Indonesian Strategy:BI policy rate set for a shake-up

Event

Local media reported Bank Indonesia (BI) is planning to de-emphasise/moveaway from the use of its existing BI reference rate, due to a lack of policytransmission mechanisms that render the rate largely ineffective. Instead, BIis looking to move towards the use of a 7-day repo instrument for settingmonetary policy. The implications are potentially material, and could eithercause investors to realise that Indonesia’s de facto real policy rates arealready much lower than generally understood, and/or result in monetarytightening. The shift may also be a reflection of political pressure to cut rates.

Impact

§ We have long argued that BI’s headline policy rate is largely irrelevant, as ithas virtually no bearing on market interest rates. In most countries, the policyrate reflects the rate at which the central bank intends to set short-term moneymarket rates through intervention/open market operations. However, inIndonesia, no such intervention occurs because money markets are underdeveloped.Instead, it is the FASBI rate (the rate at which banks can depositovernight money at BI) that acts as the de facto policy rate, by determiningbanks’ risk-free opportunity cost of capital (riskless and perfectly liquid), andhence which influences the rate-setting decisions of commercial banks.

If the above policy change does occur, there will be one of two potentialoutcomes (or some combination thereof). Firstly, if the 7-day repo rate is setat levels close to the FASBI rate, it will cause investors to realise thatIndonesia’s de facto policy rate is currently only 4.75% (i.e., only marginallypositive in real terms), not 6.75%, and that there is consequently much lessroom for additional monetary stimulus than is generally perceived. Indeed, wehighlight overleaf that Indonesia’s de facto real policy rates have in fact beennegative for most of the past three years – something poorly understood.

The second possibility is that the 7-day repo rate is set at levels somewhere inbetween the FASBI rate and BI policy rate – perhaps 5.50%. If so, and if the7-day repo rate does become the primary determinant of banks’ opportunitycost of capital, this will actually have the effect of tightening monetary policyfairly dramatically (from 4.75% de facto rates to 5.50% in the above example).

The policy change may have come in response to the growing politicalpressure BI has been experiencing to cut Indonesia’s ‘high’ policy rate. BI islikely aware that the de facto rate is actually already only 4.75%, and thatcutting it further would therefore risk tipping Indonesia’s real rates back intonegative territory. The policy shift may be a way for BI to tacitly appear to befurther reducing rates when in fact it may be tightening them in substance.

Outlook

The bulls have been arguing that Indonesia is set for an economic recovery in2016 on the back of rising government spending and BI easing. However, wehave long argued that (1) real rates are already very low in Indonesia; and (2)that there is no room for fiscal stimulus, because the deficit has already beentrending above the 3% fiscal deficit cap since mid-2015. Unfortunately,Indonesia is out of quick, easy fixes, and growth from here will have to bedone the hard way – through reforms and measures to boost productivitygrowth. This is hard, slow, risky, and relatively unprofitable growth.Meanwhile, the JCI is pricing in both high growth and high profitability.