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Indonesia's rate hike best for the medium term

Sha Ying | CNBC

Despite the lackluster reaction in Indonesia's currency and stock market, the Indonesian central bank's surprise interest rate hike was the right move, analysts say.

The Jakarta Composite index was 0.2 percent lower Friday afternoon, after Bank Indonesia surprised markets on Thursday by raising interest rates for the fourth time this year. Meanwhile, the rupiah, which has seen a sharp rout in recent months, saw further weakness.

"Sometimes the market reaction is on the contrary but [the decision to hike rates] should be positive…In our view it's the right thing to do," Ferry Wong, head of Indonesia research at Citigroup Securities told CNBC's "Cash Flow".

(Read more: Why Indonesia could be worse off than India)

The companies that I've spoken to in Indonesia haven't seen signs of slowing demand, he said. "As a result we do agree this is the right move and the market should have taken this as positive in our view," he added.

Bank Indonesia's 25 basis point rate hike, which brought the benchmark rate to 7.25 percent, took many by surprise as the bank hiked rates by 50 basis points at emergency meeting just a few weeks ago. The central bank has been desperately trying to shore up losses in the beleaguered rupiah, which has fallen over 15 percent this year as fears over a tapering of the Federal Reserve's asset purchase program prompted sharp capital outflows from the region.

(Read more: Indonesia central bank surprises market with rate hike)

Indonesia's stock market has also taken a battering, falling 16 percent since late May, though it has recovered some lost ground this month.

According to Shane Oliver, head of investment strategy and chief economist at AMP Capital, although the rate hike should help Indonesia's economy in the medium term, investors should expect more short-term pain.

"The problem is when you run a current account deficit at [around] 4% of GDP and foreign investors have lost interest in funding that current account deficit, then you have to slow demand in the economy," said Oliver.

"The problem is that it is the right thing to do in the medium term, but it can cause a lot of pain in the short term. Eventually the hike in interest rates will start to bear fruit and the economy will stabilize but in the short term we will go through a rough patch," he added.

(Read more: Indonesia: Is it time to jump back in?)

Vishnu Varathan, senior economist at Mizuho Bank, warned that Bank Indonesia may need to take additional action to limit further losses for the rupiah.

"[Thursday's] tightening was another shot at taming the dollar-rupiah bulls. And while urgency for further aggressive hikes is diminished, Bank Indonesia can't safely take its finger off the trigger yet," he said.

Bank Indonesia also revised down its 2013 gross domestic product growth forecast Thursday to 5.5-5.9 percent from 5.8-6.2 percent, and its 2014 forecast to 5.8-6.2 percent from 6-6.4 percent.

—By CNBC's Katie Holliday: Follow her on Twitter @hollidaykatie

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