ARIMBI with Extended External Sector
BANK INDONESIA
Rizki E. WimandaTarsidin Tri Winarno Idham[1]
December 2013
Abstract
Indonesia’s economy is getting more integrated with the global economy. Potential impact of global economy shocks to domestic economy propagated through trade channel and financial channel are increasingly pronounced. Risk of sudden reversal following large capital inflows poses a serious threat to Indonesia’s economy. Meanwhile, Indonesia’s own domestic concerns regarding high current account deficit as a result of high growth of imports have yet to abate. To cope with these growing concerns on external sector, Bank Indonesia’s FPAS needs to be equipped with macroeconomic model with a more complete features of external sector. This paper explores modelling of the dynamics of current account and capital flows, and its incorporation into ARIMBI + Macroprudential model.
Here we add external block to ARIMBI + Macroprudential model. This extension consists of two equations, i.e. current account gap andcapital flows gap. In addition, output gap equationis modified to accomodate current account linkage to GDP. Meanwhile credit growth gap equation is modified to account for impact of BOP surplus/deficit to domestic liquidity. Simulation of the model shows that its impulse response function is in line with theoretical background while the behaviour of main variables is maintained to be similar withARIMBI + Macroprudential. Through financial accelerator mechanism, procyclicality of real and financial sector is revealed. The simulation shows that monetary and macroprundential policy mix can mitigate unintended impact of business cycle and financial cycle, as well as bring the external sector variables (current account and capital flows) to a more sustainable level. Its forecasting performance is also improved. Thus the model is recommended to be used in FPAS.
JEL Classification: F41, F47
Keywords: Macroeconomic Model, External Sector, Exchange Rate
1. INTRODUCTION
1.1. Background
With the advent of greater global economic openness and integration, the influence of the world economy towards the domestic financial system is increasing. Global economic shocks could impact the domestic economy through the trade channel (imports/exports) and the financial channel. Although Indonesia has a proven track record for its resilience against crises, for instance during the global financial crisis of 2008, external sector shocks still demand vigilance. Currently, for example, Europe is embroiled in several crises stemming from inability to service sovereign debt.
Additionally, large capital inflows have inundated Indonesia over the past few years, which also create vulnerabilities in the domestic economy. These influx of capital inflows appreciated the rupiah, thereby undermining exports and stimulating imports. On the other hand, sizable capital inflows also brought excess liquidity into the domestic economy. Consequently, failing to channelthe capital inflows to productive sectors would trigger a surge in speculative activity and, subsequently, the formation of asset price bubbles.
The domestic economy is also vulnerable to shocks emanating from economic shifts oreconomic transformations. Indonesia’seconomy is currently experiencing a transformation, where a growing middle class population is driving robust import growth. Furthermore, commodity prices are trending downwards, leading to a deceleration in terms of export growth and, ultimately, a current account deficit. The magnitude of the current account deficit had reached 4.4% of GDP in the second quarter of 2013. Neglecting to bring the current account deficit to a more sustainable level, for instance through depreciatory exchange rate policy and sectoral policy, could disrupt exchange rate stability and price stability.
Such an unpropitious backdrop demonstrates the importance of the external sector, which covers an array of international financial and trade activities. Bank Indonesia, which adoptsa flexible inflation targeting framework (ITF), actively responds to external sector dynamics through monetary instruments in the form of intervention on the foreign exchange market and capital flow management to curbany adverse effects. Therefore to optimally support the flexible ITF, the economic model used to project and simulate policy under Bank Indonesia Forecasting and Policy Analysis System(FPAS)requires greater depth in capturing the dynamics of the external sector. In addition, Bank Indonesia’s response to external sector shocks could give rise to further policy complexity, thereby necessitating a monetary and macroprudential policy mix to also be modeled.
Based on the aforementioned considerations, it is necessary to further develop theARIMBI model in order to better capture the external sector dynamics. In this regards, the external sector enhancements will be adopted to the ARIMBI + Macroprudential model, which is the latest versionof the ARIMBI modeldeveloped in 2012.
