Insight: Rupiah redenomination: A step in the right direction

by Anwar Nasution  

Thursday, 5 August 2010

The Jakarta Post

In a hearing with the House of Representatives Commission XI last week, the Board of Governors of Bank Indonesia announced its 10-year plan to reduce the value of the rupiah by dropping three zeros from the currency. When this happens, it will be the third time Indonesia has taken such a measure. The first time was on March 19, 1950, when the currency was physically cut in two and reduced its value by a half of its face value. In addition, the values of bank deposits and Treasury papers were also cut by a half. The left hand side of the currency remained valid as a legal tender with a half value and could be exchanged with new currency until the following month. The right hand side of the currency could be exchanged for the Emergency Government Bond of 1950. The second redenomination was in 1965 when three zeros were removed from the rupiah.

The coming redenomination will be totally different from the previous schemes. In the past, monetary cutting and redenomination were parts of economic programs to stabilize the economy and combat inflation. The earlier policies were intended to reduce the monetary base and stock of money as a way to combat high inflation rates. At the end of the Korean War, the inflation rate in Indonesia rose to 33 percent in 1950 and 73 percent in 1951. The inflationary finance to finance budget deficits in the 1960s increased the inflation rate to more than 650 percent in 1965. At that time, the government increased revenues from seignorage (by printing new money); outright confiscation of financial resources (by making it difficult for money holders to convert their holding of old currency); and inflationary tax.

In contrast to the past, the coming redenomination will be carried out after the completion of the IMF Program seven years ago, in December 2003. Since then, the economy has been growing at an average rate of 5 percent per year, the inflation rate was at 4.8 percent in 2009, the budget deficit was at -1.6 percent and the debt-to-GDP ratio was at 31 percent. Meanwhile, foreign exchange reserves are accumulating because of a combination of a boom in the prices of exported natural resources and capital inflows.

Despite the case of the Bank Century bailout, the banking industry is relatively healthy even though it has not yet positively contributed to economic growth. In sum, the coming redenomination is a statement that the days of high inflation are over, and the removal of three zeros is symbol of an inflationary past. This, hopefully, will reduce citizens’ inflationary expectations.

The redenomination of 1965 failed to stabilize the economy because the roots of the problems had not been addressed, namely: civil war, mismanagement and rampant corruption. The hyper inflation rate was a reflection of a long period of large budget deficit, a weak banking system, low production and productivity because of a wide range of economic regulations and poor economic infrastructure.

The tax base and tax administration practically collapsed toward the end of the administration of president Sukarno between 1965 and 1966, because of a combination of high inflation, constant political instability and civil wars.

In addition, Indonesia declared a military confrontation against Malaysia and Singapore and mobilized non-alignment countries to form new emerging forces during the Cold War. To finance the expensive internal and external wars and international activity, the government adopted an inflationary financing policy 

At present, the government continues to use the economic stabilization package inherited from the IMF Program of 1997-2003. There are four elements of the program. First, monetary rule which consists of (i) replacing the fixed exchange rate system with a floating one; (ii) adopting explicit inflationary targeting as the objective of monetary policy. 

To achieve this target the central bank is given autonomy. The second element of the stabilization program is fiscal rule that (i) bans the central bank from financing the budget deficit and buying government bonds in the primary market; (ii) limits the government budget deficit to no more than 2 percent of annual GDP; and (iii) limits the ratio of government debt-to-GDP to sustainable levels (at present this is 31 percent). The third element of the stabilization program is to improve productivity through a wide range of deregulation and measures to increase efficiency. The fourth program is to strengthen government institutions to protect property rights, enforce contracts and correct market failures 

To make the redenomination program a success, the central bank and the government should address the current problems of the Indonesian economy. The first problem is in the banking system, which is the core of the financial system in Indonesia. The system remains inefficient as evidenced by large bank spread, low credit as a portion of GDP, and the absence of non-government long-term loans. Second, as shown by the failure of Bank Century in 2008, further efforts are needed to improve the regulatory and supervisory framework to make the

system safer. Third, to adopt the Bagehot principle in extending the lender-of-last-resort facility, which says: “lend freely at a high rate against good collateral”. Fourth, to manage the real exchange rate properly for export promotion and for shifting resources from the non-traded sector of the economy, with low productivity, to the traded sector with high productivity. Fifth, increase the tax ratio to finance growing government expenditure. Lastly, building an effective and efficient government institution 

The writer is a professor of economics at the University of Indonesia.