The increased expectation of entrepreneurs toward higher productivity and potential income is also consistent with optimistic demand conditions in Indonesia.

For instance, the retail sales index increased from 105.1 in 2010 to 209.5 in July 2016, while the consumer confidence index, which measures expected employment six months ahead also recorded a significant increase from 85.7 in September 2015 to 115.6 in June 2016. The percentage of demand for bank loans among entrepreneurs surveyed also increased from 11.8 percent in March 2016 to 36.1 percent in June 2016.

If demand-side factors reflected in business confidence indicators are strengthening, why does commercial bank credit growth remain subdued in 2016, falling to 8 to 9 percent year-on-year (yoy) from 20 to 24 percent yoy in 2013 with noticeable economic slowdown after the “taper tantrum” (i.e. an increase in the US Federal Reserve rate) in mid-2013?

The major explanation is indeed supply side factors related to a significant drop in the growth rate of commercial banks’ third party funds (i.e. deposits), suggesting the occurrence of liquidity tightening in Indonesian banking.

If commercial bank deposits can still grow by 15 percent in 2013 after the taper tantrum, they only grew around 6 percent yoy in June 2016. Taking rural banks into account, liquidity tightening has also manifested itself in the growth of central bank currency outside commercial and rural banks from 8.4 percent yoy in May 2016 to 24.8 percent yoy in June 2016.

In spite of that, the slowdown in bank deposits — particularly in a country with a credible deposit insurance system and financial safety net law — is not necessarily a bad condition for a number of reasons.

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Bank liquidity tightening might be a necessary stage toward an effective market discipline mechanism.

Firstly a decline in bank deposit growth due to higher bank risk can reflect the effectiveness of market discipline exerted by both retail and institutional depositors.

In principle, market discipline mechanism works effectively, if bank depositors react as early as possible by withdrawing part of their deposits or by requiring higher deposit rates in response to higher risks, and vice versa.

As the ratio of non-performing loans to total loans already increased, reaching 3.05 percent in June 2016 from 1.8 percent in 2013, a decrease in bank deposit growth might be partly attributed to the effectiveness of market discipline by depositors.

In the meantime, because no government bailout is available in the current financial safety net law, enhancing the market discipline mechanism by equipping depositors with tools and incentives to monitor bank risk is thus necessary to detect financial distress of banks before they collapse, not to mention the importance of effective prudential regulation and supervision, as well as recovery and resolution plans in times of crisis.

Second, the slowdown in bank deposit growth can also be associated with a new equilibrium in the financial system in which the role of capital market as a source of long-term financing, including for infrastructure, starts to emerge.

A new regulation issued by the Financial Services Authority (OJK) stipulating the minimum percentage of investment in government bonds imposed on non-bank financial institutions (NBFIs) will certainly shift NBFI deposits from the banking system to the capital market, particularly where the supply of government bonds has increased by 10.7 percent year-to-date.

Third, a decline in deposit growth can also create a new equilibrium for banks to be less dependent on interest income activities (i.e. loans), and to engage more in non-interest income activities, including through capital market.

Nonetheless, higher income diversification in banking into non-interest income activities can also be driven to support micro, small and medium enterprises (MSMEs) through microfinance institutions (MFIs). Specifically, banks can make available uncommitted loan facilities as part of their off-balance-sheet products to finance MSMEs using channeling or joint financing with MFIs.

Once uncommitted loan facilities are created, banks will generate non-interest income that can be used to finance loans in the future when uncommitted loan facilities are actually disbursed to MFIs.

As the slowdown in bank deposit growth might not always be a negative phenomenon, moderation in bank credit growth in an optimistic business environment might also be needed to avoid credit booms that may end up in financial crisis, as the non-performing loans ratio already reached 3.05 percent in June 2016. Such behavior is the so-called “the counter cyclicality of bank lending”.

This means that although banks seem to reduce lending during economic expansionary periods, they can actually become more supportive during economic downturns by granting more loans, as in 2013 after the taper tantrum, which in turn prevents prolonged economic recession from occurring.

Eventually, bank liquidity tightening can indeed be problematic in a country without credible deposit insurance and financial safety net law, as well as without alternative long-term financing from capital market. For Indonesia, this is not the case.

Bank liquidity tightening might be a necessary stage toward an effective market discipline mechanism to promote a sound and stable banking system, as well as toward a new equilibrium in the financial system with higher capital market deepening for long-term infrastructure financing.

In this regard, bank liquidity tightening is probably inevitable before Indonesia can escape from the middle-income country status in the not so distant future, along with infrastructure development that ensures higher capital stock accumulation and hence, long-run economic growth.

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The writer is senior lecturer and financial economist at Sampoerna University’s School of Business. The views expressed are his own.

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