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Monetary Policy and The Role of Exchange Rate Under Financial Distress: The Case of Indonesia

This document discusses the role of exchange rates under monetary policy during periods of financial distress, using Indonesia as a case study. It outlines two viewpoints on the limited role of exchange rates under inflation targeting frameworks and assumptions of efficient markets. However, the dynamics of Indonesia's economy differ from these assumptions, with greater financial integration increasing volatility. The document also examines "bending the rule" by including exchange rates independently in central banks' preference functions and Taylor rules, finding some merit for economies with high exchange rate pass-through and inflation volatility. Estimations of monetary policy rules for Indonesia over 2000-2007 found some role for exchange rates.

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59 views

Monetary Policy and The Role of Exchange Rate Under Financial Distress: The Case of Indonesia

This document discusses the role of exchange rates under monetary policy during periods of financial distress, using Indonesia as a case study. It outlines two viewpoints on the limited role of exchange rates under inflation targeting frameworks and assumptions of efficient markets. However, the dynamics of Indonesia's economy differ from these assumptions, with greater financial integration increasing volatility. The document also examines "bending the rule" by including exchange rates independently in central banks' preference functions and Taylor rules, finding some merit for economies with high exchange rate pass-through and inflation volatility. Estimations of monetary policy rules for Indonesia over 2000-2007 found some role for exchange rates.

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© Attribution Non-Commercial (BY-NC)
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Monetary Policy and the Role of Exchange Rate

under Financial Distress: the case of Indonesia

Miranda S. Goeltom

MONEY AND BANKING CONFERENCE, Banco Central de la Republica Argentina


Buenos Aires, 31 August 2009
Coverage .... 2

1. Financial Markets Distress, Monetary Policy and


the Role of Exchange Rate
2. Viewpoints on the Role of the Exchange Rate
under ITF
3. Role of the Exchange Rate in Flexible ITF
4. Conclusion
1. Financial Distress, Monetary Policy and Exchange Rate ... 3

Financial market distress since 2007 ...

 Common features with previous crisis episodes:


 Long period of benign macroeconomic and financial
environment
 strong and stable growth globally
 low global interest rates and pro-cyclicality of the financial
sector
 Lower perception of risk inducing search for yield.
 Led to serious asset price bubbles
1. Financial Distress, Monetary Policy and Exchange Rate ... 4

Emerging markets are affected .. But weathered the shocks


relatively better...
 Limited exposure to the US subprime
 Early stage of development of structured credit and derivative
products
 Relatively healthy banking system, and well capitalized, especially
after the 97 Asian Crisis

Nevertheless ...
• exports were hit and real sector was deteriorated
• exacerbated by increase volatility in stock market and exchange
rates
1. Financial Distress, Monetary Policy and Exchange Rate ... 5

Pose challenges to policy makers

 Need to identify the degrees of macro-financial linkages

 Seeking Optimal monetary policy instruments to increase effectiveness


 Pre-emptive nature of responses
 Easing market uncertainties
 Flexibility without hampering credibility

5
1. Financial Distress, Monetary Policy and Exchange Rate ... 6

Role of the Exchange rate:


For example, Indonesia...
• A small open economy, adopting inflation targeting with floating
exhange rate system and open capital account
• Increasingly integrated with the global financial market
• Shallow financial market and incomplete hedging instruments.
• Vulnerable to global volatility, putting pressures on the exchange rate

Under a period of financial distress:


• A shock absorber for the economy??
• Volatility merely mirroring economic adjustment process back
towards equilibrium subsequent to a shock??
6
2. Viewpoints on the Role of Exchange Rate under ITF 7

 IT literature portrays limited role of exchange rate in monetary


policy strategy

 Promotes the role of interest rate as instrument

 Generally formulated by taking into consideration its feedbak or


policy response to the deviation of inflation and output from
their targets (Taylor Rule)
2. Viewpoints on the Role of Exchange Rate under ITF 8

