Interest rate debate

State Minister of Research and Technology B.J. Habibie reopened the debates last week on the adverse impact of high interest rates on the economy. This time, Habibie supported his criticisms against what he sees as persistently high interest rates with the finding of a study made at his request by a special team of aerospace engineers in the United States, Britain, France, Germany and Japan. The essence of the study's conclusion is that high bank interest rates are inimical to economic expansion.

Elaborating on his argument, he pointed out that high interest rates are discouraging investments and consequently stifling economic growth at the expense of job creation. Further down the line, expensive credits are also causing inflationary pressures, eating into the lending revenues of banks and government receipts from corporate income tax. Habibie, himself an aerospace engineer, does not believe that a cut in bank interest rates would set off capital flight, because outgoing funds would return through the capital market. He therefore suggested that the central bank intervene to cut the high interest rates according to a specified target zone.

Habibie's views are, to a large extent, legitimate. Reducing interest rates is an essential ingredient for boosting economic growth, creating more jobs. However, the economics of interest rates is not that simple. It works through several different mechanisms that vary in their effects at different times. As regards the government intervention, as suggested by Habibie, Bank Indonesia's (central bank) monetary management always includes the interest rate among its policy tools. However, conditions in Indonesia have not yet reached those found in many developed countries, which allow for interest rate management according to a set target zone.

In so far as Indonesia is concerned, there are several factors which influence credit interest rates. The most important among them are banking efficiency, the inflation rate and expectations for inflation, the depreciation of the rupiah against the American dollar and credit risks. The present conditions of those factors are not conducive for a significant cut in interest rates.

First, most major banks are still grappling with large sums in problem loans and are undergoing intensive consolidation to meet prudential regulations. The inflation rate, though most likely to be checked at a single digit level, is estimated to exceed 7 percent this year. Given the open-capital account regime, the government cannot have an interest rate policy independent from an exchange rate policy. As the government tries to maintain the rupiah's depreciation at a maximum 5 percent a year, the interest rates cannot be allowed at levels which the people do not believe are sustainable within the management of the rupiah rate at the desired level.

The absence of an adequate credit information system, obsolete commercial laws and a weak judicial system, which make the execution of credit securities extremely difficult, all combine to make the credit risks in Indonesia much bigger than those in other countries. Obviously, the credit risk is factored in the interest rates.

Moreover, an easing in the monetary condition is not warranted, especially now, because all estimates predict a large current account deficit in the balance of payments, and the economy still tends to overheat. Low interest rates are feared to create stronger pressures on the external balance because imports may increase faster than the government expects and the domestic market will be made less attractive to both domestic savings and foreign portfolio funds. Under the present condition, the impact of an unsustainable current account deficit would be far more devastating than that of high interest rates.

No wonder the central bank's intervention into the market over the past two years, either through open market operations or prudential banking rules, has been designed mainly to tighten the monetary condition. For example, the latest measure, which was announced last September, will increase the minimum reserve requirement from 3 to 5 percent beginning in April. That will in turn have a contractile impact on lending because banks will have to put a larger amount of productive assets in the central bank as idle money.