Jakarta city at night

Shaky economy prompts rate cut in Indonesia

On February 18th Bank Indonesia (BI, the central bank) cut its benchmark policy interest rates following a scheduled monetary policy meeting. The seven-day reverse repo rate was reduced from 3.75% to 3.5%, while the deposit facility and lending facility rates were trimmed by 25 basis points to 2.75% and 4.25% respectively.

The policy decision comes amid a still dire economic situation and the persistent domestic spread of the coronavirus (Covid‑19). Indonesia recorded a 2.1% contraction in GDP in 2020, and economic indicators have pointed to still weak activity at the start of this year. The consumer confidence index stood at 84.9 in January, markedly lower than the 100 threshold for optimism. The annual rate of consumer price inflation has been consistently below BI’s target band of 2‑4% since June 2020, indicating weak household demand.

BI is particularly concerned about the value of the local currency, the rupiah, especially in the context of a substantial external debt stock. A weak rupiah: US dollar exchange rate increases debt-servicing costs. Although there is little doubt that BI is likely to have prioritised supporting the economy over combating inflation, the latest decision to reduce its benchmark policy interest rates has coincided with a mild strengthening in the exchange rate. The central bank would have probably adopted a much more aggressive loosening stance in the past 12 months or so were it not for the fact that the rupiah has been on a gradual depreciatory path against the US dollar. In 2020 the rupiah depreciated by an average of 3.6% against the US dollar.

We believe that this cut will exert downward pressure on the rupiah in the months ahead. This, coupled with an anticipated widening in the current‑account deficit, will narrow the scope of BI to sanction further cuts in the policy rates. We expect the weakening in the exchange rate to be gradual until the second quarter of 2021, after which the depreciation will accelerate, and the central bank might have to tighten its monetary policy incrementally to help shore up the value of the rupiah. However, BI will not resume a tightening cycle in earnest until late 2022, when it perceives demand-side inflationary pressure to be rising strongly.

We will review our exchange-rate forecast, as the latest rate cut will contribute to renewed depreciatory pressure on the rupiah in the coming months.

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