The global economy will still be full of uncertainties until next year, and such a situation will have a significant impact on the domestic economy. Some emerging economies, such as Turkey and Argentina, have fallen into recessions, while others like Brazil, Russia and South Korea have recorded a snail-pace economic growth of between 0.9 and 1 percent.

We have just revised our economic growth projection for Indonesia to 5.06 percent this year from our previous forecast of 5.22 percent after a weaker-than-expected first half expansion. With the slowing growth of GDP, it is highly possible that loan demand will also weaken and eventually affect the country’s banking industry.

The Indonesian banking industry remains broadly stable. Capital ratio is still robust at 22.6 percent as of June 2019, while at the same time, the nonperforming loan (NPL) ratio continued to decrease to 2.5 percent, down from 2.67 percent in the previous year. However, we continue to see some weaknesses in the sector.

Several large banks’ net profits missed expectations in this year’s second quarter. The weakening net profit growth was mostly caused by a decline in net interest margins compared to last year. In 2018, banks increased deposit interest rates more aggressively than those of lending because of Bank Indonesia’s (BI) rapid benchmark hikes and a condition of tight liquidity in the banking system.

BI steeply increased its policy rate, the BI seven-day reverse repo rate, by 175 basis points (bps) from 4.25 percent to 6 percent last year. At the same time, liquidity was tight, as shown by an increasing loan-to-deposit ratio from 89.6 percent in December 2017 to 94 percent in December 2018. This caused fierce competition among lenders in attracting third party funds. Banks last year increased their one-month deposit rates by 118 bps, while at the same time they only raised their lending rates by 34 bps for working capital loans and 18 bps for investment loans.

Most banks are very dependent on time deposits to boost third party funds growth, in which they pay a higher interest rate compared to other types of deposits, such as current account and savings account (CASA). Lately, time deposit growth has always been higher compared to CASA. As of June, time deposits grew 8.33 percent while CASA only expanded by 6.7 percent.

If banks still rely heavily on time deposits, it will be hard to improve their net interest margins as only banks with higher CASA ratios to total deposits have room to improve their profitability.

Banks have to boost their CASA growth to widen the gap between lending rates and deposit rates. The keys to increasing this growth are maintaining good relations with customers and continuing the improvement of service quality. Other than CASA, banks still have another type of funding, which is wholesale funding that includes the issuance of corporate bonds and medium term notes. The point is that banks have to find their optimal financing to improve profitability.

Meanwhile, we also see signs of weakening loan demand. The latest data suggested that loan growth slowed in June to 9.9 percent yoy, its lowest level in the past 14 months. Loans channeled to several important industries declined, as shown by the sluggish credit growth in the processing industry (6.9 percent), agriculture industry (8.4 percent) and wholesale and retail trade (7.5 percent) in the first half compared to expansions of 9.1 percent, 11.8 percent and 10.2 percent, respectively, penciled in the same period last year.

In the past couple of months, BI has undertaken accommodative policies to support the country’s economic growth. The central bank has trimmed its benchmark by 50 bps to 5.5 percent in the last two months. It also lowered the reserve requirement ratio by half of a percentage point to 6 percent. The policy mix going forward will likely remain accommodative.

We see there is still room for BI to loosen its monetary policy, as well as its macroprudential policy. We expect the central bank to cut its policy rate one more time this year by 25 bps to 5.25 percent and one more time early next year. We also see a possibility for BI to cut the reserve requirement ratio by another 50 bps to give more room for banks to increase loans disbursement. However, it will take four to six quarters for the policy mix to have impacts on the real economy.

On that basis, we see that there is still room for the banks to selectively increase loan growth amid uncertainties in the global economy and weakening domestic growth. Some industries, in our view, have good prospects in the situation. They, especially the infrastructure-related sectors, health care, pharmaceuticals and tourism, will get support from the government’s ambitious development program. Other sectors, such as fast moving consumer goods and telecommunications, will also have a bright future because of the increasing demand for their products.

An important thing that must be kept in mind during periods of high uncertainty is that banks have to maintain their asset quality to keep the NPL ratio in check. Their intermediation function needs to be improved to support the economy, but at the same time banks have to strengthen their risk management with a clear portfolio guideline. Last but not least, banks need to ensure that they have sufficient liquidity to fund their loans.

Senior financial market analyst, PT Bank Mandiri (Persero) Tbk.

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