Hoping a lower lending rate

By: Nurkholisoh Ibnu Aman
Source: The Jakarta Post, February 16, 2009

For the third time in a row, Bank Indonesia lowered its benchmark interest rate (BI rate) cutting it by 50 basis points early this month. The BI rate is now hovering at 8.25 percent, as opposed to 9.50 percent just a few weeks ago.

For some, it is considered a bold move given the shaky position of the rupiah in the currency exchange market. A lower BI rate will mean a less attractive rupiah to portfolio investors hungry for margin. For others, however, the cut is still “not good enough”.

But for businesses, the real questions are whether and when the move will be followed by commercial banks. A lower bank lending rate is now a much needed stimulus to revive the falling economy. Bank credit is eagerly expected to grease domestic consumption amid the dwindling volume of world trade.

Since the first cut of the BI rate in December 2008, bank lending rates have yet to show any signs of easing. Customers have been agonizing over the rising loan installments they have to pay every month despite the news that inflation is falling and a more relaxed monetary regime is expected. New loan applications are refused which forces business investments to scale back and household expenditure to be deferred.

There are at least three reasons that can be offered to explain this.

First, there is a certain time lag before a monetary policy is fully transmitted to the banks’ lending rate. Research on Indonesia’s monetary transmission mechanisms shows that the BI rate still works quite well in influencing interest rates, but subject to conditions in the banking system such as liquidity and risk factors. At this particular moment, the delay is specifically affected by liquidity problems in the banking industry as a result of aggressive loan growth in the past year.

Throughout 2008, banks loans grew far beyond the banks’ ability to collect funds. High demand for bank loans stemmed from both businesses that had trouble raising funds from the capital market and households who needed extra cash to weather inflation.

As a consequence, the nation’s banking industry is now focusing on regaining a balance in their loan and deposit growth. Deposit rates are increased to attract funding while lending rates are purposely kept high to hold back the demand for loans. The effectiveness of the BI rate cut in this situation is therefore “insulated”.

Second, the players in the banking industry are falling into a “waiting game”. They are reluctant to take the first step in cutting the deposit rate because they are afraid of losing their liquidity position.

Cash-starved banks insist on offering high deposit rates, making cash-rich banks hesitant to break the trend. This in turn affects the banks’ cost of capital and further delays the banks’ ability to lower their lending rates.

The situation emanated from the lack of a level playing field among one hundred plus banks in the country. Big, medium and small banks, both local and international are openly competing with each other in collecting funds and offering loans. The huge gap in operational and financial performance among these banks has hindered fair competition and efficiency in the market.

The effectiveness of a monetary policy in such an environment is unavoidably hampered.

Third, there is virtually no decent competition from nonbank financial institutions in the country’s financial market. Almost 80 percent of financial system assets in Indonesia are managed by commercial banks, leaving only a small portion of it to nonbank institutions such as the capital market, pension funds, insurance, and joint ventures.

The lack of competition has caused inertia in the behavior of banks when responding to monetary policy. They see little incentive to adjust the lending rate swiftly since they hardly have any problem with customer demand for bank loans.

Taking into account all three reasons above, a lower bank lending rate still looks viable but may need a longer interval to make it work. Existing customers may need to prepare for paying high interest a little bit longer, while aspiring ones should exercise more patience.

The writer is an economist at Bank Indonesia. This article is his personal opinion.