Friday, 8 July 2016

Fed rate hike remains imminent threat to financial sector

Arisyi Raz, Jakarta | Opinion | Tue, June 28 2016, - See more at:

Bank Indonesia lowered its benchmark BI rate by another 25 basis points (bps) from 6.75 percent to 6.50 percent recently, the fourth cut this year from 7.50 percent at the beginning of 2016, despite the threat of a possible increase in the US Federal Reserve rate. 

In addition, since April 2016 the central bank has been preparing to reformulate its policy rate through the introduction of the BI 7-Day (reverse) repo rate that will take effect in August. 

This policy rate rebranding is expected to smoothen the transmission of policy rates to the real sector.

These recent policies were among attempts made by the central bank and other financial authorities to boost the performance of the banking sector, which has faced several challenges recently. 

For instance, credit growth has been experiencing a slowdown since the beginning of the year. It stood at 8 percent in April 2016, decelerating from 8.7 percent year-on-year (yoy) in March 2016 and 10.5 percent yoy in December 2015.

The challenges do not only come from the credit side but also from the deposit side. 

For instance, the banking sector’s deposits grew by 6.2 percent yoy this month, slightly lower than 6.4 percent yoy in March 2016 and 7.3 percent in December 2015. 

Economic slowdown exacerbated by the shifting of funds from banks to other forms of investment such as securities is among the factors that have hampered deposit growth this year.

Slowing deposit growth could be troublesome for banks, particularly if they rely heavily on deposits as their source of funding. As deposit growth slows, heavy reliance on deposits will cause banks to face liquidity problems. 

Subsequently, this situation will constrain its intermediary function as it will not have sufficient funds to be extended as loans.

Fortunately, this challenge has been addressed by the central bank through the use of a loan-funding-ratio reserve requirement (LFR-RR) to replace the loan-deposit-ratio reserve requirement (LDR-RR). 

With this new regulation, banks do not have to rely on funding solely from deposits. 

In addition to deposits, banks are given incentives to acquire additional funding from securities and other sources of funds, thus removing the funding constraint.

To further support financial development, the central bank will also implement accommodative macroprudential policies that were announced last week. 

First, it will relax the loan-to-value (LTV) ratio and financing-to-value (FTV) ratio on housing and auto loans by August. 

Second, it will increase the floor of LFR-RR from 78 percent to 80 percent to provide more incentives for banking intermediary functions.

In short, banking sector development is crucial for Indonesia’s economy. The reason is that unlike several advanced financial systems such as the US that rely on the capital market to accommodate the flows of funds from savers to borrowers, our financial system is bank-based.

In other words, we rely on banks as intermediary agents to accommodate the flow of funds from savers to borrowers. Currently, Indonesia’s banking sector accounts for around 80 percent of total assets in the financial sector. 

Hence, rapid development in the banking sector not will only affect the financial system, but also provide positive effects for the whole economy.

In terms of policymaking, financial authorities are already on the right track. Hopefully, these policies will be effective and will spur Indonesia’s banking sector development. 

High credit growth indicates that business economic activities are increasing as corporations demand more loans to support their businesses. 

As corporations grow through higher levels of investments, they will generate more income. 

In turn, this will create economic growth through higher income, job creation and international trade.

Several challenges, however, remain. 
First, although rigorous attempts have been made by financial authorities to accelerate credit growth, they mainly focus on the supply side. 

In other words, these policies are expected to increase the supply of loans by banks and, to some extent, other financing institutions. 

However, some policies are also needed to provide incentives from the demand side. Through the realization of these policies, demand for credit will also increase and thus credit growth will pick up.

Second, external threats also remain. From the financial sector point of view, uncertainties regarding the possibility of a Fed fund rate hike remain the most challenging threat for the Indonesian financial sector. 

Prolonged uncertainties could affect investors’ sentiments, resulting in higher financial volatility as we experienced in September 2013 and August 2015. 

This challenge is more difficult to tackle as the origin of the risk comes from overseas (usually called exogenous). 

Nevertheless, financial authorities as well as the government could improve risk mitigation through better capital flow management, foreign currency reserve management and other measures to minimize adverse impacts.

The writer is a graduate of the University of Manchester in the UK and a professional in the banking sector.

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