T

he target of achieving a single digit lending rate by the end of 2016 has already been missed. Preliminary efforts, in the form of benchmark interest rate cuts, were suboptimal.

Throughout 2016, the policy rate was cut by 150 basis points, but lending rates only dropped by 79 basis points. As of December, the average credit rate was 12.04 percent.

This failure has not apparently dampened the spirits of Bank Indonesia (BI) in trying again to realize the single digit credit rate target this year.

From BI’s point of view, there is room to further lower credit rates this year. In fact, the decline in deposit rates is greater than that of lending rates.

However, the ability to reduce credit rates through cuts in BI’s policy rate is increasingly limited. Domestic pressures from fluctuations in inflation have been triggered by electricity price adjustments for the lowest segment of electricity users (900 VA), non-subsidized fuel and 3 kg-LPG canisters and the rise in volatile food commodity prices.

As a comparison, the Central Statistic Agency (BPS) announced that inflation during January 2017 stood at 0.97
percent. This is the highest January inflation rate for the last three years. Consequently, the targeted inflation range of 3 to 5 percent throughout 2017 may not be achieved.

External constraints include the possibility of an increase in US Federal Reserve (the Fed) benchmark interest rate three times this year and the gloomy prospects of global economic recovery. The Fed rate hike in December, for example, encouraged capital flight abroad, which affected the liquidity crunch in the domestic financial market.

Due the liquidity squeeze still overshadowing the domestic financial market, the banking industry expects high credit growth this year.

The Financial Services Authority (OJK) predicts that rupiah loans will grow by 9 to 11 percent. BI is even more optimistic in its 10-12 percent credit growth projection.

As a result, BI has to address both the issues of price stability and bank liquidity. In this context, BI, on Jan. 30, announced a change in its monetary policy orientation. While last year BI focused on reducing bank interest rates, this year BI will be focusing on maintaining bank liquidity to control inflation and interest rates.

These signals are captured from the implementation of the new open-market operation scheme. By definition, open-market operations are instruments of monetary policy to control liquidity through the sale and purchase of securities (such as Bank Indonesia certificates, government securities and foreign exchange) between BI and banks.

Previously, open-market operations used fixed-rate tenders. In such cases, BI sets the price (7-day reverse repo rate as the benchmark interest rate for a one-week tenor), while the market determines the quantity. The tenor for periods other than one week is left to the open market via an auction mechanism.

The new scheme adapts the variable-rate tender (VRT) mechanism, replacing the fixed-rate tender mechanism. Under the VRT scheme, the banks apply for the discount rate to participate in the securities auction. Thus, the market discount rate can be variable, associated with the tenor. In this case, BI determines the quantity rather than the interest rate.

Positioning the reverse repo rate for a tenor of seven days, while other tenors are left to the market, is quite reasonable. This is because the interest rate structure in the financial market is very segmented.

Each segment has its own market share and at the same time has different rates.

Therefore, open-market operations using the VRT method are claimed to better reflect the condition of market liquidity. An excess of bank liquidity for a certain tenor would be absorbed in the respective securities.

Thus, the interest rates reflect the real liquidity in the financial markets.

The VRT method also makes it easier for BI to capture preferences and market-related liquidity in various tenors, from two weeks to one year, so that bank liquidity is maintained. Solid liquidity will allow BI to control the inflation rate and prevent the banking sector from increasing interest rates.

However, it seems that BI now prefers to control the inflation rate indirectly through the role of bank liquidity. As a result, the impact of open-market operations on the inflation rate and other macroeconomic variables will have a longer lag, implying that the new scheme is probably less effective.

Moreover, open-market operations are determined through an auction mechanism based on supply and demand. If there is a shortage of supply, for example, the equilibrium discount rate resulting from the interaction between sellers and buyers in the market could fall dramatically.

In contrast, in the case of an excess supply (or oversubscription), the market discount rate could exceed the stop-out rate (SOR), or the highest rate tolerated by BI.

This means that, under the SOR, the discount rate created by the market no longer indicates the real liquidity conditions.

Consequently, the driving force of open-market operations to lower lending rates may weaken. To put it succinctly, it is difficult to expect that bankers will aggressively reduce their lending rates. Hence, the target of single digit credit rates at the end of this year will fail to realize once more.

Under these circumstances, the decline in bank lending rates always waits on the 7-day reverse repo benchmark interest rate as the basic cost of funds.

Unfortunately, the repo rate is currently status quo both in its magnitude and its movement. Consequently, it will take longer to achieve the single digit credit rate.

To sum up, worries about open-market operation ineffectiveness bring us back to the choice of stabilizing inflation or maintaining bank liquidity. Admittedly, BI does not, at present, have many policy options.

The most serious risk is that the inflation rate will run out of control while banks continue to face a lack of liquidity.
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The writer is research director at the Socio-Economic & Educational Business Institute (SEEBI) Jakarta and a lecturer at the School of Economics, State University of Jakarta.