Analysis: Is the central bank (BI) interest rate still central?

Helmi Arman
, Economist | Mon, 11/17/2008 10:48 AM | Business

Bank Indonesia's policy rate may be close to being rendered defunct. But capital restrictions introduced recently appear to be a step in the right direction.

Nowadays, new realities emerge by the hour. The economics of the world today work very differently compared to say a year, month or even a week ago. And many of the challenges we're facing now (of which most are not for the better) are unfortunately here to stay.

The break in connection between policy rates, money market rates and bank lending rates is just one of those many challenges.

For example, in the United States, the overnight policy rate of the Federal Funds has been brought down to 1 percent, from around 5 percent when the mortgage crisis first emerged in 2007. Yet the rates at which banks charge each other for short term borrowing, as indicated by LIBOR, remain unusually elevated up to today.

And the 30-year mortgage rate, a proxy for bank lending rates in general, remains stubbornly high.

Indonesia's economic fundamentals contrast markedly (in a positive way) when compared to the United States. However the global economic turmoil has had far-reaching implications, and signs of a similar disconnect between policy rates and bank rates are also emerging here at home.

Why should we be concerned about this? Policymakers, or particularly central banks, have very few instruments at their disposal to counter an economic downturn. Interest rates are often the main tool of the trade. So if they don't work like they're supposed to, impending economic downturns could easily become more protracted.

Since July, the commodity price bubble has popped and the rupiah has depreciated significantly along with other emerging market currencies. This has been accompanied by a variety of complications.

What started out as an environment of tight liquidity and rising interest rates as a result of strong loans growth has now evolved into an atmosphere of increased wariness among banks -- even domestic ones.

BI's move to lower statutory reserve requirements last month from 9 percent to 5 percent made available a substantial amount of liquidity. But contrary to many expectations, the move did little to jump-start interbank lending activity and bring down deposit rates.

For many banks, in-house limits on interbank lending are still kept on a leash, and preference is currently on having huge amounts of liquidity at one's disposal. This is evident when looking at the higher than usual daily balances in BI's very short term/overnight deposit facility.

Banks have also become wary of making longer term placements, even at BI. The one-month SBI rate continues to rise compared to the overnight policy rate. The spread between the two is now at over 1.6 percentage points, compared to just 0.25 percentage points last June.

Meanwhile, interest rates on customer deposits remain high amid fears of capital flight, be it a move of deposits among domestic banks, or a move away from local currency deposits.

It is worth noting that the latter is a function of exchange rate volatility. High net worth depositors are usually more aware about the real value of their deposits. So as the currency weakens, a higher interest rate is needed to prevent them from going for the dollar.

As incoming data points to a potentially substantial impact from the global turmoil, the government and central bank are now under pressure to act decisively to counter the forthcoming economic downturn.

They were probably right to lift their foot off the breaks last week by ending their wave of policy rate hikes. But the issue now is on whether or not there is power when they start flooring the pedal.

If current conditions persist, the time it takes for policy rate cuts to affect real sector economic activity could be much longer than usual. And the central bank may finally find out that it has lost its grip on the real economy.

There are a couple of measures that could be taken in anticipation of this. The good thing is that one had already been introduced last week, as the central bank put in place restrictions on speculative foreign currency purchases.

These restrictions should help in curbing resident capital flight, which we suspect have been increasingly responsible for the latest episodes of currency market turbulence.

However restrictions alone are not enough. The government should go further by abolishing the Rp 2 billion size limit on guaranteed deposits. It may also be a good idea to extend the guarantee to cover interbank placements.

All this needs to be done fast. In times of crisis, we may well be better off overreacting, rather than find ourselves trying helplessly to climb up after a long fall.

The writer is an economist at PT Bank Danamon Indonesia

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