Interest rates to stay high to fight inflation

Interest rates to stay high to fight inflation

JAKARTA (JP): Interest rates are likely to remain high in the
second semester of this year as the government continues to limit
monetary expansion.

The slight drop in the inflation rate in June is unlikely to
affect Bank Indonesia's tight monetary policy.

According to the research division of PT DBS Securities
Indonesia, the clampdown on loan expansion, the stricter
regulation on commercial papers and the ban on the opening of new
multifinance companies will keep loan supply below national
demand.

Lending rates, which increased by 25 to 50 basis points during
the first five months of this year to around 22 percent per
annum, are likely to stabilize at their current levels.

On the other hand, the clampdown on credit expansion will
reduce the need for aggressive funding. Therefore, deposit rates
should be maintained and the overall spread is expected to widen.
Widening spreads, however, will not automatically translate into
interest margin expansion.

The new regulation to raise banks' reserve requirement to 3
percent from the previous 2 percent has somewhat increased the
funding costs of banks, according to DBS Securities.

The securities company bases its research on nine listed banks
comprising Bank Bali, Bank Bira, Bank Danamon, Bank Niaga, Bank
Tiara, Bank Dagang Nasional Indonesia (BDNI), Bank Internasional
Indonesia (BII), Lippo Bank and Panin Bank.

According to DBS Securities, some banks which have been very
active in raising customer deposits during 1995 to reduce their
loan-to-deposit ratio, should be able to increase their deposit
growth at a slower pace than that of loans, and possibly reduce
their deposit rates. Bank Bali, BII and Bank Niaga belong in this
category. Bank Danamon, Bank Bira and Lippo Bank will be helped
by their recent rights issues, while other banks have to assume
stable net interest margins or even declining margins if they
want to reduce their loan-to-deposit ratios.

The continuous widening of the current account deficit and
fears of high inflation have prompted the central bank to give
more attention to the growth of money supply and loans.

For 1996, the monetary authority is targeting a national loan
growth of only 16 percent as compared to 19 percent last year.
The target may also apply for 1997, if the current account
deficit continues to swell.

Besides looking at the growth limit, it is also important to
pay attention to the drop between actual 1995 loan growth and
1996's quota for each bank. The larger the drop, the more
affected the interest income growth in 1996. At first appearance,
Bank Bira, Bank Danamon and BDNI would be hurt most.
Nevertheless, Bank Bira's interest income will be supported by
its recent rights issue. BDNI and Danamon's excessive loan
expansion in the fourth quarter of last year could to some extent
compensate for the big drop in loan expansion in 1996.

"Overall, we are looking at an average of 18 percent loan
growth for 1966 and 1997 in the nine listed banks, compared to
the average 30 percent growth for 1991 to 1995," DBS Securities
said in its latest report on the banking sector.

Loan loss provisions are no longer a big burden, thanks to the
new tax regulation. Most listed banks have increased provisions
of their risk assets. There is a presumption that Bank Indonesia
will increase the general provision from 0.5 percent to 1
percent. This, however, will not have much impact on most
publicly listed banks.

Some banks could even show a decline in the proportion of
provisions to their net profit. This will be the case for BII,
Lippo Bank, Bank Bali and, to a lesser extent, Panin Bank. On the
other hand, BDNI and Bank Tiara will need to make a special
effort to increase their accumulated loan loss provisions.

Many banks have admitted that possible threats to their
expansion and growth for 1996 and 1997 will come from Bank
Indonesia's regulations on the slowdown of monetary expansion,
DBS Securities said.

Several additional measures could be issued during this year,
if the loan policy is not considered effective enough to control
the growth of the money supply.

The securities company lists two potential measures that could
be introduced by the central bank -- higher reserve requirement
and loan-to-deposit ratio readjustment.

The higher reserve requirement is an unpopular move and it is
rarely used. It was used in 1995 and there is a possibility it
may be used again in 1996.

The definition of Indonesian loan-to-deposit ratio is more
lenient than the international formula because it also includes
equity as a denominator in addition to third party funds.

Both above regulations have a direct impact on loan growth and
interest rate margin. Banks therefore should be more active in
generating non-interest income as this would protect them from
the volatility of interest rates.

Unfortunately, said DBS Securities, the sources of non-
interest income are limited. Unlike in other countries,
Indonesian banks are prevented from investing in nonfinancial
companies and the sources of non-interest income mainly come from
provisions of loans, foreign exchange and letters of credit.

Investment banking activities offer an attractive source of
revenue over the long run. Nevertheless, this is still a new area
and not many banks are concentrating in it at the moment.

The share of non-interest income in total revenues in 1996 and
1997 is expected to stabilize at the current level of 24 percent.

