Falling interest rate

Bank Indonesia has steadily lowered its benchmark interest rate since early last year in a bid to fuel economic recovery and to prod banks to increase new lending to liquidity-starved businesses.

The easier stance on money has been made possible by macroeconomic stability, which has been strengthening on the back of a stronger rupiah and low inflation.

The consumer price index has also been falling steadily to bring down inflation to as low as 5.06 percent last year, from 10.03 percent in 2002 and 12.56 percent in 2001.

This low inflation rate can be attributed primarily to the appreciation of the rupiah, which has itself been fueled by a sharp reduction in country risks -- as indicated by international credit rating agencies and in steadily increasing foreign exchange reserves, portfolio capital inflows and a weakening dollar.

Macroeconomic stability is expected to increase further this year, as there seems to be no big risk of a sharp deterioration in key economic indicators, despite the national elections between April and September.

Barring any major security disturbances or political violence, the rupiah will most likely continue to appreciate or, at worst, remain stable at its current rate of around Rp 8,500 to the dollar. In turn, this will create a virtuous cycle in the economy and push down inflation further.

The government conservatively projects an average rupiah rate of Rp 8,600, inflation at 6.5 percent and benchmark interest rate at 8.5 percent for this year, and the market seems to be comfortable with these assumptions.

Bank Indonesia (BI) also seems highly optimistic that inflation will continue to be well controlled throughout 2004.

Over the past five weeks alone, the central has decreased its benchmark interest rate from 8.3 percent in December to 7.86 percent last month, and may further cut its interest rate at the weekly auction of its promissory notes today.

However, the very slow response from the banking industry to BI's strong signal of an easier money stance is worrying. Banks still seem to be facing great difficulty in extending its excess liquidity to lending. For example, when Bank Indonesia lowered the interest rate of its promissory notes from 8.06 percent to 7.86 percent during the weekly auction on Jan. 28, banks still bought more than Rp 55 trillion of the notes.

Most banks must also find it very difficult to extend its funds to corporate lending; otherwise, they would not have forfeited a potential earning of 4 to 7 percent. This is the difference between interest revenues banks will get from commercial loans -- between 11 and 15 percent -- and from BI promissory notes -- 7.86 percent.

Banks apparently remain hesitant about accelerating the pace of corporate lending, due to high credit risks turning sour and thereby threatening their capital standards.

But this condition is inimical to economic recovery. If banks remain highly averse to new lending and instead prefer to invest in financial market instruments such as mutual funds, government bonds, BI deposit certificates, treasury bonds and inter-bank market instruments, economic recovery will remain weak.

Understandably, banks should be extra careful in making big corporate loans, because most big businesses have yet to complete restructuring their operations and bad loans.

However, there are now thousands of small and medium-scale enterprises (SMEs) that are starved of investment and working capital loans. The major banks, despite their acute lack of expertise in dealing with SME borrowers, could channel excess liquidity to help these businesses through cooperation with secondary banks that have long experience in lending to SMEs.

Lending to SMEs, which make up most of the business sector and employ millions across the country, will not only speed up economic recovery, but will also provide banks with bigger earnings -- with the eventuality that some medium-scale businesses will become big enterprises and prime clients for big banks.

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