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Bank Indonesia to soothe investors’ nerves

Dimas Ardian | Bloomberg | Getty Images

After a surprise rate cut in February triggered volatility in Indonesia's bonds and currency, the central bank is likely to spare investors another shock this month, analysts say.

"The Indonesian rupiah has been volatile over the past month," said ANZ ASEAN economist Daniel Wilson. And, given that international capital flows fund Indonesia's large current and fiscal deficits, "the central bank is now managing a slow and guided depreciation" of the Indonesian rupiah," he said.

Bank Indonesia surprised markets in February with its first rate cut since 2011, which sparked a selloff in the rupiah. Comments by central bank governor Agus Martowardojo a few weeks later that inflation will slow more than expected this year triggered further selling, with the rupiah losing 3.7 percent against the U.S. dollar since the rate cut.

The central bank is expected to hold rates at Tuesday's policy meeting, according to Reuters' poll.

Keeping everyone on board

While the rupiah is currently trading at its lowest levels since August 1998, Indonesia may need to further weaken its currency to boost manufacturing exports. But the country cannot risk scaring away foreign investors, analysts say, as they're needed to help fund the current and fiscal deficits.

On Monday data showed Indonesia's exports were down 16 percent on year in February – their biggest decline in two-and-a-half years.

Bond investors for their part have retrenched from the volatility, cutting their holdings by 11.6 trillion rupiah ($876 million) between March 3 and 13, according to ANZ senior Asia rates strategist Kuma Rachapudi's note published on Friday.

The yield on the 10-year government bonds plunged almost four percent in the week following the central bank's surprise rate cut to 6.902 percent. It bounced back by nearly 11 percent the following week to 7.638 percent, but had fallen back to 7.367 percent by Monday.

"If Bank Indonesia doesn't cut rates and the currency stabilizes, we think the bond market should stabilize as well," said ANZ's Rachapudi. "With offshore investors selling bonds in the last few days, we think that this auction will be a litmus-test for Indonesian government bonds."

The Indonesian Debt Management Office will auction 10 trillion rupiah of bonds on Tuesday.

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Cheaper rupiah all the way

While Bank Indonesia will likely hold off on weakening its currency for now, analysts say it's likely later this year.

"[Bank Indonesia] is smoothing the way for an orderly depreciation," said ING Financial Markets' head of research Asia, Tim Condon.

Condon expects the rates cuts to come in the second half of this year after the central bank has confirmed that inflation has slowed. He sees rates at 6.75 percent by year-end, with the rupiah at 13,600 in a year's time.

ANZ's Wilson "still sees scope for rate cuts" and expects the next cut to come at the April or May meeting; he sees the rupiah at 13,600 at year-end.

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That should help nudge the economy back on track after growth slowed to a five-year low of 5.0 percent last year, according to Wilson. He expects gross domestic product growth of 5.4 percent this year and 6 percent in 2016.

Whether easing monetary policy will have the desired effect of lifting manufacturing exports is another question, however.

Wages have been increasing in Indonesia by around 12 percent a year since 2011, but labor productivity growth across the whole economy was just 4 percent, according to a Capital Economics note published on Monday.

Considering the rupiah's real effective exchange rate adjusted for inflation is still roughly at the same level as in the middle of 2011, "the impression is that the rupiah has had to fall sharply just to prevent Indonesian firms from becoming less competitive," according to the Capital Economics note.