Indonesia’s central bank, Bank Indonesia (BI), surprised markets this week by cutting its key interest rate, creating uncertainty for government bond yields and the rupiah. This move, defying predictions from economists, raises questions about the central bank’s strategy and its potential impact on the Indonesian economy.
Bank Indonesia lowered its seven-day reverse repurchase rate by 25 basis points to 5.75% on Wednesday. This decision contradicted the unanimous expectation of 38 economists surveyed by Bloomberg, who anticipated the central bank would maintain its policy rate. This unexpected move has sent ripples through the market, prompting investors to reassess their outlook for Indonesian bonds and currency. Rajeev De Mello, a global macro portfolio manager at Gama Asset Management SA, characterized the decision as a “risky move,” highlighting the increased financial risk for Indonesia, particularly given the existing policy uncertainty stemming from the US. He argued that this is not an opportune time for emerging market central banks to ease monetary policy.
This rate cut follows a period of significant selling pressure on Indonesian government bonds, with the 10-year yield surging over 50 basis points since the US election in November. This represents the most substantial yield increase in emerging Asia. While the rate reduction may offer temporary relief to bond yields, it introduces uncertainty about Bank Indonesia’s future actions, given its history of unexpected policy shifts. Some analysts caution that continued rate cuts could result in a balance-of-payments deficit, further destabilizing the economic outlook.
Indonesian Rupiah Performance Against USD – Illustrative Example
Prior to this decision, Bank Indonesia seemed primarily focused on bolstering the rupiah against a strengthening US dollar. The rupiah has depreciated nearly 5% against the dollar in the past year, leading many investors to believe that BI would postpone rate cuts to avoid further currency weakness. This assumption proved incorrect, with Governor Perry Warjiyo stating a shift towards “pro-stability and growth” and suggesting further potential rate cuts.
The 10-year Indonesian government bond yield reached a high of 7.32% before the rate cut announcement, its peak since November 2022, before retreating to 7.21% during Thursday’s trading. However, the future trajectory of yields remains unclear. A crucial concern for investors is the potential for the rate cut to weaken the rupiah, thereby exerting upward pressure on bond yields. The inverse correlation between the rupiah and Indonesian bond yields (-0.58) is the strongest in emerging Asia, indicating that a weaker currency often coincides with higher yields.
The rupiah underperformed its Asian counterparts on Thursday, weakening 0.4% against the dollar to 16,385. It is now less than 2% away from its lowest point since the peak of the Covid-19 pandemic in March 2020. De Mello suggests that the 10-year yield could climb towards 7.75%-8%, particularly if US-China trade tensions escalate.
Bank Indonesia’s decision contrasted with the Bank of Korea’s choice to hold rates steady on Thursday, citing concerns about the weak Korean won, despite widespread expectations of a rate cut.
Illustrative Example of Bond Auction Bid-to-Cover Ratio Trends
Indonesia’s recent bond auction saw a bid-to-cover ratio of 1.21 times, the lowest in at least five years, suggesting potential challenges in meeting future bond demand. Winson Phoon, head of fixed-income research at Maybank Securities Pte in Singapore, observes that the government seems to be front-loading bond issuance in the first quarter to mitigate risks associated with potential funding challenges and the early start of Ramadan in late February.
Bank Indonesia plans to purchase approximately 150 trillion rupiah of bonds in the secondary market this year, exceeding the roughly 100 trillion rupiah of pandemic-era bond holdings maturing in 2025. Global funds withdrew $152 million from Indonesia’s bond market on Monday, the largest single-day outflow in two months, following a robust US employment report that reinforced expectations of a slower pace of Federal Reserve rate cuts.
In conclusion, Bank Indonesia’s surprise rate cut presents a complex scenario for Indonesian bond yields and the rupiah. The move, aimed at stimulating growth, carries risks related to currency depreciation and potential capital outflows. While the short-term impact on yields may be positive, the longer-term outlook remains uncertain, contingent on factors such as US monetary policy, global trade tensions, and the performance of the rupiah. The central bank’s decision underscores the challenges facing emerging markets in navigating a volatile global economic landscape.