 Two key arguments for the perceived limited role of the


exchange rate under ITF.
 Merely a transmission channel of monetary policy in
influencing the ultimate target of monetary policy, namely
inflation (Diagram 1.).
 direct inclusion in the response function give excessive
impacts on the economic system (Taylor, 2001).
 Using the exchange rate as a direct instrument can erode
the effectiveness of monetary policy.
 Central bank’s direct intervention in the foreign
exchange market can be counterproductive,
suggesting dualism of monetary policy signals ,
confusing economic players. (Svensson, 2001; Mishkin
and Schmidt-Hebbel, 2001).
Viewpoints on the Role of Exchange Rate under ITF 9

Diagram 1. Flowchart of Exchange Rate against Inflation

Open Market Monetary Policy


Operation Instrument

UIP Short term


EXCHANGE RATE Operational Target
Interest Rate

Exchange Rate Aggregate


Pass-through Demand

Inflation Ultimate Target

Source: Hufner, 2004


10
Viewpoints on the Role of Exchange Rate under ITF

Two complementing assumptions regarding the role the


exchange rate as an economic shock absorber.
The financial system is assumed to operate efficiently allowing
market players to perform optimal portfolio adjustments, minimizing
liquidity risk and solvency risk in the financial system
 Uncovered Interest Rate Parity (UIP) sound and hold
 The belief that exchange rate volatility is primarily attributable to real
shocks such as the terms of trade, economic productivity and real
interest rate, less than the effect of nominal shocks, such as currency
in circulation.
The exchange rate steers the economy towards its long-
term equilibrium when real fluctuations occur, Illustrating
the process of an economic stabilizer as well as absorber
11
Viewpoints on the Role of Exchange Rate under ITF

•Hence, the view that xchange rate plays a limited role in


monetary policy strategy.

Free floating exchange rate system is recommended as the


optimal policy option for an economy that uses ITF
Viewpoints on the Role of Exchange Rate under ITF 12

The dynamics of Indonesia’s economy over the past 10 years have led to
differences between the assumptions and empirical facts.
Two arguments:
FIRST, Greater integration pushed the dynamics of domestic financial market,
and a slide in global financial market performance can rapidly trigger excessive
asset price volatility and promote financial fragility.
Investment Portfolio and Foreign Direct Investment (Net)

3
FPI (nett)

-2
FDI (nett)

-7

Source: Bank Indonesia


-12
1993 1996 1999 2002 2005 2008
Viewpoints on the Role of Exchange Rate under ITF 13

 SECOND:
 Inflation in Indonesia remains persistently high. Permanent inflation in
Indonesia remains high; in the range of 6% - 7%.
Inflation Decomposition
16
Inflasi Permanen
Permanent Inflation
Actual Aktual
Inflasi Inflation

Trend
13
(%)
Rate(%)

11
Annual rate
Annually

3
01-1 02-1 03-1 04-1 05-1 06-1 07-1 08-1* 09-1* 10-1*
Years-Quarters
3. Incomplete study: “Bending the Rule” 14

 Indonesia, a salient fact:


 After gaining independence in 1999, and the Central Bank objective is
price stability, inflation (CPI) is trending down, except for end 2005
whereby domestic fuel price was increased by nearly 80%.
 Inflation Targeting Framework (ITF) was formally adopted in May 2005.,
and monetary policy remain anchored to inflation to curb exchange rate
passs-through.
 However, in a non-fully efficient financial system, and in an economy with
relatively large foreign short term debt, exchange rate pressures can
exacerbate economic volatility.
 Can exchange rate be included independently with inflation and economic
growth in a central bank’s preference function.
 “Bending rule”: the role of the exchange rate can be further identified within
operational monetary policy.
Bending Rule ... 15

To measure the role of the exchange rate using the Taylor rule:

The presence of interest smoothing:

