Earlier this year, Bank Indonesia officials informed that the existing BI rate would be replaced as it failed to influence markets significantly. The 7-day reverse repo rate is the rate on government bonds (surat utang negara, SUN) sold by Bank Indonesia to local commercial banks with the requirement that these bonds are bought back by the central bank within a seven-day period. The existing BI rate, on the other hand, has a tenor of one year, implying that the 7-day reverse repo is much more flexible to incorporate the latest dynamics in the nation's financial markets.

However, linking the benchmark monetary tool to government bonds (and thus to the financing of the government's state budgets) causes concern whether Bank Indonesia can remain independent in terms of monetary policy making. For the central government there is the dilemma of (1) offering high SUN coupon rates to attract investors but coming at higher costs, or (2) lower SUN coupon rates, implying lower costs, but somewhat discouraging investor appetite.

The reverse repo rate is currently set at 5.25 percent, significantly below the existing BI rate at 6.50 percent. However, Bank Indonesia emphasized that adopting the 7-day repo rate does not imply further monetary easing. Since the start of 2016 Bank Indonesia has cut the existing BI rate from 7.50 percent to 6.50 percent through four rate cuts (each involving a 25 basis point cut).

Despite Bank Indonesia's monetary easing since the start of the year, Indonesia's lending rates failed to lower accordingly or significantly. This points at weak transmission of the existing policy rate to the money market, banking industry and real sector of Indonesia. Bank Indonesia is convinced that the 7-day repo rate has a stronger correlation with the money market rates, is transactional or tradeable on the market and increases financial market deepening. On the one hand, it is positive that the central bank will implement a better benchmark. On the other hand, it implies that the central bank of Indonesia has been working with an inefficient benchmark monetary tool for the past 11 years.

The timing of implementation of the new benchmark is considered perfect as both Indonesia's inflation and current account deficit have improved markedly over the past year. Contrary to the existing BI rate, the 7-day reverse repo will also reflect Indonesia's inflation rate more accurately. In July 2016 Indonesia's inflation stood at 3.21 percent (y/y).

The 7-day reverse repo should lead to lower lending rates and falling net interest margins of Indonesian banks. Thus, shares of locally-listed banks may feel temporary selling pressure after the implementation of the new benchmark tool.

Regarding Bank Indonesia's deposit facility rate and lending facility rate, the central bank will safeguard stable fluctuation between a maximum of 75 basis points above the 7-day reverse repo rate and a minimum of 75 basis points below the reverse repo.

New BI Seven-Day Reverse Repo:

Enhance effectiveness of monetary policy changes to influence market liquidity
Replaces the current reference rate (BI rate) that is not directly tied to the money markets
Encourages lower lending rates of local banks