The impact of monetary policy toward indonesian stock market under inflation targeting regime

Author:Maria Praptiningsih

Maria Praptiningsih. Department of Business Management, Faculty of Economics, Petra Christian University, Surabaya, Indonesia (e-mail:

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1. Introduction

Stock market has become one of the main subjects in terms of macroeconomic stability. Since the monetary policy has, an objective to achieve the price stability in terms macro economy, therefore the stance of the Central Bank whereas the monetary authority is needed to influence the stock market particularly. Movements in the stock market can have a significant impact on the macro-economy.1 Reversely, the change in macroeconomic variables can have a significant impact as well on the movements in the stock market. These relationships will have a significant result in order to provide comprehensive information to the policy makers to respond and create optimal policy in terms of macroeconomic stabilization.

Nevertheless, it is still difficult to identify the monetary policy response to the stock market. However, based on the theory that the monetary policy can influence the stock market by its instruments, such as the interest rates, therefore, we would like to emphasize on the stock marketPage 241 response to the change on macroeconomic variables. These variables will represent the stance of monetary policy in terms of inflation targeting framework. The adoption of inflation targeting framework based on the objectives of the Central Bank to achieve the price and macro-economy stabilities, through setting the range of inflation target.

According to the Bank Indonesia Yearly Report2, stated that during the Asian Crisis on 1997 to 2000, the foreign investors tend to implement only hit and run trade strategies. It means that the investors attempt to boost their gain only on a very short time. Meanwhile, the similar situation had happened on money market. This condition pushed the investors more un-sensitive regarding the change of interest rates. In terms of high country risk, the difference between domestic and international interest rates might not be the only main reasons for investors to change their portfolios. In fact, there were several arguments that investors had change their portfolio from Indonesian capital market to other countries.3 First, there was a profit motive, regarding the high interest rate on other capital market particular on United States of America. Second, it was called flight to quality motive. The motive occurred in order to maintain their portfolio because of the downward performance on emerging market particularly. These two particular factors were indirectly became barrier to the portfolio investment and capital inflow to Indonesian financial market.

Increasingly, the central bank started to implement some policies in order to improve the performance of capital market, namely the regulation on stock pricing. However, this particular policy was un-sufficient to boost up the capital market performance. Moreover, the downturn performance of capital market remains until 2002. At the end of 2001, the Composite Index was 5.83% decreased from 416.3 to 392.0 levels. It was mainly affected by the depreciation on rupiah; the increase on Bank Indonesia rate to 17%; and the downgrade of investment rating in Indonesia, from “stable” to “negative” based on Moody’s on March 2001.4 Furthermore, these circumstances even worst when the government raised the tax policy particular on bond return to 0.003%. This policy was contra-productive in terms of improving the capital market performance as one of the financing institution.

In addition, we can analyze the stock market fluctuation in detail from the following figures.5 There are the movements of Jakarta Composite Index (from 1990 to 2009) as well as the LQ45 index (from 1994 to 2009), given as follows:

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Figure 1

The Jakarta Composite Index (JCI) and LQ45 Index Movements


Source: Bloomberg, 2010

According to figure 1 above, we can see that the similar movement are happened on LQ45 Index as on Jakarta Composite Index (JCI). The LQ45 index is the index of forty-five stocks that most liquid and have the highest market capitalization. It means that investors also attempt to invest and re-arrange their financial portfolio on Jakarta Composite Index as well as LQ45 Index.

During 2003, there was an increase on price index, volume of trading in the stock market, bond market, and mutual funds. This was affected by the decline in the interest rate. Several factors had boosting the positive performance of Indonesian capital market.6 There were: (1) relatively low bank interest rate, which enable the investor to gain higher profit on capital market instead of bank deposits; (2) improved foreign investors’ perception on Indonesian capital market as well as the country risk and a significant difference on interest rate that cause high capital inflows to gain short-term profits; (3) relatively stable on macroeconomic indicators. This was reflected by increased Jakarta Composite Index (JCI) in response to increased stock trading both by domestic and foreign investors. The JCI closed at level 691.9 and increased up by 266.9. This increased JCI gained a profit of 62.8% compared the position at end 2002. Positive performance also occurred upon LQ45 index, which increased 59.9 to 151.9 in 2003 compared to previous year. The improved JCI and LQ45 performance was related to several international stock exchanges positive performance and relatively low bank interest rate.

