Journal Issue

Financial Reform in Indonesia: Improving the effectiveness of the monetary control system

International Monetary Fund. External Relations Dept.
Published Date:
December 1988
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V. Sundararajan and Lazaros Molho

The financial system and policies in Indonesia have been strongly influenced by developments in the petroleum sector—accounting for more than half of export receipts and public sector revenues—and by the high degree of openness of the economy to capital flows. Following the oil boom in the 1970s, the decline in oil revenues in 1982–83 led to a marked weakening of the external accounts, triggering a comprehensive adjustment effort. A key component of the adjustment effort was the reform of the financial system beginning June 1, 1983. This entailed the abolition of interest rate controls and of credit ceilings, a change in the central bank’s funding role, and the introduction of new money market instruments. These measures were introduced together with a large devaluation, tax reform, and a streamlining of public sector investment and subsidy programs. This article analyzes the evolution and effectiveness of Indonesia’s monetary control system following the financial reform.

The financial reform and the attendant expansion in the range of monetary control instruments greatly enhanced the authorities’ technical ability to coordinate exchange rate and monetary policies. This is important in the Indonesian context because the fairly open capital account implies that any perceived misalignment between domestic and international interest rates—corrected for exchange rate expectations—may give rise to massive capital movements. As a result, external balance can be secured only through careful coordination of the settings of monetary and exchange rate policies. Despite the authorities’ efforts to stabilize exchange rate expectations—by keeping the intervention rate vis-à-vis the US dollar on a predictable path over long periods of time—periodic speculative attacks on the domestic currency have underscored the need for a supportive monetary policy.


The Indonesian financial system is dominated by the central bank—Bank Indonesia (BI)—and deposit money banks (DMB) which together hold over 90 percent of the total gross assets of the organized financial system. The nonbank financial institutions (NBFIs) have been growing rapidly but still account for only around 4 percent of gross assets of the organized financial system. Before the financial reform, the major BI instruments of monetary policy were credit ceilings for individual banks, interest rate controls for state banks, and a selective rediscount mechanism (liquidity credits) designed to reallocate credit at subsidized interest rates.

The Indonesian money market consisted of a fairly segmented interbank market and a small market for the liabilities of NBFIs. The maturities in the interbank market were generally quite short, from overnight to one week, and rates were set competitively. However, the market was dominated by the large state banks, which were normally the chief suppliers of funds to other participants.

The pre-reform system of monetary control helped limit the expansion of bank credit, but it also produced some undesirable side effects. The continuing expansion of BI’s liquidity credits and net foreign assets fueled a rapid expansion of reserve money leaving the banking system—especially the state banks—with a large accumulation of surplus funds. In the absence of an adequate supply of domestic money market instruments, banks increased their net holdings of foreign assets, and thereby their exposure to exchange rate risk. Reflecting these developments, the share of BI in the total international reserves held by the banking system fell from over 90 percent in 1977 to less than 50 percent in 1983. The redistribution of the system’s international reserves allowed DMBs to become an increasingly important participant in the foreign exchange market. This in turn diminished the effectiveness and credibility of BI’s exchange rate policy as long as the DMBs’ excess reserve position was perpetuated.

The combination of excess liquidity in the banking system and interest rate controls produced distortions in the pattern of domestic financial intermediation which could have undermined both monetary control and external balance. The deposit rate ceilings that applied only to state banks, together with their excess liquidity, reduced their willingness or ability to compete for private sector deposits. This made them increasingly dependent on captive customers such as public enterprises. As a result, between 1979 and 1982, the annual growth rate of time deposits for state banks was only 8 percent, compared with 75 percent for private banks and 43 percent for NBFIs. The latter were not subject to either interest rate controls or credit ceilings. Thus, the system of direct credit controls seemed to favor the growth of the less regulated types of institutions, thereby weakening the effectiveness of the monetary control mechanism.

The financial reform

In view of the deteriorating macroeconomic environment in the early 1980s, the Indonesian authorities, as mentioned above, initiated their financial reform by replacing the old system of restrictions on financial institutions with a more indirect system of monetary control. Interest rate controls on state banks were eliminated and a wide range of loan categories—accounting for 50 percent of total loans outstanding prior to the reform—were made ineligible for liquidity credits. Credit ceilings on individual banks were also eliminated. The authorities introduced a new mechanism of monetary control that would rely principally on open market mechanisms complemented by a system of new rediscount facilities.

