E

arly this year, the government announced its intention to bring interest rates down to single digits in order to expand credit growth. The announcement was followed by Bank Indonesia’s (BI) move to gradually lower the BI rate.

Only a few days ago, Vice President Jusuf Kalla hinted that BI would cut its benchmark interest rate again in August.

There is an interesting question to ask. Is cutting the BI rate effective at spurring credit growth? What are the important factors that determine credit growth?

Using Indonesian quarterly data from early 2005 to 2016, I carried out quantitative analysis to gauge the factors determining credit growth in Indonesia.

Interestingly, the data show that a change in the BI rate does not significantly affect credit growth.

Raising domestic demand and liquidity are, instead, the most significant factors in spurring growth. The results of the study are as follows.

First, stronger GDP growth raises demand for lending, which in turns leads to higher credit growth.

It is interesting that when GDP growth drivers consist of consumption and investment, it is only consumption growth that has a significant positive effect on credit growth, with investment growth showing no significant
correlation.

The result is in line with the finding of Chatib Basri, the former finance minister, in an article published in Kompas on June 16.

In the article, Chatib explained that in Indonesia, the causality between consumption and investment occurred, where consumption affects investment, but not the other way around.

The implication is that deregulation and interest rates cuts do not necessarily produce demand, but an increase in consumption will encourage production.

Second, the change in the BI rate does not significantly affect credit growth. However, a lower US Federal Reserve fund rate and lower deposit rate lead to higher credit growth.

The Fed fund rate and deposit rate are related to liquidity. A higher Fed Fund rate causes funds in emerging market economies to flee, reducing market liquidity.

Indonesia was hit by capital outflow and suffered tight liquidity during the Fed’s “Taper Tantrum” in 2013 when the Fed signaled its intention to end quantitative easing and raise interest rates.

This had a significant impact on Indonesian market liquidity.

On the other hand, a higher deposit rate indicates tight market liquidity.

When market liquidity is easing, banks do not face fierce competition to earn deposits, which they need as funding to extend credit.

However, when market liquidity is tight, banks will raise the deposit rate to attract deposits.

Third, domestic deposit growth and non-resident liability growth of domestic banks contribute positively to credit growth.

These two variables are the main contributor to Indonesian banks’ funding. 75 percent of Indonesian banks’ funding is sourced from domestic deposits and 15 percent from foreign funding accounts.

An increase in these sources of funding, which are also related to liquidity, increase the ability of banks to extend credit.

Fourth, a higher net interest margin (NIM) correlates positively with higher credit growth. This finding is contrary to government and the Financial Services Authority (OJK) expectations to lower banks’ NIM in an effort to expand credit growth.

To explain this finding, it is important to note that the banking industry retains a large proportion of its profit for capital addition.

Greater capital addition is needed since banks have to maintain their capital adequacy ratios (CAR) while extending credit.

A higher NIM means greater profitability, leading to greater capital addition and greater capability to extend credit.

Although higher NIM is usually associated with inefficiency, it is possible that in Indonesia, higher NIM is needed for banks to achieve higher credit growth.

The quantitative study shows that the important factors driving credit growth are domestic consumption, market liquidity and banks’ profitability.

Stimulating consumption to drive credit growth backs Chatib Basri’s policy suggestion.

The disbursement of 13th and 14th salaries is expected to stimulate short-term demand.

In addition, Basri suggests allocating funds to expand cash transfer programs and cash for work, as well as creating short-term, labor-intensive projects that can provide immediate income for people.

In addition, the government and BI should hand-in-hand manage inflation by controlling the volatility of food prices as well as administered prices, managing increasing wages, fixing inefficient logistics and managing core inflation.

Higher inflation does not only hamper consumption growth, it also limits the ability of banks to reduce deposit rates.

Ensuring the availability of liquidity is another important factor. Government and OJK efforts to bring lending and deposit rates down will struggle if market liquidity is tight.

Tight market liquidity increases competition between banks, private corporations and the government to get liquidity for funding.

Government and private corporations absorb liquidity by issuing bonds.

It is important for the government not to suddenly absorb liquidity through unanticipated bond issuance.

Hence, the government should plan how to finance budget deficit and as soon as the government receives funding from the market, it has to be spent quickly.

Otherwise, the government could cause tight market liquidity, pushing banks to increase their deposit rates and thus hindering the expansion of credit growth.

Higher bank profitability, indicated by higher NIM in this study, leads to higher credit growth.

However, the government and OJK have been emphasizing the desire to reduce banks’ NIM, arguing that current NIM is too high when compared with other ASEAN countries.

Our NIM is currently ranging between 5 percent and 6 percent while in other ASEAN countries it is between 3 percent and 4 percent.

In Thailand and Malaysia, the lending rate is around 7 percent and 5 percent, respectively, while the deposit rate is around 1.3 percent and 3.3 percent.

Can we compare NIM, lending rates and deposit rates without looking at inflation rates and the government bond yield? The answer is no.

Thailand’s inflation is in negative territory at -1 percent to -0.5 percent and the one-year government bond yield is 1.5 percent.

In Malaysia, the inflation rate is between 2 percent and 3 percent and the one-year government bond yield is 2.58 percent

In conclusion, the quantitative study reveals that lowering the BI rate does not lead to significantly higher credit growth. It might be effective, but not in the short run.

Nevertheless, stimulating consumption, maintaining market liquidity and banks’ capital addition are the most significant factors.
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The writer is an analyst at CReco Research Institute.