• The move by Bank Indonesia (BI) to cut interest rates for the third successive month reflects growing concerns about the country’s fiscal situation. Government revenue looks set to fall short of its target by IDR150tn-250tn ($11.4bn-19bn) this year.
  • We think the central bank is unlikely to cut benchmark rates in April unless there is clear evidence that the commercial banks are beginning to follow its lead, though it has the scope to do so if it deemed it necessary.
  • We do not think commercial banks have sufficient incentive to cut their lending rates until there is greater certainty about the direction of the government’s economic policy, which is in doubt amid rumours of another cabinet reshuffle as coalitions realign.

BI cut its benchmark interest rate 25 basis points – to 6.75 per cent – for the third successive month last week. It also cut its deposit facility rate 25 basis points to 4.75 per cent and its lending facility rate 25 basis points to 7.25 per cent. 

We think BI’s move – which comes amid a general improvement in the outlook for Asean – was primarily motivated by domestic concerns. 

Concerns about rupiah appreciation

Successive rate cuts always carry the risk of fanning inflation, but so far this year price increases have been modest. Inflation remained low at 0.42 per cent YTD on March 18 aided by cuts to electricity tariffs at the start of the year.

The speedy appreciation of the rupiah clearly played a role in BI’s decision to cut rates again, with the central bank hoping to put downward pressure on the exchange rate.

The rupiah had risen 5 per cent YTD against the US dollar as of March 21, while government efforts to encourage local businesses to conduct transactions in rupiah rather than US dollars has pushed up demand for onshore rupiah, with US-dollar-financed domestic transactions totalling just $3bn in January, down from a monthly average of $7.3bn in 2015.

Offsetting fiscal shortfall

However, the main driver behind the BI’s aggressive monetary loosening is the impact on the economy of the government’s stuttering progress on fiscal spending, with parallel concerns over the short-term outlook for fiscal revenue.

Government revenue looks set to fall short of the official target by IDR150tn-250tn this fiscal year because of:

  • the slump in oil prices; and
  • parliamentary delays to efforts to implement a tax amnesty plan, which would encourage wealthy Indonesians to declare offshore asset holdings at a tax rate of just 1 per cent. 

The resultant slide towards a fiscal deficit recently prompted the energy ministry to propose a further cut in diesel subsidies.

Cuts impact likely to be limited

BI’s move is, of course, intended to encourage commercial banks to lower lending rates and boost credit growth, which has been flagging. In a similar vein, BI has been easing its open market operations rates to try and boost commercial bank liquidity (see chart).

However, we do not expect a surge in lending. Over the last decade, there has been little direct correlation between BI’s benchmark rates and commercial rates because of banks’ reluctance to assume greater levels of risk. And there is little to suggest this dynamic has changed.

Average investment lending rates at commercial banks have been generally creeping upwards over the last five years. Elsewhere, the average rate for consumer loans hit 13.94 per cent in January, the highest rate since 2011 (see chart).

Deposit rates, meanwhile, have declined, but only slightly (see chart), indicating that banks remain focused on shoring up their capital adequacy ratios.

We are also doubtful about the cut’s impact because we expect non-performing loan ratios to rise, particularly at medium-sized lenders, which could push up average credit costs.

BI may hold back on further cuts

In sum, we do not think commercial banks have sufficient incentive to cut their lending rates until there is greater certainty about the direction of the government’s economic policy, which is in doubt amid rumours of another cabinet reshuffle as coalitions realign.

BI still has the economic scope to cut benchmark rates by 25 basis points one more time in April. However, we think it will probably put any additional cuts on hold unless there is clear evidence that commercial banks are beginning to follow its lead.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.
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