Posted on July 28, 2018

Bank Indonesia (BI, the central bank) left its benchmark policy rate on hold at 5.25% following the conclusion of its latest Board of Governors meeting on July 19th. The unchanged decision on policy is noteworthy as it follows three recent rate hikes by the central bank, including a larger-than-expected 50bp increase at its last monthly meeting. Taken together, these three hikes have lifted BI’s policy rate by a cumulative 100bp since mid-May.

With GDP growth currently languishing towards the bottom of BI’s target range of 5.1-5.5% for this year and core inflation, at 2.7% y/y, also at the lower end of BI’s 2.5-4.5% inflation target zone, domestic fundamentals, if anything, would argue for looser, not tighter, policy settings. External pressures and, in particular, the need to support Indonesia’s currency, the rupiah, against the rampant US dollar have been the driving force behind this year’s policy tightening. Today the rupiah is under pressure not only from a widening of Indonesia’s trade balance over the last year but also rising US interest rates that are sucking capital out of emerging markets in general. Indonesia is vulnerable to these dynamics. Its relatively large external financing requirements- a current account deficit of 2.4% of GDP in the first quarter of 2018 - are in large part covered by volatile portfolio flows, particularly into the government debt where foreign ownership is high by emerging market standards.

With global investors’ confidence in the US Federal Reserve’s capacity to keep delivering a steady drip-feed of interest rate hikes, these bond flows have predictably reversed, leaving the rupiah under pressure. The rupiah lost 5.2% of its value against the US in the first half of the year although BI’s policy tightening since mid-May has blunted, but not reversed, the speed of decline in recent weeks. BI made clear in both the policy statement and press briefing that followed last week’s unchanged decision that this was a “hawkish hold”. BI Governor Warjiyo stressed that BI’s “stance is still hawkish” and that the “focus is still on maintaining economic stability, especially the rupiah exchange rate”.

Despite BI’s hawkish rhetoric, the rupiah has continued to slip against the US dollar since the decision, falling a further 0.7% or so at time of writing. With outflow pressures on emerging markets expected to persist given the booming US economy and escalating US-China trade tensions, BI’s policy pause is likely to be short-lived. We accordingly target another 50bp of policy tightening this year with the next increase in rates potentially arriving as soon as BI’s next scheduled meeting on August 15th-16th. While further policy tightening will necessarily add to the headwinds facing the Indonesian economy in the short-term, its macro-economic outlook still remains relatively benign. Recent higher frequency data show little, if any, sign of slowdown. The latest data on credit growth, for example, was better than expected. Up 10.3% y/y in June, it leaves BI’s forecast for 10-12% credit growth this year broadly on track.

BI can also continue to mitigate some of the negative impact of higher interest on domestic demand via macro-prudential measures, such as lower loan-to-value norms for mortgage lending. Solid consumer demand growth remains the backbone of the Indonesian economy. With this still running steadily around 5% per annum and recent readings of consumer confidence at record highs, overall GDP growth should continue to tick along at a similar pace. Q2 GDP growth, released on August 7th, should hold close to Q1’s 5.1% y/y rate. While these growth rates are well below the government’s longer-term 7% aspiration, they are nonetheless superior to the lion’s share of emerging markets.

Moreover, Bank Indonesia’s pro-active approach to policy tightening under new Governor Perry Warjiyo so far this year has helped limit the downside risks to the rupiah and the wider macro-economy. Historically, Bank Indonesia has adopted a more reactive approach to policy tightening, waiting until decisive rupiah weakness forces its hand. Once ‘behind the curve’, more, not less, policy tightening is then usually required to stabilise expectations around the currency. Governor Warjiyo’s front-loading of policy tightening so far this a year and the clear signal that further rate hikes are likely to support the rupiah is therefore to be applauded. While higher interest rates may add to the short-term headwinds facing the economy, they will critically help cement central bank credibility, put a floor under the rupiah and so foster Indonesia’s longer-term macro-economic stability.