Responses of Retail Interest Rate to Policy Rate in Indonesia

Aditya Suselo1 and Dony Abdul Chalid2*

1 Departement of Management, Faculty of Economics and Business, Universitas Indonesia Kampus baru UI, Depok 16424, West Java, Indonesia

2 Departement of Management, Faculty of Economics and Business, Universitas Indonesia Kampus baru UI, Depok 16424, West Java, Indonesia

ABSTRACT

Transmission of monetary policy have several channels, and one of them is through interest rate channel. Using banks data in Indonesia for period 2006-2016, this study attempt to measure the change of bank’s interest rate toward the change in central bank’s policy rate, by seeing the momentum of interest rate pass through using error – correction model. The results show the adjustments of retail bank rates as between loans and deposit, between type, and across maturities are different. The results provide some evidences about the inefficiency of monetary policy through interest rate channel of in Indonesia.

Keywords : Bank, Interest rate pass through, central bank policy rate, commercial bank interest rate, Indonesia

* Corresponding author: E-mail: donny.abdul@ui.ac.id.

1. Introduction

The effectiveness of monetary policy is influenced by the monetary policy transmission

mechanism that influences the magnitude of the influence of monetary policy on real sector

conditions. The magnitude of the interest rate pass-through¸ is defined as a change in the

interest rate of the bank when there is a change in the Central Bank's benchmark interest rate

(Amarasekara, 2005; Gigineishvili, 2011), which is often referred to as monetary policy

transmission power can be known (De Bondt, 2002). The interest rate pass through is said to

be perfect if one unit changes at the central bank's benchmark interest rate, resulting in a

single unit of change in the interest rate of banking (Amarasekara, 2005). Thus, the more

perfect the rate of interest rate pass through that occurs, the process of monetary policy

transmission mechanism through the interest rate channel will also be more effective (Mojon,

2000). Conditions such as economic cycles, imperfect information, internal banking

conditions and the presence of volatility risks that prevent banks from responding fully to

changes in benchmark interest rates resulting in asymmetric interest rate pass through or

imperfect interest rate pass through (Kuan M. , Binh NTT, and Hui WS, 2008). This

imperfect interest rate pass throughs varies for every economic condition (Gigineishvili,

2011). Cottareli and Kourelis (1994) define imperfect interest rate pass through as interest

rate stickiness, where changes in money market and banking interest rates change smaller and

tend to have delays in both the short term and long term.

Empirical studies that discuss the issue of asymmetry of momentum of interest rate pass

through have been done quite a lot (De Bondt, 2002; Epinosa Vega and Rebucci, 2003;

Tieman, 2004). This study wanted to see how far the interest rates of banks can move

following policy rates, as measured by the momentum of interest rate pass through in

Indonesia. In its development, based on UU No. 3 of 2004, Pasal 7, it is explained that Bank

Indonesia which functions as Central Bank has monetary authority, in order to maintain the

stability of Indonesian rupiah currency. One of the efforts of Bank Indonesia to maintain the

stability of currency values is to establish the Inflation Targeting Framework (ITF) in 2005.

The more perfect momentum of the interest rate pass through between the reference rate and

the interest rate of the bank, the more effective the monetary policy applied by the Central

Bank (Mojon, 2000). This study will try to measure the momentum component of the interest

rate pass through to measure the effectiveness of the BI rate as an operational instrument of

monetary policy through the interest rate channel, which is shown by the magnitude of the

pass-through coefficient between the interest rate and the Banking interest rate.

2. Literature Review

Previous studies by several researchers (Hannan & Berger, 1991, Schnolnick, 1996, Dueker,

2000; Lim, 2001; Sarno & Thornton, 2003; Hofmann & Mizen; 2004; Gambacorta &

Lannotti, 2007; Payne & Waters, 2008 ) found that the interest rates of Commercial Banks

between one Bank and another were asymmetric. In addition, they also found that in more

concentrated markets the level of price stiffness is also greater, and changes in deposit rates

tend to be more rigid when the magnitude of the change is increased rather than declining.

Referring to the framework that has been made by (Hannan & Berger, 1991; Schnolnick,

1996) to analyze the asymmetric rate adjustment of deposit and lending rates at commercial

banks in Singapore and Malaysia, using cointegration method. It was found that Banks that

would adjust their interest rates by decreasing, would tend to be faster than adjustments by

increasing interest rates.

