Simalakama Increase in Reference Interest Rates

The tight money policy adopted by BI to maintain rupiah stability has the potential to increase economic costs.

KOMPAS/PRIYOMBODO

Employees are checking the stock of US dollars at the foreign exchange PT V8 Valasindo in Jakarta, on Sunday (21/4/2024). The exchange rate of the rupiah against the US dollar on Friday (19/4/2024), according to the Jakarta Interbank Spot Dollar Rate (JISDOR), weakened by 0.63 percent to Rp 16,280.

The policy of raising the benchmark interest rate by Bank Indonesia is like a double-edged sword. On the one hand, maintaining the stability of the rupian exchange rate. However, on the other hand, the real economic sector may become increasingly pressured.

After a full week of the rupiah exchange rate touching a psychological level above Rp16,000 per US dollar, Bank Indonesia took decisive action by raising the benchmark interest rate. As of April 24, 2024, the BI Rate reached 6.25 percent, up 25 basis points after being held at 6.00 percent for six months prior. Moreover, the current interest rate is the highest since 2016.

The step was taken as an effort to save the weakening garuda currency throughout this year. After reaching the number of IDR 15,026 per US dollar on July 21, 2023, the rupiah has not strengthened again to the range of IDR 14,000 per US dollar. The increasingly declining rupiah is said to be one of the effects of the deteriorating global economic situation due to escalating geopolitical conflicts in several regions.

On the other hand, the weakening of the rupiah has also occurred due to the strengthening of the US dollar, driven by the still high interest rates of The Fed. Until now, the Central Bank of the United States has maintained its reference interest rate in the range of 5.25-5.50 percent, the highest in at least two decades. It has not yet decreased even though The Fed has signaled several times for a reduction.

It turns out that the Fed's interest rate is still at a fairly high figure and is expected to remain for a long period of time (higher for longer).

The high benchmark interest rate causes people around the world, both individuals and corporations, to be more attracted to investing their capital in the US. The demand for the US dollar is also increasing, making the US dollar stronger.

This fact is also the background behind BI taking the decision to increase interest rates, in order to prevent the outflow of investment that is already embedded in Indonesia (capital outflow). Referring to BI records, as much as IDR 21.46 trillion of foreign capital left the country in the third week of April 2024. This figure is based on non-resident records in the domestic financial market in transactions from 16-18 April 2024. IDR 9.79 trillion was recorded on the SBN market, IDR 3.67 trillion in the stock market, and IDR 8.0 trillion in Bank Indonesia Rupiah Securities.

Also read: Reference Interest and Stimulus Needs

Without anticipation, the outflow of foreign capital may become increasingly uncontrollable. In turn, this will make the exchange rate of the rupiah increasingly powerless. In other words, an increase in interest rates is expected to curb the outflow of capital. Simultaneously, it will also help to prevent the depreciation of the rupiah.

At the same time, the policy of raising interest rates was taken as an anticipation of the skyrocketing inflation rate. Despite being within the target range of 2.5±1 percent, the inflation rate in March 2024 is getting closer to the upper limit set. It reached 3.05 percent, an increase compared to the previous month which was still held at 2.75 percent.

Nonetheless, it cannot be denied that it is not easy to control inflation at this time. This is because the recent price increases are mainly driven by domestic supply disruptions, especially for basic necessities. Crop failure and disruptions in the global supply chain have made it impossible to fulfill all aspects of supply.

Simalakama

Behind all the high hopes for the policy, it must be acknowledged that the decision to raise interest rates can also bring other potential impacts that could burden the economy. In a macro scheme, higher interest rates will suppress investment due to the higher costs that must be paid.

The reason is that every increase in the benchmark interest rate by BI will be followed by an increase in deposit and credit interest rates. With the benchmark interest rate rising to 6.25 percent, deposit and credit interest rates also rise by 25 basis points each, to 5.5 percent and 7.00 percent, respectively. The higher loan costs will have an impact on sluggish investments which will result in a decrease in Gross Domestic Product (GDP).

Borrowing the formula for calculating GDP from the expenditure side, a country's economy is supported by consumption, investment, government spending, and international trade balance. Therefore, when investment decreases, it will also lower the overall economic performance.

Also read: BI Interest Rates Rise, Bank Credit Distribution Risks Slowing

On a more realistic level in society, an increase in interest rates will also pressure the buying power of the community. Especially for property products such as houses and vehicles. Moreover, even without an increase in interest rates, people struggle to obtain housing. At the same time, the community is under pressure due to the rise in basic prices. The double burden is weighing heavily on society.

In the long term, this situation will make economic performance even more difficult. Because, if the purchasing power of the community is under pressure, aggregate consumption will decrease. Returning to the formula for calculating GDP, which indicates the country's economic performance, consumption is one of its constituent components. For Indonesia, community consumption even becomes the defense fortress of the economy, with its contribution in the range of 56 percent of the entire GDP.

This means that both investment and consumption are potentially degraded at the same time due to the increasingly high interest rates. Meanwhile, foreign trade performance, which is one of the pillars, is also in a condition that is not entirely reliable. This is because the global economy's shakeup has not yet found a point of certainty.

Even though the amount of exports in March 2024 increased compared to the previous month, its value is still lower than the same period last year, both monthly and quarterly. Between January and March 2023, Indonesia's export value reached Rp 67.06 billion US dollars, but this year it was only Rp 62.2 billion US dollars or a decrease of around 4.19 percent.

Not only in terms of expenditure, but the national GDP from the real sector also potentially affected. The increasing cost of credit will also disrupt the performance of corporations and manufacturing in the homeland. However, just like consumption, the manufacturing industry sector still remains the main pillar of the economy. Its proportion reaches 18.67 percent of the total GDP.

Also read: Era of High Interest Rates Continues, Banks Consider Adjustments

Do not let the good performance currently achieved by the manufacturing industry decline. One of the indicators is seen from the size of the Prompt Manufacturing Index (PMI-BI) which is in an expansionary level. In the first quarter of 2024, PMI-BI reached 52.80 percent, which is better than the previous quarter of 51.20 percent. The Central Bank of Indonesia sees a more optimistic outlook for the next quarter with a target of 54.31 percent.

However, it must be remembered that the current achievement is slightly deviating from the set target of 53.39 percent. With the current situation, both global and local, coupled with policies that are predicted to burden the economy such as the increase in interest rates, achieving a higher PMI-BI target also seems to be not easy to realize.

The government needs to design a safety net for the manufacturing industry so that it is not deeply affected. This is because degradation in the processing industry will affect the lives of millions of people considering that manufacturing is a capital-intensive sector. If the economic life of industrial workers is disrupted, this will in turn weaken the national economy, and so on. (R&D COMPAS)