Narrowing Interest Rate Differential Between BI and the Fed Weakens Rupiah

The potential for three more interest rate hikes by the U.S. Federal Reserve (The Fed) by the end of the year has strengthened the dollar against major world currencies. This sentiment has also led to the dollar strengthening against regional currencies, including the Indonesian Rupiah. Analysts predict that The Fed will raise its benchmark interest rate by 25 basis points (bps) to two percent in its mid-year meeting.

After Bank Indonesia (BI) lowered its benchmark interest rate, the BI 7-day Reverse Repo Rate, to its lowest level of 4.25%, The Fed has taken the opposite approach by raising its benchmark rate. BI lowered its interest rate to stimulate the real economy amid sluggish business activity. Meanwhile, the U.S. central bank is raising its interest rate to curb inflation. Currently, the interest rate differential between BI and The Fed is only 250 bps, whereas at the beginning of 2015, the difference was 500 bps.

The Fed's interest rate hike has narrowed the interest rate differential between the U.S. central bank and the Rupiah. This means that the potential for profit from investing in Indonesia is diminishing. This is causing foreign investors to exit the domestic financial market. Fundamentally, the Rupiah remains strong, supported by economic growth above five percent, controlled inflation, sufficient foreign exchange reserves to cover more than seven months of exports and government foreign debt, and a manageable budget and trade deficit.