Then there is research on Banking in Australia conducted by Lim (2001). The research used

multivariate asymmetric error correction model. The results of this study indicate that the

Bank tends to make easy adjustment of interest rates when monetary easing compared to the

time of monetary tightening. Then, it was found that the rate of adjustment of interest rates in

the short term is still asymmetry, but has become symmetry in the long term.

A study conducted by Cecchetti (1999) suggests that the problem of asymmetry in monetary

policy transmission in the European Banking system is due to the differences in the financial

structure of each country in Europe. Then, still on the continent of Europe, research

conducted by Favero et al. (1999) suggests that credit channels are a critical channel in

identifying the asymmetry of monetary policy transmission in Europe.

Several studies have shown that the rate of asymmetry of Banking interest rates with short-

term periods is lower than long-term, due to the effect of sticky lending rates (Borio & Fritz,

1995; Donnay & Degryse, 2001; Gambacorta, 2008). The notion of such sticky lending rates

is the time required by the Bank to make adjustments to changes in the benchmark interest

rates made by the Central Bank. According to (Stiglitz & Weiss, 1981; Calem et al., 2006)

the explanation of the delay can be due to the agency cost and customer switching cost.

Burgstaller (2003) looks at the dynamic response of lending rates to changes in policy rates

and money market rates in Austria. Through the Structural Vector Autoregression (SVAR)

method, Burgstaller shows that the power and rate of transmission of interest rates depends

on whether the interest rate increasing or declining. Implementation of the European

Monetary Union (EMU) in 1999 also had a significant impact on reducing asymmetric effects

and accelerating transmission.

Hovarth, et al (2004) also tested the interest rate pass-through mechanism in Hungary.

Through the Error Correction Model (ECM) method it was found that the adjustment of

Banking interest rate incomplete pass-through and stiffness. Meanwhile, through the

Threshold Auto Regressive (TAR) method it is found that the rate of adjustment of the Bank's

interest rate depends on the size of the official interest rate change and the long-term balance.

The yield shock and volatility also affect the speed of adjustment.

Added some other studies related to interest rate pass-through, including Sander and

Kleimeier (2002) which obtained results that with imperfect competition and cost adjustment

frameworks, there has been an increasing rigidity in deposit rates and reduced stiffness in

loan rates in European countries.

Based on research by Apergis & Cooray (2015), this study will examine the amount of

Interest Pass Through in Indonesian Banking industry. To see these magnitudes, Apergis &

Cooray (2015) connects the benchmark interest rate with deposit rates and loan rates . The

relationship between the benchmark interest rate with the deposit rate and loan rate is

measured through the amount of Interest Rate Pass Through, where as the magnitude of the

Interest Rate Pass Through indicates that the relationship is going on perfectly and quickly.

(Amarasekara, 2005) it is explained that a perfect Pass Through occurs when a single unit

change in the central bank's benchmark interest rate, will result in a single unit of change in

the interest rate of the Banking. Empirically, these changes can be observed through changes

in the prices of assets (Credit) and liabilities (Deposit) money offered by the Banking.

Based on a study conducted by Zulkhibri (2012), it was found that the short-term and long-

term interest rate pass through in Malaysia is imperfect, with the amount of momentum

different for each financial institution and its products. Then, Rocha (2012) also found that

the interaction between loan rates, deposit rates and interbank rates in Banking Portugal is

asymmetric, and has diverse values between loan and deposit sectors with different tenors.

3. Research Method

3.1. Data

This research uses banking data in Indonesia in 2006 - 2016 period. The sources used for data

at Banking level are from Eikon, Datastream, BI publication, annual financial report of Bank

and Report of Central Bureau of Statistics "BI Rate and Interest Rate of Rupiah Credit by

Group of Banks ".

