Indonesia: stabilizing the exchange rate along its

fundamental

1
Perry Warjiyo

Abstract

For a small open economy like Indonesia, exchange rate movement does not always
reflect fundamental value. Increasing exchange rate volatility often occurs as a result
of volatile capital flows, irrational behaviour of market players, the microstructure
conditions of the market, and offshore market influence. In this case, relying solely
on interest rate policy to achieve the inflation target and maintain stability is not
always sufficient. Our strategy is to include exchange rate policy in the monetary
and macroprudential policy mix consisting of five policy instruments, i.e. interest
rate policy, exchange rate policy, management of capital flows, macroprudential
policy, and monetary policy communication. Under this framework, foreign
exchange intervention is implemented with the primary motivation of stabilizing the
exchange rate along its fundamental path and maintaining financial system stability.
In the case of Indonesia, the intervention has been able to reduce the inflation pass-
through effects of rupiah depreciation due to a recent period of capital outflows
and current account deficit. The central bank also performed dual interventions in
both the foreign exchange and bond markets to support financial system stability.
Keywords: exchange rate, monetary policy, central banking, open economy
macroeconomics
JEL classification: E52, E58, F31, F41

1
Deputy Governor, Bank Indonesia.

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A. Exchange rate policy under inflation targeting

Under the standard inflation targeting framework, interest rate response is the main
instrument to achieve the inflation target. A fully flexible exchange rate is usually
adopted as a shock absorber for external shocks to the domestic economy. The
monetary response to the pass-through effects of the exchange rate on the
domestic economy, including achievement of the inflation target, is based primarily
on interest rate policy.
For a small open economy like Indonesia, however, exchange rate movement
does not always reflect fundamental value. This is particularly so since the onset of
global crisis in 2008. Volatile capital flows, increasing risk appetite among global
investors, and news on the progress of crisis resolution in the advanced countries
may give rise to increasing exchange rate volatility beyond the fundamental.
Exchange rate overshooting is often amplified by a relatively shallow and inefficient
domestic foreign exchange market. Excessive exchange rate movement has
detrimental impact on the domestic economy as well as on monetary and financial
stability, and thus, managing the exchange rate cannot be based solely on
manipulating interest rates.
Under these circumstances, Indonesia regards exchange rate policy as an
integral part of an overall monetary and macroprudential policy mix designed to
achieve price stability while paying due attention to economic growth as well as
monetary and financial system stability. The general thrust of the policy is to
stabilize the exchange rate along its fundamental. Operationally, this involves a
number of steps. First, a methodology is developed to assess a number of options
for determining a fundamental level of the exchange rate that is consistent with the
objective of managing the external and internal balances.2 Second, a simulation is
conducted to assess how consistent the path of the exchange rate’s fundamental is
with the inflation and macroeconomic forecast, as part of the inflation targeting
exercise. Finally, decisions are made with regard to the interest rate response and
corresponding exchange rate path that are consistent with the objective of
achieving the inflation target.
Thus, under the framework, the monetary and macroprudential policy mix
consists of the following five policy instruments. First, the interest rate policy is the
main instrument to achieve the inflation target in the context of the forecasting and
policy analysis described above. The decision on the policy rate, i.e. the BI rate, is
made so as to ensure that the inflation forecast over the policy horizon (two years
ahead) will fall within the inflation target range (4.5%±1% for 2013 and 2014).
Second, the exchange rate policy is geared toward maintaining the stability of
exchange rate along the chosen fundamental path that is consistent with the
inflation and macroeconomic forecast over the policy horizon. The volatility of day-
to-day exchange rate movements along the chosen fundamental path is smoothed
out by symmetric foreign exchange intervention.

2
A number of methods are available to assess the fundamental level of the exchange rate, including
those developed by the IMF (the CGER and Macroeconomic Balance). Nonetheless, due to the
uncertainties involving these fundamental exchange rate levels, judgment is needed to decide
which exchange rate path is consistent with the objective of price stability, given the
macroeconomic forecast over the policy horizon.

