BI Rate at 7.5%, Advantages or Disadvantages? (Part 1)

Central Bank interest rate is a rate in which a reference for commercial bank to set interest rate for deposit and loan. On Tuesday, 7 October 2014, once again Indonesia Central Bank or commonly known as Bank Indonesia (BI) has set its interest rate or BI rate at 7.5%. It means almost a year BI had decided to keep BI rate at 7.5%. There are numerous questions emerging among people, why does BI rate remain maintained at 7.5%? Certainly this decision has its own aim, nevertheless through this essay I would like to present my own opinion regarding effects of BI rate. I will divide my analysis into two parts in which this part, as first part, will discuss effects of BI rate to inflation rate and real sector, while second part will discuss the effects of BI rate to exchange rate and economy growth.

Effects of BI rate to Inflation

The basic relationship of money supply, inflation, and interest rate is when there is much money supply in the society causing high inflation. To avoid this problem, Central Bank will set its interest rate at the rate in which people will tend to keep their money at the Bank because they will get high interest rate for their saving. The amount of money supply will be reduced so the inflation rate can be maintained well.

Now let us discuss what happened in Indonesia. BI had set its BI rate at 7.5% almost a year. This rate is quite high compared to BI rate years ago. If BI has an intention to set BI rate at 7.5% to maintain inflation rate, now we shall look the financial data about Indonesia inflation. In 2011 and 2012 when BI rate at the range 4% to 5%, inflation rate at the time were 5.4% and 4.3% respectively. Inflation at this rate could be claimed as normal inflation because it reflected economy growth stable. Nevertheless in 2013, inflation rate increased sharply to 7.7%. There were plenty of factors causing a rise of inflation at the time, yet one thing can be noticed, in 2013, BI started to increase its BI rate gradually. It also seems inflation targeted by BI for 2014 financial year at 4.5% may fail to be reached.

Indeed, the effect of increasing of BI rate is many commercial banks overload of liquidity. Many people are keen to keep their money at the Bank instead of using it for investment. In addition, at the time, there is a spat among commercial bank in setting deposit rate in order to attract people to save their money in the certain Bank. So why does inflation rate remain high? The answer is imported inflation. Inflation is caused by weakening of Indonesian Rupiah towards United State Dollar. Therefore, it can be concluded that BI rate succeed to reduce the amount of money supply in the society, yet it fails to attract foreign investors to buy Rupiah instead of United State Dollar. BI rate at 7.5% fails to make capital in flow to Indonesia.

Effects of BI rate to real sector

As I mention earlier, BI rate at 7.5% only makes people to tend to save their money at the Bank because they may get high profit from payment of interest of their saving. Nevertheless what is the effect of BI rate to real sector? In my opinion, the development of real sector will be slow down.

It is correct that with high interest rate of deposit, Bank have overload liquidity which can be used to give a loan for entrepreneurs to raise their business because basic function of Bank is an intermediary institution to channel money from society of the owners of capital into society who need money to develop their business. Yet the effect of high interest rate of deposit is Bank will impose high interest rate for loan. In investment, there is a law which says that high profit means high risk, so when a Bank imposes high interest rate for loan, certainly the Bank will get high profit from the loan, yet on the other hand, Bank may also encounter potential problem of high Non Performing Loan (NPL) in which a loaner cannot pay its instalment and interest.

Furthermore, in economy condition like today in which the demand of world declining, many entrepreneurs do not intend to take credit in order to expand their business. As we know that in Europe, countries which joined in Euro currency are still facing problem of economy growth. Europe Central Bank had applied numerous policies for accelerating economy growth such as imposing central bank interest rate at 0.5% and buying credit which has asset as its back up. Hence the effect of low economy growth of many countries is the demand of some commodities such as rubber and crude palm oil, in which Indonesia is one of the biggest countries producing those commodities, decrease significantly.

As it has been stated in demand-supply law, when demand decrease while supply stagnant or even increase, it will cause the price of the product decreasing, and vice versa. So, the effect of decreasing demand in rubber, crude palm oil, and other commodities is price of those commodities declining sharply and affecting purchasing power of Indonesia people. Multiplier effect of declining in those commodities price is the demand for food, clothing, and housing decrease which cause sales decreasing eventually. Therefore, entrepreneurs do not want to take high interest rate credit because they do not want their business going to bankruptcy.

To sum up, in my opinion, high interest rate of BI, at 7.5%, will make the development of real sectors become weakening. BI rate become one of numerous obstacles to accelerate economy in Indonesia.