Bank Indonesia s Experience on Policy Mix Sahminan Department of Economic and Monetary Policy Bank Indonesia Central Bank Policy Mix: Issues, Challenges and Policy Responses Jakarta, 9-13 April 2018
Outline 2 1. Dynamics and Challenges of the Post-GFC 2. Why Policy Mix? 3. Bank Indonesia s Policy Mix
Challenge # 1: Large and volatile capital flows 3 More dynamic capital flows in the post-gfc period. Capital flow volatility creates financial system vulnerability. A significant portion of capital inflows tends toward short-term financial instruments, which are particularly vulnerable to a sudden reversal.
Challenge # 1: Large and volatile capital flows 4 Foreign capital flows have led to Rupiah appreciation/ depreciation, which could potentially influence the current account. Exchange rate volatility increases in the post-gfc period.
Challenge # 2: Commodity price shock 5 The end of the commodity supercycle era, together with a growing middleincome population in Indonesia and rupiah appreciation, contributed to a current account (CA) deficit, which surpassed 4.27% in the second quarter of 2014.
Challenge # 3: Highly procyclical financial sector 6 Financial sector procyclicality also became more prevalent when driven by foreign capital inflows. Flows of liquidity into domestic economy drive up asset prices and risks to financial stability
Policy Challenges 7 2014-2015 Divergence global recovery Cap inflows 2014, Outflows 2015 Fall in commodity prices Slowdown GDP growth Credit growth slowdown High inflation 2014 Low inflation 2015 2012-2013 Capital reversal, (Euro crisis 2012, and Taper Tantrum, 2013) Commodity prices decline High GDP growth High credit growth High inflation (2013) CA deficit 2008-2009 Global recession Capital reversal Low commodity prices GDP growth slowdown Low credit growth Low inflation CA surplus 2010-2011 Global recovery Capital inflows High commodity prices GDP growth recovered High credit growth Low inflation CA surplus
Outline 8 1. Dynamics and Challenges of the Post-GFC 2. Why Policy Mix? 3. Bank Indonesia s Policy Mix
Monetary Stability and Financial Stability Nexus 9 Under the conventional view, there is generally no trade-off between monetary stability and financial stability The conventional view is that monetary stability supports financial stability. Monetary or price stability as more of a sufficient condition for financial stability (Schwartz, 1995). Inflation is one of the main factors behind financial market (in)stability. In the reverse relationship, banking (and/or exchange rate) crisis will trigger monetary instability. (Goldfajn and Gupta, 2002). The new environment hypothesis suggests a trade-off. Successful inflation control by the central bank can foster overly optimistic market perceptions and forecasts for the future of the economy. Incorrect perceptions create a false sense of security and lead to miscalculation of asset values with possible future negative impact. Overoptimistic expectations can lead to drastically escalating activity on the asset and credit markets that surpasses the level of potential productivity improvement. This in turn drives up asset prices and fuels a booming trend and inflationary pressure (Borio et al., 2001)
Monetary Stability and Financial Stability Nexus 10 The trade-off possibly arises in the short-term, during a period of sudden disinflation. Issing (2003). In medium and long-term, within the context of the forward-looking central bank strategy of achieving price stability, this conflict will disappear. Borio and Zhu (2008) put forward the existence of risk-taking channel. Some empirical studies support the argument of a risk-taking channel in the monetary policy transmission mechanism. Altunbas et al. (2009) and De Nicolò et al. (2010) suggest that monetary policy easing will increase risk taking, but this relationship depends on the health of the banking system, i.e. less so for poorly capitalized banks.