The presence ad-hoc role of rexchange rate:


16
Bending Rule ...

 This slight bending of the rule is an interesting format since it takes


into account the exchange rate’s role.
 Doubt may emerge, also considered inconsistent with basic ITF
substance, however, several empirical observations for economies
characterized by large exchange rate pass-through as well as
relatively high and unstable inflation accords merit to this rule
bending (Edwards, 2006).
 Technically, for small open economies the addition of an exchange
rate variable offers the possibility of achieving system stability,
providing that the data used is contemporaneous. If the data is
lagged then such an addition is unnecessary (Bask, 2006) .
Bending Rule ... The Indonesian case 17

 Parsimonious Taylor rule estimations using equation (2) and (3)


conducted for the period of 2000.1 – 2007.4:

 It was generally concluded that the behavior of these two rules can be
explained by the data.
 The quite large short-term exchange rate effect is greater than Chile’s
economy, which is zero, but far less than Mexico with a short-term
effect of 0.8.
Assessment of monetary policy response during crisis 18

 Though much simplified, the bending rule has indicated


that it outperforms the simple rule .. enables a more optimal
countercyclical policy response
Inflation and Monetary Policy Response
20

16

12

0
2000 2001 2002 2003 2004 2005 2006 2007 2008

Inflation (anualized) Actual 1-m SBI rate


Bending rule SBI rate BI Rate
Simple rule SBI rate
19
Assessment of monetary policy response during crisis

 Indonesia’s monetary policy response during the period of


crisis was gradualist ....

Inflation and Monetary Policy Response


20

16

12

0
2000 2001 2002 2003 2004 2005 2006 2007 2008

Inflation (anualized) Actual 1-m SBI rate


Bending rule SBI rate BI Rate
Simple rule SBI rate
Role of Intervention ... 20

 Hence, policy strategy using the interest rate as a primary


instrument must be buttressed by other policy strategies, through
measured intervention in the foreign exchange market coupled
with sterilized intervention.

 Cautious intervention is implemented during the excessive


market pressure.
 Considered effective in managing expectations of
depreciation and short-term inflation.
 Still hold the key principle that in the long run exchange rate
fluctuations are strongly influenced by fundamental factors.
Role of Intervention ... 21

Foreign Exchange Reserve (USD million, end of period)

Periode Indonesia Singapore Malaysia India Brazil Rusia South Korea Australia
Jun-04 34,851 101,604 51,955 114,129 48,860 84,463 167,030 na
Dec-04 36,321 112,575 64,906 125,164 53,960 120,809 199,066 na
Jun-05 33,865 114,898 73,617 132,942 60,946 147,776 204,986 na
Jan-06 35,076 119,746 70,197 133,281 53,961 181,401 216,933 na
Jun-06 40,107 128,316 77,975 155,968 62,283 243,175 224,360 na
Dec-06 41,579 135,342 81,724 170,187 86,226 295,568 234,260 52,821
Jun-07 50,924 144,056 97,680 206,114 143,117 397,398 250,700 65,391
Dec-07 56,920 162,957 100,635 266,767 165,507 464,379 262,220 24,237
Jun-08 59,450 176,650 125,063 302,050 184,592 554,501 258,100 31,547
Sep-08 57,108 168,802 109,052 282,652 205,271 542,094 239,670 26,442
Dec-08 51,640 174,196 90,605 245,870 192,950 412,547 201,220 29,047
Mar-09 54,840 166,099 86,855 241,597 189,903 368,146 206,340 27,972
Conclusion 22

 Policy flexibility is crucial in the short term so that the policy


response instituted does not undermine the actions taken to
maintain macroeconomic stability.
 ITF implementation in needs to be more elastic and flexible
compared to the existing standard analysis, in particular during
widespread crisis.
 Several preconditions still need to be considered, especially
relating to the role of the financial sector as a mediator as well
as a channel of global portfolio movements.

Thank You .....

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