Analysis: Bank Indonesia Opts for Monetary Tightening to Offset Pressures
For the first time in four years Bank Indonesia opted for monetary tightening by raising the benchmark interest rate (the 7-Day Reverse Repo Rate) by 25 basis points (bps) to 4.50 percent. Also the deposit facility and lending facility rates were raised by 25 bps to 3.75 percent and 5.25 percent, respectively (effective per 18 May 2018). This latest move is part of Bank Indonesia's efforts to maintain economic stability amid the high degree of uncertainty in global financial markets.
Earlier in May 2018 Bank Indonesia had already confirmed that it engaged in rupiah stabilization efforts through the selling of foreign currency (thus leading to the nation's declining foreign exchange reserves) and through purchasing bonds. Despite these efforts capital outflows continued thus severe pressures on the rupiah, bonds, and stocks continued.
Bank Indonesia also said it implements macroprudential policy, including keeping the countercyclical capital buffer (CCB) at zero percent, in a bid to maintain financial system stability and improve the banking sector's intermediation function.
Meanwhile, Bank Indonesia Governor Agus Martowardojo added that the central bank would be prepared to readjust its key interest rate again in the remainder of the year in an effort to safeguard economic stability and prevent the rupiah from falling deeper. If the rupiah's depreciation continues, then it will threaten the central bank's inflation target (currently set at the range of 2.5 - 4.5 percent year-on-year, y/y).
Below we present Bank Indonesia's statement that was released after the interest rate hike.
Global economic growth is projected to improve in 2018, despite the ongoing global liquidity rebalancing process. The global economic growth projection for 2018 has been upgraded from 3.8 percent to 3.9 percent, mainly on the back of accelerated economic growth in the US (which stems from improving investment and consumption, amid the ongoing normalization of US monetary policy). Economic growth in the European Union (EU) is also projected to accelerate this year, supported by exports and consumption as well as the bloc's accommodative monetary policy. In the developing economies, China is expected to maintain solid growth as consumption and private investment increases, while the economic rebalancing process progresses well.
The promising international economic outlook will stimulate world trade and keep international commodity prices high, including crude oil that has just reached a four-year high. Against a backdrop of increasing global economic recovery momentum, US dollar liquidity tends to tighten, resulting in the rising US treasury security yield and broad US dollar appreciation, which has prompted downside pressures on other global currencies, including the rupiah. Bank Indonesia sees several external risks, including hikes in the US Fed Funds Rate and US treasury security yields, the rising crude oil price, tension in the US-China trade, and geopolitical issues related to the cancellation of the US-Iran nuclear deal.
Meanwhile, at home, economic growth in Indonesia was solid in the first quarter of 2018 at 5.06 percent (y/y), accelerating from growth in the same period one year earlier (5.01 percent y/y), backed by increasing investment and resilient private consumption. Investment accelerated from 7.27 percent (y/y) to 7.95 percent (y/y), representing the highest rate recorded in the past five years, with growth underpinned by improving non-building investment to fuel increasing production. Strong building investment was maintained in line with ongoing government infrastructure projects. Furthermore, private consumption remains solid as campaign spending is ramped up during the approach to the local elections that are to be held in mid-2018. Tenacious domestic demand, however, has induced a surge of imports, primarily of capital goods and raw materials, while robust export performance has been maintained, albeit moderating from the previous period.
Regionally, economic gains have been reported in Java, Bali, Maluku and Papua. Consequently, Bank Indonesia's projection for full-year 2018 economic growth is kept at the range of 5.1 - 5.5 percent (y/y).
Indonesia's current account deficit narrowed in Q1-2018 (compared to the preceding quarter), backed by external sector resilience. The current account recorded a USD $5.5 billion deficit (equivalent to 2.1 percent of GDP) in the first quarter of 2018 (compared with a USD $6.0 billion deficit, or 2.3 percent of GDP, in Q4-2017). The smaller current account deficit was mainly attributed to a smaller services trade deficit together with a larger secondary income account surplus. Meanwhile, the capital and financial account maintained a surplus despite growing global financial market uncertainty. The capital and financial account surplus stood at USD $1.9 billion in Q1-2018, supported by an influx of direct investment that reflects the favorable domestic economic outlook perceived by global investors.
