Nowadays, tight liquidity is the center stage issue amongst local banks. Testimony to this is the increase in time deposit rates, running well above BI's rate, coupled with a fair amount of liquidity tied up in government bonds.

These signs have, in turn, led us to question whether lowering interest rates would be the appropriate step to help the banking sector amid concerns about the weakening outlook for Indonesia's economy.

The global economic downturn has just begun and the Indonesian economy is undoubtedly not immune to this downtrend. Cutting back on expansion plans and lowering production volumes will likely affect employment numbers, which will lead to lower disposable income per capita and weaker consumer spending power.

The export market has also been correspondingly impacted by the downtrend in economic growth. Exporters are hungry to secure their share of the pie in a shrinking market. China with its strong economic growth over the past few years has also shown a slow down in its economic uptrend.

Judging from the aforementioned conditions, we believe that a slow down in our economic growth is inevitable.

Meanwhile, we foresee that cutting interest rates by 25 or 50 basis points might not help boost the economic outlook through the facilitation of cost of funding reductions, but rather send the wrong signal to the currency market, creating further weakening in the rupiah. It should be noted that the BI rate is no longer used as a benchmark to attract liquidity.

At this stage, anecdotal evidence suggests that banks have not complied with the central bank's request to not compete with one another by breaking the agreed ceiling deposit rate of around 12.00 percent per annum.

In fact, both local and foreign banks are currently offering up to 14.00 percent per annum interest rate in an attempt to deal with tightening liquidity.

That said, we can safely disregard growth in lending over the short term. Ironically, even banks with sound liquidity will be reluctant to lend out money fearing that loans may turn sour should Indonesia's economic growth plummet.

Moreover, we foresee that investment, in general, is expected to remain stagnant at least in the short-term.

Meanwhile, the flow of credit to more "certain" industries such as the commodity related sectors has shown signs of easing on the back of the recent dive in commodity prices, as demand has rapidly slowed in the global market.

Apart from the tight liquidity situation, we are also facing higher volatility in the rupiah/dollar exchange rate, which has depreciated some 16 percent in the past month alone.

We believe that the underlying uncertainties are coming from three main factors (as quoted by some sources), namely United States dollar debt repayments, speculation as well as the continued outflow by foreign investors from stocks and the bond market. These have resulted in persistent weariness over the state of rupiah weakness for currency players.

In our view, should the rupiah continue to weaken, further negative effects will arise, such as a deterioration in confidence, particularly ahead of next year's parliamentary and presidential elections. In the last election, it is worth noting that the rupiah depreciated 12 percent between January through to June 2004.

Meanwhile, the limited Rp 2 billion deposit guarantee per account might not be good enough to assure depositors into keeping their money in Indonesian banks. Statistics from the Indonesia Deposit Insurance Corporation have indicated that deposits for amounts above Rp 2 billion account for approximately 40 percent of total deposits.

Indeed, the lack of confidence in local banks might be viewed as a golden opportunity for neighboring countries such as Singapore to win over Indonesian depositors by providing a full blanket guarantee to all their depositors.

In order to prevent falling confidence in the exchange rate, we should be cautious in monitoring the interest rate spread between the BI rate and US Fed rate, which is usually well maintained at between 7.50 percent and 8.50 percent.

A sudden cut in the BI rate might in fact send the wrong signal to the market, further compounding the liquidity problem in the banking sector.

If the spread between the BI rate and the U.S. Fed rate were too narrow, it might not justify the risk premium required by depositors, leading to capital flight and a further squeeze in domestic market liquidity.

We, hence, believe that the government should implement measures to stimulate investment and consumption in the near future.

We believe the recent plan to reduce the premium gasoline price by Rp 500 per liter is a step in the right direction to raise consumption via improvements in consumer purchasing power. However, for consumers at the grass root level, lowering both kerosene and diesel prices are ingredients to stimulate the economy from a bottom-up perspective.

The writer is the vice president and deputy head of research at Bahana Securities

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