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Policy rate and banking liquidity
For four consecutive months, Bank Indonesia (BI) has cut its benchmark interest rate, the BI seven-day reverse repo rate, by 100 basis points (bps) to 5 percent
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or four consecutive months, Bank Indonesia (BI) has cut its benchmark interest rate, the BI seven-day reverse repo rate, by 100 basis points (bps) to 5 percent. BI’s aggressiveness in easing its money policy is not without reason.
First, the inflation rate remained under control, estimated at the range target of 2.5 to 4.5 percent throughout this year.
Second, investment returns on domestic financial assets are still attractive to foreign capital. Portfolio capital inflows until early October reached Rp 192.6 trillion (US$13.3 billion).
Third, the position of foreign exchange reserves at the end of September was recorded at $124.3 billion, equivalent to financing 7.2 months of imports or seven months of imports plus payment of government foreign debt. This amount is above the international adequacy standard of thee months of imports.
Fourth, the exchange rate also shows stability. In October, the rupiah saw a 1.18 percent appreciation point-to-point from September. With this development, the rupiah booked a 2.5 percent rise during the first 10 months of the year.
Fifth, the policy rate cut is needed to stimulate domestic economic growth amid slowing global economic conditions.
Supported by the stability of several key macroeconomic variables above, BI decided to ease the money policy as a preemptive measure. The policy rate cut is also consistent with the relaxation of loan-to-value for property and motor vehicles and of the macroprudential intermediation ratio for Islamic banking.
However, cutting interest rates when banks are experiencing liquidity problems seems to be unusual. The big question here is whether the cut in the policy rate is effective in improving the liquidity of banks.
Conceptually, the benchmark interest rate policy has a direct impact on banks’ interest rates. Deposit and lending rates will inevitably decrease given the lower cost of funds. The decline in loan interest rates is projected to drive up the demand for lending.
The demand for lending has soared because the end of the year is a period for window dressing. Many corporations, including the banking industry, feel the need to boost their performance in order to enhance their annual financial statements.
The corporate desire to boost performance combined with the desire of banks to improve their loan portfolios has pushed lending growth to the double-digit target this year.
On the other hand, the decline in deposit rates will put the brakes on the rate of growth of third-party funds (DPK), whose owners have recently become increasingly responsive to movements in deposit rates. A slight decrease in deposit interest rates is already a strong enough reason for DPK owners to withdraw their funds from banks.
Fund owners continue to be tempted to balance portfolios between deposits in banks, stocks, bonds, foreign exchange or even gold. As a result, the soaring gold price lately is thought to be an escape for third-party funds. Under the above problematic circumstances, banks will experience heavy liquidity pressures. The DPK growth lags far behind the rate of lending growth. The lending-deposit ratio has exceeded the upper limit set by BI, which is 94 percent.
Consequently, banks may not be able to fulfill the increasing loan demand. If banks force themselves to increase lending, it will backfire. Banks have to find other alternative sources of funds that are more expensive.
The option to increase lending from their own capital is not so good because of Basel III principles and the Financial Accounting Standards Statement (PSAK) 71 concerning adequacy capital that will be effective next year.
In addition, lending in bearish economic conditions is riskier. Therefore, a reasonable choice for banks falls on risk-free government securities (bonds). Bank holdings of government bonds as of the end of August surged by 26 percent from January. Put another way, bank funds only revolving around financial assets instead flow to the real economic sectors.
At this point, the notion that macroprudential policies to control liquidity are only effective when interest rates are unchanged seems to be proven. One basic principle in economic policy that must not be forgotten is the proposition of ceteris paribus (other factors remain unchanged).
When BI plays in the realm of liquidity through macroprudential policy, the monetary policy through the benchmark interest rate should not be changed.
Both types of policies that are applied almost simultaneously cause confusion. The response of economic actors will be then apathetic. The heaviest risk is that the monetary policy has no impact on liquidity, while the macroprudential policy is not effective in pumping lending.
In such a case, BI should be more patient and for the impact of previous policies on the economy before releasing new policies. This way, the impact of the benchmark interest rate policy is more measurable, as are the effects of macroprudential policies.
Eventually, BI must choose to prioritize between liquidity and interest rates. Without a clear priority scale, the optimism of economic actors that has emerged in the face of 2020 will be dim.
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Research director at the Socio-Economic and Educational Business Institute (SEEBI) Jakarta and lecturer at the State University of Jakarta’s School of Economics.
The views expressed are his own.
