Indonesia: Central bank on the move Asia Pacific Economic Outlook, Q1 2017

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Bank Indonesia has cut interest rates six times this year; but now, it is likely to keep them unchanged until early 2017, as the volatility in financial markets is not likely to ease until there is more clarity on the US Federal Reserve’s interest rates and the new US administration’s agenda.

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On November 22, Bank Indonesia (BI) announced that it would ease reserve requirement rules for banks from 2017 to reduce volatility in money markets.1 BI’s latest move comes on the heels of six rate cuts this year to stimulate the economy. With GDP growth hovering around 5.0 percent—much below President Joko Widodo’s 7.0 percent target—and the government’s fiscal push losing steam, BI has increasingly taken on the mantle of aiding economic activity. Unfortunately, the central bank has not been able to push up lending by much, with lenders not yet passing on the rate cuts proportionately to borrowers. BI is hoping that this scenario will change and both consumers and businesses ramp up borrowing. The latter, in particular, will aid investments, a key to long-term growth.

BI will likely hold its easing spree until Q1 2017

In October, BI cut its policy rate—the reverse repo rate—for the sixth time this year by 25 basis points to 4.75 percent. BI’s easing spree has been facilitated by a drop in inflation, which is now tending toward the lower end of the central bank’s 3–5 percent range. The easing spree appears well timed, given the current bout of currency weakening post the US presidential election on November 8. Between November 8 and November 21, the Indonesian rupiah has fallen by about 2.5 percent against the US dollar, reversing half of its gains since the beginning of the year (figure 1).2

The rupiah has weakened against the US dollar since November 8

The rupiah, of course, is not alone; a host of other Asian currencies witnessed losses in recent days. While uncertainty related to the new US administration’s policies is one factor weighing on global markets, a rise in bond yields and inflation expectations in the United States has set the stage for a rate hike by the US Federal Reserve (Fed) in December. As a result, there has been a sharp outflow of capital from emerging markets, including Indonesia. According to Bloomberg, foreign investors sold about $1 billion of Indonesian debt and $444.2 million in domestic equities between November 8 and 19, 2016.3

The volatility in financial markets is not likely to die down soon, at least not until there is more clarity on the Fed’s interest rate path and the new US administration’s economic agenda. BI will hence be more wary of cutting rates in the near term, even as it keeps track of the weakness of the rupiah and its indirect impact on inflation—the central bank has already intervened in the currency markets to stem the rupiah’s slide. As it did in its latest policy meet in November, BI is likely to keep interest rates unchanged until early 2017.

It is not only external conditions that will force BI to adopt a wait-and-watch approach. The central bank would ideally want to observe the impact of its six rate cuts. Banks, for example, have not cut lending rates proportionately.4 Bank credit, as a result, has not gone up as desired. In September, for example, total credit by commercial banks went up 6.4 percent year over year, the slowest in about seven years. Also, banks have been wary about rising bad debt. The share of nonperforming loans in the total credit has been going up since December 2013, and was 3.1 percent in September (figure 2). The supply side of bank credit is therefore facing headwinds not likely to go away soon.

Loan growth has slowed, while nonperforming loans are going up

GDP growth not pushing far beyond 5.0 percent

In Q3, the economy grew by 5.0 percent year over year, marginally lower than the 5.2 percent rise in Q2. Private consumption continues to be the key growth driver, with household spending rising 5.0 percent. Investments, however, disappointed in Q3, with growth in gross fixed capital formation slowing to 4.1 percent from 5.1 percent in the previous quarter. While investment in buildings remains healthy, spending on machinery and equipment fell by 6.8 percent, the third consecutive quarter of decline. Part of this is likely related to a drop in government spending (-3.0 percent) in the quarter, with the construction of many key projects suffering delays.5

Exports continue to be Indonesia’s Achilles’ heel, with the sector contracting for the eighth straight quarter in Q3. Slowing growth in key markets, especially China, and weak commodity prices have weighed on Indonesia’s exports in the past two years. In Q3, for example, oil and gas exports contracted by 8.2 percent. However, a rise in hard metal prices helped the mining sector post a small expansion in Q3 (0.1 percent), the first rise in seven quarters. Coal mining activity, however, continued to remain subdued (figure 3).

Mining growth turned positive for the first time in seven quarters in Q3

Consumers to the rescue

Consumers will continue to be the flagbearers of the economy in the near term. Household spending growth has averaged 5.0 percent this year, in line with trends in 2014 and 2015. Consumers have benefitted from a healthy labor market—unemployment (non-seasonally adjusted) was 5.6 percent in Q3, lower than a year ago—and easy monetary policy. Slowing inflation will also aid household consumption due to real income gains. Headline inflation was 3.3 percent year over year in October, about 3 percentage points lower than a year before. No wonder, then, that consumers are upbeat, with consumer confidence in October rising to its highest level since March 2015.6

Support from consumers will come in handy for a government that has had to cut spending in order to keep the fiscal deficit in check. The government will, however, find new inflows of funds from a tax amnesty law passed in July; in the first of three phases of the amnesty that ended in September, the government collected about $7.5 billion, amounting to 58.9 percent of the intended target.7 Improvement in fiscal management could aid the government’s bid for a movement from junk rating to investment grade. If this is coupled with a rise in the ease of doing business—Indonesia moved up 15 positions in the World Bank’s latest rankings—it will add to positive sentiment about the economy.8 Global investors will definitely be waiting and watching with interest.