1.2. Scope of the study
This research aims to enhancethe external sector in the ARIMBI + Macroprudential modelto include current account and capital flow dynamics. Maintainingthat the ARIMBI + Macroprudentialmodel is an aggregate and parsimoneous model, the enhancement will be kept simple and usesas few additional equations and variables as possible. The selected variables, among others, include the current account (CA) gap and capital flow (CF) gap. This external sector expansion will also maintain consistency with other variables as well asutilizeexisting variables.
1.3. Research Objectives
The objectives of the research are as follows:
1)To explore possible external sector enhancementsin the ARIMBI + Macroprudential model, while ensuring that the resulting model, “ARIMBI withExtended External Sector”, is robust and can accurately and consistently forecast and simulate policy.
2)To improve the applicability of the ARIMBI + Macroprudentialmodel in supporting thepolicy formulationat Bank Indonesia. By expanding the external sector in the ARIMBI + Macroprudential model, greater range of issues in the external sector could be better analysed and, subsequently, more accuratesimulation of policy mix responses to address them.
2. LITERATURE REVIEW
Inlinewith increasing dynamismin the global economy, as a consequence of greater economic openness and integration, the external sector is rightfully receiving considerable attention. A plethora of research exists regarding the dynamics of the external sector, the role of the exchange rate and the policy instituted by the central bank.
2.1. Current Account Dynamics
Over the past few periods, the current account (CA) of Indonesia has run a substantial deficit, peaking at 4.4% of GDP in the second quarter of 2013. The current account deficit is primarily attributable to excessive import growth in line with stronger domestic demand. The current account gap (defined as the difference between the currentbalance of the current account and current account norms) is widening. Lee, et al. (2008) stated that CA norms are the equilibrium current account balance. In this context, the value of CA norms is a function of the fiscal balance, oil balance, economic growth, relative income and demographic variables like population growth and the dependency ratio. CA norms in Indonesia are presently in the range of –1.7% (CA/GDP ratio).
Conceptually, there is acertain level of exchange rate in linewith CA norms, otherwise known as the equilibrium real exchange rate. According to Lee, et al. (2008), based on a macroeconomic balance approach, the magnitude of exchange rate appreciation/depreciation required to achieve the equilibrium real exchange rate is the inverse of the CA gap divided by the elasticity of the current account (CA). However, in this case the CA gap is defined as the difference between the underlying current account balance (namelythe current account balance when the output gap is zero, domestically and in trade partner countries) and CA norms. The definition of the CA gap as specified by Lee, et al. (2008) is different to that defined within this research, which is elaborated in the following section.
2.2. Capital Flows Dynamics
As a consequence of the global financial crisis (GFC) in 2008-2009, which adversely impacted the economies of advanced countries, large foreign capital flowed into emerging economies, including Indonesia. With persistently robust economic growth, coupled with economic and financial stability, Indonesia became an attractive investment destination.This sizable capital inflows to Indonesia continued until2012, however a capital reversal became increasingly noticeable in 2013.
Unsal (2011)statedthat the challenge to policymakers, concerning the influx of capital flows, is preventing the domestic economy from overheating and the implications on the rate of inflation, as well as minimising the risks associated with the impact on financial stability, which is predicted to be undermined as credit and financing became more easily accessible. Monetary policy could be utilised to overcome the effect on inflation, however macroprudential policy is required to mitigate the impact on financial stability.
According to Capistrán, Cuadra and Ramos-Francia (2011), emerging economies face the very real threat of a capital reversal.In addition to the benefits that can be derivedfrom capital inflows, there is also the risk of a sudden reversal that could endanger financial and economic stability. The potential for a sudden reversal increased as the sovereign debt crisis in Europe proliferated during August 2011. To reveal how a central bank and government should respond to such an external shock, Capistrán, Cuadra and Ramos-Francia (2011) developed a small-scale macroeconomic model using a New Keynesian framework. The results show that credible monetary and fiscal policy can boost the degree of freedom for policymakers in responding to such adverse external shocks.
