The dramatic decline in the value of the rupiah in the last couple of months set alarm bells ringing and spurred discussions about a repeat of the 1997 Asian Financial Crisis. Though a major financial crisis is unlikely due to Indonesia’s relatively strong economic fundamentals, we expect the rupiah to continue experiencing downward pressure in the next 12 months. The depreciation will likely be driven by a range of external events and domestic factors.
While the impact of certain events such as rising US interest rates and intensifying US-China trade tensions are much discussed, domestic factors will also be key drivers of the currency’s performance in 2019:
- The widening current account deficit
Indonesia’s current account deficit has been widening, which is increasing the downward pressure on the rupiah. To curb the weakness, the government is introducing measures to reduce imports. While these efforts will provide some support, they are unlikely to prove sufficient to alter the directional trend of the rupiah in 2019.
Another factor that may result in a significant shift in Indonesia’s current account is changes in prices of certain commodities. An increase in prices of commodities such as rubber, coal, and palm oil could increase the value of Indonesia’s exports and provide support to the rupiah. On the other hand, a continued rise in oil prices may result in an increase in the value of imports, pushing down the value of the currency. Overall, we believe that downside risks from changes in commodity prices will outweigh the potential gains for the rupiah in 2019.
- A large budget deficit
Indonesia’s persistent fiscal deficit makes the government increasingly dependent on debt financing. With about 40% of the public debt being held by foreigners, the Indonesian rupiah is highly vulnerable to external shocks and emerging market sell-offs.
To reduce exposure to risks, the Jokowi administration plans on cutting its fiscal deficit to 1.8% of GDP in 2019 from the expected 2.3% in 2018. Details of the 2019 state budget, which will likely be released in the coming weeks, will provide greater insight into the government’s 2019 plans. Until then, the government’s ability to achieve its target while also increasing social spending to win support in the upcoming elections remains doubtful. Without a reduction in the fiscal deficit, the rupiah will likely continue to weaken further.
- An insufficient tightening of monetary policy
The rupiah is highly vulnerable to US interest rate hikes as increases in Fed rates result in large capital outflows from Indonesia, driving down the value of the rupiah. Continuous rate hikes by the Indonesian central bank can help reduce capital outflows and support the currency. The central bank governor, Perry Warjiyo, has even vowed to continue implementing “pre-emptive, front-loading, and ahead-of-the-curve monetary policy” to maintain currency stability.
However, while the central bank seems committed to stabilizing the rupiah through increases in interest rates, several rate hikes will likely be required to significantly support the currency. As the required high-frequency rate hikes could reduce economic growth and inflation in the medium-term, the central bank may be unwilling to press on with the rate hikes necessary to defend the rupiah against capital outflows in 2019.
- The upcoming presidential election
The period surrounding the national elections, to be held in April 2019, may see heightened political risk. The rupiah may experience increased volatility and depreciation as investors in financial markets seek to reduce risks from potential election outcomes. With campaigning for the elections just kicking off, we are monitoring the candidates’ policy priorities to evaluate the potential impact on the currency following the elections.
Insufficient government and central bank efforts, upcoming presidential elections, and external triggers will likely drive the weakening of the rupiah in 2019. Continued rupiah depreciation and volatility can negatively impact MNCs performance in Indonesia, increasing costs and dampening demand. As executives solidify their strategic plans for 2019, it is important to evaluate how these factors and the rupiah’s performance will impact them next year.
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