Can a 5.25 per cent interest rate lift the rupiah?

This article is a column; all content and opinions are the author’s personal views and not necessarily the stance of the editorial team.

As the rupiah’s exchange rate repeatedly breaches psychological thresholds and approaches its weakest level in history, public attention returns to one instrument deemed most effective in safeguarding currency stability: Bank Indonesia’s policy rate.

The question is, if the policy rate is at 5.25 per cent, is that strong enough to lift the rupiah?

This question matters because in the public mind, the relationship between interest rates and the exchange rate appears simple. When rates rise, the rupiah strengthens; when rates fall, it weakens.

But in practice, exchange-rate dynamics are far more complex than a simple change in monetary policy numbers.

In international economics theory, particularly the interest rate parity concept, differences in interest rates between countries influence international capital flows. Global investors tend to place their funds in countries offering higher returns with acceptable levels of risk.

When Bank Indonesia raises the policy rate to 5.25 per cent, domestic financial instruments such as deposits, government bonds, and rupiah-denominated securities become more attractive.

Demand for the rupiah increases because investors must buy rupiah first in order to invest in Indonesia.

In theory, that increased demand should strengthen the exchange rate.

But theory only works optimally when other factors are relatively stable. If global risk rises, investors actually favour assets considered safe havens such as the US dollar, US government bonds, or gold, even if yields in emerging markets are higher.

Therefore, a rate rise does not automatically strengthen the rupiah.

Why is the rupiah still vulnerable? Currently, the rupiah’s biggest challenges come from abroad.

The US policy rate remains comparatively high relative to the pre-pandemic period. The yields on US government bonds remain attractive to global investors.

In such conditions, the interest rate differential between Indonesia and the United States becomes relatively narrow. Consequently, the appeal of rupiah assets is not as strong as hoped.

Additionally, geopolitical tensions across various regions of the world have prompted investors to reduce exposure to emerging market markets.