178 BIS Papers No 73

 Third, management of capital flows, especially short-term and volatile flows,
is conducted to help stabilize the exchange rate as well as mitigate the risks of
capital reversal and financial system instability. This has involved a number of
macroprudential measures consistent with the principles of a free foreign exchange
system, e.g. applying a six-month holding period for BI’s certificates, limits on short-
term bank offshore borrowing, and foreign exchange reserve requirements.
Fourth, macroprudential policy is formulated to ensure financial system
stability and support the management of domestic demand in line with the overall
inflation and macroeconomic forecast. The objective here is to strengthen the
resilience of the financial system, including its ability to withstand exchange rate
risk, to mitigate the pro-cyclicality of the intermediation function, and to enhance
the efficiency of the financial system. A number of macroprudential measures have
been used in this context, including the application of a loan-to-value ratio to
contain excessive lending in the real estate and automotive sectors.
Finally, monetary policy communication is continuously conducted to
manage expectations so that they are in line with the inflation and macroeconomic
forecast. This is important not only for transparency, but even more importantly to
foster more forward-looking expectations and thus strengthen monetary policy
responses.

B. Foreign exchange intervention: motivation and tactics

As an element of the implementation of overall monetary and macroprudential

policy, the primary motivation of foreign exchange intervention is to stabilize the
exchange rate along its fundamental path. The emphasis is more on supporting
price stability and financial system stability than on maintaining external
competitiveness. Thus, with current account surpluses and sizable capital inflows
during the period from the onset of the global crisis up to August 2011, the rupiah
appreciated by as much as 14.9% in 2009, then by 4.6% in 2010 and 5.4% up to
August 2011 – an appreciation helpful in mitigating imported inflation due to high
global commodity prices during the period.
The situation was reversed as the global crisis worsened in September 2011
with the downgrading of the US ratings and the aggravation of the Greek crisis. The
immediate impacts took the form of huge capital outflows from Indonesia. Heavy
pressures led to exchange rate overshooting, threatening overall macroeconomic
and financial system stability as well as the momentum of economic growth. Even
though capital inflows resumed in 2012 as the global financial market improved,
pressures on the exchange rate continued as the current account went into deficit
territory with declining global commodity prices. Overall, the rupiah depreciated
6.9% from August to December 2011, and 6.6% in 2012. Graph 1 depicts the supply-
demand situation in the foreign exchange market, while Graph 2 shows the
corresponding path and volatility of the rupiah exchange rate.

Experience in Indonesia shows that understanding the behaviour of

international investors is important for the conduct of foreign exchange
intervention, given the effect of that behaviour on the nature and size of capital
flows as well as exchange rate movements. Two aspects need to be considered.
First, types of international investors, i.e. whether they are hedge fund or long-term
investors. Hedge fund investors are typically short-term operators looking for

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currency gain (carry trade), and thus often provoke volatility in the capital flows and
exchange rate. Long-term investors seek higher yield (interest and capital gains)
based on economic fundamentals, and thus they are more stable in their behaviour
as regards capital flows and exchange rates.

FX market supply-demand Graph 1

Rupiah exchange rate Graph 2

Second, the nature of factors that affect changes in the behaviour of

international investors, i.e. whether they are of global or domestic origin, also
matters. The origin of the factors does not matter to hedge funds, and any news
affecting currency gain may influence their portfolio decisions. On the other hand,
the portfolio decisions of long-term investors, as long as they have confidence in
the country’s economic fundamentals, are not easily affected by any short-term or
technical news that influences exchange rate movements.
We are able to study these international investors’ behaviour closely, since the
central bank functions include custody, settlement and sub-registry of government

