DILEMMA WITH STRONGER RUPIAH- June 2010

INDONESIAN COMMERCIAL NEWSLETTER

June 2010

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DILEMMA WITH STRONGER RUPIAH

The Indonesian currency rupiah has gained strength against the US dollar in the past several months. Earlier rupiah fluctuated and hovered in the range of 9,200-9,300 to the dollar, but lately the currency has continued to pick up to cross the psychological level and settle below the level of 9,000.

Some are pleased with the rupiah appreciation but others were worried. Stronger rupiah signals greater market confidence in the country's economy, but on the contrary growing rupiah value will contribute to increase in production cost for export commodities and weaken their competitiveness.

Indonesia's interest rates high

Rupiah began to gain strength with growing inflows of foreign investment entering the country's capital market as well as financial market. The foreign investors buy shares, bonds and state securities such as SUN, SUKUK, and SBI.

The foreign investors are lured into the country by good performance of the country's economy which managed to expand when many other economies were badly battered by the global financial crisis. In 2009, Indonesia's economy grew 4.5 % while other countries were struggling to lift themselves out from economic recession. In entering the year of 2010, Indonesian economy grew stronger with the global economy recovering.

In addition, Indonesia has become more attractive for investors as its interest rates are relatively high compared other countries. The Indonesian central bank, Bank Indonesia, still maintains its benchmark interest rate of 6.5%. Other countries set lower interest rate. The central bank of the Philippines, for example, sets an interest rate of only 4%.

Relatively stable political and security condition, contributes to greater attractiveness of Indonesia to investors. Unfortunately portfolio investors still dominate investment in the country, although foreign director investment has also indicated healthy growth.

The strong inflows of foreign investment into Indonesia are marked by the steady rise of the Jakarta Composite Index (JCI) to peak over 3,000 points and the rupiah strengthening.

The present condition causes a dilemma for Bank Indonesia as it has to maintain the relatively high interest rate if it is to keep foreign investment in the country. However, the high interest rate makes it difficult to raise fund for investment in the country. The cost of fund is reported to be the highest in Southeast Asia.

According to a joint survey by Asian Development Bank (ADB), Islamic Development Bank IDB) and the International Labor Organization (ILO), after the regional monetary crisis in 1997, Indonesian lending rate has been the highest in Southeast Asia. The survey held to see critical hurdles in Indonesian economic development showed that in December, 2009, real lending rate in Indonesia was 10.9%. According to data from Bank Indonesia , the lending rate was even higher at 13% on investment credits.

The real lending rate was much higher compared with in other countries. In Malaysia, for example, the real lending rate was only 3.8%, in the Philippines it was also 3.8% , in Singapore 6.1% and in Thailand it was only 2.3%.

Unless there is change, the competitiveness of Indonesian economy will decline as investors would be in difficulty to secure cheap fund to finance working capital and investment.

It is not easy for Bank Indonesia to halt the rupiah rise by cutting interest rate.

In addition, stronger rupiah will result in cheaper prices of imported products which will be more competitive facing local products. In fact many companies choose to become traders importing goods to be sold in the country rather than producing goods that could not compete in the market. Exporters also will suffer a setback in business as their commodities will be less competitive in international market with higher prices of basic materials.

Bank Indonesia, however, will find not it easy to cut the interest rate on its benchmark interest rate (Bi Rate) now already at its record low. The BI rate could be cut safely only when the inflation rate is low as it also function to control inflation.

In the past two months, the country's inflation rate has scaled up. In the first half of the year, the inflation rate reached 2.42% and inflation year-on-year in June was 5.05% or already about the same level as the target of 5%+1% set by the central bank for this year. The figures, therefore, show that the central bank would not be easy to cut the interest rate without triggering a surge in inflation rate.

Apart from triggering inflation, a cut in interest rate is also feared to cause a reverse in the foreign capital flows. The result could be a decline in confidence in the country's economy.

So far, a decline in BI rate has not directly been followed with a proportional cut in lending rate. Therefore, a cut in the BI rate would not be effective enough to bring down lending rates.

The problem is until now the central bank has not found the right way to force banks to cut their lending rate and boost credit expansion. The central bank plans to set a minimum LDR (loan to deposit ratio) and banks failing to meet the minimum level will have their minimum reserve (GWM) in the central bank raised The plan drew strong protest from bankers as it is feared to cause liquidity problem or forcing banks to slow down efforts to raise third party fund rather than expanding credits.

Meanwhile, the business sector wants that a ceiling is set on net interest margin (NIM) as they consider the NIM set by banks is too high. The central bank also has no easy answer to the demand. High NIM is said to be one of the factors causing large amount of approved credits not drawn by borrowers. In Indonesia, NIM is slightly above 6% as against only 3%-4% in neighboring countries.

The fact that the condition of big and small banks is not the same makes it difficult to set a certain ceiling for NIM. The levels of NIM vary depending on their market segments. The fact also shows that the structure of the country's banking industry is not well set that it is not easy to classify banks by their market segments.

Currently, Bank Indonesia is still analyzing data about funds that have to be spent by banks in their operations. The central bank asked banks to provide the details specifying cost of promotion, building rents, etc. The data are needed by the central bank to draft a regulation which will serve as a reference for banks to improve certain costs.

The central bank, therefore, has failed in the past two years in encouraging banks to cut their lending rates and increase lending. With its duty to control credits the central bank tends to maintain its benchmark interest rate allowing banks to keep their high lending rates. With that tendency, rupiah is expected to continue to scale up or remain stable at the present level.

Role of the government

With no much choice to take it is difficult for the central bank to work alone in brining down the interest rate. Bank Indonesia is not the only agency charged with the task of keeping the inflation rate low as inflation is determined by a number of factors including inefficiency in goods distribution and delay in shipments.

For example, the highways along the northern part of Java have been badly damaged and repairs are made ahead of Idul Fitri when the roads would be busier resulting in delay in goods distribution needed during the Idul Fitri celebrations. Normally shipment with trucks from the western end to the eastern end or vice versa in Java would take 1-2 days, but now it would need 3-4 days.

In the past several months the prices of various essential commodities like chicken meat and vegetables have soared merely on delay in supply. As a result the country's inflation rose that it is feared inflation may exceed the target figure set by the government.

Controlling inflation only with monetary instruments held by the central bank, would be difficult as the cause of the inflation is an increase in cost. Raising the interest rate would draw protest form the business sector. The role of the government is important to give greater guarantee in delivery of goods by removing hurdles in distribution .

Development and improvement of road infrastructure is therefore, urgent to facilitate transport to better guarantee delivery and improve the competitiveness of export commodities. The government should address the problem more seriously by cracking down on illegal levies causing by high cost economy.

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