Indonesia’s central bank, Bank Indonesia (BI), shifted its strategy in 2015, moving away from policies that had defended the floundering rupiah against further depreciation after ongoing devaluation between 2013 and 2015. In January 2016 the bank surprised stakeholders with a decision to cut interest rates, making further cuts in February and March, thereby signalling a shift toward more accommodative, pro-growth monetary policy.
The business community has praised the moves, which have supported the rupiah and curbed increases in import prices. Yet challenges remain. Commercial rates are stubbornly high despite the cuts, and access to credit, particularly among small and medium-sized enterprises (SMEs), is a major growth impediment. Nonetheless, the new strategy will underpin existing efforts to boost lending across a host of sectors, further supporting ongoing government efforts to bolster economic growth, while plans to adopt a new reverse repo rate should see lending cuts translate into measurable economic benefits over the medium term.
For several years BI’s monetary policy has been firmly focused on protecting the rupiah, which depreciated significantly in recent years, falling from roughly 7600 to the US dollar in November 2011, to a low of 14,600 by mid-September 2015, a level not seen since the 1997-98 Asian financial crisis. The rupiah lost 35% of its value between January 2013 and January 2016, according to Bloomberg, weighed down by a host of challenges including the end of a commodities super cycle, which had kept prices of palm oil and minerals high until 2011, slowing economic growth in China and US monetary policy tightening, which had a noticeable effect on emerging market currencies and capital outflows (see overview).
In January 2016 the Institute of International Finance reported that for the first time in decades, more money left emerging markets in 2015 than entered them, projecting total outflows from emerging markets to hit a net $540bn.
Indonesia felt the impact of this, with the World Bank reporting that total capital inflows to the country declined from $45bn in 2014 to $17.1bn in 2015, a 62% contraction. In response to these challenges, BI adopted an extremely cautious monetary policy emphasising rate hikes, currency protection and inflation containment. The bank surprised the market with a 50-basis-point hike to the benchmark rate in July 2013, bringing it to 6.5%, as annual inflation projections concurrently rose to 7.9%. It then boosted rates further over the next 18 months, culminating in a November 2014 rate hike to 7.75%, its highest level since 2009.
Cooler Heads Prevail
Indonesia is dependent on portfolio inflows to finance its external deficit, meaning a premature rate cut posed a risk to future foreign inflows. Therefore, despite stakeholder calls for monetary easing throughout much of 2015, BI governor Agus Martowardojo eventually won praise for resisting pressure to cut rates, arguing at the time that inflation was too high to cut rates without harming the rupiah. Although the removal of $18bn of fuel subsidies in early 2015 kept inflation somewhat elevated during the first half of the year, it later dropped from over 7% in August 2015 to 3.35% in December 2015, finally enabling a rate cut.
Bankers who had long expected a policy shift were rewarded in January 2016, with Nikkei Asian Review reporting that BI was set to shift its focus away from currency protection and towards economic growth. In January 2016 BI moved to cut interest rates for the first time in nearly a year, dropping the rate by 25 basis points to 7.25%. The decision came just hours after a terrorist attack killed nine people at a shopping centre and surprised analysts who expected the bank to hold off on a cut to defend the rupiah.
Nikkei Asian Review reported that the decision was driven in large part by changes in the structure of board meetings. The duration of monthly rate decisions extended was to two days in 2015, while Darmin Nasution, former BI governor and now the coordinating minister for the economy, encouraged the central bank to heed President Joko Widodo’s calls for lower rates. The bank moved to cut rates again in the following month, by an additional 25 basis points to 7%.
A further rate cut came in March 2016, just hours after the US Federal Reserve announced that it would hold its benchmark rate and lower the path of any future rises, leading emerging market currencies and stock markets to rally. BI once again cut 25 basis points, with the benchmark rate set at 6.75% in mid-2016. BI and the central government also announced the establishment of a special team that will coordinate efforts to gradually lower the cost of borrowing over time.
The market reaction was positive, with media reporting that the Jakarta Composite Index rose by 0.23% the day after BI’s announcement, despite the global stock price turmoil. Bloomberg reported that overseas investors who injected almost $4bn into rupiah sovereign debt in the four months to January 2016 had won big, as the rupiah had become considerably more undervalued than many of its peers. Falling oil prices and China’s economic slowdown expected to help keep inflation under 5% in 2016, creating additional space for monetary easing.
BI’s patience paid off; tight monetary policy helped bring the country’s current account deficit down from 4.4% of GDP during the second quarter of 2013 to 2% in 2015, while the rupiah rallied by a world-leading 5.6% between October 2015 and January 2016, one percentage point more than the Malaysian ringgit. As of June 2016 the rupiah was trading at 13,300 to the US dollar, an improvement over 13,800 in February 2016.
Inflation is also in check as the result of falling crude prices, hovering at 3.3% in June 2016, down from 4.6% in March 2016, and further underpinning the bank’s decision to cut rates. The country’s budget deficit, also considered a currency risk, shrank to 2% of GDP in 2015, compared to 3.1% in 2014. Moody’s later reported that this engineered macro-adjustment directly addressed investor concerns over external imbalances, praising the country for its sound monetary policy.
Despite these positive steps, some challenges remain. Central bank interest rates and lending rates at private banks are still disparate, with corporate lending rates generally set at 9% and mortgage rates set at 11%. Some banks are now arguing that further rate cuts could significantly impact their profitability. “The government is becoming quite activist. Requiring banks to lower rates abruptly is not good for business. If you look at how loans are priced, it’s based on a set inflation rate of 5%, plus real interest of between 1% and 2%, which together make the BI interest rate,” Kahlil Rowter, chief economist at Danareksa Sekuritas, a local investment bank, told OBG. “From that risk-free rate overhead, banks make profits by adding a margin of 1-2%. It’s not a huge profit, though, and the sense we get is that corporate loans were already correctly priced.”
In March 2016 Fitch ratings agency reported that the Indonesian banking sector’s 5.4% net interest margin is the highest in South-east Asia. Although Fitch wrote that these wide margins are a key strength for the country’s major banks – making any efforts to undermine them negative from a ratings perspective – the agency also wrote that the government’s medium-term goal of bringing commercial lending rates into the single digits will likely be to the benefit of most businesses.
Currency forecaster Ebury projected in January 2016 that the rupiah will finish 2016 at 13,800 to the US dollar, 0.3% higher than at the start of the year and a more bullish estimate than the median figure 14,592 recorded in a Bloomberg survey of 30 analysts.
However, risks remain – London-based debt fund management firm Pioneer Investment Management reported that expansionary fiscal policy and weak tax collection will continue to put pressure on the budget and could spur inflation. The Australia & New Zealand Banking Group, for example, forecast the government will reduce rates to 6.25% by the end of the third quarter of 2016, writing that further monetary easing will be positive for growth, support the rupiah and encourage more bond inflows.
BI continued to hold rates steady at 6.75% as of May 2016, with the authorities announcing plans to pause the policy of monetary easing ahead of adopting a new seven-day reverse repo rate, which came into effect in August 2016 and was set at 5.25%.
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