Satria Sambijantoro and Rendi A. Witular, Jakarta – The central bank suggested on Friday that the economy "must grow below 6 percent" to avoid risks stemming from soaring inflation, the weakening of the rupiah and continuous deficits in balance of payments.
Given the deteriorating external imbalances, coupled with uncertainty in the global economy Bank Indonesia (BI) believes monetary tightening measures are required to ensure economic growth remains on a sustainable track.
"It's better for the economy to grow below 6 percent, but with manageable inflation and improvements in the current account," said BI executive director for monetary policy, Dody Budi Waluyo.
"BI's decision to raise its key interest rate by 50 basis points to 6.5 percent [on Thursday] is aimed at ensuring the economy is heading in the right direction," he said.
In June, BI became the only central bank in Asia to raise the key interest rate this year. The move was in response to huge inflationary pressure stemming from the fuel price increase, as well as to contain capital outflows that put pressure on the rupiah.
The 25 basis points increase in the BI rate in June was followed by an even more aggressive tightening of 50 basis points this month.
"Other countries are also seeing weakening exports and high current account deficits, but they don't have to deal with [inflationary pressure from] fuel price increases. This is why we have make stronger policy decisions compared to other economies in the region," Dody explained.
The government set a growth target of 6.3 percent for the economy this year, but BI says it will be between 5.8 to 6.2 percent.
Ideally, Indonesia "must grow below 6 percent" to prevent the deteriorated external imbalances from escalating, Dody said.
Concerns have emanated over Indonesia's weak external position, with the country posting a staggering US$6.6 billion deficit in its balance of payments (BOP) in the first quarter this year. The deficit was mainly attributed to the weak performance of its current account, one of BOP's main components, with the rest being capital account.
In the first quarter this year, current account deficit stood at $5.27 billion, or 2.4 percent of gross domestic product (GDP), meaning imports of goods and services far exceeded exports.
Posting economic growth above 5 percent is still "quite okay", especially given the recent slowdown in the global economy, BI spokesperson Difi Johansyah said.
"With lower economic growth, credit expansion will slow, eventually leading to a healthier balance of payments," Difi said. "This is because Indonesia current account deficit has been known to widen if it posts credit growth of more than 25 percent, which puts the rupiah at risk."
Economists and banking stakeholders have long urged BI to perform monetary tightening, warning the central bank about inflation threats from the excessively strong purchasing power.
Bank Central Asia (BCA) president director Jahja Setiaatmadja said that the rate increase meant that BI was responding to previous calls from the market, for a change in the rate policy.
"The aggressive rate policy today is aimed at coping with the reality of market as the rate should have been raised in April," said Jahja, adding that former BI governor Darmin Nasution was "too populist" because he occasionally failed to adjust to current market behavior. Darmin was replaced by former finance minister and banker Agus Martowardojo in May.
Jahja warned that the high interest rate regime was likely to stay until next year as the purchasing power of the public remained strong amid the unusually high prices of food commodities.
"There are indications that demand from the middle- to lower-income segment is still strong. Traders will not raise their prices if they know consumers can no longer afford it," said Jahja.
"With the strong demand, it will be difficult to see inflation below 4 percent next year. It will probably hover between 6 and 7 percent, meaning interest rates will remain high to cope with the pressure," said Jahja.