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Macroprudential policy in an economic downturn
Indonesian economic growth in the third quarter of 2016 was recorded at 5.02 percent year-on-year (yoy), lower than in the previous quarter with 5.19 percent. Given this situation, we must look at the macroprudential policy response to the economic downturn.
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Lower than expected: A bank staff member counts banknotes at a bank in Jakarta on Sept. 26. Bank Indonesia sees Indonesia's economic growth in the third quarter as unlikely to be as strong as previously expected and only reach 5 percent year-on-year (yoy). (Antara Photo/Muhammad Adimaja))
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ndonesian economic growth in the third quarter of 2016 was recorded at 5.02 percent year-on-year (yoy), lower than in the previous quarter with 5.19 percent. In addition, credit growth in the third quarter fell to 6.47 percent yoy from 8.89 percent in the previous quarter, continuing a downtrend that began in 2015. Given this situation, we must look at the macroprudential policy response to the economic downturn.
Prudential means that people prepare an umbrella when they see a grey cloud in the sky as a sign of rain. However, days are not preditctable. On a particular day it can be sunny in the morning but turn to heavy rain at midday. A similar perspective can be applied to the economy. Recently, shocks to the economy have become more and more unpredictable as a consequence of global reform, divergent economic policies and a global economic slowdown.
The dynamic activity of the economy forms a business and financial cycle. Accordingly, financial institutions naturally move in line with the cycle of the economy, which also represents their risk-taking behavior (procyclical). Correspondingly, the policy response should be countercyclical in character. If growth is excessive, the macroprudential policy response is to smoothen growth, and vice versa. The benefit is to mitigate a crisis or prevent the economy from entering a recession. One of the macroprudential policy instruments is called a countercyclical capital buffer (CCB). Financial institutions should save up capital (including CCB) in times of a rising economy and use it for credit expansion during an economic downturn.
In macroprudential policymaking, a comprehensive perspective on economic and financial activity is important, because financial institutions tend to manage financial problems in a partial manner. For example, in a phase of economic downturn, the non-performing loans (NPLs) ratio tends to increase. The natural response by financial institutions is to increase their capital, even though this response would further increase the burden of business owners and worsen the economy.
Macroprudential policy in Indonesia was quite successful during high-growth economic phases, such as the property boom from 2012 to 2013. Property credit growth reached 45 percent yoy in mid 2012. As a macroprudential policy response, Bank Indonesia issued two regulations on the loan-to-value (LTV) ratio in 2012 and 2013, which smoothened property credit growth to below 15 percent yoy in 2014. On the other hand, during economic downturn phases, the macroprudential policy response in Indonesia has not yet been reviewed.
Using empirical studies in 69 countries as a sample during 2002 to 2014, Buchholz (2015) investigated the effectiveness of macroprudential policy during financial downturns. Particularly, this study focused on the banks’ leverage cap as a macroprudential instrument.
The main finding of this study suggests that real credit growth rates in countries that had implemented leverage caps prior to the crisis were considerably higher than the rates in countries that had not. This suggests that macroprudential policy does indeed have a stabilizing effect on real credit growth during a financial downturn.
In Indonesia, in order to ensure its effectiveness, macroprudential policy should be implemented in synergy with other macroeconomic policies, such as monetary policy, fiscal policy and real sector policy. Those policies are highly intertwined in maintaining macroeconomic stability and supporting economic growth.
The global financial crisis was a result of financial imbalances developed by low inflation and small output gaps. Given this, it is important to note that macroecnomic and monetary stability can only be achieved with financial stability.
As a response to the slowdown in economic growth, Bank Indonesia has loosened its monetary policy by lowering its key interest rate from 7.5 percent at the end of 2015 to 6.5 percent in July 2016. This loose monetary policy was continued after Bank Indonesia changed its monetary instrument to the BI-7 day (reverse) repo rate from 5.25 percent in July 2016 to 4.75 percent in October 2016. In this context, it is important to note that monetary policy is implemented across the board, while macroprudential policy can be tailored to more specific targets. In line with monetary policy, Bank Indonesia also loosened its macroprudential policy on LTV and minimum reserve requirements and the loan-to-funding ratio in August 2016. Bank Indonesia still took into account a potential increase of credit risks.
This combination of monetary and macroprudential policies also should be supported by the government’s budget policies, which can stimulate economic growth through government spending and investment.
In conclusion, considering recent macroprudential policy responses, the effectiveness of this policy still needs time to be proven. Its interaction with monetary and fiscal policies is crucial in order to ensure the effectiveness of those policies in stabilizing credit growth in the economic downturn phase. Indeed, a combination of macroprudential policies with monetary and fiscal policies could be used to stimulate economic growth.
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