Open market-type operations. In the absence of any domestic public debt instruments, BI began issuing its own debt certificate, the Sertificat Bank Indonesia (SBI) in early 1984 using conventional auctions. The new instrument could be readily marketed in the initial environment of excess liquidity. The sale of SBIs would, in principle, allow the authorities to absorb or inject bank reserves at their own initiative and to influence domestic money market conditions, by varying the volume of issues in relation to redemptions. In addition to improving the effectiveness of monetary policy, the new instrument could eventually serve to unify and strengthen the domestic money market. The frequency of auctions, the range of maturities, and the policies toward rediscounting of the SBIs were all adjusted over time, based on market developments and monetary policy considerations.

The auctioning mechanism allows BI to determine either the interest rate on SBIs or the volume of SBIs sold. Initially, the authorities generally aimed for an interest rate target. However, since May-June 1987, following recurrent episodes of speculative capital outflows, BI has tightened monetary policy and focused more on the quantity of liquidity in the banking system, allowing for a much greater degree of interest rate flexibility than in the past.

The sales of SBIs rose from a modest level initially to more than Rp 2 trillion outstanding, or the equivalent of around 30 percent of reserve money, in mid-1986. Demand for SBIs fell sharply thereafter, particularly in late 1986 and early 1987, when speculation on an imminent depreciation gave rise to large capital outflows. Despite their losses of international reserves, the authorities kept the cut-off interest rate on SBIs unchanged during this period. Since July 1987, however, following the increase in the cut-off rate, the sales of SBIs have risen again.

Discount facilities. BI established two new rediscount facilities in February 1984 to complement the new system of reserve money management. The first was designed to facilitate day-to-day reserve management by financial institutions with short-term support. The second discount facility was designed to encourage long-term lending by providing temporary relief to alleviate risks resulting from a shortening of deposit maturities following deregulation. The two discount facilities remained largely unused. Banks were generally reluctant to borrow from BI, even when the discount rate was substantially below interbank rates, lest such borrowing be interpreted by the market and BI as compromising their solvency. In order to inject liquidity in greater volume than was possible through the two discount facilities, and to further develop money markets, the authorities introduced a new money market facility in February 1985.

The new facility allowed the rediscounting of a new type of money market instrument, and established institutional arrangements for the secondary trading of this instrument. Banks and NBFIs were allowed to trade the new instruments among themselves or with BI. The First Indonesian Finance and Investment Corporation (FICORINVEST, one of the NBFIs controlled by BI) was appointed market maker, standing ready to buy and sell money market paper and funding its holdings of this paper either in the market or through a “liquidity line” from BI. The newly created money market instruments, known as SBPUs (Surat Berharga Pasar Uang), included promissory notes or trade bills issued by customers, and interbank-promissory notes, that were drawn up according to specified regulations and endorsed by the selling bank or NBFI.

The introduction of SBPUs invigorated the money market and served to integrate the market for bank credit. The volume of SBPUs outstanding rose sharply during 1985 and 1986, reaching a peak in December 1986 of Rp 1.1 trillion or the equivalent of 53 percent of banks’ required reserves. The use of SBPUs broadened participation and expanded the range of maturities of paper traded in the money market, while also helping ease the regulation-induced segmentation in the loan market. For example, although state banks were prohibited from extending credits to joint ventures, they could buy SBPUs issued by joint ventures which were already endorsed by private banks or NBFIs. Similarly, even though there was a prohibition against foreign bank lending to enterprises outside Jakarta, these banks could buy SBPUs issued by such enterprises if they were already endorsed by national banks or NBFIs.

Impact of the reform

The reform measures proved highly effective in stimulating competition among banks. Reflecting the increased competition for deposits, the state banks raised their time deposit rates to levels that were close to the rates offered by private banks. As a result, the financial reform strengthened the competitive position of domestic banks, which sharply raised their share of the deposit market at the expense of foreign banks.

Perhaps the most conspicuous success of the reform was the rapid surge in the growth of total domestic currency deposits after June 1983. Rupiah time and savings deposits rose by the equivalent of about eight percentage points of GDP between March 1983 and December 1986, while foreign currency deposits with DMBs, which had existed in the past, grew by only 1.5 percent of GDP during the same period. This pattern was a marked reversal of the pre-reform trend of faster growth in foreign currency deposits and was partly due to the exchange rate adjustment in 1983. While data are not available on the effect of the reform measures on deposits offshore, one can infer that the total portfolio shifts from foreign to domestic currency deposits were even more pronounced, contributing substantially to the strengthening of Indonesia’s external accounts, consistent with the authorities’ principal objective.

Indonesia: factors affecting reserve money, 1983–87(In billions of rupiahs)
Change in reserve money1,2634971,721434
Due to autonomous factors11,3083181,709-240
Due to new policy instruments-4517912674
of which
Change in SBIs outstanding-45-198-1,1931,275
Change in SBI rediscounts946-902
Change in SBPU rediscounts205417313
Sources: Bank Indonesia and IMF staff estimates.

