Exchange Arrangements and Long-term Economic Growth in Indonesia

This paper analyses the relationship between different exchange rate arrangements and long-term economic growth in Indonesia during 1870-2023 through fluctuations in the real effective exchange rate (REER) which the country’s trade-exposed producers faced. Using an adapted classification of exchange arrangements from Ilzetzki, Reinhardt and Rogoff (2019), the paper creates a taxonomy of Indonesia’s 26 exchange arrangements since 1870, aggregated for three periods. During 1877-1940 monetary policy eliminated nominal exchange risk and encouraged foreign trade and inward investment. However, this was at the expense of subjecting trade-exposed domestic producers to instability in the REER, which discouraged manufacturing industry until the introduction of import protection in the 1930s. During 1940-1978 the exchange arrangements forced producers to face overvalued official exchange rates that offered import protection. However, overbearing regulations allocating scarce foreign exchange and controlling foreign trade encouraged evasive business behaviour to minimise exchange risk and limited inward foreign investment. After 1967, Indonesia’s oil export boom resolved its foreign exchange shortages and facilitated a return in 1978 to an exchange arrangement that guaranteed a more realistic and predictable exchange rate. During 1978-2023, the

exchange arrangements softened REER fluctuations. Nevertheless, this came at the  expense of limited competitiveness of trade-exposed producers, particularly during the commodity export boom of the 2000s. The paper establishes that Indonesia’s currency was long undervalued and uses an Error Vector Model to analyse the impact of REER fluctuations and the main foreign exchange arrangements on economic growth. It finds that REER depreciation generally had a negative effect on GDP growth, but with only  modest statistical significance. Only the managed float of 1975-1997 and 2000-2013 had a positive and statistically significant relationship with GDP growth.