3.2. Research Model

In line with research conducted by Apergis & Cooray (2015), this study will use regression

model to know the amount of Interest Rate Pass Through from Banking industry, measured

by short term and long term, by looking at deposit rates and loan rates. The research model is

based on and adapted by the presence of cointegration among the variables to be tested, so it

is used Error Correction Model (Liu et.al, 2008; Zulkhibri, 2012; Rocha, 2012). This research

will use the main model as follows:𝞓yt = β0𝞓xt + δ(yt-1 – α0 – α1Xt-1) + ∑i=1

q

β i𝞓xt-i + ∑i=1

p

γ i𝞓yt-iWhere yt is the interest rate of the Bank which is the time series of the dependent

variable:

• Working capital loan rate (LNRATEMK)

• Investment loan rate (LNRATEINV)

• Consumer loan rate (LNRATEC)

• Deposit rate with 1 month tenor (DRATE1M)

• Deposit rate with 3 month tenor (DRATE3M)

• Deposit rate with 6 month tenor (DRATE6M)

• Deposit rate with 12 month tenor (DRATE12M)

• Deposit rate with 24 month tenor (DRATE24M)

While Xt is the central bank's benchmark interest rate (BIRATE) which is the time series of

independent variables.

Non-perfect long-term pass through will also have different coefficient values from one

statistically, which is smaller. The faster and perfect rate of interest rate pass-through

between the benchmark interest rate and the Bank's interest rate, it indicates that the monetary

policy applied by the Central Bank can be well implemented, and it also shows that the lower

the friction in the monetary policy transmission mechanism through the interest rate channels

(Mojon, 2000).

4. Results4.1. Descriptive Statistics

%BI RATE DRATE1M DRATE3M DRATE6M

DRATE12M DRATE24M LNRATEC LNRATEINV LNRATEMK

Mean 7,54 7,61 7,99 8,23 8,51 8,83 14,97 12,75 13,13Median 7,5 7,18 7,49 7,87 8,23 8,99 14,48 12,32 12,76Maximum 12,75 12,01 12,32 12,2 12,38 12,93 17,88 15,94 16,35Minimum 4,75 5,35 5,61 5,87 5,81 5,36 13,03 11,14 11,35Standar Deviation 1,76 1,58 1,68 1,6 1,81 1,98 1,53 1,32 1,35Observation 133 133 133 133 133 133 133 133 133

Table 1.0 Descriptive Statistics Variable

Source: Processed Researcher (2017)

From the loan side, the descriptive statistics in Table 1.0 confirm that there is a significant

difference between the BI Rate and loan rates, which indicates that one of the ways banks

earn income is through loan channeling. From the mean value of each type of loan,

investment loan has the lowest mean value, followed by working capital loan and the highest

consumption loan. Intuitively, investment loan is supposed to have the lowest margin. This is

explained by the purpose of financing from investment loan, which is to finance the fixed

assets which will generally be a guarantee of the loan transaction. From the standard

deviation value of each type of loan, it is seen that investment loan has the lowest standard

deviation followed by working capital loan and consumption loan. The high standard

deviation on consumption shows that the change in the consumption loan rates is relatively

dynamic, since banks make periodic adjustments to consumer loans, because users of

consumption loans are bulk, so banks have a high risk because they can not pay much

attention to user profiles consumption loans appropriately. Then, for working capital loans

and investment loans have a lower standard deviation. Indicates that the volatility or changes

in lending rates are relatively more rigid. This can be due to the fact that the use of

investment and working capital generally has a relatively long period of time, and the bank

can clarify loan users more accurately. The three types of loans also appear to have a standard

deviation below the BI rate as the reference rate.

4.2. Results

The stationary test results indicate that all time series variables used are not stationary at

stationary level but stationary at the first derivative level I (1), which is tested at a 95%

confidence level. Therefore, the Johansen cointegration test can be performed on all time

series variables. The selection of lag uses two tests: Akaike's Information Criterion (AIC) and

Schwarz Information Criterion (SIC). Both methods have the advantage of other methods

because these two methods are suitable for time series data. AIC and SIC can explain the

suitability of the model with existing data and the value occurring in the future (Gujarati,

2003: 536). The best model is the model that has the smallest AIC and SIC value (Gklezakou

& Mylonakis, 2010: 318). The maximum time lag selection is limited to 6 months, which

refers to studies and observations made by Mojon (2000) on the ECB, which explains that

studies with monthly data intervals should use the maximum time lag 6. Based on the optimal

lag time test results, it can be seen that each variable has an optimal lag that is different from

one another. The determination of a large lag was decided by the suitability of AIC and SIC

tests. When there is a difference between the decision and the AIC and the SIC, the

researcher adjusts to the smallest selection of AIC and SIC.

