Interest rate debate

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.