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nflation has reared its ugly head recently as raw materials prices spiked on adverse weather conditions. In August-September, we do not expect inflationary pressure to subside on electricity tariff hike and seasonality caused by the fasting month and Lebaran.

This has created some speculations in the market that the central bank may no longer keep its benchmark rate at the current historical low level of 6.50 percent. Our economist expects higher benchmark rate would be brought forward to the fourth quarter, 2010 from 2011 previously.

While the threat of price inflation could also result in banks demanding higher lending rates, we are of the view that lending rates are likely to remain flat this year due to time lag. Point in case was BI rates having to decline 275 basis points last year before while lending rates edged down by only 170 basis points to 12.6 percent.

Nevertheless, in the second quarter, 2010, the loan growth (based on six banks under our coverage) reached 16.1 percent year-on-year, helped by the increase in consumer/retail loans, which grew 22.5 percent year-on-year while SME/corporate loans expanded 12.9 percent year-on-year. As it is becoming more expensive to finance business expansions by issuing new bonds, banks have better opportunities to penetrate corporate loans in second half, 2010, compared to the first half, 2010.

Although higher interest rates would assist in cooling the economy and prevent non-performing loan bubbles from forming, increases in interest rates have the propensity to slow down the economy, which is against the government’s aim.

As interest rates rise, consumer demand falls and disposable income shrinks, adversely impacting credit card payments. Additionally, the longer the terms of loan maturity, the more risky price inflation is. This means that long-term loans i.e., mortgages would start to slow down on rate hikes although demand for property could arguably remain strong and under-served.

However, banks with structurally low funding costs have room to re-price loans without significantly impacting loan growth. Additionally, we believe the current low average loan to deposit ratio (LDR) of 71.1 percent (based on six banks under our coverage) provides strong-loan growth support.

It is important to note that loan growth is not only a function of pricing but also economic outlook (see chart). Testimony to this was when BI raised rates from 8 percent in the first quarter, 2008 to 9.25 percent at end of the third quarter, 2008, loans still grew 34.6 percent year-on-year.

Despite structurally low funding costs, higher default risks stemming from higher interest rates will restrain banks from aggressively channelling loans to certain segments. Banks’ higher risk aversion to lend will be challenging for BI, which is attempting to spur loan growth to boost economic growth.

At the end of the day, BI will have the difficult task of balancing between containing inflation and fostering loan growth. Additionally, in a rising interest rate environment, the most important issue would be for BI to know when to stop its series of interest rate increases.

This higher interest environment will eventually create unfavorable trend in both equity and bond markets. The higher cost of equity would lead to lower equity value for listed Indonesian banks. In this light, we have downgraded our rating on the banking sector to neutral from overweight previously. Additionally, we have decreased our targeted 2011 Price to Book Value Ratio for the sector on higher cost of equity.

In a period of rising interest rate environment, banks carrying higher proportions of floating-rate earnings assets and fixed-rate liabilities would benefit. This means that banks with high exposures to variable coupon rate government bonds, linked to the BI rate, would generate extra incomes to their bottom lines.

Additionally, banks with higher proportion of corporate/SME loans would have the flexibility to faster adjust upward their lending rates. In this light, Bank Mandiri with 83 percent corporate/SME loans and 98 percent floating rate government bonds would benefit most, followed by Bank Negara Indonesia (84 percent; 52 percent), BCA (76 percent; 37 percent) and BRI (52 percent; 25 percent).

The writer is the deputy head of research at Bahana Securities.