From the literature it is possible to observe a correlation between capital flows, macroeconomic conditions and financial stability. Capital flows increaseinvestment activity which,in turn, drives economic growth. On the other hand, capital flows also spur expansive credit growth. Meanwhile, there also exists procyclicality between the financial sector and real sector, as reflected by real credit growth that tends to mirror GDP growth. The significant impact of capital flows on the economy demands synergy between monetary policy and macroprudential policy in order to mitigate excessive economic and financial turbulence.
Juhro and Goeltom (2012) statedthat in response to capital flowsdynamics, amid inflationary pressures, Bank Indonesia should implement unconventional policy using multiple instruments. The framework applied is enhanced ITF, where the overriding objective is the inflation target. However, the enhanced ITF is more flexible than its normal counterpart. The central bank is not merely focused on achieving the inflation target but also takes into account a number of other considerations, including financial sector stability, the dynamics of capital flows as well as the exchange rate.With such a policy perspective, the achievement of macroeconomic stability is not only related to monetary stability (price stability), but is also related to the stability of the financial system.
2.3. The Exchange Rate in terms of Monetary Policy
For a small open economy like Indonesia, the exchange rate plays a central role in the economy.Monetary policy is transmitted, among others, through its impact on the exchange rate.As is widely accepted, monetary policy is transmitted thorough a number of channels, including the exchange rate channel. Changes to thepolicy rate will influence the rupiah exchange rate through Interest Rate Parity (IRP). Raising the policy rate (which subsequentlyincreased the deposit rates) will appreciate the rupiah and vice versa. Furthermore, changes in the value of the rupiah will have adirect pass-through and/or indirect pass-througheffects on exports - imports, GDP as well as inflation.
Meanwhile, In response to the increasingly complex task faced by Bank Indonesia, particularlyin maintaining financial system stability and macroeconomic stability, the central bank implements aflexible inflation targeting framework (F-ITF). One policy instrument available to Bank Indonesia is intervention on the foreign exchange market.Existing macroeconomic models, however, do not fully support the F-ITF. For example, in the existingARIMBI core model there is no equation to express foreign exchange intervention.
In general, macroeconomic models utilised by countries adhering to an inflation targeting framework tend to institute monetary policy based on the Taylor rule. The basic version stipulates that a central bank only responds to changes in the inflation gap and output gap. Another version specifies that in addition to responding to both of the aforementioned gaps, a central bank also responds to exchange rate dynamics, marked by the inclusion of a variable for the exchange rate in the Taylor rule. Despite inclusion in the Taylor rule, the exchange rate is not a policy instrument. In that context, monetary policy is merely implemented through the Taylor rule. As stated by Taylor (2001), there areseveralresearches dedicated to the inclusion of the exchange rate in the monetary policy rule, including that conducted by Ball (1999), Svensson (2000) and Taylor (1999). In thesepapers, the exchange rate variable represents one component of the Taylor rule (in this case the real exchange rate). Furthermore, there exists an exchange rate rule, which is used as a guide for the central bank when intervening on the foreign exchange market. The rule responds to the dynamics of the capital account (CA) and capital flows, as detailed by Escudé (2009).
2.4. Modelling the External Sector
Modelling the external sector has becomean inseparable part of macroeconomic modelling. In theBI Model, namely SOFIE model (Tjahjono, et al., 2010), the external sector is modelled through the inclusion of equations for exports, imports, the nominal exchange rate, the real exchange rate, the interest rate differential and the current account (CA). In this model, the real exchange rate is influenced, among others, by Net Foreign Assets (NFA). Meanwhile, in another Bank Indonesia macroeconomic model, MODBI (Wimanda, et al., 2012), in addition to the previously mentioned variables, portfolio investment as well as the capital and financial account are also modelled. According to MODBI model, NFA also affects the real exchange rate. Additionally, the equilibrium real exchange rate is modelled using the Macroeconomic Balance Approach in a satellite model. In this instance, the exchange rate is particularly susceptible to the level of current account gap (the gap between the GDP to CA ratio and CA norms). Meanwhile, economic fundamentals influence the level of CA norms.