180 BIS Papers No 73

bond transactions in the secondary market. The focus is to provide a climate that is
attractive to long-term investors. The policy objective of stabilizing the exchange
rate along its fundamental serves this type of international investor well. We
complement the conduct of foreign exchange intervention with active
communication to international investors through our Investor Relation Unit (IRU),
e.g. by teleconferencing, meetings, seminars, and our website’s continuous updates
on recent economic developments and other information.
Tactically, foreign exchange intervention is conducted through agent banks to
buy and sell foreign currency (mostly US dollars) depending on excess supply or
demand conditions in the market. The aim is to smooth out the volatility of
exchange rate movements along the chosen fundamental path. Most transactions
are spot, but the central bank is also conducting swap and forward transactions as
the bank’s needs and foreign exchange liquidity conditions dictate. Since mid-2012,
the central bank is also offering foreign exchange term deposits (through weekly
auctions) to those banks that are experiencing a temporary excess of foreign
exchange liquidity.
The conduct of foreign exchange intervention is integrated with domestic-
currency monetary operations to ensure that any impact on domestic liquidity is
managed and is consistent with supporting the interest rate policy (sterilized
intervention). During periods of heavy appreciatory pressure on the rupiah, the
expansion of domestic liquidity from the purchase of foreign exchange to stabilize
the exchange rate is absorbed through domestic monetary operations providing
more domestic currency term deposits, reverse repo operations using government
bonds, and the deposit facility. And the opposite is true when the rupiah faces
downward pressures. This sterilized intervention is designed to ensure that the
objectives of maintaining price stability, exchange rate stability and financial system
stability can be attained.
Since September 2011, particularly during heavy capital outflows, the central
bank’s foreign exchange intervention has been strengthened by the purchase of
government bonds in the secondary market. During these periods, in addition to
stabilizing the exchange rate along the fundamental, more intervention by the
central bank to supply foreign exchange was needed to provide for the increasing
demand from foreign investors who wanted to reverse their Indonesian portfolio
investments (mostly in the form of their holdings of government bonds). Central
bank purchases of government bonds in the secondary market actually serve a
number of purposes. First, such purchasing supports the foreign exchange
intervention to stabilize the exchange rate, since it directly addresses the root cause
of depreciation pressure, namely, reversals of foreign portfolio investments in
government bonds. Second, the purchase of government bonds acts to recycle back
into the financial system the domestic currency liquidity that was absorbed by
foreign exchange intervention, so that it is consistent with the overall objective of
the domestic monetary operations. Third, the operation is also consistent with the
central bank’s goal of employing government bonds, in preference to its own bills,
as monetary instruments. And finally, the dual intervention in both foreign exchange
and bond markets helps strengthen overall financial system stability by keeping two
of the three financial markets stable.

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C. Effectiveness of foreign exchange intervention

To assess the effectiveness of foreign exchange intervention, one could examine a

number of aspects that are in line with the central bank’s overall objective of
maintaining price stability as well as monetary and financial system stability. First,
there is the question of what the objective of the exchange rate policy is – merely
smoothing volatility, or also managing the path of exchange rate movement,
gaining the ability to influence exchange rate expectations, and other things.
Second, there is the matter of the depth and behaviour of the microstructure of the
foreign exchange market, e.g. the number of players, volume of transactions,
availability and variety of financial instruments, liquidity conditions and distribution
across players, counter-party risks, and the infrastructure needed for efficient
market functioning. The other aspect that is often important for the effectiveness of
foreign exchange intervention is the adequacy of international reserves relative to
the depth of the markets and the country’s external vulnerability. In general, the
more reserves there are, the more effective foreign exchange intervention will be.
In Indonesia’s case, we view exchange rate movement as not always reflecting
the economic fundamentals, let alone being consistent with the overall objective of
achieving price stability and supporting financial system stability. Exchange rate
overshooting occurs because of a number of factors, e.g. volatile capital flows,
irrational behaviour of market players, and the microstructure conditions of the
market, as well as influence from offshore markets. Thus, as stated above, the
objective of foreign exchange intervention is to stabilize the exchange rate along its
fundamental path. And judging from the perspective of this objective, the
intervention conducted has proven able to manage the exchange rate volatility and
ensure a path that is consistent with achieving the inflation target and supporting
financial stability. Over the more medium term, the rupiah gradually appreciated
during the period up to August 2011 and has been gradually depreciating since,
reflecting overall macroeconomic developments during these two episodes in the
Indonesian economy.
From the short-term perspective, the effectiveness of intervention in influencing
exchange rate expectations is more difficult to assess, since the exchange rate is
more susceptible to news developments and market reactions to them. In general,
when market reactions are not excessive, supply and demand in the market in most
cases can balance each other, and intervention may be more effective in influencing
both the spot and forward exchange markets if it is used to deal with any remaining
excess demand or supply in the market. Information on the distribution of spot
quotations and forward forecasts among market players could be used as input
when conducting intervention.
However, when news and market reactions are erratic, these two distributions
tend to widen, and even their central tendencies tend to diverge from the central
bank’s view on where the fundamental exchange rate path should be. The spread
between offshore and onshore exchange rates also tends to widen. An example is
what happened to the rupiah early this year, when the news included a number of
negative items, including widening current account deficits, the issue of increasing
fuel subsidy burdens and fiscal sustainability, and worries about foreign exchange
liquidity in the domestic market. The spread between offshore and onshore forward
rates widened to as much as RP 275 or about 2.8 percent of the RP 9650 per US
dollar exchange rate at that time (Graph 3). The spread is closing at present, as the