Monetary Stability and Financial Stability Nexus 11 The complexity of the problems in the financial sector, accompanied procyclicality behavior, ultimately takes its toll on the workings of monetary policy transmission mechanism. In an event when the economy moves at an expansion phase, characterized by macroeconomic stability and escalating growth, investor confidence raises optimism when assessing the economy. This risk-taking behavior, which firstly triggered by monetary policy, will eventually push up credit demand and asset prices. Changes in the financial sector as reflected in adjustments of financial variables (financial stability) influence aggregate outcomes such as economic growth and employment, which are directly linked to monetary stability. A healthy macroeconomic environment and monetary stability has bidirectional feedback with financial system stability. Any developments between monetary and financial stability will be considered by monetary policy makers through macro-prudential policy feedback rule, which are scrutinized under financial stability framework.
Integration of Monetary and Macroprudential Policy 12 The dynamics during the global financial crisis has shown that monetary policy needs to be further directed to anticipate macroeconomic instability risk stemming from financial system. Central bank needs to strengthen the framework of monetary and financial system stability, which requires a right monetary and macroprudential policy integration. To maintain price stability, as the main goal of monetary policy, central banks traditionally use interest rate as their main instrument. However, keeping price stability is not sufficient to guarantee macroeconomic stability, as financial system with its procyclical behavior may trigger excessive economic fluctuation. The goal of macroprudential policy is to strengthen financial system resilience and safeguard financial stability. With its countercyclical role, macroprudential policy contributes to supporting the goal of monetary policy in maintaining price and output stability.
Monetary Policy vs. Macroprudential Policy 13 13 13 Monetary Policy VS Macroprudential Policy Monetary Policy addresses risks associated with: Economic Growth Inflation Current Account Deficit Exchange rate Both risks are interrelated (interconnected), but required different policies to address these risks Macroprudential policy addresses risks to financial system caused by: Weakening of financial condition Financial and sectoral imbalances Imprudent Behavior, etc.
Monetary Policy vs. Macroprudential Policy 14 Both policies can also be conflicting trade off 22 14 Financial Condition Asset Price Bubble vs Monetary Condition Low Inflation Credit or liquidity needs to besqueezed Interest rate need to be higher Risk takingbehavior Credit is evenhigher Economic contraction Inflation is too low Capitalinflow Supply of credit ishigher Interest rate islower A tight monetary policy through higher reserve requirements to reduce exchange rate pressure liquidity problems for banks Macroprudential policy which requires high capital to maintain the stability of the financial system hamper economic growth (aggregate demand). A loose monetary policy that encourages growth financialinstability. make excessive credit expansion lead to
Outline 15 1. Dynamics and Challenges of the Post-GFC 2. Why Policy Mix? 3. Bank Indonesia s Policy Mix
Monetary Regime 16 Bank Indonesia policy regimes have changed overtime as a response to domestic and external developments. The adjustments, fostered by faster globalization and two major financial crises in 1997/98 and 2008/09, have had major implications on monetary management. Global uncertainty Global liq. into EMs Financial risk on/off Asian Crisis The GFC 1997/98 2008/09 Multiple objectives (by CB Law of 1968) Credit ceiling Financial liberalization (since 1980s) Open cap account Managed floating XR Monetary targeting Floatig XR New CB Law (1999) Independence Single objective Road to ITF Transitional period of ITF: 2000-2005 ITF Lite Formal ITF (July 2005) Interest rate Flexible ITF Mandate on Macroprudential Policy 16
The Optimal Policy Responses? 17 Policy challenges The multiple challenges as a result of dynamic capital flows imply that monetary authorities should employ multiple instruments (a policy mix). Maintaining low inflation alone without preserving financial stability is insufficient. Exchange rate dynamics are largely influenced by investor risk perception; need for managing the exchange rate in order to avoid excessive volatility. There is justification to implement a less rigid ITF (Flexible ITF) It requires integration of monetary and macroprudential policy, including capital flow management and exchange rate policy.
5 Principles of enhancement under Flexible ITF 18 1 Continuing the policy framework to adhere to inflation target as the overriding objective of monetary policy 2 Integrating monetary and macroprudential policy 3 Managing the dynamics of capital flows and exchange rates. 4 Strengthening policy communication strategy as part of policy instruments. 5 Strengthening BI and Government policy coordination.
