Bank Indonesia Surprises With Rate Increase to 7.25%

Updated September 12, 2013, 10:03 a.m. ET

Bank Indonesia Surprises With Rate Increase

Central Bank Raises Its Overnight Policy Rate to 7.25%

FARIDA HUSNA And ANDREAS ISMAR

JAKARTA—Indonesia’s central bank on Thursday announced a surprise increase in its policy interest rate, reflecting its commitment to protect the country’s currency, as global sentiment remains fragile. Bank Indonesia raised its benchmark rate by a quarter percentage point to 7.25%, just two weeks after raising it by a half percentage point. It also raised a key money-market rate, known as the Fasbi rate, by a quarter percentage point to 5.50%.“Defending the currency is a policy priority,” said Christian de Guzman, a sovereign debt analyst with Moody’s Investors Service.

Indonesia’s currency has lately been hurtby an exodus from emerging-market assets, since the U.S. Federal Reserve in May began preparing to wind down its support for the U.S. economy. In recent weeks, the rupiah has continued to fall, even as other hard-hit currencies like the Indian rupee have begun to recover.

Some observers say rate hikes are a quick way to restore investor confidence and cool an economy that has been overheating. Others say tightening policy in a slowing economy is risky.

Anton Gunawan, a Jakarta-based economist at Bank Danamon and one of two people nominated to become a senior deputy governor at Bank Indonesia, said the decision seemed to be intended “just to please portfolio investors.”

“It seems that BI is not confident and is still worried about the possible shocks that could happen if the Fed starts tapering,” he said.

Others hailed the central bank’s move.

“This is exactly what the country requires to iron out its imbalances and get into a position where everyone can once again look forward to a renewed, sustainable recovery,” Credit Suisse economist Robert Prior-Wandesforde said.

Central banks in South Korea, New Zealand and the Philippines held rates steady on Thursday, in contract to the Bank Indonesia move. But in India, the central bank has recently tightened liquidity and taken steps to restore investor confidence in the economy and currency.

In recent years, Indonesia’s economy has grown at more than 6% annually on the back of commodity exports to China. As domestic demand expanded, imports of oil and consumer goods boomed. The result was a trade deficit, which hit a record of $2.3 billion in July.

Slowing China demand and higher U.S. interest rates have changed Indonesia’s situation. Growth is slowing toward 5%, consumer inflation is moving toward double digits and investors have retreated from Indonesian stocks and bonds.

Some investors have returned to Indonesian assets since the central bank raised rates at an extraordinary meeting Aug. 29. The Jakarta Composite Index has risen about 5.6% since then, but the rupiah has struggled to make up lost ground.

The currency has fallen about 15% so far this year, despite attempts by the central bank to prop it up by spending nearly $20 billion of its foreign-exchange reserves. The rupiah rose strongly after Thursday’s rate decision and was quoted at IDR11,350 to the dollar late Thursday, up from IDR11,600 to the dollar a day earlier.

The central bank “aims to regain the initiative over the currency,” said Peter Kinsella, a currency analyst at Commerzbank. Bank Indonesia is “prepared to lift rates to help stabilize the currency, even at the expense of growth short-term.”

But others say Bank Indonesia should step aside and allow the exchange rate to fall—as South Africa recently has done—which would boost exports and crimp imports by making them more costly in local-currency terms.

Lars Christensen, head of emerging-market research at Danske Bank in Copenhagen, said Indonesia risked “raising rates at the wrong time,” just as economic growth is slowing.

“I do think there’s an element of panic, an element of ‘we don’t want to lose control of the currency,'” he said after the decision.

Raising rates in such a situation could make Bank Indonesia appear to be acting haphazardly, instead of keeping a longer-term focus on fighting inflation, Mr. Christensen said.

Part of the problem is that inflation in Indonesia is difficult to target because of large shocks from agricultural prices. In addition, the presence of an extensive subsidy program blunts the beneficial impact of a weaker rupiah: The weaker currency will help reduce imports but will also blow out the government’s budget for fuel subsidies. In June, the government reduced the level of fuel subsidies, a politically sensitive move that has contributed to soaring inflation.

“Raising rates to support the currency has had little effect, which isn’t surprising since the selloff stems from disappointment in the pace of structural reform,” Moody’s Analytics wrote in a note to clients Thursday.

Bank Indonesia has won praise for becoming more independent from political interference in recent years. But it also has failed to meet its stated inflation goals. The bank currently has a year-end target of 3.5%-5.5% on-year growth in consumer prices—but says it actually expects inflation to come in at almost 10%.

The central bank Thursday cut its economic growth forecast for this year to 5.5%-5.9%, from a previous range of 5.8%-6.2%, which would mark the first year of growth below 6% since 2009. It also lowered next year’s growth outlook to 5.8%-6.2%, from 6.0%-6.4%.