Protecting the Rupiah
The rupiah depreciation will have many implications, such as an increase in fuel subsidies, difficulty in importing capital goods as well as raw materials, foreign debt payments, a rise in inflation, and so on.
The pressure on the rupiah has not lifted. The rupiah exchange rate weakened further to Rp 14,003 per US dollar on the spot market. The Jakarta Composite Index (JCI) also fell to 5,849 last Friday, a 9 percent decline compared to the level at the beginning of the year.
The rupiah depreciation will have many implications, such as an increase in fuel subsidies, difficulty in importing capital goods as well as raw materials, foreign debt payments, a rise in inflation, and so on.
From the external side, the US Federal Reserve\'s announcement on May 2 to maintain its benchmark interest rate at 1.5-1.75 percent indicates that the rate hike trend will continue. Moreover, the performance of the US economy, as the basis of the Fed’s rate policy, is improving. During this year, the US employment growth has been quite impressive. The economy added 176,000 jobs in January, 324,000 jobs in February, 245,000 jobs in March and 164,000 jobs in April.
Therefore, it is almost certain that the Fed will continue its interest rate normalization policy. With a 2 percent inflation target, I expect the US interest rate will reach a norm of around 2.5 percent. This means that the Fed still has space to raise its benchmark rate further by another 100 basis points. However, the problem is that we do not know how soon or how long it will take to achieve the 2.5 percent interest rate target.
Of course, we hope the interest rate will not reach the target this year but in a longer span of time, because if the rate increases more quickly than expected, the appreciation of the US dollar (or the worldwide currency depreciation) will occur much faster and the rupiah will suffer more.
The dollar index has gained 3.43 percent in the past three weeks. If we refer to this figure, the rupiah exchange rate has weakened only 1.8 percent in the same period. This means that the rupiah is still performing better than those of the six major currencies of the US’s trade partners – the euro, the Japanese yen, the British pound sterling, the Canadian dollar, the Swedish krona and the Swiss franc. However, the aspect most feared is not the rate of rupiah depreciation, but its psychological impact. The current weakening of the rupiah causes trauma or a sense of déjà vu harking back to the financial crisis 20 years ago, when the rupiah plunged to Rp 15,000-Rp 17,000 to the US dollar. There is a high risk that the rupiah’s fall will cause panic.
The hike in the Fed\'s benchmark interest rate has not only contributed to the depreciation of the world\'s currencies, but also to weakening of the NYSE Composite Index. The Dow Jones Industrial Average, which reached a record high of 26,616 on Jan. 26, dropped to 24,262 last Friday. In fact, with the solid performance of the US economy, the Dow should have strengthened. Why is it the other way around?
I suspect this is caused by two things. First, the previous index was too high on the back of the euphoria over the US economy’s positive performance. The Dow has reached its peak and is unlikely to rise again; it might even undergo a correction. Secondly, a correction occurred when the Fed began to raise its interest rates. The interest rate hike caused liquidity to migrate from the capital market to the money market.
The same possibility may also apply to the JCI. After experiencing a long rally that brought the index to 6,635, the JCI became prone to correction. The correction has now occurred, triggered by the US dollar strengthening against the rupiah. Investors immediately moved their investment in rupiah-denominated shares and bonds to US dollar-denominated assets.
The migration is continuing, as investors tend to follow the trend in global capital markets. When a sell-off occurred in New York, US, the behavior of investors in Jakarta was also affected. Globalization has affected the behavior of investors everywhere.
Forex reserves
Then, how can we stabilize the rupiah? Bank Indonesia (BI) is still actively intervening in the rupiah exchange rate on the market. The foreign exchange reserves that once reached a record high of $131.97 billion (February 2018) have now declined to about $124 billion. Upon the recent developments, BI and its ASEAN counterparts have activated the financial sector safety net under the Chiang Mai Initiative.
The scheme established in 2000 is intended to help ASEAN countries cope with liquidity problems caused by their weakening currencies and the depletion of their forex reserves.
Three East Asian countries have huge foreign exchange holders ready to help, such as China and Hong Kong (with combined foreign reserves of $3.65 trillion), Japan ($1.26 trillion) and South Korea ($390 billion). This scheme has become an alternative to the IMF fund injection. The three countries have set aside up to $240 billion in standby funds. With this scheme, let\'s say Indonesia can raise $60 billion in liquidity to add to its forex reserves. However, we do not know when and under what conditions this scheme will be undertaken, because we have never experienced it.
While hoping the Chiang Mai scheme will not be necessary, we still have to optimize the available monetary instruments. Intervention has been done repeatedly, but we do not really know how deep the power of the "enemy" extends in the money market. Therefore, it is not wise to rely solely on the strength of forex reserves as “ammunition” in market intervention.
So far, BI has sent a signal to the market that it is ready to take another instrument option in raising the interest rate. Unfortunately, the market has ignored the signal. A positive response will only ensue if the central bank finally realizes its rate hike plan.
With the benchmark interest rate now at 4.25 percent, this low rate may trigger a liquidity migration from rupiah deposits to a foreign currency-denominated asset. BI has certainly noticed that the world trend of low interest rates and inflation have almost come to an end. We cannot oppose the cycle of "interest rate normalization". Therefore, a 25-50 basis point increase in BI’s benchmark interest rate is urgent and unavoidable.
Please raise the interest rate, in order to avoid a steeper decline in forex reserves.
A. Tony Prasetiantono, Head of the Center of Economics and Public Policy Studies, Gadjah Mada University