A Market Test for Recovery Policy
Yopie Hidayat (Contributor)
BANK Indonesia (BI) has decided a policy to boost economic growth. This is certainly a great relief for the government because the country’s economy is still reeling from the pandemic. Latest government projections put the economy at minus 4.3 percent growth year-on-year at the end of Q2 2020. However, BI’s alignment causes a consequence: the fall of rupiah.
Before the policy was set, the rupiah had recovered from its lowest point in 22 years, Rp16,575 per US dollar, at the height of the market panic on March 23. At the start of June, foreign capital had returned after the panic subsided. The rupiah significantly appreciated to Rp13,878 per US dollar. Now, that strength is slowly evaporating because of the market response to BI’s policy.
In the last five days, until Friday, July 17, the rupiah exchange rate to the US dollar has dropped two percent. Until the Jakarta market closed on Friday afternoon, the rate for US$1 has reached Rp14,725. This weakening trend is occurring amidst a global financial market that is still gripped by pessimism as the Covid-19 pandemic keeps growing everywhere.
There are two central bank policies that cast doubt on the strength of rupiah. First, BI has made a commitment to create rupiah liquidity by buying a minimum of Rp397.5 trillion in government bonds and up to a maximum of Rp570 trillion. Second, the policy on interest rates. On Thursday, June 16, BI once again lowered its benchmark interest rate, or the BI 7-Day Reverse Repo Rate, to 4 percent.
Considering various recent indicators, BI’s decision to lower interest rates is appropriate. Inflation rate at the end of June, for example, was only at 1.97 percent. It is the lowest in 20 years. This number is below BI’s lowest target, which is between 2 to 4 percent.
The stability of the rupiah which has persisted since early June has also become a consideration for BI to decide. The rupiah is stable because it is supported by foreign investment fund flow into government bonds, enticed by relatively high yields compared to other Asian countries. In real terms, the yield of these bonds are more meaningful due to the very low inflation of rupiah.
The combination of abundant liquidity and cheaper interest is a classic recipe to push the wheels of the economy so that it moves faster and recovers from the shock of the plague. The injection of liquidity from BI will act as a stimulus to fund government programs. Meanwhile, lower interest rates will affect credit interest and cost of capital in the business sector.
Unfortunately, the market sees more on the risk factors of these two policies. The purchase of government bonds by BI, for example, is not yet done. However, the market is already calculating how the massive BI injection will inflate the amount of money circulation. Such a significant addition of rupiah will clearly dilute its value against foreign currency. Investors’ confidence on the rupiah is starting to waver.
Meanwhile, the lower interest rates has affected foreign investors’ confidence in Indonesia. So far, foreign investors have relied on a carry trade strategy to make profit in Indonesia. They borrow dollars that now have close to zero percent interest, and they invest it in rupiah. The sizable margin makes investing in rupiah more appealing. But the reverse is also true, in that smaller margins due to BI lowering interest rates will make investors reconsider their acts. The market will also weigh other risks, such as the possibility of recovery programs being held back and the government’s ability to handle the pandemic.
The negative reaction on Friday, July 17, is like a test from market. The signal is clear: the market is not convinced that the various policies for economic recovery and the handling of the pandemic are adequate. The government and the central bank should not hold back in correcting these two things, so that the rupiah does not fall too deep.