Indonesia's central bank raised its benchmark BI rate by 25 basis points to 6.0 percent in what it described as a pre-emptive move to "rising inflation expectations and to maintain macroeconomic stability and financial system stability amid increasing uncertainty in global financial markets."
The rate hike by Bank Indonesia follows Tuesday's 25 basis point increase in its overnight deposit rate to 4.25 percent, underlining authorities' determination to defend and stabilize the rupiah, which has come under pressure along with the exchange rates of most Asian and emerging market currencies in recent weeks.
"Pressure on the rupiah was associated with the repositioning of financial assets from emerging markets in line with the possibility of monetary policy adjustments by the Fed and negative sentiment towards domestic fiscal and current account deficits," Bank Indonesia said.
"Bank Indonesia continues to maintain the stability of rupiah exchange rates in line with its economic fundamentals and provides adequate liquidity in the foreign exchange market," it added.
The rupiah has been steadily depreciating since hitting a recent high of 8,455 to the U.S. dollar in August 2011, down 16.8 percent to 9,877 rupiah per dollar today.
But since May 22, when the U.S. Federal Reserve chairman said the U.S. may reduce its asset purchases "in the next few meetings," the decline in the rupiah's exchange rate has accelerated and trading has become volatile with rupiah forward rates falling as foreign investors withdraw money.
"Rupiah depreciation pressure increased in May," Bank Indonesia said, noting it had declined by 0.74 percent to the U.S. dollar.
Earlier this week, when Bank Indonesia raised its deposit rate, it said that it was "fully prepared to take necessary measures to stabilise monetary conditions in light of recent rupiah depreciation."
The rupiah has been under pressure for a while due to uncertainty over the government's plan to cut popular fuel subsidies that have boosted the budget deficit. The delay in cutting those subsidies has unnerved foreign investors while the plan to cut subsidies has driven up inflationary expectations. Last month Standard and Poor's revised its outlook on Indonesia to stable from positive.
"Going forward, Bank Indonesia believes that the financial stability will be maintained with banking intermediary function at a moderate level in line with a decelerating economic performance," the central bank said.
Last month the central bank warned that it would not hesitate to adjust its policy rate and was closely monitoring inflationary pressures from the plan to cut fuel subsidies, which would lead to higher fuel prices. The bank has often expressed its concern over the impact on inflation from such a move and a deputy governor signaled in late May that the central bank was shifting to a tightening bias.
Bank Indonesia's previous change in its rate was in February 2012 when it cut the BI rate by 25 basis points from 6.0 percent.
Indonesia's inflation rate eased slightly in May to 5.47 percent from 5.57 percent in April but the central bank repeated that inflation expectations have been rising ahead of the anticipated government policy on fuel subsidies with higher administered prices due to higher electricity tariffs and a disruption in the supply of propane.
Bank Indonesia targets inflation of 4.5 percent, plus/minus one percentage point.
The central bank's new governor, former finance minister Agus Martowardojo who took over three weeks ago, has warned that inflation could surge to as high as 7.76 percent if the government raises subsidised fuel prices.
Growth in Indonesia's economy in the second quarter of this year is forecast to be in the lower bound of the bank's forecast of 5.9-6.1 percent due to slower global growth due to Europe's continuing crises and a slowdown in China, the bank said.
"These conditions restrained the growth of exports and investment, especially non-construction investment," the central bank said, adding that growth continues to be driven by strong household consumptions and investment in construction.
In the first quarter, Indonesia's Gross Domestic Product eased to annual growth of 6.02 percent, slightly down from 6.11 percent in the fourth quarter. Last month the central bank forecast 2013 growth in the lower range of its 6.2-6.6 percent forecast compared with 2012's growth of 6.2 percent.
Indonesia's balance of payments is expected to improve in the second quarter, the bank said, due to surplus in the capital and financial accounts despite a deficit in the first quarter. Exports are still subdued due to weak external demand and lower global commodity prices while imports continue to rise.
Indonesia's international reserves were US$ 105.1 billion at the end of May, the bank said, the equivalent of 5.8 months of imports and debt service payments.
"Going forward, Bank Indonesia believes that the financial stability will be maintained with banking intermediary function at moderate level in line with a decelerating economic performance," the central bank said.