Bank Danamon and Bank Tiara appear to be at the low end in DBS
Securities's list in generating fee-based income because both
have been too dependent on interest income over the last two
years, following their capital raising in 1994 and 1995
respectively. In the top rank is BDNI, followed by Bank Bali,
Bank Niaga, BII, Bank Bira, Panin Bank and Lippo Bank.

Efficiency

Overall, the banks have been able to report an improvement in
their efficiency program during the last three years. This is
reflected in a steady decline of operating expenses as a
percentage of total revenue ratio.

The trend is expected to continue in the foreseeable future,
despite some anomalies in some banks, as the era of aggressive
branch expansion is over.

The banks are now concentrating more on improving their
existing branch profitability. The average operating expense to
gross income is expected to improve to 57.3 percent in 1996 from
61.5 percent last year.

Bank Niaga, Bank Danamon, Bank Lippo and Bank Bali's operating
costs are among the highest, based on such a ratio.

Bank Bali and Bank Danamon remain aggressive with plans to
expand their branches over the next two years, Bank Niaga's
relatively high operating expenses are mainly due to personnel
expenses as the bank pays higher-than-average salaries to its
employees in order to prevent staff-hijacking. Lippo Bank's high
cost is a direct result of its concentration in the retail
market, which results in big interest margins. The bank needs to
pay more attention to this issue, given the fact that its margin
premium is under attack.

Challenges

Among the new regulations issued in 1995, the one on capital
requirement will have the greatest impact on the banking
industry's performance in the foreseeable future, according to
DBS Securities.

"We expect there will be massive capital raising over the next
few years, as was the case in 1993 to 1994," it said.

Listed banks are expected to raise at least Rp 4 trillion
from rights issues during 1996 and 1998 to meet the capital
requirement.

These rights issue will have to compete with the initial
public offerings of larger banks such as state-owned Bank Negara
Indonesia (BNI) 1946 and Bank Central Asia (BCA), which plan to
go public during that period.

Further more, the risk of rights issues will be influenced by
the general election in 1997 and the presidential election in
1998 which will affect sentiments on the stock market.

Massive capital raising is expected to sustain even after 1998
because some banks will have to raise capital more than once in
order to meet the minimum 12 percent capital adequacy ratio
requirement. Bank Danamon has just completed its rights issue
which raised Rp 840 billion from the market. This will increase
its capital adequacy ratio to 12.7 percent by end of 1996.

Bank Danamon, however, will have to raise more funds again in
the future before the year 2001. In other ways, the sector's
earning per share growth will be constrained by shares dilution.

From a different angle, the massive capital raising will also
benefit the banking sector. The rights issue and BNI's
initial public offering are expected to increase the sector's
capitalization by 75 percent in three years.

Normally, the existing capital or capital adequacy ratio will
gradually become insufficient following the speed of loan growth
and will slowly be affected by internal growth factors such as
return on assets and dividend payout ratio.

Banks, therefore, should be more concerned with their
profitability because higher profitability would mitigate the
need to raise more capital.

According to the central bank's new capital requirement, new
foreign exchange banks should have a paid-up capital of Rp 50
billion in 1995 and Rp 150 billion in 1999. Their capital
adequacy ratios should be at least 8 percent in 1995, 10 percent
in 1996 and 12 percent in 1999.

Existing foreign exchange banks' paid-up capital should be at
least Rp 50 billion in 1995, Rp 100 billion in 1997 and Rp 150
billion in 1999. Their capital adequacy ratios should reach at
least 8 percent in 1995, 9 percent in 1997, 10 percent in 1999
and 12 percent by the year 2001.

Restructuring

Despite some reported improvements over the last two years,
the sector will continue to consolidate for the next few years.
The excessive number of banks within the marketplace is another
clear obstacle to creating a healthy and solid banking system.

There are currently 240 banks with 5,191 branch offices in
Indonesia, far more than any other country in Asia. Around 40
percent of the loan market is controlled by seven state-owned
banks and 28 percent belong to listed banks, while the remaining
32 percent are nonlisted private banks.

It is believed that these banks are operating below the
efficiency level and most of them are undercapitalized.

The government has indicated its wish to reduce the number of
banks. To facilitate this, some measures have been issued by the
central bank for viable mergers and acquisition activities. There
have been several mergers and acquisitions over the last two
years, however most were orchestrated by the central bank.

"We see this as a risk to the larger and healthier banks. It
is possible that the central bank may ask a large and healthy
bank to rescue smaller banks that are in trouble," DBS Securities
said in its assessment.

Nevertheless, the unsatisfactory development of mergers and
acquisitions have prompted the central bank to use other means to
solve the problem. It is said that they are now working on new
rulings to facilitate the liquidation of problem banks. (hen)