Monetary and Macroprudential Policy Mix Transmission 19 Under the new institutional setting, the central bank s policy formulation evaluates the strategic role of monetary policy and financial system Policy Instruments Operational Targets & Indicators Policy Indicators Ultimate Goal Monetary Instruments Policy Rate Liquidity Management FX Intervention Macroprudential Instruments Liquidity Credit Capital Flows Operational Targets ST Interest rate Operational Indicators Exchange rate FX reserves Monetary Credit Expected Inflation Aggregate demand & Supply Balance of Payments Credit growth and quality Asset Prices Risk taking behavior Stability of Rupiah Financial System Stability Policy Communication Policy Coordination
Monetary Stability Monetary and Macroprudential Policy Mix 20 High Inflation 2014-2015 2012-2013 Monetary Policy Macroprudential Policy Monetary Policy Macroprudential Policy 2008-2009 2010-2011 Monetary Policy Monetary Policy Low inflation Macroprudential Policy Low Credit Growth Financial Stability Macroprudential Policy High Credit Growth
Managing the Trilemma 21
Policy Mix Responses to Capital Flows 22 Monetary Policy Measures Interest rate Reserve Requirement Sterilized FX market intervention Dual intervention (FX and bonds intervention simultanously) FX Reserve accummulation Macroprudential Measures Limiting Short Terms Borrowings Exposure of Banks (eg 30% capital) LDR-linked reserve requirement Loan To Value Ratio for Housing Loans and Down Payment Rule for Automotive Loans Risk Management of Corporate FX borrowings (hedging requirement, FX liquidity req, credit rating) Capital Flows Management Minimum Holding periods for short term bills (CB bills) - Increase duration during inflows - Reduce duration during outflows Structural Policy Financial market deepening (FX market, bonds market and money market) Export proceed regulation
Optimal Policy Responses 23 Period Shocks and Impacts Policy Responses 2010-2011 Capital inflows impact on excess liquidity Commodity super cycle impact on CA surplus Exchange rate appreciation Reserves accumulation Increase RR Months Holding Period (MHP) Net Open Position (NOP) 2012-2013 Capital outflows Rupiah depreciation Declining commodity prices CA deficit Credit growth property boom 2014 Large capital inflows Declining commodity prices CA deficit Mild Rupiah depreciation Declining economic growth Exchange rate, more flexible Dual intervention (USD intervention and buy bonds) Tighten LTV and LDR linked RR Tight monetary policy 2015 Fed normalisation capital outflows Rupiah depreciation CA deficit + capital outflows BOP deficit Declining economic growth Tight monetary policy Dual intervention (USD intervention and buy bonds) Loosen LTV and LDR linked RR
Timeline: Post-GFC Macroprudential & CFM Measures 24 Introduced SBI Lengthening Maturity Profile (implemented in a number of phases from Mar to Dec 2011) Increase Primary Rupiah RR from 5% to 8% Increased Foreign Currency RR from 1% to 5%. Introduced LDR based RR. Increased Foreign Currency RR from 5% to 8%. Introduced Receipt of Export Proceeds Regulation Introduced Prudential Principles for the Management of Non-Bank Corporate External Debt to corporate borrowers of foreign loans Relaxed to 1 week (from 1 MHP) Mar 2010 Jul Nov 2011 Jan Mar May Jun 2012 Mar Dec 2013 Mar Oct 2014 Oct 2015 Jun Introduced One Month Holding Period for SBI Introduced Rupiah Term Deposits Introduced Six Month Holding Period (MHP) for SBI Introduced LTV for Property and Automobile sectors. Relaxed LTV ratio Normalized the Policy to Limit Bank s Short Term Ext. Borrowing (effective no later that the end of Jan 2011 with a 3-mo transition period) Introduced new LTV scheme. Increased Secondary RR gradually from 2.5% to 4% in Dec. Adjust LDR based RR.
THANK YOU 25