182 BIS Papers No 73

 central bank intensifies its efforts to supply foreign exchange to the market and its
communications on the balance of payments situation.

Exchange rate: onshore vs. NDF Graph 3

The microstructure of the domestic foreign exchange market also influences

the effectiveness of intervention. Even though there are 72 foreign exchange banks
in Indonesia, only about 22 to 38 banks actively trade in the foreign exchange
market. Domestic state-owned banks constantly supply foreign exchange, while
foreign banks' supply or demand depends on capital inflow/outflow. The volume of
transactions is relatively small, and it tends to be larger during periods of heavy
portfolio inflows (up to August 2011) but lower afterwards (Graph 4). Most
transactions are spot, although forward transactions are developing. There are
counter-party transaction limits, especially for smaller banks. Foreign exchange
transactions must have underlyings and are limited to domestic players only.

Volume of FX transactions Graph 4

USD

Domestic Banks vs. Foreign Banks

Domestic Banks vs. Domestic Banks

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 Under these conditions, rupiah exchange rate movements are prone to changes
in perceptions and market conditions, both domestically and offshore. On one hand,
the thinness of the market makes the banks heavily dependent on the central bank
to absorb any excess supply in the market (during current account surplus and/or
large capital inflow periods) and to supply any excess demand in the market (during
current account deficit and/or capital outflow periods). Thus, the adequacy of
foreign exchange reserves will increase the effectiveness of intervention, and for
that reason it needs to be continuously assessed in relation to current balance of
payments dynamics. On the other hand, the effectiveness of intervention will also
depend on the central bank’s ability to influence market expectations, since short-
term exchange rate movements are susceptible to any change in perceptions under
these microstructure conditions.
The foregoing discussion points to the need for complementing foreign
exchange intervention with other policies that are designed to manage the volatility
of capital flows and deepen the domestic market. For that reason, as discussed
earlier, a number of policies have been put in place in Indonesia to manage short-
term and volatile capital flows, e.g. a holding period for investment in the central
bank bills, limits on short-term offshore borrowing, etc. Capital flow management is
guided by the following three principles. First, it must be consistent with principles
regarding the foreign exchange system. The prudential measures for managing
capital flows apply to both residents and non-residents, and thus they are not
regarded as capital controls. Second, we welcome long-term capital flows that
benefit the economy, and thus our measures target short-term and speculative
capital flows. Third, the measures are designed so that they can be monitored and
implemented effectively.
To increase the supply of foreign exchange in the market, a regulation has been
issued requiring that foreign exchange receipts from exports and offshore
borrowing be repatriated to domestic banks. Continuous efforts have also been
directed toward deepening the domestic foreign exchange market to include
offering foreign exchange term deposits, and toward relaxing forward transactions.
The most recent measure in this area is the establishment of a market reference rate
for onshore foreign exchange transactions, including forward transactions, thus
limiting the impact of the offshore NDF rate on the domestic market.

D. Impacts on price stability and financial system stability

As explained in the first part of this paper, the success of foreign exchange
intervention in Indonesia will be judged on its contribution to achieving the inflation
target and supporting financial system stability. As to the former goal, exchange
rate policy should be able to reduce inflation pressures stemming from foreign
commodity prices (imported inflation). Thus, rupiah exchange appreciation in 2009,
2010, and 2011 (up to August) helped to reduce imported inflation during these
periods of high commodity prices. This was made possible by a sizable balance of
payments surplus due to both the current account surplus and huge capital inflows
during the period. Subsequently, the policy has been able to reduce the inflation
pass-through effects of rupiah depreciation due to capital outflows and a current
account deficit. The decline in global commodity prices since 2012 was helpful to
the policy. In 2012, for example, the rupiah depreciation of about 6.6% in nominal
terms was less than the decline of Indonesian external commodity prices, which was
roughly 14.7%.

