INDONESIA RATE CUT – Very aggressive, CLSA

Bank Indonesia cut its policy rate by 25bp to
5.75%.This was an aggressive move since it
was combined with a 25bp cut in the floor of
the interest rate corridor. Bank Indonesia has
effectively cut rates by 150bp over the last four
to five months.
BI cut the policy rate by 75bp in 4Q11 to 6%. It
then cut the overnight deposit facility (Fasbi
rate) by 50bp to 4%. This is the floor of the
interest rate corridor, with the roof represented
by the overnight lending facility at 6.75%.

Since mid-2011, the interbank rate has been
tracking the floor (Fasbi rate) rather than the
policy rate and therefore dropped by an
equivalent 50bp in January (first chart). If BI
had just cut the policy rate yesterday, it would
not have been that significant. However, it cut
the floor by 25bp as well to 3.75%. Interbank
rates will now likely follow with a 25bp decline.
The economy is strong and, arguably, does not
need this aggressive monetary stimulus.
Investment was growing at a 20% QoQ
annualised pace in 4Q11. Bank Indonesia
justified the 25bp cut on ‘the decreasing global
economic prospect in line with prolonged euro
area crisis and slowing down in emerging
market economies’.
Bank Indonesia has been unsuccessful in
getting the banks to lower their lending rates
but is determined to maintain high credit
growth. The huge foreign capital inflows that
spilled over into domestic liquidity may dry up
this year. In response to this concern, Bank
Indonesia has shown that it will maintain
buoyant domestic liquidity, keeping the cost of
capital low and reducing the incentive for the
banks to park their funds with the central bank.
It will rely on competition between the banks to
steer lending rates lower.
If that were the end of the story, we would just
shrug off yesterday’s rate cut as ‘a little over the
top’. However, the rate cut was in the face of a
renewed inflation threat. The rising oil price has
been raising fuel subsidies which may force the
government to hike the domestic fuel price. Bank
Indonesia insisted that it ‘will continue to be
vigilant on the impacts of government policy
regarding energy’. So, yes, Bank Indonesia is alert
to the risk of a domestic fuel price increase but it
cut interest rates anyway. Investors may not find
this very reassuring.
Our projection for inflation, currently at 3.7%, is
shown both for the base case, with no fuel price
increase, and for the risk case, with an assumed
40% domestic fuel price increase in July (second
chart). In 2008, the 40% fuel price increase
resulted in a 5 percentage point inflation spike. On
this occasion, given the deflationary global
environment, we would expect a 3 ppt inflation
spike. This would raise our inflation forecast to
6.8% by end-2012 and 7.8% by end-2013.

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