Stability vs Stimulus
During the Bank Indonesia (BI) board of governors meeting on 19-20 June 2019, the central bank again decided to maintain its benchmark interest rate at 6 percent. This means that the BI’s interest rate has remained unchanged for eight consecutive months.Bank Indonesia continued to serve bitter pills to the economy – of course, on the pretext that the decision was necessary to maintain economic stability. In fact, the rupiah exchange rate and inflation has remained relatively stable this year.
The anomaly indicates the existence of crucial problems that must be addressed and resolved structurally and massively, as partial and conventional approaches are no longer adequate. If not, Indonesia will continue to face an endless dilemma.
Included among these problems are pressures on the balance of payments and the trade deficit. The current account deficit was 2.6 percent of gross domestic product (GDP) in the first quarter this year. The trade balance recorded a deficit of US$8.57 billion in 2018. In fact, the trade balance continued to suffer a deficit of $2.14 billion through May 2019.
As the United States-China trade war is escalating, commodity prices are expected to remain under pressure. This means that it will be difficult to improve Indonesia\'s export performance.
Finally, in order to compensate for the risks of the trade deficit, the capital account balance should be positive. The problem is that direct foreign investment has declined. Therefore, the interest rate should be high in order to lure foreign funds in the form of hot money or portfolio investments.
The question is, to what extent will the policy be effective in maintaining economic stability? In response to coping with the impact of the trade war, many countries have eased their monetary policies to revive the real sector, by reducing the benchmark interest rate to provide stimulus.
The US Federal Reserve (the Fed), which was expected to maintain its interest rates until the end of 2020, is instead planning to lower its benchmark rate before the yearend.
If Indonesia continues to maintain high interest rates, the real sector will become increasingly uncompetitive. High interest rates will increase the costs of funds, which will create a high-cost economy and make domestic products uncompetitive so they are unable to compete with imported goods.
In the midst of the escalating trade war, of course, many countries – especially China –are looking for a safety net. The vast Indonesian market will become an easy target for imported goods, which means that trade deficit pressures of the will become even more of a concern.
This is not to mention that the lower interest rates abroad could cause an increase in foreign loans. The foreign debts of the private sector have the potential to rise again. If the investments are not export-oriented, the pressures on the rupiah will increase.
Alternative
To compensate for this bitter pill, BI has also launched an alternative, “herbal medicine”, by reducing the minimum statutory reserves (GWM) requirement by 50 basis points (bps), or 0.5 percent. The reserve requirement for conventional commercial banks is 6 percent and 3.5 percent for Islamic banks. This means that the amount of funds banks must placed in a BI checking account has been lowered. This step is expected to ease the liquidity of banks and contribute around Rp 25 trillion towards increasing bank loans.
Cutting the reserve requirement is expected to effectively ease liquidity. A reduction in the benchmark interest rate is not always followed by a decline in bank lending rates.
The problem is, will the lower reserve requirement ease liquidity? The answer is, again, a vicious circle. A crucial point to encourage credit expansion is reducing lending rates. It is proven that undisbursed loans remained high until April 2019, comprising 30 percent of all loans.
Moreover, the government’s policy to cut taxes on interest incomes from government bonds will place banks in a more difficult situation.
Banks also have to compete with the government to fight for funds from the market. A battle over interest rates among banks cannot be avoided amid the liquidity drought. Moreover, the government’s policy to cut taxes on interest incomes from government bonds will place banks in a more difficult situation.
As a result, bank credit growth in April 2019 fell slightly to 11.1 percent from 11.5 percent in March 2019, while third-party funds only grew 6.6 percent in April, down from 7.2 percent in March.
Meanwhile, as part of the investment incentives for the real sector, the government is lowering the corporate income tax from 25 percent to 20 percent, especially for foreign investments. The main obstacle to increasing investment is not taxation. The critical issue is ease of doing business in Indonesia, especially in relation to contractual certainties and starting businesses, for which Indonesia ranked respectively 146th and 134th among the 190 countries in the World Bank’s 2019 ease of doing business index. Indonesia ranks 112nd in paying tax. Korea also imposes a corporate income tax of 25 percent, but it ranks 21st. This means that tax rates alone do not define incentives.
The crucial factors are tax administration, transparency and regulatory consistency. The most obvious example is the simplified tax payment system, such as the facility to pay taxes through bank transfers, which encourages taxpayers to meet their tax obligations and improve tax compliance.
The reduced corporate income tax rate will make it difficult to achieve the tax revenue targets. The cut will result in a decline in this year’s projected income tax revenue, from Rp 265.78 trillion to Rp 212.63 trillion.
It is very likely that the government will lose about Rp 53.16 trillion in corporate income tax revenues due to the reduced tax rate. This means that the budget deficit will further increase to Rp 349.16 trillion, or 2.12 percent of GDP.
Another consequence is that the government will face a dilemma in whether to increase debts or to reduce spending. Cutting spending, aside from being difficult, can negate the fiscal stimulus, while increasing debts will increase the risks to fiscal sustainability.
Conversely, if pressure is maintained on the brake pedal, the car will not have the power to propel it forward and upward.
As with driving along an ascending road, the driver must press harder on the gas pedal. Without increased power, the car will roll down the road. This means that educing interest rates without implementing effective fiscal incentives to drive the real sector will risk financial stability. Conversely, if pressure is maintained on the brake pedal, the car will not have the power to propel it forward and upward.
The government must "detoxify" the various barriers to investment in the real sector, including by quickly resolving the inefficiencies that have made airline tickets very expensive, so as not to incur additional logistics costs.
ENNY SRI HARTATI, Senior Researcher, Institute for Development of Economics and Finance