Taming Rupiah Exchange Rate Volatility

BI as the monetary authority carries out the mandate to achieve rupiah stability which is reflected in inflation and the exchange rate.

KOMPAS/HERYUNANTO

Illustration

Board of Governors Meeting Bank Indonesia April 2024 increases reference interest BI Rate by 25 basis points to 6.25 percent. This increase is the first time since the BI Rate was maintained at the level of 6 percent for six consecutive months since October 2023.

Global dynamics prompted BI's decision to increase the BI Rate and this is still consistent with the stance of pro-stability monetary policy.

Global dynamics

It cannot be denied that the world is still linked to the hegemony of the US dollar as the global currency (reserve currency).

In early 2024, the market predicts that The Fed will soon lower the benchmark interest rate this year, following the controlled inflation of the US. However, the US inflation in the first three months of 2024 turned out to be higher than forecasted, with an increasing trend to 3.5 percent in March 2024.

Also read: The BI Rate Increase is Expected Not to Disrupt Regional Economic Growth

In addition, the US economic performance remains resilient. The reduction in benchmark interest rates, which was originally expected by the market, could be delayed due to these conditions. As a result, the US dollar remains strong due to attractive yields from high interest rates in the US.

The impact of the strengthening of the US dollar was felt by many countries in the Asian region. The Financial Times (20/4/2024) observed exchange rate fluctuations experienced by large economies, namely Japan, Korea and China.

The weakening of the yen against the US dollar still faces challenges due to the difference in Japan's benchmark interest rates, which have recently turned around from negative interest rates. China's central bank authorities have expressed their commitment to maintaining the stability of the yuan currency in the midst of the momentum of the growing domestic economy in the "Land of the Bamboo Curtain".

On the other hand, the geopolitical tensions in the Middle East that escalated due to friction between Israel and Iran have triggered an increase in global uncertainty. This condition can have an impact on the increase of global risk premiums, which certainly affect the world economy. This should be anticipated well so that its impact does not disrupt the domestic economy.

Reference interest and exchange rates

The Central Bank (BI) as the monetary authority is tasked with achieving the stability of the rupiah, reflected in two dimensions: inflation and exchange rates. Indonesia's inflation rate was recorded at 3.05 percent (yoy) in March 2024, relatively well-controlled within the target range of 2.5 (yoy) percent. This rate hike by BI is seen as more anticipating the stability of the exchange rate amid increasing global risks.

The benchmark interest is an important monetary policy instrument in reducing exchange rate volatility. Financial markets naturally have a tendency to direct capital towards higher returns (flight to quality). The central bank raised the benchmark interest to maintain the attractiveness of yields and foreign portfolio inflows to domestic financial assets.

BI as the monetary authority carries out the mandate to achieve rupiah stability which is reflected in two dimensions, inflation and the exchange rate.

Market innovation support

The effect of benchmark interest rates in the market must be supported by effective transmission channels. If observed closely, BI has various ways to support the transmission of benchmark interest rates towards the goal of exchange rate stability.

BI remains in the market through foreign exchange market interventions and state securities in the secondary market. BI also continues to encourage money market deepening which is increasingly oriented towards market mechanisms (pro-market) to support the effectiveness of monetary policy.

BI foreign exchange securities and BI foreign exchange sukuk instruments enable market players to transact with BI to manage foreign exchange risks. This innovation can also attract larger capital inflows because foreign exchange instruments can be traded on the secondary market and can be owned by foreign investors.

Apart from that, transactions using local currency (local currency transactions) initiated by BI are currently increasingly being established with seven partner countries. This is useful in reducing the dependence of the domestic economy on the use of US dollars in transactions between countries.

Another important aspect in supporting exchange rate stability is a developed financial market. Exchange rate derivative transactions on the Indonesian foreign exchange market still need to continue to be developed. A deep and efficient derivatives market is needed so that financial institutions and investors can manage risk effectively through hedging transactions to anticipate exchange rate fluctuations.

Forex market deepening can also have wider impacts, including capital market development, as stated by Wolter Bossu and his colleagues in a working paper with the IMF (2020). The development of the domestic derivatives market in the form of foreign exchange swaps (FX swaps) and interest rate swaps must continue to be worked on.

Innovative breakthroughs from market players and synergy with authorities are needed to form market discipline that is resilient in supporting the development of the derivatives market.

Also read: Get Ready for a High Cost Economy in 2024

BI's correct response

As yields in the US increase and the global risk premium increases, this increase in the BI Rate can be seen as the right step in an effort to maintain the stability of the Rupiah exchange rate from global pressures.

Indonesia already has a strong, resilient, transparent, and clear monetary policy framework. This fact provides a positive push as one of the prerequisites for the development of the domestic financial market has been met. The next task is to develop an efficient market structure and stimulate demand, so that ultimately the financial market can support the strengthening of BI's monetary policy transmission.

Kristianus Pramudito Isyunanda, Executor of the BI Law Doctoral Study Program at University College London