Bank Indonesia’s Mulligan; If Jakarta’s central bankers lack resolve to defend the rupiah, reserves are no defense

Updated August 29, 2013, 3:55 p.m. ET

Bank Indonesia’s Mulligan

If Jakarta’s central bankers lack resolve to defend the rupiah, reserves are no defense.

Bank Indonesia stepped into the breach Thursday with a 50-basis-point increase in its main policy interest rate. For the moment at least that has stanched the flight from the rupiah, which lost 9% of its value this month and 4.4% last week. The local stock market, which is down more than 20% from its peak in May, also stabilized. Tightening was the right move. But the question is whether the market is convinced Bank Indonesia has the fortitude and independence to lead rather than react. That’s because at its regular Aug. 15 meeting the central bank flinched from a rate hike and instead tightened reserve ratios. After the market delivered a negative verdict, it reversed course at Thursday’s emergency meeting. Now it must convince investors that it learned from the mistake.Few are willing to predict that Indonesia will reprise the 1997 crisis, when the rupiah collapsed and the Suharto regime had to go cap in hand to the International Monetary Fund for a bailout. Still, there are some parallels between the situations then and now, and Indonesia is seriously vulnerable to a balance of payments crisis.

As a result of the U.S. Federal Reserve’s rounds of quantitative easing, cheap money has gradually returned Indonesia’s credit-to-GDP ratio to pre-1997 heights. True, this measure of leverage expanded less markedly than in some of its neighbors. But Jakarta must also contend with a large current account deficit, which spiked to 4.4% of GDP in the second quarter. With inflation at around 9%, real interest rates are negative, meaning it’s still cheap to invest—and also to short the rupiah.

On the other side of the argument, Indonesia’s fundamentals remain strong, with growth for the year expected to remain close to 6%. The government did well when it cut fuel subsidies in June, which should improve its fiscal position and reduce the trade deficit. It also unveiled a package of liberalization measures last Friday to boost investment and growth.

Still the central bank will likely be the decisive player in shoring up confidence. Bank Indonesia had $92.6 billion in forex reserves at the end of July, down 18% this year according to Bloomberg, and that should be sufficient to meet the country’s obligations and defend the rupiah. It can also call on support from Asian neighbors through a system of swaps set up after the 1997 crisis.

One of the main lessons from that experience, however, is that no amount of reserves is sufficient if they are not deployed correctly. The dilemma that Indonesia faces now is the same as 16 years ago, that monetary policy is often expected to serve two goals—exchange-rate stability and the health of the domestic economy. But when a crisis of confidence approaches and they conflict, it must choose the former or else achieve neither.

In other words, if the central bank follows the standard advice of the IMF and allows the rupiah to float, there is no telling how far it will fall. Currency depreciation is the IMF’s choice to stop a balance of payments crisis on the theory it makes exports cheaper and imports more expensive. But in practice, the destruction of the currency as a stable store of value creates financial chaos, which can then make trade freeze up.

It also inflicts hardship on the population through lower living standards, and that has political consequences. Recall that in 1998 Jakarta burned with riots as inflation hit 60%. When then-President Suharto briefly flirted with a currency board pegging to the dollar, a glimmer of hope emerged and the rupiah rallied by 30%. But by that point, he didn’t have the political strength to impose the high interest rates it required.

As in the aftermath of past credit booms, the markets are once again probing developing countries for weakness. Bank Indonesia’s resolve will determine whether Indonesia coasts through relatively unscathed or faces another severe setback.