Rupiah and interest rates

The move by Indonesia's central bank last week to significantly raise the ceiling interest rates on time deposits under the blanket guarantee scheme should be welcomed as a correct and timely measure to save the rupiah exchange rate from wild volatility.

Indeed, with two of the world's largest economies -- the United States and China-- about to tighten their monetary policies to ward off inflation, countries like Indonesia that greatly depend on the export market for economic growth should make the necessary adjustments.

Bank Indonesia early last week raised the ceiling interest rates on one-month to two-year time deposits from a range of 6.11 percent to 6.18 percent, to 7.25 percent to 7.80 percent, under the government's blanket guarantee program. This move gives banks more leeway to increase the interest rates they can offer depositors.

The rupiah fell to as low as Rp 8,734.50 against the U.S. dollar last week, slightly below the floor of the Rp 8,200 to Rp 8,700 range, or the comfort zone, the central bank has pledged to maintain for the local unit.

A combination of internal factors -- security disturbances in Maluku, Makassar and Riau -- and external factors, notably the tighter money policy imposed by China and strong speculation of a similar monetary move in the U.S, which strengthened the American dollar, were responsible for the negative sentiment on the rupiah.

Even though the U.S. Federal Reserve has yet to raise its funds rate, something that has been widely predicted by financial market analysts over the last two months, Bank Indonesia's decision last week was nevertheless the right move. Almost all pundits have predicted a rise in the Fed's funds rate as inevitable, saying it is only a matter of time. Many expect it in June, while some other analysts foresee such a move in August.

Obviously, Bank Indonesia cannot make its interest rate policy independent from its exchange rate policy. If the central bank is committed to maintaining the rupiah in its "comfort zone", it consequently must raise interest rates in anticipation of the Fed rate hike, otherwise many big depositors may shift to dollar positions.

Bank Indonesia is right in asserting that the weakening of the rupiah is only a temporary phenomenon that will soon pass because the fundamentals of the economy remain strong.

Movements in financial markets rarely reflect changes in economic fundamentals, because they are based on the market perception of what is likely to happen and this perception is formed mainly by the information market players currently have.

The perception now is that the American dollar will strengthen because of the upcoming move to be taken by the Federal Reserve to tighten its monetary stance to ward off inflation. Without adjustments to its domestic interest rates, the rupiah may come under attacks because many depositors may realign the composition of their deposits in favor of the greenback.

Even last week's monetary measure now makes it possible for commercial banks to raise their deposit rates to as high as 7 percent, most major banks will most likely maintain their rates at their current range of 5.5 percent to 5.7 percent because they are still awash with excess liquidity.

Just see how the central bank has steadily lowered its benchmark interest rate on certificates of deposit from as high as 8.3 percent early this year to 7.32 percent last week, and yet commercial banks remain hesitant to accelerate the pace of their corporate lending due to the high risk of credit turning sour.

The uncertainty that will remain until the country's elections are completed in September further adds to the banks' overly cautious stance on lending.

Bank Indonesia's latest monthly report showed that as of March, commercial banks' outstanding balance in such central bank open-market instruments as SBIs remained quite high at more than Rp 155 trillion (US$18.3 billion). Most analysts estimate that the loan to deposit ratio within the banking industry is hovering at about 50 percent. As long as the SBI rate remains much higher than deposit rates, banks will not feel compelled to expand their lending.

We therefore see this latest monetary measure by the central bank more as a preemptive move to protect the rupiah against speculative attacks, rather than an attempt to prod banks into raising their deposit rates.