All Eyes on the Benchmark Interest Rate
DIDIE SW
Finally, the US central bank, the Federal Reserve, raised its benchmark interest rate (federal funds rate/FFR) by 25 basis points from 0.75 percent to 1 percent on March 15, 2017 or March 16, 2017 Indonesian time.
In fact, the FFR is predicted to triple during 2017. The rate trend has become the center of attention in global financial markets, including Indonesia. Why? Because the increase in the FFR can affect the central bank\'s benchmark 7-Day Reverse Repo Rate (BI 7-Day RR), deposit rates, lending rates, the rupiah’s value against the US dollar, foreign exchange reserves as well as fund flows in the capital and financial markets.
So, what is the future direction of the BI 7-Day RR? The Federal Reserve’s Board of Governors in its meeting from Dec. 13-14, 2016 decided to raise the FFR by 25 basis points (bps) from 0.50 percent to 0.75 percent, which could affect the level of the BI 7-Day RR. However, BI kept its benchmark rate unchanged at 4.75 percent during the meetings of the Board of Governors in December 2016 and in January, February and March 2017.
BI also maintained the deposit facility interest rate at 4 percent and the lending facility at 5.5 percent. The deposit facility is for bank deposits at the central bank, while the lending facility is for the central bank\'s lending to banks that need additional daily liquidity. It was intended to cope with potential global and domestic risks.
Implications
It is possible that BI will no longer be able to keep its benchmark interest rate at the current level, especially once the planned increases in the FFR take hold. I predict the FFR will rise again in the second quarter of 2017 on the condition that economic indicators improve.
Let’s say economic growth improves, the unemployment rate declines, the number of unemployed decreases and job vacancies rise. Based on these factors, it is likely the FFR will only increase twice in 2017.
Why? Because this is the orientation period, the first 100 days in office for Trump, an entrepreneur who out of nowhere became the number one in the US. In more straightforward language, he needs time to adjust his radical policies with the bureaucracy, parliament and the existing laws.
As a concrete example of this, the three-month ban on entering the United States imposed on immigrants from seven countries (Iran, Iraq, Syria, Yemen, Lebanon, Sudan and Somalia) was stopped in its tracks by the Supreme Court. As a result, any increase in the FFR, I predict, will be around 25 bps. Again, the rate is raised if the Fed sees US economic indicators showing significant improvement.
What then are the implications of the rising FFR on Indonesia? First, should the FFR rise steadily, the BI 7-Day RR could be forced to rise. Even if the FFR will increase "only" twice, there is no guarantee that the BI 7-Day RR will rise twice. It could be more, so that it can reach the range of 5-6 percent in 2017.
It is also highly dependent on inflation and the exchange rate. As a result, the current reduction in deposit interest rates could come to an end. In fact, for the time being, deposit rates have gone down quite sharply, by 146 bps, for a tenor of one month, because of the decline in the cost of funds.
The Indonesian Banking Statistics report, published on Feb. 16, 2017, shows that the average interest rate on rupiah deposits at commercial banks fell significantly on an annual basis, from 7.58 percent in December 2015 to 6.45 percent in December 2016 for a tenor of one month. For a period of three months, the average interest rate on deposits fell from 8.15 percent to 6.79 percent and from 8.54 percent to 7.08 percent for six months. For a tenor of 12 months, the average interest rate on deposits fell from 8.58 percent to 7.35 percent in the same period.
By contrast, the average lending interest rates of commercial bank fell by just 110 bps for working capital loans and 91 bps for investment loans. While the average interest rate loans for consumer credit fell only 29 bps.
The difference between the decrease in interest rates on deposits and credits pushed the net interest margin (net interest margin/NIM) of commercial banks up by 24 bps from 5.39 percent in December 2015 to 5.63 percent in December 2016.
This was a blessing in disguise, especially for the top national banks. Their net interest margin rose amid the economic slowdown. See, the NIM of banks in the category of BOOK 1, with a core capital of less than Rp 1 trillion rose from 6.14 percent in December 2015 to 6.30 percent in December 2016.
