BI data showed that the country’s foreign exchange reserves have been on a steady decline in the first quarter of 2024, down by almost US$4 billion a month in the February-March period. Besides the high demand for US dollar ahead of Ramadan and Eid, the decline was also attributed to the intervention measures carried out by BI to ensure that Rupiah stay below Rp16,000 in the first quarter.
While Eid had a positive impact on the economy (as it stimulated increased household spending across social classes), it also spurred demand for US dollars as businesses needed to settle their transactions in American currency. Unfortunately, a rapidly changing geopolitical situation led to more uncertainly after Iran and Israel engaged in a tit for tat, in an already volatile region.
Fundamentally, when the global economy slows down, demand for energy will also decline. However, intensifying tensions between Iran and Israel will have broad implications, since Iran is one of the world’s major oil producers. It was thus unsurprising that global oil prices have surged to US$90 per barrel. Nevertheless, many analysts predicted that this will only be temporary, considering that it occurs during a global economic slowdown. Oil prices are expected to return to a fundamental level of around US$80 per barrel for the remainder of 2024. If however the conflict widens, and major powers that back the combatants get dragged into the war, it is almost certain that oil prices will breach US$100 per barrel.
Rising oil prices will naturally push inflation higher, as energy-related costs will be passed on to consumers through higher price tags of everyday goods. Unlike in Indonesia, inflation tends to surge more quickly in developed countries, because such nations do not subsidize energy prices. If the Israel-Iran conflict spins out of control, it is highly likely that the government will be forced to raise the price of fuel to alleviate fiscal burdens compounded by sharp currency depreciation.
Monetary policy shift
To some extent, rising geopolitical tensions have had contagious effect on Indonesia’s financial sector. Amid ever-greater uncertainty, global investors in the money market have become increasingly worried about Indonesia’s economic outlook, despite stability in the short term. The implication is that they tend to move relatively riskier assets to “safe havens” such as gold and the greenback, as can be seen from their rising value.
To arrest the currency decline, BI did not only launch foreign exchange market intervention: it also increased its key policy rate from 6 to 6.25 percent. This signaled that it will adopt a “pro-stability” monetary policy stance. The hike also illustrates that Rupiah depreciation is considered sufficiently sharp, and thus requires the central bank’s monetary policy operation to calm the market. In fact, a 25 bps increase is not sufficient to stabilize the Rupiah, as it still hovers above Rp16,200 per US dollar and has continued to fluctuate after the two-day policy meeting. On the other hand, a more aggressive stance in raising the base rate risks slowing the economy further.
A BI rate hike also indicates a shift from a loose to a tight monetary policy, and from an optimistic to an increasingly pessimistic outlook. This was an about-face, as BI, which often toes a Fed line, actually signaled last year that it may relax the benchmark interest rate – since inflation was relatively contained. Unfortunately, this hope is likely to be dashed in 2024, as a rising geopolitical temperature stands in the way of global economic recovery.
The world’s central banks, especially those of developing countries, tend to adjust their benchmark interest rates in lockstep with the Fed’s decision. Of course, they also need to take into account the economic readiness of their respective countries, but one thing is certain: the fraught geopolitical situation this time around means that the higher-for-longer interest rate environment is likely to persist. The implication is that the world needs to be prepared for slower economic growth, Indonesia being no exception.