Friday, March 28, 2008
Low Interest Rates to Fuel Indonesia's Economic Growth
Source: The Jakarta Post

The slowing global economy has raised concerns that Indonesia's economic expansion may be derailed, but a slowdown has yet to materialize.

Indeed, the Indonesian economy continued to grow briskly in the final quarter of 2007 and, looking ahead, early indications show the Indonesian economy will continue to show firm growth for the rest of this year. So what are the main factors underpinning the firm growth, and is this economic expansion sustainable?

In Q4 2007 it grew by 6.25 percent year-on-year, slightly less than the year-on-year growth in Q3 2007. However, the growth rate in Q4 was still high. Thus it seemed the global economic slowdown had not yet had a major impact on the Indonesian economy.

By expenditure, the economic growth in Q4 2007 was supported by household spending (which grew by 5.62 percent y-o-y), investments (which grew by 12.07 percent y-o-y), and exports (which grew by 7.27 percent y-o-y).

For the full year of 2007, the economy grew by 6.32 percent, faster than the growth rate of 5.51 percent in 2006. In 2004 and 2005 the economy grew by 4.9 percent and 5.7 percent respectively. As such, it seems Indonesia's economic growth is continuing to accelerate over the long term.

Some observers, however, take the view that the faster growth in the economy is attributable to the sustained increases in commodity prices.

Some also suggest the fast growth is due to a bubble in Indonesia's financial sector. In this regard, they point toward huge gains in share prices. Such views, however, are not entirely accurate.

By sector, the transportation and communications sector posted the highest growth rate in 2007 (this sector grew by 14.38 percent). In contrast, the mining sector only grew by 1.98 percent in 2007.

Besides the transportation and communications sector, other sectors also experienced significant growth. As such, Indonesia's economic growth was not solely due to high commodity prices or a bubble in the financial sector.

Some economic pundits used to say it was difficult for the economy to grow at a brisker pace due to "supply bottlenecks". These bottlenecks included a lack of decent infrastructure and the high cost economy. They argued that the growth of the economy had little to do with the level of interest rates.

In reality, however, economic data shows the economy is very sensitive to movements in interest rates. Indeed, the economy tends to grow at a faster rate in an environment of low interest rates.

In the past, a lack of competition in the banking system has meant easing monetary policy has not had such a big impact on the economy. This was evident during the 2004-2005 period, when banks were reluctant to reduce lending rates although they cut deposit rates as much as they could.

As a result, when the central bank lowered its benchmark rate to around 7.4 percent at the time, the interest rate (spread between lending rates and deposit rates) rose sharply. Such a condition reduced the effectiveness of BI's monetary policy.

There is evidence, however, monetary policy transmission has since improved because the banking system is now more responsive to changes in BI's monetary policy stance.

When the central bank recently lowered interest rates, the lending-deposit interest rate differential did not increase as much as it did in the 2004-2005 period. This meant lending rates fell at a faster rate than before.

As a result, with the BI rate currently standing at 8 percent (or higher than the level in the 2004-2005 period when the SBI rate was about 7.4 percent), the lending rate (for working capital) has fallen to 13.0 percent, or its lowest level in the last few decades.

Low interest rates mean a lower opportunity cost of money. This will spur consumption and eventually investment -- which will, in turn, lead to brisker overall economic activity.

The impact of lower interest rates can be seen in the strong household spending in 2007. And, although at a somewhat slower pace, investment activity also picked up. Investment growth increased from 7.0 percent in Q1 2007 to 12.01 percent in Q4 2007, and the currently relatively low interest rates are expected to help investment growth reach double digits in 2008.

Please note that from Q2 2004 to Q2 2005, investment grew by around 15 percent on average.

Signs of strong domestic demand can already be seen in early 2008. Motorcycle sales, for example, reached 938 thousand units in January-February 2008 or up by 35.6 percent from sales in the same period of 2007.

Cement consumption in the first two months of 2008 rose to 5.8 million tons, or up by 17.5 percent from 4.9 million tons in the same period of 2007. Domestic car sales also rose significantly. In the first two months of 2008, car sales reached 88,685 units, or up by 75.7 percent from 50,480 units in the first two months of 2007.

High inflationary pressures at the beginning of the year, however, have given rise to concerns over the sustainability of the economic growth. High inflation will erode consumer purchasing power -- which will, in turn, slow household spending and the overall economic activity.

Nevertheless, inflationary pressure in the upcoming months is expected to ease, given the rice harvest season will begin in March. Rice prices are expected to fall in March and April, pushing down the overall inflation figures in upcoming months.

Higher crude oil prices have put more pressure on the state budget since higher oil prices mean higher fuel subsidies. The government, however, seems to prefer the option of maintaining its fuel subsidies rather than increasing fuel prices.

Indeed, significant fuel price increases would have major ramifications in the economy, such as reducing people's purchasing power and pushing up inflation (which, in turn, would lead to higher interest rates).

In order to finance the large increase in fuel subsidies, the government shall reduce expenditure not related to infrastructure projects. At the current oil price level, we believe the government's measures should be sufficient to maintain the sustainability of the state budget.

Unless the government suddenly opts to hike fuel prices, we expect inflation to remain in check and fall below 7 percent by July 2008. For the full year of 2008, inflation is expected to stay below 7 percent.

As such, the SBI interest rate is not expected to be hiked in the near term. This means the lending rate is likely to remain at a relatively low level for the rest of 2008. Against this backdrop, domestic demand is expected to remain strong for 2008.

All in all, we believe Indonesia's economic expansion shall continue through 2008, and expect the economy grow by 6.34 percent.