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Jakarta Post

Goodbye JIBOR, welcome IndONIA

Bank Indonesia (BI) continues to look for the right formula to deal with growing uncertainty in the financial sector

Haryo Kuncoro (The Jakarta Post)
Jakarta
Thu, August 16, 2018

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Goodbye JIBOR, welcome IndONIA

B

ank Indonesia (BI) continues to look for the right formula to deal with growing uncertainty in the financial sector. Curbing the impact of a further increase in the United States interest rate will be the nearest test.

To further maintain market stability, for example, BI launched a new benchmark interest rate for the country’s overnight interbank money market rate on Aug.1 to improve the reliability of its reference rate.

The new interest reference rate is called the Indonesia Overnight Index Average (IndONIA), which will eventually replace the overnight Jakarta Interbank Offered Rate (JIBOR) as the base interest rate in the Interbank Money Market (PUAB). JIBOR will be used until the new benchmark rate is fully enforced in January, 2019.

The system in determining the IndONIA rate is still based on the JIBOR overnight rate, but its mechanism has been changed.

The JIBOR overnight rate is based on the quotation of indicative interest rates provided by bank participating banks. In BI’s point of view, the determination of PUAB interest rates is still dominated by certain banks, especially large banks that are able to meet the quotation requirements.

Therefore, the JIBOR overnight rate does not reflect the BI seven-day reverse repo rate, which is adjusted monthly by the central bank. The credibility aspect of the JIBOR overnight rate as a basic reference is often disputed.

IndONIA is based on overnight money market transactions. Therefore, it produces a real PUAB interest rate without being dictated by small banks, large banks, foreign banks, or even state-owned banks. In essence, market participants have a firm foundation over PUAB interest rates.

Another advantage of IndONIA is that the interest rates can change every day. The PUAB interest rate also reflects the condition of bank liquidity requirements. With such a mechanism, the interest rate will not be too far off from the seven-day repo rate.

The deepening of the financial market becomes another goal targeted by BI. IndONIA’s interest rate is expected to encourage hedging and derivative transactions to be more efficient. The premium of hedge transactions, which use IndONIA as their benchmark will obviously be more stable.

IndONIA is used as the basis for short-term hedging instruments, such as the Overnight Index Swap, while JIBOR is used as a benchmark rate for transactions with a longer tenor (one week, one month. Three months and 12 months), such as the Interest Rate Swap (IRS).

The existence of IRS is highly relevant when dealing with the exchange rate fluctuations.

Many companies are still reluctant to make hedging transactions. When they have to import, they prefer to buy US dollars in the spot market, even at a higher price. With the IRS, companies can lock up their rupiah so that the demand for US dollars is more manageable. Eventually, the stability of the rupiah can also be maintained.

In the wider scope, IndONIA also has the potential to attract foreign investors. The introduction of IndONIA is helpful for foreign investors to manage their portfolio investment. They can calculate the yield that they will earn from each of the financial assets being held more precisely.

However, the implementation of IndONIA will still leave a big question mark, especially in regard to the readiness of each bank. IndONIA is determined by market mechanisms. If there is excess supply, the interest rates can drop dramatically. Conversely, if there is a supply shortage, the interest rates can skyrocket.

The root of the problem is that not all banks are able to provide sufficient liquidity. The oligopolistic banking industry is the major obstacle. Accordingly, BI must first strengthen market players then build its market. The absence of strong market players makes PUAB a vehicle for liquidity transactions biased and the interest rate can be misleading.

For example, the excess liquidity of a group of banks is available for a seven-day tenor. Meanwhile, another bank’s liquidity needs one month. The borrowing banks are forced to use one-month tenor liquidity with interest rates that are somewhat similar to the seven-day tenor, which is more expensive. Consequently, there will be idle funds due to mismatching.

Moreover, PUAB is seen by some banks as an alternative to meet liquidity needs. If it is not urgent, some banks are looking for liquidity from other sources. Similar for other banks, PUAB becomes a temporary transit for their idle funds, rather than offering them to other banks.

The above thesis seems close to reality. So far, the term structure of interest rates between the shortest tenors with the longest tenor is thin. It seems that there is no significant yield difference for banks in lending the funds — let say — for one-month and three-month tenors.

Under shallow financial markets, the excess liquidity will accumulate in transactions with a particular tenor deemed most “safe”. If this is the case, the IndONIA effect will undoubtedly fail to accommodate longer-term interest rates. Therefore, interest rates will not really reflect the condition of bank liquidity.

As a result, without strong market participants and compatible incentives in each segment, IndONIA may be incapable of controlling PUAB interest rate and liquidity. Use of the JIBOR overnight rate in US dollar transactions provides valuable lessons since it is rarely used by market participants.

The failure of IndONIA in delivering a benchmark interest rate is quite risky, not only for the banking sector itself but also for inflation, exchange rate movement, or even financial system stability. Anyway, goodbye JIBOR, welcome IndONIA.

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The writer is research director at the Socio-Economic and Educational Business Institute Jakarta and lecturer at the School of Economics, State University of Jakarta.

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