Analysis: Bank Indonesia Holds Policy Rate at 4.25% in December

Bank Indonesia said the current interest rate environment is consistent with efforts to maintain macroeconomic and financial system stability, while also building further momentum for domestic economic recovery. Monetary easing that took place in August and September 2017 (cutting the benchmark interest rate by a combined 0.50 percent) is regarded sufficient to continue driving the economic recovery process against a backdrop of increasingly robust macroeconomic stability.

The central bank of Indonesia will also remain monitoring several risks that stem from abroad, namely monetary policy normalization in several advanced economies and geopolitical risks.

The global economic recovery is becoming more balanced, supported by persistently high commodities prices. Global economic growth in 2017 is expected to accelerate from one year ago with more balanced sources of growth from advanced as well as developing countries. US economic growth ticked upwards on the back of increasing investment and stable consumption. The economy of Europe posted solid gains, supported by consumption and export performance. Furthermore, consumption and exports also helped to drive China's economy in line with the economic rebalancing process that is currently underway, albeit gradually, in the world's second-largest economy.

Improving economies around the globe managed to edge up world trade and international commodities prices, including crude oil. Meanwhile, the interest rate hike in the USA (the Federal Reserve deciding to hike the FFR by 25 basis points on 13 December 2017) was in line with estimates. The global economy is expected to improve, along with strong commodities prices and world trade volume. However, several risks will continue to demand vigilance (most notably monetary policy normalization in several advanced economies and geopolitical risks).

Gross domestic product (GDP) of Indonesia occurs gradually and uneven. National economic growth is projected at 5.10 percent (y/y) for 2017, up slightly from 5.02 percent (y/y) in the preceding year. Domestic economic growth has been bolstered by a surge of commodity exports that drive the non-building investment, particularly amongst commodity-based firms. Fiscal stimuli from the central government related to infrastructure development also encourages rising building investment.

On the other hand, investment in non-commodity sectors has not shown significant improvement, while household consumption only improved slightly. In terms of household consumption, a shift in consumption pattern was detected toward leisure. It was also detected that the upper-middle class society of the country still prefers to delay consumption.

In 2018, the economy is expected to build further momentum based on equitable investment, fiscal stimuli from the government, and the favorable impact of global economic gains. Bank Indonesia expects the economy to grow at the range of 5.1 5.5 percent (y/y) in 2018.

Indonesia's balance of payments (BoP) in 2017 is expected to record a comparatively large surplus and maintaining a healthy current account deficit of below 2 percent of GDP. The significant BoP surplus primarily stems from the capital and financial account, which increased on the position recorded in 2016, particularly in the form of direct and portfolio investments, in line with the improvement in investor perceptions of the domestic economic outlook. The under-control current account deficit was supported by a large non-oil & gas trade surplus despite a wider oil & gas trade deficit. Nevertheless, the services account and primary income account also recorded large deficits linked, among others, to a large transportation services account deficit and the repatriation payments on foreign investment returns.

Meanwhile, the position of foreign reserve exchange at the end of November 2017 stood at USD $125.97 billion, up from USD $116.4 billion at the end of 2016. These reserve assets are equivalent to 8.4 months of imports or 8.1 months of imports and servicing government external debt, which is well above the international standard of around three months. Looking ahead, Bank Indonesia projects a slightly wider current account deficit in 2018 due to the ongoing domestic economic recovery but remaining at a healthy level of 2.0 - 2.5 percent of GDP.

The Indonesian rupiah remained relatively stable throughout 2017 despite the emergence of external pressures at the beginning of the fourth quarter. The rupiah was stable as of September but external factors began to erode the value of the currency in October 2017. Nevertheless, rupiah depreciation was consistent with broad US dollar appreciation against nearly all major global currencies after the United States began to normalize its monetary policy stance, confirmed upcoming tax reforms and the markets anticipated a further FFR hike towards the end of the year. In November, the rupiah rebounded in line with maintained macroeconomic stability and the promising domestic economic outlook, so that by point-to-point (ptp), the rupiah appreciated 0.27 percent (m/m) to close at a level of IDR 13,526 per US dollar. Moving forward, Bank Indonesia shall continue to stabilize rupiah exchange rates in line with the currency's fundamental value, while maintaining market mechanisms.

Indonesian Rupiah versus US Dollar (JISDOR):

| Source: Bank Indonesia

Inflation remains low at 3.30 percent (y/y) in November 2017, which is still within Bank Indonesia's inflation target of 3 - 5 percent (y/y) for 2017. Low and controlled inflation is mainly contributed by the low inflationary pressures on volatile foods (VF) due to adequate supply, government policy to stabilize food prices and low international food prices. The volatile foods inflation currently stands at its lowest rate in the past 14 years. Core inflation also continued to decline thanks to anchored expectations, stable exchange rates and limited domestic demand.

Meanwhile, inflationary pressures on administered prices (AP) intensified mainly due to the 900 VA electricity tariff increase in the first half of 2017, as part of ongoing government-led energy reforms. The consumer price index (CPI), as a measure of headline inflation, stood at 0.20 percent (m/m) in November 2017, bringing the cumulative rate to 2.87 percent. Bank Indonesia projects low and controlled inflation in 2018 within the new target corridor of 2.5 - 4.5 percent (y/y).

Financial system stability was maintained despite a suboptimal bank intermediation function. Such dynamics were explained by a capital adequacy ratio (CAR) in the banking industry of 23.2 percent and a liquidity ratio of 22.7 percent as of October 2017. Meanwhile, non-performing loans (NPL) were recorded at 2.96 percent (gross) and 1.25 percent (net). Monetary policy was successfully transmitted through the interest rate channel, as evidenced by banks' proclivity to continue lowering deposit and lending rates.

Nonetheless, transmission through the credit channel was less optimal, indicated by limited credit growth in line with weak demand for new loans and the selective nature of banks when disbursing new loans. Consequently, credit growth in October 2017 stood at 8.16 percent (y/y), up from 7.86 percent (y/y) in the month earlier. Conversely, growth of economic financing through the financial markets, including issuances of stocks, bonds and medium-term notes (MTN), surged to 45.5 percent (y/y) in October 2017. Meanwhile, deposit growth was observed to decelerate from 11.7 percent (y/y) to 11.0 percent (y/y) over the same period.

In 2017, deposit and credit growth have expanded by 9.0 percent and 8.0 percent, respectively. Congruent with increasing economic activity and the impact of previous monetary and macroprudential policy easing, Bank Indonesia projects stronger deposit and credit growth for 2018 at the range of 9.0 - 11.0 percent (y/y) and 10.0 - 12.0 percent (y/y), respectively.

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