184 BIS Papers No 73

Exchange rate, global commodity prices and core inflation Graph 5

Graph 5 depicts developments in the exchange rate, global commodity prices,

and core inflation, while Graph 6 breaks CPI inflation down into core inflation,
volatile food prices, and administered prices. During the first episode, nominal
rupiah appreciation was able to mitigate the impact of high global commodity
prices on tradeable core inflation. Subsequently, depreciation of the rupiah has not
had significant pass-through effects on tradeable core inflation, as it coincided with
the decline in global commodity prices. In most cases, core inflation can be
maintained below 4.50% and plays a significant role in the efforts of the central
bank to achieve the inflation target. CPI inflation declined from 6.96% in 2010 to
3.79% in 2011 (inflation target 5%±1%) and to 4.32% in 2012 (inflation target
4.5%±1%).

Inflation: CPI, core, volatile food, administered prices Graph 6

20
CPI
% , y oy
16
Cor e
Vola t ile Food
12
A dm inist e r e d Pr ice s

8 7.48

4
4.32
2.42
0 4.57

-4

-8
10
11
12

10
11
12

10
11
12

10
11
12
1
2
3
4
5
6
7
8
9

1
2
3
4
5
6
7
8
9

1
2
3
4
5
6
7
8
9

1
2
3
4
5
6
7
8
9

2009 2010 2011 2012 2013

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 As to supporting financial system stability, this has been managed through dual
interventions of the central bank in both the foreign exchange and bond markets.
Not only can exchange rate stability thus be maintained, but also the dual
intervention has been able to ensure that domestic liquidity is sufficient and
consistent with managing monetary and financial system stability. This is in contrast
to what happened in 2008, when heavy foreign exchange intervention to defend the
rupiah from the impacts of the global crisis caused a shortage of domestic liquidity
and put pressures on conditions for banks, especially smaller banks. Furthermore, as
discussed above, central bank purchases of government bonds in the secondary
market have been able to address the root cause of exchange rate pressures and
helped to stabilize the financial markets.
Graph 7 shows the evolution of the monetary policy rate (BI rate) and monetary
aggregates. With the help of exchange rate policy geared toward stabilizing the
rupiah along its fundamental path and managing imported inflation, the BI rate can
be consistently designed to control inflation so that it falls within the target.
Monetary operations are conducted to manage domestic liquidity consistent with
the interest rate policy, as shown in the evolution of monetary aggregates, which
reflect the economy’s liquidity conditions. Graph 8 depicts the downward shift in the
yield structure of government bonds, in line with inflation that was under control,
and the decline in the policy rate. Foreign ownership of government bonds is also
stable at about 30% of the outstanding amount, and there has been a shift toward
longer-term maturity.

Interest policy rate and monetary aggregates Graph 7

30 14
%, yoy %, yoy
M2 M1 BI Rate (RHS)
25
12
21.53
20
10
15.68 16.4
15 14.9

8
10

6
5
Per Des 2012
Rata-rata periode sebelum krisis
Mei 2006-Sept 2008 M1: 21.5%, M2: 15,7%
0 4
Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12
Mar-10

Mar-11

Mar-12
May-10

May-11

May-12
Nov-10

Nov-11

Nov-12
Sep-10

Sep-11

Sep-12

In summary, exchange rate policy in Indonesia is geared toward price stability

and financial system stability. The main motivation of foreign exchange intervention
is to stabilize the exchange rate along its fundamental, consistent with these
objectives. Tactically, this has been done through dual intervention: in the foreign
exchange market in addition to the central bank’s operations in the secondary
government bond market. The policy has been strengthened with other measures

186 BIS Papers No 73

 to manage short-term and volatile capital flows, with macroprudential policies, and
with on-going efforts to deepen domestic financial markets.

Term structure of government bond yield Graph 8

8 Des 2011 - Des 2012 (YoY) bps

% 30
7,5 Dec-11
Dec-12 10
7
-10
6,5
-30
6

5,5 -50

5 -70

4,5 -90

4 -110
1 2 3 4 5 6 7 8 9 10 15 20 30
Maturity
Tenor (years)

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