The Johansen Cointegration Test can be seen that there is no cointegration between

(DRATE1M, BIRATE); (DRATE3M, BIRATE); (DRATE12M, BIRATE) and (LNRATEC,

BIRATE). Thus, the error-correction model estimation will be performed using BIRATE as

an independent variable, and (DRATE6M, DRATE24M, LNRATEINV and LNRATEMK)

bivariate (1 dependent 1 independent), which can be seen in table 1.1 below.

The error correction model estimation is performed by performing optimum lag

specifications, as well as the use of assumptions in accordance with (Wojcik, 2011). In

accordance with the model specification that can provide the most appropriate estimation

results, the estimated long-term and short term interest rate pass through can be done as

follows:

This table summarizes the estimated value of coefficients α1, obtained from the VECM

estimation results between independent and dependent variables.

Dependent Independent

Assumtion α1 Pass Through Rate

DRATE6M BIRATE #40,481299

* ImperfectDRATE24

M BIRATE #41,804644

* PerfectLNRATEIN

V BIRATE #40,232985

* Imperfect

LNRATEMK BIRATE #20,690603

* Imperfect*significant at α = 5%

Table 1.1 Estimated Long Term Interest Rate Pass Through Indicator

Source: Processed Researcher (2017)

The assumptions used in ECM estimates are based on the characteristics of the given interest

rate. Deposit rate with a tenor of 6 months and 24 months is a deposit rate that has a long

period of time so it can bring up a pattern. Similarly for investment loan rate are generally

given for long-term purposes such as buying fixed assets, so that long-term nature will bring

a pattern. Therefore, the deposit rate with the tenor of 6 months and 24 months and the

investment loan rate will use assumption # 4. In contrast to the working capital loan rates,

which are generally provided for immediate purposes, such as salaries of employees, to buy

raw materials, and the magnitude of these requirements is very fluctuating making it difficult

to find a pattern. Thus, the working capital loan rate will use assumption # 2.

Based on the result of research, the estimation of error correction model on long term is

significant at 95% confidence level. In general, the momentum of interest rate pass through

deposits and loan, is in line with the Bank Indonesia reference rate. The interest rate response

also depends on the internal condition of the banking system itself. Magnitude pass through

coefficients smaller than 1 indicate that there is friction within the monetary policy

transmission mechanism through long-term interest rates. It can be interpreted that after

reaching the long-term equilibrium, a change of 1 unit of BI Rate will have a change effect of

less than 1 unit of Banking interest rate except for deposit rate with 24 month tenor, which

can be seen the pass through degrees are declared perfect because the magnitude α1 is greater

than 1 (1.8046> 1), which has the sense that there is a strong reaction of the Banking in the

form of deposit products with a longer tenor.

Like an empirical study conducted by some former researchers, the Bank's interest rate will

reach a long-term equilibrium, which means that the Bank's interest rate will be more sticky

to the benchmark interest rate when the time period of the Bank's interest rate is longer. In

this study, the deposit rate with 24 months tenor and investment loan rate were classified as

long-term, but pass through rate was found to be perfect only at the deposit rate with 24

months tenor and was not found in the investment loan rate.

The pass through rate is found to be perfect at the deposit rate with 24 months tenor because

the deposit can be one of the Bank's funding sources, due to the long period of time. Thus, in

this case banks will adjust interest rates with reference rates, so that deposit products with a

24-month tenor becomes attractive. On this long-term deposit, what the Bank intends to

obtain is the certainty that the Bank's internal condition has adequate liquidity conditions, so

that the margin to be achieved through deposit products with 24-months tenor is also not too

significant. In general, a perfect pass through is due to the different internal conditions of the

banking system. For banks with stable and large internal conditions, then the bank has the

power to provide a relatively low interest rate, because the bank has a reputation that leads to

public trust that the bank will not go bankrupt. Conversely, for banks with relatively

inadequate internal conditions, the bank will provide interest rates to customers with larger

quantities.

While pass through rate is not found perfect on investment loan rate, in other words

investment loan rate does not fully move in the direction of the reference rate. As the

benchmark interest rate is raised, it can become a burden for businesses that have loan with

the Bank, which can cause the business world to become difficult, which can lead to the

occurrence of bad loans. Conversely, when the open reference tribe is lowered, it can create a

problem for the Bank's internal, as it reduces the Bank's margin. Therefore, the magnitude of

changes in benchmark interest rates is not fully attached to changes in lending rates.

