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Welcome to the monetary dominance regime

Last month, Bank Indonesia (BI) decided to maintain its benchmark interest rate, BI’s seven-day reverse repo rate at 4.75 percent. This decision was made only a day after the United States Federal Reserve increased its policy rate, the Fed funds rate, by 25 basis points from 0.5 to 0.75 percent.

The policy stance of BI also marks the end of monetary policy easing that has been initiated since the beginning of this year.

Haryo Kuncoro (The Jakarta Post)
Jakarta
Wed, December 28, 2016

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Welcome to the monetary dominance regime Bank Indonesia (BI) decided to maintain its benchmark interest rate. (Antara/-)

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ast month, Bank Indonesia (BI) decided to maintain its benchmark interest rate, BI’s seven-day reverse repo rate at 4.75 percent. This decision was made only a day after the United States Federal Reserve increased its policy rate, the Fed funds rate, by 25 basis points from 0.5 to 0.75 percent.

The policy stance of BI also marks the end of monetary policy easing that has been initiated since the beginning of this year.

Throughout the year, the accumulated benchmark interest rate cuts have reached 150 basis points. Also, the reserve requirement has also declined by 150 basis points as well.

On the other hand, the increase of the Fed funds rate has become a tipping point for the Fed to tighten monetary policy. The Fed has signaled it will again hike its rate three times in 2017, twice in 2018, and once each preceding year respectively. It seems that the Fed is going to restore the rate to a “normal” level of 3.5 percent as the pre-global financial crisis era.

As a result, BI’s repo rate and the Fed rate are moving in the same direction. The convergence of interest rate hypothesis is supported by economic theory.

Conceptually, prevailing interest rates in one country will approximate to interest rates in other countries both in magnitude and change in direction. A slight differential in rates is enough for capital owners to rush out of a market.

In this circumstance, BI seemingly has been able to reap the valuable lessons from the experience of last year.

In December 2015 when the Fed rate was raised, a month later BI lowered its benchmark interest rate. Consequently, the rupiah slumped and foreign exchange reserves shrank sharply induced by a massive capital outflow.

However, in the next few months BI’s repo rate faces a number of fresh challenges. In the domestic context, the first challenge is the rise of administered prices, such as electricity rate, fuel price, and gas price adjustments. Of course, they have a substantial effect on inflation.

An inflation rate hike tends to repress the exchange rate. An empirical study by Taguchi and Sohn (2014) indicates that the degree of pass-through of the exchange rate is weak. It means that exchange rate movements are not represented fully by the fluctuation in inflation. Consequently, benchmark interest rates may climb higher than it ought to.The second is how to maintain the recovery momentum of domestic economic growth. BI’s aim of helping the government to achieve an economic growth target of 5.1 percent next year becomes more difficult. The growth of bank credit throughout this year, for example, has failed to penetrate the two-digit level.

For 2017, the central bank estimates that rupiah loans could grow 10 to 12 percent. Unfortunately, the high growth of credit is not being followed by an increase in fund collection. As a result, the loan-to-deposit ratio currently has reached 92 percent, implying the banks’ ability to expand credit is limited.

Moreover, the borrowing interest rate is still at double-digit levels making the risk of liquidity mismatch inevitable. Simply, for the moment, much cannot be expected from the transmission mechanism of monetary policy to the real sector through interest rates and credit channels.

Along with those two challenges above, the monetary policy through BI’s repo rate is still constrained by some external risks. Some efforts to maintain economic growth and inflation rates will be plagued by financial market uncertainty and the gloomy prospects for global economic recovery.

Admittedly, the performance of the economy so far is largely determined by global conditions. China accounted for 15.5 percent of Indonesia’s total trade, Europe 11.4 percent, Japan 10.7 percent, and the US 10 percent. Those four major Indonesian trading partners are having their own economic problems.

Given this environment, the government must rely on fiscal policy to maintain economic growth. A possible solution is to accelerate the realization of government capital expenditure, primarily infrastructure spending.

However, this strategy will not be smooth sailing because there is still the threat of a state budget shortfall as a result of smaller than expected revenue.

Thus, the size of the state budget deficit potentially is widening. The conditions will undoubtedly encourage the government to issue bonds again to meet its financing needs. Eventually, the ultimate risk returns back again to the threat of Fed rate hikes in the coming years.

Based on the dominance of external threats faced by BI, the Finance Ministry is directly involved in the maintenance of price stability, such as the control of prices of goods and services that are not regulated by the government.

The fiscal authority also has a responsibility to stabilize the exchange rate in relation to the principal and interest payments of foreign government debt. Similarly, the private sector (households and firms) will almost likely reduce their expenditures.

In a broader perspective, the uncertainties in the global economy seem to have delivered a new era in Indonesian economic policy.

The main task of BI’s repo rate as a monetary instrument in guarding the value of the rupiah seems to be a turning point in macroeconomic policy to a shift into the realm of monetary dominance.

More concretely, BI will control, instead of liberalize, the financial market. Through increasing the repo rate gradually, the monetary authority will start conditioning other economic sectors to support “stability over growth” programs. Consequently, there will be massive mobility of resources going to maintaining low inflation and stable exchange rate efforts.

As a result, the monetary agenda will be the main actor changing the direction of economic policy. Welcome to the monetary dominance regime.

 

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