Interest Rate Environment: Why Bank Indonesia Left it Unchanged?
Indonesia’s central bank (Bank Indonesia) decided to hold the country’s key interest rate (BI rate) at 7.50 percent, the deposit facility rate at 5.50 percent, and the lending facility rate at 8.00 percent at the Board of Governor’s Meeting conducted on Tuesday 17 March 2015. Bank Indonesia said that its decision is in line with its ongoing efforts to push inflation back to the target range of 4±1 percent for both 2015 and 2016, and to guide the country’s current account deficit towards a healthier level at 2.5-3 percent of GDP in the medium term.
In its press release Bank Indonesia stated that it also strengthens measures to maintain rupiah and macroeconomic stability amid current high uncertainty (and volatility) in global financial markets. Rupiah stability, inflation at about 4 percent (y/y) and a healthier current account balance are the key matters for the central bank. As such, the central bank supports the Indonesian government’s efforts to implement speedy structural reforms. The government announced several reforms to strengthen the domestic economy (specifically boosting exports and limit imports), which include waiving value-added tax for shipbuilders as well as other strategic industries, imposing temporary anti-dumping taxes, increasing the mandatory biofuel content in diesel to 15 percent, providing tax allowances to export-oriented companies, expanding visa-free short-term visits to citizens of 30 new countries, merging the country’s state reinsurance firms, and requiring all commodity exporters to accept letters of credit (L/C) only in selling their goods.
Bank Indonesia said that the process of global economic recovery has continued, supported by the structural economic improvement of the US economy evidenced by increasing consumer spending, strengthening manufacturing indicators, declining crude oil prices, and a falling unemployment rate. However, this improvement also implies that there will be another chapter in the US monetary policy - higher interest rates - although the timing of implementation remains clouded by uncertainty. For sure, and we have already been witnessing this development, the US dollar will appreciate against almost all currencies, and uncertainty in global financial markets will increase. Bank Indonesia expects that further monetary tightening in the USA will result in capital outflows from emerging markets, including Indonesia. However, the European Central Bank's quantitative easing program, which started in March 2015 and will further weaken the Euro, is expected to offset part of the negative impact brought about by the Federal Reserve's monetary tightening. On the other hand, China's economy is forecast to continue to slow due to declining investment, which means that global commodity prices will have difficulty to rise.
Regarding the economy of Indonesia, Bank Indonesia detects an improvement in 2015 compared to the preceding year (when Indonesia grew at a five-year low of 5.02 percent y/y) on the back of rising private consumption (as purchasing power improves amid easing inflation), rising government consumption/spending and more investment as a result of the improving investment climate and the multiplier effect brought about by the realization of various infrastructure projects. However, Indonesian exports are expected to decline further amid falling commodity prices and lingering weak global demand. As such, Indonesia’s central bank expects to see the economy growing between 5.4 and 5.8 percent (y/y) in 2015.
A positive development is that Indonesia posted a trade surplus in February 2015 (USD $0.74 billion), primarily due to the surplus in the country’s non-oil and gas trade balance and sharply declining oil and gas imports. Due to two straight trade surpluses in the first two months of 2015, Bank Indonesia expects to see an improvement in the country’s current account balance in the first quarter of 2015. Indonesia’s structural current account deficit (which started in late 2011) is a reason why Indonesia is more vulnerable to capital outflows in times of global economic shocks and therefore the government and central bank are eager to improve this balance.
Regarding the financial account, foreign capital inflows are expected to remain strong on the back of the continued improving outlook for the domestic economy. Up to February 2015, foreign portfolio investment inflows to Indonesia’s financial market reached USD $4.3 billion contributing to the accumulation of the country’s foreign exchange reserve to USD $115.5 billion at end-February 2015, or equivalent to seven months of imports, or 6.8 months of imports plus the government's foreign debt payment (well above international adequacy standards).
However, amid worldwide bullish US dollar momentum, the rupiah exchange rate has depreciated. Moreover, the weakening of the Euro currency (a result of the ECB's quantitative easing program) adds pressures on emerging market currencies, including the rupiah. On average, the rupiah depreciated 1.38 percent (m/m) in February to a level of IDR 12,757 per US dollar. To support the stability of the rupiah, Bank Indonesia conducts market interventions as well as the purchase of government bonds in the secondary market.
A positive point is that inflation has eased and is likely to fall within Bank Indonesia’s target range of 4.0±1 percent in 2015. The consumer price index (CPI) recorded deflation of 0.36 percent (m/m), primarily caused by deflation in the volatile foods group as well as in the administered prices group. Meanwhile, core inflation declined from 0.61 percent (m/m) in January to 0.34 percent (m/m) in February, or 4.96 percent (y/y). This decline was driven by lower global commodity prices and weakening domestic demand.
Bank Indonesia sees solid financial system stability in Indonesia, supported by the resilient banking system and the relatively stable performance of financial markets. The banking industry is solid as credit, liquidity and market risks are stable, along with the support of strong capital. At the end of January 2015, the capital adequacy ratio (CAR) increased to 20.84 percent, far above the required minimum ratio of 8 percent, while the non-performing loan (NPL) rate remained low at approximately 2.0 percent. Bank Indonesia further said that, Indonesian banks’ lending growth rose to 11.5 percent (y/y) at the end of January, thus remained stable compared to 11.6 percent (y/y) at the end of the previous month. Loan growth is expected to improve in the months ahead. Meanwhile, growth in third-party funds at the end of January was recorded at 14.2 percent (y/y), higher than the 12.3 percentage point growth at the end of the previous month. Bank Indonesia estimates that bank loans and third-party funds are to grow by 15-17 percent and 14-16 percent, respectively, in 2015.
Bank Indonesia’s decision to leave its interest rate environment unchanged was expected and therefore markets reacted positively. Based on the Bloomberg Dollar Index, the rupiah appreciated 0.49 percent to IDR 13,181 per US dollar on Tuesday (17/03), while the benchmark Jakarta Composite Index rose 0.07 percent to 5,439.15 points.
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