Considering a 25 basis points rate hike should already be priced in, it may not be enough to give sufficient support to the rupiah. After all, the rupiah keeps on depreciating up to the moment of writing. This could pave the way for a more firmer approach. Moreover, newly inaugurated Bank Indonesia Governor Perry Warjiyo has stated in recent interviews that it "takes courage to adopt the policies required, which are sound and preemptive. If you live under uncertainty, don't linger over it. You have to preempt the uncertainty." Thus, he takes a hawkish tone.

Bank Indonesia emphasized that it is continuously active in the market to defend the rupiah. Two key strategies are the purchase of bonds in the secondary market and the selling of foreign exchange (US dollar). However, these strategies proved to have limited impact amid broad-based US dollar strength. Meanwhile, the country's foreign exchange reserves (although still at comfortable levels) have declined rapidly in recent months.

Raising Indonesia's benchmark interest rate (the seven-day reverse repo rate) has more impact than selling US dollars or buying bonds as it becomes more attractive for foreign investors to invest in rupiah assets. For example, after two rate hikes in May 2018 (Bank Indonesia raised its key rate from 4.25 percent to 4.75 percent) the rupiah showed significant appreciation versus the US dollar. However, rupiah appreciation only lasted for about two weeks (last week of May and first week of June). It are primarily external pressures (including concern over a global trade war, the Federal Reserve's June rate hike, the Federal Reserve's signs that faster hikes are on the way, and the weakening Chinese yuan) are putting pressure on the rupiah, hence investors seek safe haven assets.

But there are also internal factors at play. For example, Indonesia is one of those emerging economies that has to cope with a rather wide current account deficit (and it is widening in 2018 compared to the preceding year). Market participants may also not be too enthusiastic to see the Indonesian government spending more money on energy subsidies amid rising crude oil prices. Indonesian Finance Ministry Sri Mulyani Indrawati therefore said that "the government would look into the fiscal side, particularly the budget deficit, state revenue and state expenditure as well as the schedule of the government's debt paper issuance to minimize rupiah vulnerability".

Reasons why Bank Indonesia could decide to become more aggressive in terms of defending the rupiah also involve inflation and foreign US dollar-denominated debt. A weakening rupiah raises concern about imported inflation, while a high degree of (US dollar-denominated) foreign debt in the private sector could trigger financial trouble for private companies.

The negative consequence of a sharp raise in the benchmark interest rate is that borrowing costs are bound to climb accordingly in Southeast Asia's largest economy. This will be a problem for companies that seek loans for business expansion as well as for individuals who seek loans to finance the purchase of a house, car or motorcycle. Moreover, credit growth has already been subdued for quite a while. Therefore, overall macroeconomic growth is likely to continue its trend of very modest acceleration.

Bank Indonesia had earlier announced that it would relax the loan-to-value ratio (by allowing lower down payment obligations) in the property sector to encourage credit growth (somewhat offsetting the impact of a higher benchmark interest rate). We hope to hear more about such plans later today after Bank Indonesia has completed its policy meeting.

What is positive is that Indonesia's benchmark Jakarta Composite Index rebounded 0.95 percent in the first trading session on Friday (29/06) after a 2.08 percent decline on the preceding trading day.

However, Bank Indonesia's benchmark rupiah rate (Jakarta Interbank Spot Dollar Rate, abbreviated JISDOR) depreciated 0.93 percent to IDR 14,404 per US dollar on Friday (29/06).

Indonesian Rupiah versus US Dollar (JISDOR):

| Source: Bank Indonesia

This article was written by Richard van der Schaar, Managing Director of Indonesia Investments. He obtained his Masters degree in Southeast Asian Studies from Leiden University (the Netherlands) and now focuses on economic and political developments in Indonesia. He can be contacted at