For the banks grouped in the category of BOOK 2 (core capital of Rp 1 trillion to Rp 5 trillion), the NIM rose from 4.74 percent to 5.08 percent. Similarly, for banks of BOOK 3 category (core capital of Rp 5 trillion to Rp 30 trillion), the NIM increased from 4.49 percent to 4.77 percent and for those in BOOK 4 (core capital above Rp 30 trillion), the NIM increased from 6.36 percent to 6.50 percent.
That’s one of the reasons why the national banks were able to achieve high profits even in unfavorable economic conditions. In fact, the Financial Services Authority (OJK) has been working hard to push national banks to lower their NIM to 4-5 percent from the present industry average of 5.63 percent. To that end, the OJK offers incentives in the form of making it easier for banks to open new branches.
The purpose is to ensure that national banks are able to compete with banks in other ASEAN countries, which have NIM of 2-4 percent. However, amid the gloomy economic outlook, the incentives are not so attractive, considering that now is not the time to open new offices but to improve operations.
Second, slowly but surely, an increase in the BI 7-Day RR will push up interest rates on deposits. Throughout 2016, the growth of third-party funds (DPK) was 9.25 percent, higher than the credit growth of 7.58 percent. Although DPK began to rise, national banking liquidity was still tight.
The tight liquidity can be attributed to several factors, including big depositors such as state-owned companies, pension funds and insurance companies withdrawing most of their funds due to the fall in deposit rates.
In addition, the OJK rules require pension funds and life insurance companies to place at least 20 percent of their investments in Government Securities (SBN) no later than Dec. 31, 2016 and 30 percent by Dec. 31, 2017.
Third, the liquidity crunch could further tighten deposits, which could cause a deposit interest rate war. Unfortunately, a deposit rate war would make it hard for the loan interest rate to drop; instead it would rise, though slowly.
The logical consequence of this is that the single-digit lending rates targeted by the government are unlikely to materialize. The government hopes that lending rates will become more affordable so that the real sector can use more bank credit to support business expansion that could fuel economic growth. However, that hope has not become a reality so far, which shows that more affordable lending rates are not the only thing that appeals to the real sector.
Indeed, the government has launched more than a dozen economic policy packages, but most have not touched directly the basic needs of the real sector. In addition, it must be acknowledged that due to the gloomy economic outlook, manufacturers have limited their production. A symptom of this is the high volume of undisbursed credit, which rose by 6.95 percent from Rp 1,219.52 trillion in December 2015 to Rp 1,304.24 trillion in December 2016. In fact, loans to other banks that have not been drawn increased by a sharp 64.28 percent from Rp 7.53 trillion to Rp 12.37 trillion.
Fourth, an increase in the BI 7-Day RR could encourage hot money outflows from the financial markets. This places BI in a difficult position. It means that BI’s policy to maintain or even lower the benchmark interest may attract criticism from the public. If the BI 7-Day RR is considered "too low" by foreign investors, it could lead to an outflow of hot money back to US or to markets that offer higher returns.
A number of other developing countries offer higher interest rates, such as Argentina with 24.75 percent, Venezuela with 22.48 percent, Egypt with 14.75 percent, Nigeria with 14 percent, Brazil with 13 percent, Kazakhstan with 12 percent, Bangladesh with 6.75 percent, Vietnam with 6.50 and India with 6.25 percent, which compares to 4.75 percent in Indonesia.
Fourth, a depletion of foreign funds in the financial markets could push down the value of the rupiah against the US dollar. At the end, the central bank has to intervene in the market by disbursing more funds. This move will hit foreign exchange reserves, which have reached $119.86 billion as of the end of February 2017, rising from $116.89 billion at the end of January.
Waiting for sacred steps
Therefore, the central bank is expected to play an important role as a “sacred warrior” in monetary policy. In plain language, BI must devise a strategy in setting the BI 7-Day RR. BI’s decision to maintain, lower or raise the benchmark interest must take into consideration various implications and economic conditions in the country.
It should be noted that the removal of electricity subsidies for users of 900 VA, the rise in fuel prices and the increase in the re-registration of motor vehicles could trigger inflation. BI is also required to consider possible changes in global conditions, such as the economic effects of Trump’s presidency, China’s reaction to the threat of US protectionism in trade and the Brexit effect. BI’s steps should be market-friendly and in line with fiscal policy, one of the pillars of spurring economic growth.
PAUL SUTARYONO
Banking observer and former assistant vice president of BNI
