Bank Indonesia's Loosening Monetary Policy: Impact of Lower Interest Rates
In the first three policy meetings of 2016, Indonesia's central bank (Bank Indonesia) cut its benchmark BI rate gradually yet aggressively from 7.50 percent to 6.75 percent as inflation, the rupiah rate and Indonesia's current account deficit were regarded as 'under control'. At the same time, Indonesia's lender of last resort acknowledged the BI rate has failed to influence borrowing costs and market liquidity effectively and therefore decided to adopt the seven-day reverse repurchase rate (reverse repo) as the nation's new benchmark starting from August 2016.
Moreover, a lower interest rate environment opens room for accelerated economic growth. Recently, Juda Agung, Executive Director of Bank Indonesia's Economic and Monetary Policy Department, said Indonesia's export performance will most likely remain bleak in 2016 given the sluggish global economy and persistently low commodity prices. This would imply that the desired acceleration of Indonesia's economic growth has to be fueled mainly by domestic growth. A low interest rate environment is one of the strategies that can achieve this target. Lower interest rates imply that borrowing becomes cheaper, hence it encourages borrowing and investment thus the economic wheels are in motion. However there are also negative aspects to this process. For example, inflation can rise and this would undermine people's purchasing power as well as the sustainability of economic expansion.
The Indonesian government as well as financial authorities such as Bank Indonesia and the Financial Services Authority (OJK) have repeatedly emphasized that they are eager to push Indonesia's lending rates down to single-digit margins in order to boost credit growth (for both consumer credit and corporate credit) and economic expansion. In Indonesia lending rates in the banking sector tend to climb rapidly when Bank Indonesia decides to conduct an interest rate hike. However, when there is an interest rate cut (and we have seen three cuts in the January-March 2016 period) lending rates tend to fall rather slowly and reluctantly.
Here we take a closer look at the consequences of the central bank's lower interest rate environment. In theory Indonesia's push for lower interest rates has the following consequences:
Lower Borrowing Costs
A lower interest rate environment gives rise to lower borrowing costs, implying that it becomes cheaper for consumers and investors to obtain funds. For consumers it becomes, for example, less expensive to purchase a house using a mortgage scheme. In Indonesia this mortgage is called house ownership credit (kredit pemilikan rumah, abbreviated KPR) or apartment ownership credit (kredit pemilikan apartemen, KPA). Meanwhile, for businesses it becomes more attractive to take up a loan for business expansion. As such, both consumer and businesses have more funds available hence economic activity grows.
Rising Asset Prices
Amid the low interest rate environment consumers are encouraged to purchase assets (for example property). Higher demand for these assets will give rise to rising asset prices (implying people's wealth rises accordingly). This explains why Indonesia's property companies have repeatedly requested Bank Indonesia to lower its key BI rate in 2014 and 2015.
Rising Stock Prices
Lower interest rates not only impact on lending rates but also on deposit rates. As deposit rates fall it becomes less attractive for people and investors to put money in deposit accounts or in the bond market. A more attractive option is the stock market, particularly as stocks should rise given consumers and businesses have more funds available for consumption and investment or business expansion.
Depreciating Pressures on the Currency
When Bank Indonesia lowers its interest rate environment it becomes less attractive to save rupiah-denominated funds. Reduced demand for the rupiah causes depreciating pressures on the currency. This explains why the rupiah tends to depreciate sharply in the hours following an interest rate cut. It also implies that Indonesia's exports become more competitive, while imports become more expensive. For a nation that has a high import-content in the output of its manufacturing industry (such as Indonesia) it would mean that its competitiveness reduces.
Rising Inflation
Because the low interest rate environment encourages consumption, investment and business expansion, inflationary pressures rise accordingly (that explains why the US Federal Reserve, European Central Bank and the Bank of Japan have implemented low - or even negative - interest rates in an effort to boost inflation). Currently, Indonesia's inflation rate is safe at 3.60 percent (y/y) in April 2016. However, inflation may somewhat rise in the months ahead due to rising consumption amid the Ramadan and Idul Fitri celebrations.