In April 2018 Indonesia's trade balance recorded a deficit of USD $1.63 billion, mainly due to increasing non-oil & gas imports as economic activity at home increased. The position of Indonesia's foreign exchange reserves fell to USD $124.9 billion per end-April, equivalent to 7.7 months of imports or 7.4 months of imports and servicing of government external debt, which is well above the international adequacy standard of three months. Consistent with increasing domestic economic recovery momentum, Bank Indonesia anticipates a controlled current account deficit at the range of 2.0 - 2.5 percent of GDP, which is well below the 3 percent of GDP threshold that is regarded to separate a sustainable deficit from an unsustainable one.
The Indonesian rupiah depreciated in Q1-2018, sparked by global US dollar strength. The rupiah depreciated 1.47 percent in the first quarter of 2018 and 1.06 percent in April 2018. The depreciation of the rupiah exchange rate was controlled on the back of strong domestic economic fundamentals and appropriate stabilization measures implemented by Bank Indonesia. These rupiah stabilization measures during the current period of global liquidity rebalancing was also supported by efforts to optimize monetary operations to maintain adequate liquidity.
Indonesian Rupiah versus US Dollar (JISDOR):| Source: Bank Indonesia
Indonesian inflation in April 2018 remained under control within the central bank's target corridor, underpinned by food price corrections and anchored expectations. CPI inflation stood at 0.10 percent month-on-month (m/m) in April 2018, down from 0.20 percent (m/m) in the preceding month. Annually, CPI inflation accelerated to 3.41 percent (y/y), which is within the central bank's target range for 2018 at 2.5 - 4.5 percent (y/y). Inflation was controlled in line with volatile foods deflation and lower core inflation, contrasting the slight bump in administered prices. Low and stable core inflation was linked to monetary policy consistency in terms of containing inflationary pressures. Volatile foods recorded deflation after a number of food commodities experienced price corrections. In contrast, the rise in administered price inflation was down to higher non-subsidized fuel prices. Bank Indonesia expects inflation to remain within the target corridor in 2018. To that end, policy coordination between Bank Indonesia and the central government will constantly be strengthened, primarily in anticipation of the seasonal spike in demand for volatile foods during Ramadan and Eid-ul-Fitr (Idul Fitri).
Indonesia's financial system remains stable and the bank intermediation function is improving. Maintained financial system stability is reflected in the relatively high capital adequacy ratio (CAR) of the national banking industry, reaching 22.5 percent, and a sound liquidity ratio of 21.2 percent in March 2018. In addition, the non-performing loans (NPL) ratio decreased to 2.75 percent (gross) or 1.25 percent (net) in March 2018. Maintained financial system stability has contributed positively to the improving bank intermediation function. The average deposit and lending rates in rupiah fell, though limited, to 5.84 percent and 11.20 percent, respectively, in March 2018. The banking industry reported credit growth at 8.5 percent (y/y) in March 2018, up from a pace of 8.2 percent (y/y) in the preceding month.
On the other hand, economic financing through the capital market remained high in March 2018, reaching IDR 42.9 trillion (gross), mainly from corporate bonds as well as medium-term notes and negotiable certificates of deposits. Nonetheless, the banking industry conceded weaker deposit growth in the reporting period, decreasing from 8.4 percent (y/y) to 7.7 percent (y/y). With the domestic economy gaining momentum and ongoing consolidation in the corporate and banking sectors, Bank Indonesia projects stronger deposit and credit growth in 2018 at the range of 10.0 - 12.0 percent (y/y) and 9.0 - 11.0 percent (y/y), respectively.