Several analysts expect that the central bank of Indonesia (Bank Indonesia) will raise its key interest rate (BI rate) again in the first Semester of 2014 in order to anticipate the winding down of the Federal Reserve's monthly USD $85 billion stimulus program (quantitative easing). Currently, the BI rate is set at 7.50 percent but analysts say that the market should be prepared for a hike to 8.0 percent in the first half of 2014. Between June and November 2013, Bank Indonesia has already raised its benchmark interest rate from 5.75 to 7.50 percent.
The Federal Reserve's tapering of asset purchases has large implications for emerging markets such as Indonesia. In May 2013, when the Federal Reserve began speculating about an end to its quantitative easing program, global investors quickly pulled their money out of riskier assets (which indicates that the liquidity brought on by US quantitative easing can be a blessing in disguise for emerging markets as these mainly constitute portfolio investments and are thus characterized by sudden and volatile movements). Indonesia was (and still is) considered risky because the country contains a number of problems in its financial make-up. Although easing, Indonesia's current account deficit is still large at USD $8.4 billion (3.8 percent of GDP) in Q3-2013. Moreover, the country has had to cope with high inflation after the government increased prices of subsidized fuels in June 2013 (the central bank expects a 9 percent inflation rate year-on-year by the end of 2013). In combination with largescale capital outflows - triggered by speculation about the winding down of QE3 - from Indonesia's stock and bond market, it resulted in a seriously depreciating rupiah exchange rate. Since the start of 2013, the rupiah fell 20.2 percent against the US dollar (up to 18 November 2013).
Indonesian Rupiah vs US Dollar:| Source: Bank Indonesia
The tapering of QE3 will result in rising 10-year US treasuries' yields (above three percent) while US dollar liquidity tightens. Market participants will prefer to invest in quality bonds with higher interest rates, particularly those issued by market leaders and repeat issuers. Although Indonesia has a strong outlook, confirmed by Fitch Ratings' BBB-/stable outlook rating for Indonesia's sovereign credit rating, the country will feel the impact of capital outflows again when the Federal Reserve starts to wind down its stimulus program.
In anticipation of this situation, Bank Indonesia is expected to raise its BI rate to 8.0 percent in the first half of 2014. Agus Martowardojo, governor of Bank Indonesia, has already showed the market on several occasions that he prefers to use the BI rate as the instrument for monetary policy to avert possible shocks that originate from the global economy.