The inclusion of Current Account (to illustrate the dynamics of international trade) and the Capital and Financial Account (to exemplify the dynamics of international finance in the form of capital flows) as well as the exchange rate are vital in terms of macroeconomic modelling. The importance of the inclusionof current account and capital flows in a macroeconomic model is highlighted by Ghosh, et al. (2008) as the following:
Figure 2.1: Capital Flows and Current Account Balance
Figure 2.1. above shows five conditions as follow: (i) conditions where capital inflows respond to the CA financing requirement; (ii) conditions where capital inflows merely used to get a high yield; (iii) conditions where pressures emerge in the balance of payments due to a current account surplus; (iv) conditions where the current account surplus is offset by capital outflows; and (v) pre-crisis and crisis conditions (that transpire due to a current account deficit and/or capital outflows are not offset by capital inflows and/or a current account surplus). The illustration developed by Ghosh, et al. (2008)shows that there is ideal current account and capital flow conditions, where both are found in a state of equilibrium.
An exchange rate rule could also be incorporated in the model, similar to that developed by Escudé (2009). In this example a macroeconomic model was developed with monetary policy implemented based on the Taylor rule and exchange rate rule, which concomitantly respond to the dynamics of the economy. The exchange rate rule is a reaction function of the output gap, inflation gap, trade balance-to-GDP gap (the gap between trade balance-to-GDP ratio and its long-run target)as well as the reserve-to-GDP gap (the gap between reserve-to-GDP ratio and itslong-run target). The results show that a managed exchange rate regime guided by the exchange rate rule produces lower losses than a floating or pegged exchange rate regime.
3. CONCEPTUAL FRAMEWORK
The macroeconomic model utilised by the central bank for forecasting and policy analysisis continuously refined and thus expected to more accurately capture economic dynamics. In previous research, the core model used in the forecasting and policy analysis system (FPAS)of Bank Indonesia, namely ARIMBI, was developed to accommodate the financial sector in the model, and to model procyclicality as well as macroprudential policy required to control the dynamics of credit growth. The model developed became known as the ARIMBI + Macroprudential model. As mentioned previously, external sector performance is modelled using the ARIMBI + Macroprudentialmodel, not the ARIMBI model currently in use. Therefore, the model will not only accommodate the features of the financial sector but also more detailed features of the external sector.
As the global economy becomes more open and integrated, theinfluenceit has on the domestic economy also becomes more profound. Moreover, it is becoming increasingly important to pay due regard to the external sector. Thecurrent ARIMBI + Macroprudentialmodel does not fully capture the dynamics of the external sector. Inclusion of the external sector in the ARIMBI + Macroprudentialmodel, among others, is indicated by the presence of the global economy block, that contains equations for the output gap, Phillips curve and Taylor rule of the global economy. The impact on the domestic economy is transmitted through the variables: global output gap (in the output gap equation), international nominal interest rate (that forms part of the Uncovered Interest Parity equation), as well as the rupiah exchange rate, nominal and real. The international price variable influences the domestic economy through the real exchange rate equation.
In the ARIMBI + Macroprudentialmodel, the transmission mechanism of international economic variables to the domestic economy is not explicitly modelled because the model usesan aggregate variable in the form of the output gap, excluding the determinant components. Furthermore, the import/export variable is also omitted (showing the transmission from international trade) along with the variable that reflects liquidity from the external sector (showing the transmission from the international financial side). The model does not capture the dynamics of the current account or capital flows as neither is modelled. In fact, both are crucial considering that problems arising in the external sector could be observed from the magnitude of the current account deficit and level of capital flows.