T

he current trend of slower domestic economic growth has caused a deceleration of banks' loan growth this year. In August, loan growth dropped to 14 percent year-on-year (y-o-y) as compared to 15.7 percent in July, decelerating for the 11th consecutive month.

If we fix the exchange rate at the same level as a year ago (the rupiah has already depreciated by around 7 percent in the last year), we will have a rate of loan growth of around 12.7 percent y-o-y. The deceleration in loan growth has actually already been anticipated since the beginning of the year as an impact of Bank Indonesia's (BI) tightening monetary policy, which has been conducted since last year.

The tightening monetary policies were in the form of a higher benchmark rate to 7.5 percent (vs the lowest level of 5.75 percent) and several macro-prudential measures to dampen inflationary pressure and calm rupiah volatility. BI has actually targeted bank loan growth at a level of 15 to 17 percent this year. In fact, we estimate that the deceleration could persist until next year when global interest rates rise as a result of the US's Federal Reserve's move to raise its benchmark rate. Having said that, we expect loan growth in 2015 will be in the range of 16 to 18 percent or lower than the average loan growth of 20.4 percent in the period of 2009'2013.

On more detailed data, working capital loans grew 14.4 percent y-o-y, investment loans 17.6 percent and consumer loans 10.6 percent. Despite the slower trend in domestic investment in 2014 (we expect that it will grow at only around 4.6 percent), the investment loan growth still posted a resilient figure.

On the flip side, deposit growth improved to 12.1 percent y-o-y and hence the loan-to-deposit ratio (LDR) declined to 90.7 percent in August. Most of the growth came from time deposits which grew almost 20 percent y-o-y, while current and savings account (CASA) deposits increased 6 percent y-o-y.

Total deposits started to improve again in August, growing at 12.1 percent y-o-y to Rp 3.86 quadrillion, compared to 11.6 percent y-o-y in July. Foreign-currency denominated deposits also accounted for 16.4 percent of total deposits, and adjusting the growth rate to a similar exchange rate a year ago resulted in a total deposit growth of 10.9 percent y-o-y.

Overall, the magnitude of the deceleration in deposit growth is still lower than in loan growth if we compare it to last year's performance. At year-end 2013, deposit growth reached 13.6 percent y-o-y, on the other hand loan growth reached 21.6 percent y-o-y. However, it is worth noting that the loan growth is always higher than deposit growth and this creates pressure on the liquidity side.

Aside from the liquidity issue, asset quality is also becoming a major issue in the banking sector amid lower GDP growth and declining commodity prices.

The industry's gross Non Performing Loans (NPL) rose 36 percent y-o-y to Rp 80.7 trillion in August, with the NPL ratio rising again for the second month to 2.31 percent from 2.24 percent in July. The level of NPL is the highest since April 2012 even though it declined by year-end 2012 to 1.5 percent.

Based on sector, NPL in the construction industry kept increasing to 4.6 percent from 4.4 percent (the highest among industries) while mining declined to 2.5 percent from 3.1 percent.

The NPL rate in wholesale & retail trade increased to 3.3 percent from 3.2 percent and in community services to 3.9 percent from 3.7 percent. The rising NPL trend should be closely watched since the challenges in the banking sector in the short term are quite high. The expectation of higher subsidized fuel prices and the Fed Fund Rate could boost domestic interest rates and in the end will increase the industry's cost of production.

Despite increasing time-deposit rates, which rose 233 basis points (bps) to 8.46 percent for the one-month term (1M) deposits and 324 bps to 9.52 percent for three-month (3M) deposits, average lending rates were reduced in August, particularly in private national banks.

The average lending rate for working-capital loans declined 16 bps to 12.54 percent, for investment loans down 15 bps to 12.17 percent while for consumer loans it fell 1 bp to 13.31 percent.

Average 1M time deposit rates increased 2bps to 8.46 percent. Average 1M and 3M term-deposit rates have increased 233 bps and 324 bps, respectively, in the past 12 months. We believe that the expectation of persistent tight liquidity will sustain growth in the deposit and lending rates.

Going forward, we see several challenges in the banking sector due to the current macroeconomic conditions. Those challenges are: 1) the expectation of a fuel price hike by Rp 2,000 (a 30 percent hike) per liter to Rp 8,500 that will drive the inflation rate higher in the short run. Based on our calculations every 10 percent rise in fuel prices will drive the inflation rate to increase by 0.7 percentage points. Thus, in total, the inflation rate will possibly reach 7.5 percent in 2014. 2) higher Fed fund rates starting in mid 2015 and probably to mid 2016. The expectation of a rate hike is in the range of 2 to 3 percent by the end of 2016. Historically a rise in the Fed fund rates will boost the US treasury rates and finally Indonesia's domestic interest rates. We expect Indonesia's benchmark rate to reach 7.75 percent.

The rising interest rates, coupled with a possible deceleration in economic growth in 2014 will create both challenges to bank liquidity and asset quality in the short term. However, we still feel there are some opportunities for the banking sector in 2015. The first one is through the acceleration of infrastructure development under the new government. This acceleration will support domestic economic growth and finally have an impact on the real sector. The growing real sector will have a mutual benefit on the financial sector. Another opportunity will come from the subdued interest rates if the fuel-price hike really occurs this year. Lower inflation will ease domestic liquidity in the medium term.

In sum, we expect that the decelerating economic growth will cause the credit growth this year to slow compared to last year. We predict loans this year will grow by around 15 to 17 percent and deposits will grow around 12 percent to 14 percent. Furthermore, we expect that credit growth will persist at a low level compared to 2013. In 2015, credit growth will reach 16 to 18 percent amid significant risks externally and internally. However, the banking sector will still be resilient due to positive factors, such as room for lending growth, stable macroeconomic conditions and slightly better export and investment performances as a result of the recovering the US economy.