Rupiah's rough ride – when will it stop?

The Indonesian rupiah has gone through a rough ride this year as the currency continues to weaken against the US dollar. In early May, it breached its psychological barrier of Rp14,000 per US dollar, making it the second-worst performer in Asia in the February-to-April period.

The country’s central bank, Bank Indonesia, has intervened several times by buying sovereign bonds and selling foreign currency to stabilise the rupiah. However, the currency’s downward trend continues. As of July 13 2018, the rupiah stood at around Rp14,400 per US dollar.

USD to IDR exchange rate; 3 July 2017 to 3 July 2018; Source: https://www.xe.com.

I will highlight below the factors behind the rupiah’s depreciation while also elaborating on the winners and losers of the weakening currency. I will also discuss the prospect of the rupiah bouncing back.

Driving forces

One domestic factor behind the weakening of the rupiah is the lower-than-expected growth of Indonesia’s gross domestic product (GDP) as a result of sluggish consumer demand.

However, the depreciation against the US dollar is not isolated to the rupiah. Other major Asian currencies have fallen against the dollar too. In other words, external factors have also played an important role in the depreciation of the rupiah.

A major external factor in the weakening of rupiah is the aggressive decisions of the Federal Reserve (the Fed) to raise interest rates in the US. The Fed has raised US interest rates two times in the first half of 2018. These decisions were taken to control inflation in the US following the country’s recovery from the global financial crisis.

The US rate hikes lure investors to invest more in US dollar-denominated financial assets and drive their portfolios away from emerging countries like Indonesia. This triggers higher demand for the US dollar, and hence strengthens the dollar against other currencies including the rupiah.

Winners and losers

The rupiah depreciation is bad news for Indonesians travelling overseas as well as for Indonesian online shoppers. Plane tickets, hotel fares and prices of imported goods that are quoted in dollars become more expensive.

When importers lose out, Indonesian exporters on the other hand benefit from the situation. Foreigners will find Indonesian products cheaper to purchase with the weakening currency. Indonesia’s manufactured goods and other key export products will therefore gain competitiveness in the world market.

In the bigger context, the increase in exports, combined with the decrease in imports, will result in an increase in Indonesia’s net exports. This will be favourable to stimulate short-run growth in Indonesia, whose annual economic growth remains stagnant at the 5% level over the past few years.

For a more comprehensive analysis of the impacts of the currency depreciation, we also need to look at the rupiah’s movement in terms of its real effective exchange rate (REER) index.

The REER index goes beyond the simple nominal valuation of the rupiah against the US dollar. The index measures the weighted average value of rupiah in relation to a basket of several currencies of Indonesia’s key trading partners such as the US dollar, the Chinese yuan, the euro and the Japanese yen. Further, the index also incorporates the effects of domestic and foreign inflation on Indonesian trade competitiveness.

Putting it simply, we can only conclude that Indonesia will gain trade competitiveness if the rupiah not only depreciates against the US dollar but also declines in terms of its REER index. Data obtained from global macroeconomic database CEIC show a decrease in the rupiah’s REER index between April 2017 and March 2018. This verifies that the rupiah depreciation would have improved Indonesia’s trade competitiveness and helped to stimulate growth.

In short, the weakening of the rupiah is actually a positive thing for the country’s economy.

However, a further depreciation of the currency must be treated with caution as it can cause more harms than gains.

A further depreciation will create a greater burden for the Indonesian government in paying its debts in foreign currencies.

Inflation rates will also increase as domestic production in Indonesia becomes more expensive because of the higher prices of imported materials. Consequently, Indonesia can expect Bank Indonesia to further increase interest rates to both control inflation and stimulate a higher demand for the rupiah.

Future prospects

It should not come as a surprise if the rupiah touches the Rp15,000 level by the end of the year.

The Fed is expected to further raise interest rates in US. It has in fact signalled its intention to have two more rate hikes this year.

Adding to these, now we have the China-US trade war. The trade conflict will likely have negative impacts on Indonesia’s exports in commodities such as biodiesel and the derivative products of crude palm oil.

Given that China and US are Indonesia’s top two export destinations, the negative implication of the trade conflict for these two countries can also hurt Indonesia. This will reduce demand for the rupiah and lead to its further weakening.

Bank Indonesia in this case needs to be prepared to sell more of its foreign exchange reserves to avert a crisis for the rupiah. Fortunately, unlike the 1998 Asian financial crisis, the central bank is now better equipped with more reserves to intervene in the market should the ride get too rough.

So, rupiah, brace yourself! The rough ride will persist in the near future.

Tommy Soesmanto does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.