A more integrated global economy will have a greater impact on individual economies, especially a small open economy such as Indonesia. One of the impacts on Indonesia comes from the volatility of the rupiah. The rupiah’s weakening trend seems inevitable, following the weakening pattern of regional currencies against the US dollar.

The rupiah’s fluctuation is driven not only by changes in the national economic fundamentals, but also by the sudden change in foreign investor behavior, which may significantly influence the flow of foreign funds and the offshore markets. As we already know, Indonesia adopted the floating exchange rate system after the Asian financial crisis of 1997/1998.

In this system, the rupiah exchange rate is determined by the supply and demand mechanism in the foreign exchange market. However, the rupiah’s fluctuation, in practice, can be easily influenced by profit-taking behaviors, shortening duration, currency swap and loss-minimizing acts by foreign investors.

In the first quarter of 2018, the rupiah fluctuated between Rp 13,268 and Rp 13,803 per US dollar, with 0.19 percent daily rupiah volatility. The US dollar appreciation, as reflected by a higher Dollar Index (DXY), re-touched level 90 in early April 2018 after a long time hovering in the range of level 88 to 89.

The recent weakening catalysts of the rupiah are mostly derived from external factors. First, the market expects that the Federal Reserve is prone to be more aggressive in adopting monetary tightening after the new governor, Jerome Powell, signaled for a hawkish monetary policy. The Fed members are also quite confident that the US economic growth and inflation rate shall increase, as expected, soon.

Additionally, the Fed is still on track to lift its benchmark rate gradually in 2018 to 2.25 percent from its current level of 1.75 percent. The recent FOMC meeting also states that US inflation is expected to move up this year and stabilize at around 2 percent over the medium term, along with stronger labor market conditions.

Second, the market is still looking forward to the implementation of the Trump administration’s inward-looking political and economic policies. This can be an additional catalyst for the Fed to further raise its benchmark rate this year and next year.

Third, the role of foreign investors is also very large. The appetite of investors to grab higher profits has made the domestic financial market vulnerable to capital flight. Global uncertainty and concerns about geo-political conflicts between countries tend to make many investors choose safe haven instruments, such as the US dollar, Swiss franc and Japanese yen. Gold and oil commodities are also considered as safe alternative investments when global turmoil occurs.

In addition, the rising 10-year US treasury yield and dividend repatriation season in the second quarter of 2018 have put more pressure on the rupiah. At the time of capital flight, the rupiah will depreciate with a wave of selling. On April 20 there was a Rp 20 trillion (year to date) outflow in the stock markets, causing the rupiah to depreciated to Rp 13,878 per US$, the weakest position since 2015.

Understanding investor behaviors in order to minimize capital outflow is indeed not an easy thing, yet it is very crucial to do so. According to Bank Indonesia, there are two aspects to be observed from investor behaviors. First is to know the type of investor. Hedge funds investors are looking for currency gains (carry trades) while long-term investors seek for higher yields from interest and capital gains based on fundamentals. The behavior of long-term investors thus tends to be relatively steadier toward capital flows and currency transactions. Second is to understand factors influencing the foreign investors’ behavior, such as their origins, risk appetites and confidences.

When the rupiah suffers heavily from a sharp decline, which majorly disrupts the stability of the financial system, the role of Bank Indonesia becomes very important and necessary. Bank Indonesia has several policy instruments to maintain the rupiah’s stability, including a policy mix used to maintain exchange rate stability and the financial system. This policy mix includes macro-prudential and monetary policies comprising five policy instruments, namely interest rate policy, exchange rate policy, capital flows management, macro-prudential policy and monetary policy communication. In relation to the exchange rate, Bank Indonesia indeed has to be in the market to maintain the rupiah’s stability. Its policy provides an important role to ensure that the rupiah exchange rate is at its fundamental value, as well as to maintain stability of the financial system.

Facing the current situation, Bank Indonesia has undertaken a policy to maintain the rupiah stability. One of them is using foreign exchange reserves. At the end of March 2018, the foreign exchange reserve position was reported at around US$126 billion, decreasing by $5.98 billion from the position in January 2018, $131.98 billion.

These shrinking foreign exchange reserves are a result of the foreign exchange use for foreign debt repayment and stabilization of the rupiah. Furthermore, the declining placement of bank foreign exchange at Bank Indonesia, in line with the requirement of repayment of foreign currency liabilities, also affects the foreign exchange reserve decrease in March 2018.

In the short and medium term, we see that potential rupiah volatility shall remain high. The Fed and Trump administration policies, along with capital outflows, are the key factors from the external side, which may put major pressure on the rupiah’s movement. The potential for widening the current account deficit may also be the next catalyst of the rupiah’s volatility. Therefore, although the outlook for the domestic economy in general remains positive, both fiscal and monetary policy consistency is crucial to maintaining the rupiah’s stability and investor confidence ahead.

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The writer is senior quantitative analyst with PT Bank Mandiri, Tbk.

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