Understanding the BI Rate

Early last month, the central bank of Indonesia, Bank Indonesia (BI) announced an increase in the BI rate to be 6.75%, from the previous 6.50%. What is the BI rate? Why it is increased? And how it would affect the JCI? Although I do believe that most of you are already understand ‘bout this, but hopefully this article can shed some light for those who do not yet get it.

BI rate, or interest rate of Bank Indonesia, is the annual interest rate set by BI as a benchmark for interest rates on loans and deposits for banks and financial institutions throughout Indonesia. To put it simply if the BI rate rose from 6.50% to 6.75%, then the interest on loans and deposits in banks and other financial institutions can also go up. This benchmark is only a reference and is not a rule, so it does not compel. A commercial bank may raise interest on their credit by reason of the increase of BI rate, but on the other hand the interest on deposit or savings of its customers do not rise at all. 

As for BI itself, BI rate is the interest rate for Bank Indonesia Certificates (SBI), which is distributed to the banks. When the BI rate rose to 6.75%, then commercial banks can put their funds in BI in the form of SBI, and will receive a 6.75% of interest per year. For example, if a bank put Rp10 billion of third party funds in BI, then they will receive Rp675 million per annum, without the need for 'do something' at all. 

So here we will find the logic: If the BI rate is increased, then the bank would certainly prefer to put their third party funds in BI rather than channeling it back into the community in the form of credit. Because despite the interest is smaller than the commercial credit interest (6.75% versus 12.5% or more), but the guarantor is the government, so the risk of the credit is very small, even close to zero. If the money of the people 'deposited' in BI, then the amount of cash circulating in the community will be reduced, and eventually lower the inflation rate. That is why the BI rate is an instrument that is usually powerful enough to bring down the inflation rate. So it is natural that when the inflation had increase more than expected, many party then demanded BI to raise the rate.

In addition to BI rate, BI also have a few other instruments that also aims to suppress the growth of inflation, like sukuk, Indonesian retail bonds, government securities, etc.. Basically all use the same principle: to absorb the money from the community, so that the amount of cash circulating in the community would reduced.

When the amount of cash circulating in the community is reduced, inflation rate will indeed depressed, but on the other hand it may also suppress the economic growth. For example, if the banks refuse to give loans to entrepreneurs because they prefer to put their funds in BI, then the entrepreneur would having difficulties in expanding his business, and in aggregate it will suppress the growth of the overall economics. That's why, if the rate of inflation has been under control, then BI could lower the BI rate back, so that the funds that had been deposited can be poured back into the community, to grow the economy and create jobs. 

When BI raise the BI rate for the last time, they consider that the economic growth was stable, while the rate of inflation was getting out of hand. Based on data from Central Agency of Statistics (Badan Pusat Statistik/BPS), economic growth in 2010 was 6.10%, better than the government's target of 5.80%. While the inflation rate in the same period was 6.96%, significantly higher than the national budget assumption of 5.30%. 

Then what is the relationship between the BI rate and the capital market? 

When the inflation began to be out of control, then the operational costs of the companies listed on the Stock Exchange would swollen, due to rising prices of raw material, employee salaries, etc.. As a result, the net profit may go down, and the sentiment would push down the share price. And if this happens to a lot of stocks, then the index will also go down. So when BI increase the BI rate, the expectations is that inflation would going under control, so the JCI could also rebound.

However, the increase in the BI rate will not necessarily strengthen JCI, because the investors are not so concerned about the BI rate, but the rate of inflation. In the short term, the increase in the BI rate would potentially weakening the JCI. Why? Because due to the increase of BI rate, the interest rate on deposits, sukuk, etc., usually (though not always) will also rise. So, the investors in the capital markets would have an alternative investment that is no less favorable than stock investments. Retail sukuk for example, it had 8.15% of fixed income per annum. With the level of risk that is close to zero, then of course the rate is quite tempting. If investors switching their funds from stocks to the sukuk, then of course JCI will be more depressed. 

When this article was written, JCI is still moving sideways in the range of 3,400's. Some leading stocks are still depressed deep enough, some even deeper than expected. Hopefully the increase of BI rate will successfully reduced the rate of inflation, so that JCI can step on the gas again. You see, the latest data from the BPS states that the annual inflation rate at the end of January 2011 had already penetrated 7.02%, seems like trouble.

Original article was written on February 15, 2011.

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