As the global economic outlook continues to worsen, relatively open emerging markets like Indonesia must strike a balance between supporting growth and maintaining financial stability.
As the eurozone crisis drags on and growth in China and India looks soft, the fear is that all the hot money that flowed into Indonesia over the last few years will just as readily rush back out the door.
Although it kept its benchmark interest rate on hold at a record low of 5.75 per cent on Tuesday, Bank Indonesia, the central bank, noted the deteriorating global climate and emphasized its recent efforts to support the weakening rupiah and prevent the build up of inflationary pressures.
The big policy from BI was not the decision to hold rates but the attempts to support the currency, says Fauzi Ichsan, an economist at Standard Chartered in Jakarta.
In a statement released alongside the latest rate decision, BI said that it would encourage more supply of foreign currency “to manage depreciation pressure triggered by worsening crisis in euro area and negative sentiment in the global financial market.” The central bank has already said it will introduce dollar term deposits in a bid draw more foreign currency into the market.
While demand for dollars is high due to the semi-annual repatriation of profits and repayment of foreign currency loans, supply is weak because of a dearth of new external portfolio investors and the fact that exporters are sitting on their dollars in expectation of a further weakening in the rupiah.
Indonesia’s foreign exchange reserves have already fallen to $111.5bn at the end of May from $116.4bn at the end of April.
Fitch, a credit rating agency, said last week that this decline was not yet a “cause for concern”.
But if the euro crisis drags on for months, Ichsan believes that reserves of $111.5bn, or 6.2 weeks of import cover, will not be sufficient.
“The biggest concern for BI is the currency and the outcome will be very much determined by how the crisis in Europe is handled by the EU and IMF,” he said.
Currency traders are not feeling too optimistic. Short positions on the rupiah have increased to the highest level since 2008, according to a Reuters survey.
Indonesia is not alone in this situation and other emerging markets like India have also seen their currency take a hit as a result of the gathering storm.
More open emerging markets like Indonesia might suffer the sharpest outflows in tough times but, the hope is, their relative openness will help maintain long-term investor credibility, ensuring the foreign money comes back when sentiment turns.