Indicates that this facility was not available at that time.

The autonomous factors include those items in the central bank’s balance sheet that have not been deliberately used as tools of monetary policy and whose monetary effects are only incidental. The principal autonomous factors in Bl’s balance sheet are net foreign assets, net claims on government, claims on the private sector, and liquidity credits to banks.

Includes the two rediscount facilities and the special credit facility.

Sources: Bank Indonesia and IMF staff estimates.

Indicates that this facility was not available at that time.

The autonomous factors include those items in the central bank’s balance sheet that have not been deliberately used as tools of monetary policy and whose monetary effects are only incidental. The principal autonomous factors in Bl’s balance sheet are net foreign assets, net claims on government, claims on the private sector, and liquidity credits to banks.

Includes the two rediscount facilities and the special credit facility.

As regards the effectiveness of monetary policy, the new money market instruments greatly improved the authorities’ technical ability to manage monetary and reserve aggregates, but this ability was not always used. In particular, in periods when monetary policy was geared to stabilizing interest rates, the absorption or injection of bank reserves was largely left to the discretion of the banking system. For example, in 1985/86 (fiscal year ending in March) net sales of SBIs were almost equal to the net increase in total rediscounts, leaving reserve money unaffected (see table). With BI becoming the principal channel of interbank funds, little room was left for direct trading among money market participants. This outcome reflected the interest rate structure, which made SBIs more attractive than short-term SBPUs as an outlet for banks’ excess liquidity, and the funding of loans through SBPUs more attractive than funding through deposits.

In 1986/87, the authorities again accommodated the banks’ liquidity needs by maintaining SBI-SBPU interest rates unchanged in the face of large capital outflows. The pegging of interest rates allowed banks to readily replenish their reserves—through redemptions of SBIs and through greater recourse to the SBPU facility—without exerting much pressure on domestic interest rates. The stability of interest rates, however, was at the expense of a large decline in Bl’s net foreign assets and large fluctuations in banks’ excess reserve positions.

The setting of interest rate targets during a transitional period following financial reform is sometimes justified, because the alternative of money and credit targets could prove destabilizing in the presence of shifts in the money demand function. However, the maintenance of a rigid interest rate target in the presence of speculative and reversible capital outflows could seriously undermine stability. When the exchange rate is fixed, in particular, the credibility of the government’s exchange rate policy may hinge on its willingness to endure substantial fluctuations in interest rates.

Since mid-1987, following renewed speculation against the rupiah, the Indonesian authorities have adopted a more flexible interest rate policy, while also eliminating the automatic rediscounting of SBPUs. These measures helped restore confidence in the rupiah, triggered large increases in domestic deposit and loan rates, and spurred private capital inflows.

Some lessons

Major lessons of the Indonesian monetary reform experience so far can be summarized as follows:

  • Direct controls on interest rates and credit allocation could lead to significant distortions in financial intermediation, which could weaken the effectiveness of monetary control. To improve the usefulness of monetary policy in securing external balance, it may be necessary to replace interest rate and credit controls with a less direct but more effective monetary control system. Such a system will also be conducive to a better integrated, more competitive, and more efficient financial system.
  • The move to an indirect system of monetary and interest rate management does not presuppose the existence of a sophisticated money market. The institutional arrangements for the initiation of open market-type operations can be made quite quickly and market participants can develop adequate trading skills through a process of “learning by doing.” The creation by the authorities of marketable money market instruments, in particular, may be the first stage in the long process toward the development of smoothly functioning domestic financial markets.
  • Following financial reform, the pace of liberalization of interest rates on money market instruments is conditioned not only by institutional developments but also by the choice of monetary policy targets to deal with domestic and external shocks. If the reform measures give rise to large shifts in the portfolio behavior of the public, the authorities may find it convenient to pursue a monetary policy based on the targeting of interest rates for a transitional period following the reform. This may entail a high degree of variability of monetary and reserve aggregates and, if the interest rate target is rigid, it may make it more difficult to maintain exchange rate stability. The development of a truly independent money market would also be hindered by a rigid interest rate policy.
  • The selection of a monetary policy target will also depend on the authorities’ views as regards the complex interrelationships between exchange rate expectations, exchange rate policy, and financial policies. In times of pressure on the exchange rate, in particular, more emphasis on targeting credit aggregates together with greater flexibility of interest rates could help limit the outflow of speculative capital by increasing the potential costs of speculation. The pursuit of a nonaccommodating credit policy might also help enhance the credibility of the authorities’ exchange rate target, by making it clear that the monetary effects of reserve outflows would not be sterilized. The successful implementation of such a policy, however, would require more careful coordination between open market and rediscount operations than is necessary for the targeting of interest rates.

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