factor to contribute the economic growth. One thing to be noted, this sequence of condition is only true if and only if the interest rate leverage is below 1 percentage point
The mechanism is quite rational; the increasing level of interest rate would impede not only the aggregate demand but also the export projection. These factors would obstruct the phase of economic growth in the first quarter. But in the following periods, along with the Rupiah’s appreciation, the aggregate demand would be more than doubled since the effect of imported inflation was gradually diminished. On the other side, the export growth had also had the retrieving trend. This is Based on the fact that more than a half of export products have a massive dependency from the import components so that the Rupiah’s appreciation would lead to decrease in the cost of production. These factors would undoubtedly underwrite the economic growth for the forthcoming periods.
To wrap things up, I would say that the previous mistake should be considered as a factor to comprise the future policy. Furthermore, the policy makers should have enough credibility to diminish all of the mistakes that have been done before. With credibility, any economic turbulence could be easily tackled with the given policy instruments.
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