That table summarizes the estimated value of coefficients β1, obtained from the VECM

estimation results between independent and dependent variables.

Dependent Independent Assumtion β0 Pass Through Rate δDRATE6M BIRATE #4 0,138743** Imperfect -0,059673*

DRATE24M BIRATE #4 0,313778* Imperfect -0,01083LNRATEINV BIRATE #4 0,178266* Imperfect -0,016522*LNRATEMK BIRATE #2 0,198202* Imperfect -0,020946**significant at α = 5%**significant at α = 10%

Table 1.2 Estimated Short Term Interest Rate Pass Through Indicator

Source: Processed Researcher (2017)

Based on the result of the research, the estimation of error correction model in the short term

is significant at 95% confidence level for the variable of deposit rate with 24 months and the

investment loan and working capital loan, and significant at 90% confidence level for deposit

with 6 months tenor variable.

The magnitude of pass-through coefficient (β0) smaller than 1 indicates that there is friction

within the monetary policy transmission mechanism through short-term interest rate

channels. Interpretation of the results is in the short term, a change of 1 unit of BI Rate

reference rate will have a change effect of less than 1 unit of the Bank's benchmark interest

rate. Short term pass-through coefficients are found in all variables, although the magnitude

is still imperfect.

The error-correction coefficient term δ can be interpreted as the rate of adjustment of short-

term interest rates to long-term interest rates. The negative and significant values of the

coefficients indicate that there is a correction towards long-term equilibrium. Whereas if the

results are found positive then it shows that the system is getting away from long-term

equilibrium. Based on the results of the process, it can be seen that the deposit rate with 6

months tenor and the investment loan and working capital loan rates have negative and

significant, which indicate that on the channel of deposit rate with 6 months tenor and the

investment loan rate and working capital loan rate, make adjustments slowly to achieve long-

term equilibrium. Meanwhile, on the deposit rate with 24 months tenor, there is no

significant error correction term, which indicates that the deposit rate with 24 months tenor

classified as having long term period (greater than 1), is in equilibrium condition.

5. Conclusions

This study examines the magnitude of the momentum of interest pass through on the Banking

in Indonesia period 2006 to 2016, consisting of all commercial banks with active status. The

conclusions of this research are as follows: Some research variables are deposits with tenor of

1 month; 3 months; and 12 months and consumption loan does not have cointegration with BI

reference interest rate. The absence of cointegration for deposit with tenor of 1-month and 3

months can be caused by short tenor, so that people can easily change their deposit place in

other banks, so that the change in bank deposit rate is more based on internal change.

Meanwhile, the absence of cointegration for deposits with 12 months tenor indicates that the

deposits are not something favored by the public, which means that people prefer deposits

with longer tenors, which can be represented by 24 months tenor. Then, the absence of

cointegration in consumer loan indicates that changes in consumption loan rates are based on

internal bank decisions, such as the risk of a larger customer profile.

In the long-term period, the error correction model estimation for the deposit rate variable is

significant, with the deposit rate with 6 months tenor having an imperfect pass through and

the deposit rate with 24 months tenor having the perfect pass through. In the short-term

period, the estimated error correction model for deposit rates is significant, with the deposit

rate with tenor of 6 months and 24 months having a pass through imperfectly. The difference

in pass through rate indicates that there is a degree of friction on the channel of deposit rate

that varies in level.

In the long-term period, the error correction model estimation for loan rate variable is

significant, with the working capital loan rate and investment loan rate which has pass

through is imperfect. In the short-term period, the error correction model estimation for the

variable of loan rate is significant, with the working capital loan rate and investment loan rate

which has pass through is imperfect. The difference between the pass through rate indicates

that there is a degree of friction in the lending rate channel that varies in level.

The state monetary authorities should take into account the effectiveness of the applied

monetary policy, so that the objective of the establishment of the policy can be fully related

to the Banking rate, where one of the indicators of achievement of success is the perfect

magnitude pass through. Therefore, monetary authorites may pay more attention to the time

of interest rate change, because based on the momentum of interest rate pass through, it can

be seen that the longer the period of time then interest rate pass through is also nearing

perfect, because banks need time to be able to adapt change in BI interest rate completely.

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www.bi.go.id/id/publikasi/jurnal-ekonomi (Alur Transmisi dan Efektifitias Kebijakan Moneter Ganda di Indonesia, 2012