The stock market performance was remained bullish on 2004.7 The continuing trends as on 2003 pushed the composite index above the 1,000 level before year-end. The bullish domestic stock market resulted from continuously improving fundamentals, both in macro and micro contexts, as well as market optimism over the new government. The upward trend continued during 2005. However, the JCI index started to fluctuate, even still a positive gain. Internal factors were driving negative sentiment on the stock market included the upward trend in domestic interest rates in consequence to the tight bias monetary policy stance adopted to reduce inflationPage 243 and depreciation on rupiah. The other factors that bearing down on the JCI were the surge in world oil prices to almost $70 per barrel.8 The market had negative projections on the performance the stock markets. Moreover, it also induced by the raised on the domestic interest rates regarding the tight monetary policy stance. Eventually, the fluctuation on stock market continued until year-mid on 2008, when the global financial crisis had happened. The Composite Index closed at 1,355 at the end of 2008, a drop of 50.64% compared to the previous year. At the beginning of 2008, the index was relatively impressive. It was 2,830 level which was the highest level ever recorded since the beginning of Indonesia Stock Exchange.

Furthermore, Bank Indonesia attempted to minimize the negative impact of any economic shocks that can dropped financial markets performance as well as the macro stability. Therefore, the policies of Bank Indonesia, which is represent by the Indonesian Capital Market and Financial Institution Supervisory Agency and the Indonesian Stock Exchange Board are plays an important role in limiting a deeper financial markets decline, particular on Composite Index.

According to the consequence of monetary policy stance toward the financial markets performance through the financial systems mechanisms, then we provide a brief summary of several macroeconomic performances in terms of particular indicators, as follows:

Table 1.

Selected Macreconomic Indicators9


Description 2003 2004 2005 2006 2007 2008
GDP Growth 4.7 5.0 5.7 5.7 6.3 6.1
CPI Inflation 5.1 6.4 17.1 6.6 6.6 11.0
Core Inflation 6.9 6.7 9.8 6.0 6.3 8.3
Average Exchange Rate (Rp/$) 8,572.0 8,940.0 9,713.0 9,167.0 9,140.0 9,241.0
SBI (1 month)/BI Rate since July 2005 8.3 7.4 12.8 9.8 8.0 8.6
Current Account/GDP 3.4 0.6 0.1 2.9 2.5 0.1

Sources: BPS-Statistic Indonesia; Bank Indonesia

In 2005, CPI inflation rose gradually to 17.1%, following the October hikes in fuel prices. The shocks in this index was primarily driven by fuel prices and other administered prices, in particular transportation tariffs. Higher inflation expectations and rupiah depreciation also raised core inflation while downward pressure from the output gap remained relatively insignificant. Against the backdrop, CPI inflation was above the determined target of 6%+/-1% for 2005. The core inflation rate was high in 2005, peaking at 9.7%, primarily attributable to high inflationary expectations and depreciating exchange rates. Higher inflationary expectations from the public were visible as Q1-2005 closely associated with the government’s plan to adjust domestic fuel prices in line with global oil prices and weaker exchange rates.

The rise in the Bank Indonesia (BI) rate, that is, an anchor for the interest rate determination in Indonesia, and deposit rate was followed by a limited increase in lending rate, whereas thePage 244 volume of credit allocation remained relatively high. The lending rate began to increase during October 2005 to 15.18% from 13.41% at the end of 2004. This verified that the role of banks in financing the economy remains imperative. In brief, the rise in the BI Rate has not negatively affected bank intermediation. In order to reduce inflation and restore monetary stability, Bank...

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