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Jakarta Post

Lending rate rigidity: Should we be worried?

In times of turbulence, it is counter intuitive to expect banks to raise or even sustain loans growth

Helmi Arman (The Jakarta Post)
Fri, March 13, 2009

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Lending rate rigidity: Should we be worried?

In times of turbulence, it is counter intuitive to expect banks to raise or even sustain loans growth. However, banks could still play a key role for the economy this year, i.e. through financing the fiscal deficit.

While Bank Indonesia (BI) has cut its benchmark policy rate by 1.75 percentage points since early December 2008, bank lending rates appear to have been downward rigid. The average base lending rate of commercial banks has only gone down by around 0.2 percentage points so far since January 2009.

This tepid movement in commercial bank interest rates has been a subject of recent discussion in various media. It has also become a source of frustration for many policy makers and politicians. And, a few days ago, Indonesia's highest authority joined the chorus in urging banks to start lowering their lending rates too.

Actually, in the current global turmoil, stickiness in lending rates is not an Indonesia-specific problem, nor is it something we're unfamiliar with. When Bank Indonesia began cutting rates in 2002, for example, it took several quarters for bank lending rates to follow with a significant move. This was also the case in 2006, although the lag was somewhat shorter.

From a broader perspective, it is not just interest rates that have become a problem. There is also the issue of credit expansion, or lack of it. As of December 2008, outstanding commercial bank credit shrunk 1 percent month on month, equivalent to a substantial 24 percent annual decline after seasonal adjustment. Although we expect credit to still grow positively this year, December's contraction gives us an idea of the potential slowdown that's about to come.

Interest rates and credit growth are inextricably linked. Just as any other goods or service for sale, credit usually grows faster when it is priced cheaply, i.e. when the interest rate is low. Thus, the phenomenon of banks being hesitant in lowering interest rates could be a sign that they are to some extent rationing the supply of credit.

But this issue does not only involve a rationing of credit supply. There is also an apparent drop in credit demand, which occurs naturally in an economic downturn. Economic growth already slowed from 6.4 to 5.2 percent year on year in the last quarter of last year. And data also shows key manufacturing industries already facing negative growth.

Therefore, as manufacturing output heads toward a deeper contraction, it appears counter intuitive at this juncture to suggest firms need to be given more credit.

As sales decline, working capital and expansion needs are naturally reduced. So in spite of there being some resilient sectors in the economy, a broad based slow-down in economic growth represents a reason for banks to curtail - as opposed to accelerate - the rate of credit growth.

This elevated level of risk aversion among commercial banks should be temporary, but may persist for some time, i.e. at least until the extent of Indonesia's economic downturn is fully revealed.

However, it should not be cause for grave concern since most of Indonesia's commercial banks are well capitalized. One should hence expect lending activity to eventually rebound just as in any previous episode of recovery.

But until that happens, forcing banks to lend for non-economic reasons could prove counterproductive, if not disastrous. Policymakers should be mindful of the limitations of using monetary policy in countering the current economic downturn.

So now we see banks curtailing loans growth and placing new funds into money market instruments such as central bank certificates (SBIs). Does this mean that banks are completely out of the picture in funding this year's economic growth? Not necessarily.

One way to make use of the current bout of risk aversion is to utilize bank liquidity to help finance the government budget deficit. By the end of February, outstanding SBIs amounted to nearly Rp 260 trillion (US$21.6 billion), most of which is held by banks. This figure is nearly enough to finance the 2009 fiscal deficit two times over!

So far, the government has been lucky. As the rate on SBIs drops and risk aversion stays elevated, banks have been seeking higher yielding but safe destinations for liquidity placement. Funds have been moved towards longer money market tenors including into short term government bonds and treasury bills.

During the first 10 weeks of 2009, commercial bank ownership of government bonds surged by around Rp 12 trillion.

There appears to be potential for this number to increase further in the near future, at least as long as bank liquidity keeps rising or the SBI rate continues to decline.

But what the authorities could do more of is to make t-bills a more popular and thus more liquid destination for liquidity placement, perhaps by using them as a monetary instrument in place of SBIs.

One may recall that this issue had been the subject of intense discussion several years ago, but for some reason it went cold. Now the government is in need of financing to fund its stimulus programs and banks are sitting on hoards of liquidity. If there is ever a right time to revive the SBI - t-bill replacement discourse, that time should be now.

Using domestic bank liquidity to help finance the fiscal deficit should be a win-win solution for both the banks and the government. One thing's for sure, it definitely looks more appealing compared to selling US dollar debt to foreign fund managers at fire-sale prices.

The author is currently an economist at Bank Danamon Indonesia. The views expressed herein are personal.

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