Normalizing Interest Rate

Last week, the rupiah strengthened against the US dollar over three to four consecutive days, giving fresh hope that Bank Indonesia would not raise its benchmark interest rate (the 7-Day Reverse Repo Rate) during the board of governors meeting this week.

KOMPAS/PRIYOMBODO

An employee of money changer PT Valuta Artha Mas serves a customer buying foreign currency in Jakarta, Monday (17/9/2018). Based on the Jakarta interbank spot dollar reference rate, the rupiah changed hands at Rp 14,859 per US Dollar on Monday (17/9).

Last week, the rupiah strengthened against the US dollar over three to four consecutive days, giving fresh hope that Bank Indonesia (BI) would not raise its benchmark interest rate (the 7-Day Reverse Repo Rate) during the board of governors meeting this week.

However, on Monday, the US dollar suddenly strengthened against nearly all currencies, including the rupiah, which traded at Rp 14,867 per US dollar. Among Asian currencies, the US dollar rose 0.36 percent against the rupiah, weaker than the Korean won (0.46 percent) but higher than the Indian rupee (0.31 percent), the Thai baht and Taiwan dollar (0.22 percent each), the Philippine peso (0.18 percent), the Chinese yuan and the Malaysian ringgit (0.15 percent each) and the Singapore dollar (0.14 percent). The exchange rate remained unchanged for the Hong Kong dollar and the Japanese yen.

According to analysts, the US dollar rose this time due to an escalation in the US-China trade war and the implementation of Brexit (the separation of Britain from the European Union). As a result, global investors played safe by holding onto US dollar-denominated assets. However, I suspect there is another factor: the Fed’s meeting this week (Sept. 25-26), when it is expected to raise interest rates further.

US President Donald Trump actually does not want the interest rate to be raised, because this would strengthen the US dollar further, which would then affect the competitiveness of US products. However, it appears that the Fed will go ahead with its plan.

Why? First, the declining trend in US inflation, which fell to 2.7 percent in August from 2.9 percent in June and July. However, this is not good enough because the ideal inflation for the US is "around 2 percent". Therefore, interest rates need to be raised again to lower inflation.

Second, the recent US economic data is rather impressive. Economic growth, based on the performance of the second quarter, is expected to reach 4.2 percent this year, the highest growth since 2014. The projected growth is also supported by improvement in US employment in July, when about 201,000 new jobs were created. The number of new jobs in the US has continued to increase since January, increasing to 324,000 from 147,000. Unemployment in the US is relatively low at only 3.9 percent.

The improvements in economic growth and employment have raised investor confidence to hold onto the US dollar. On the other hand, it also raises the Fed’s confidence to raise the benchmark interest rate, which is currently at 2 percent.

The Fed needs to immediately implement a normalization policy, because the benchmark interest rate is still lower than inflation. The current negative real interest rate of 0.7 percent is considered unfair for savers.

With such conditions, it is most likely that the Fed will raise the interest rate further during this week’s meeting. As usual, the market has begun reacting before the Fed actually raises the interest rate. Therefore, the best option for BI is to raise its benchmark interest rate so that it will not be much lower than the Fed’s rate.

The Fed\'s lowest benchmark rate was 0.25 percent. It is 2 percent now and is expected to be raised to 2.5 percent; BI\'s lowest interest rate was 4.25 percent and its current rate is 5.5 percent. This means that the Fed has raised its benchmark interest rate by 1.75 percentage points, while BI has only raised its interest rate by 1.25 percentage points. In other words, BI has not fully implemented the ahead of the curve policy as BI Governor Perry Warjiyo had planned. The BI interest rate still lags somewhat behind the Fed’s. This fact explains why the rupiah exchange rate recently fell to as low as Rp 15,000 per US dollar, which was considered to be an inappropriate level.

The rupiah is too low (undervalued). During the 1998 crisis, the rupiah was also undervalued and helped increase exports and reduce imports toward a surplus in the trade balance.

Inflexible

However, the situation today is different. The weakening rupiah cannot contribute immediately to a trade surplus because of three combined factors. First, our exports are not flexible to changes in the foreign exchange rate, because most are primary commodities. Second, other currencies (including competitors’) are also depreciating at the same time, so that their products are equally cheap. Third, the deficit in Indonesia\'s oil and gas sector has deepened because our oil production has continued to decline (to less than 800,000 barrels per day), while world oil prices have risen to US$77 per barrel.

Increasing BI\'s benchmark interest rate is actually undesirable, and the policy may hurt the efforts of the Financial Services Authority (OJK) to encourage credit expansion beyond 10 percent. Similarly, non-performing loans (NPLs) are expected to increase above 3 percent.

KOMPAS/HERU SRI KUMORO

A. Tony Prasetiantono

However, that is the price that must be paid in the effort to stabilize the rupiah. Compared to the cost of protecting the rupiah during the 1998 crisis, it is far lower. During the crisis, BI once raised the savings rates of commercial banks by 60-70 percent on the advice of the International Monetary Fund (IMF), which resulted in insolvency and bankruptcy.

If the Fed raises its interest rate again, it will reach 3.25 percent next year. It is likely that BI will also respond by raising its interest rate to 6.5 percent. However, if US inflation can be reduced soon, for example to 2 percent, the Fed may delay the rate hike. The Fed\'s interest rate may rise to a maximum of only 2.75 percent so that the BI interest rate can be limited to a maximum of 6 percent. This is the level that is considered the "new normal".

Another fundamental difference is that the banking industry, which is at the heart of the economy, has changed. In 1998, all banks were insolvent and had to be injected with fresh capital of about Rp 650 trillion ($43.60 billion today). Presently, almost all banks are healthy and are recording profits of Rp 20 trillion to Rp 30 trillion.

A. Tony Prasetiantono, Head of the Center for Economics and Public Policy Studies, Gadjah Mada University