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As differentials between domestic and U.S. interest rates
narrow, the central bank may be only a stone's throw away from deciding
whether or not to further cut rates.
In this regard, policy may not necessarily be confined to historical
figures; however, potential exchange rate volatility remains a factor
that needs to be fully considered.
The pace of recent interest rate cuts came as a surprise to many. Since
May, the central bank has lowered the Bank Indonesia reference rate (or
BI rate) by two-and-a-half percentage points, the last reduction being
a half percentage point cut to 10.25 percent. This is far from the
forecasts made at the beginning of the year by economists, including
myself, who expected the BI rate to be standing at around 11 percent by
the year-end.
By looking at the inflation-adjusted, or "real", interest rate, it
looks as though the central bank still has some way to go. The current
spread between the BI rate and the inflation rate, if compared to the
market consensus of 6.6 percent inflation next year, stands at nearly
three-and-three-quarter percentage points, which is still quite high.
However, it remains to be seen whether the BI rate can go anywhere near
the seven percent lows they were at last year. One often cited reason
is that the differential between the BI rate and the Fed Funds rate
(the benchmark U.S. interest rate) is nearing an historical low.
A look at monthly historical data shows that the interest rate on
central bank certificates has always been kept above the Fed Funds
rate, with the lowest level being around 4.4 percent back in 1993. With
the BI rate now at 10.25 percent, the interest rate differential stands
at five percent, just a step or two away from the historical low.
Traditional notions suggest that an adequate interest rate differential
between the BI rate and the Fed Funds rate must be maintained to keep
rupiah-denominated bonds and money-market instruments attractive.
Not doing so would heighten the risk of capital outflows. This concern
is understandable since non-residents currently hold the equivalent of
nearly US$6 billion worth of rupiah government bonds, nearly double
their position a year ago. A significant shift in sentiment may have
implications for the stability of the rupiah exchange rate.
But many question the need for policy to be confined to history. Some
argue that the Bank Indonesia reference rate is currently still well
above other comparable interest rates in the region -- hence, so too
are interest rate differentials.
Some of Indonesia's closest neighbors, such as Thailand and Malaysia,
even have interest rates maintained below the Fed Funds rate.
For example, Thailand's 14-day policy rate is currently below the Fed
Funds rate by a quarter percentage point. Meanwhile in Malaysia, the
rate on a one-month government treasury bill stands at around
one-and-three-quarter percentage points below the Fed Funds rate.
However, it should also be noted that in Thailand and Malaysia,
exporters are obliged to surrender their foreign exchange proceeds to
designated domestic banks. This helps to strengthen the supply of
foreign exchange relative to the domestic currency.
Malaysia even goes further by maintaining intervention bands on the
ringgit to avoid volatile and abrupt exchange rate movements.
On the other hand, Indonesia does not have these stabilizing
instruments. The repatriation of exporters' foreign exchange proceeds
-- one crucial supply of domestic foreign exchange -- thus depends on
many factors, such as the interest rate on U.S. dollar deposits offered
by domestic banks and the outlook for the U.S. dollar in general.
Amid expectations of continued dollar depreciation this year, and
following the rise in the interest rates on U.S. dollar deposits
offered by domestic banks, many say that the foreign exchange proceeds
that were parked overseas last year have been gradually returning -- as
shown by rapidly rising international reserves in the domestic banking
system. In this regard, it could be that the scope for interest rate
differentials to further narrow is probably not confined to historical
lows.
But in spite of that and several months of relative stability, there is
still a strong case for being cautious. The case is built on the
potential volatility of the rupiah-dollar exchange rate.
Higher volatility means higher risk, and higher risk may mean a higher
premium over the Fed Funds rate compared to other Asian currencies.
What do the figures say in this regard? Over the last six months, the
weekly volatility of the rupiah was approximately twice that of the
Thai baht and even the Philippines peso.
Compared to the Singapore dollar, it is nearly three times as volatile!
Similar results are obtained using longer sample periods, i.e., up to
two years.
Given this higher risk, it may just be that the spread between domestic
interest rates and the Fed Funds rate for Indonesia, although not
necessarily confined to historical lows, must be kept higher compared
to those of other Asian countries. How much higher? That would really
be up to the market to decide.
-- The writer is an economist at Bahana Sekuritas.
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