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ince the beginning of 2018, the rupiah has weakened against the United States dollar to as low as Rp 14,200. Even though the currency recovered slightly after Bank Indonesia’s preemptive move to raise its policy rate by 50 basis points to 4.75 percent last month, the rupiah remains under pressure.

There are at least two fundamental factors influencing the movement of the rupiah. The first is the difference in inflation rates. The currency of a country with a relatively high inflation rate tends to weaken. This is related to the theory of Purchasing Power Parity (PPP), used to analyze the effect of inflation between two countries on foreign exchange rates using two variables; the spot exchange rate and the difference in inflation rate between two countries.

The theory concludes that the spot exchange rate of a currency changes in reaction to inflation. The logic is simple and intuitive. When inflation increases, the purchasing power parity will decrease. In other words, when the price of domestic products increases, people will tend to look for alternative offers from other countries offering lower prices.

The result of this is twofold. First, this country will import more products from other countries with lower prices, and second, the exports of this country will drop as trading partners switch their imports to other countries. As a result, the value of the domestic currency will weaken along with the surge in demand for foreign currency.

The second fundamental factor is the balance of payments (BOP). Briefly, a nation’s balance of payments measures all economic transactions between that nation’s people and the people of all other nations. In general, the BOP consists of two accounts: current account and capital account.

While the current account records foreign exchange traffic from international trading, such as exports and imports, the capital account records foreign exchange traffic from cross-border investment, such as portfolio investment in foreign capital markets and foreign direct investment.

If Indonesia’s current account records a surplus, there is an excess supply of foreign currency, i.e. US dollars, in the domestic market. A simple supply and demand analysis suggests that the value of the US dollar will fall, while the rupiah will strengthen.

In the case of a current account deficit, the trend is the opposite. Unfortunately, however, Indonesia has been experiencing mostly current-account deficits since late 2011. The deficit has been financed by a surplus in the capital account, thanks to the robust domestic economy which sustains foreign investor confidence.

The current account deficit is predicted in the range of 2.3 percent of the gross domestic product (GDP) throughout 2018, wider than the 1.7 percent of the GDP seen in 2017. In the first quarter of 2018, Bank Indonesia reported current account deficit of $5.542 billion, or 2.15 percent of the GDP.

Then, one might argue that the subsequent lower value of the rupiah due to the current account deficit will make Indonesian exports cheaper and imports more expensive. The value of exports should rise, and that of imports should fall and thus, the deficit should be eliminated automatically.

But will this always be the case? The success of a depreciating rupiah in terms of lowering the current account deficit will depend on foreigners’ elasticity of demand for Indonesian exports and domestic consumers’ elasticity of demand for imported goods. In fact, however, many countries experience a worsening current account deficit along with a depreciating currency.

Why might this be the case? The main reason is a time lag. It takes time for producers and consumers to adjust their purchases to the changed prices brought about by the changed exchange rate.

In other words, demand for both export and import goods is less elastic in the short term. Consequently, export revenues may not rise, but the value of imports may rise as import prices increase, leading to a deeper current account deficit.

So, we better not expect a lower current account deficit due to currency depreciation. Instead, we should improve the value of exports. Certainly, there are other ways, such as attracting more tourists to Indonesia to bring foreign exchange, but foreign trade in goods and services, including transportation and insurance, is the largest component of the current account.

However, it has to be emphasized that the Indonesian government should promote exports of highly competitive manufactured products. Why manufactured?

For at least two reasons. First, Indonesian exports still consist mostly of raw commodities, which are insensitive to the exchange rate movement. The expected adjustment mechanism of the rupiah depreciation to enhance the export of manufactured products does not materialize. This condition illustrates the low competitiveness of manufactured Indonesian export goods.

Empirical evidence shows that a larger contribution of Indonesian exports to GDP (a more open economy to international trade) will have a positive effect in reducing income inequality — measured by the Gini coefficient.

Furthermore, using the data of 33 provinces published the by Central Statistics Agency (BPS), our study finds that the impact of trade openness is better in provinces with a broader manufacturing base than in provinces producing mostly minerals.

Equally interesting, the Gini coefficient in Central Sulawesi declined from 0.41 in 2013 to 0.34 in 2017 in line with a shift in the province’s exports structure from natural resource to manufacture-based. In 2013, nickel ore accounted for 74 percent of the province’s total exports, but in 2017, iron and steel dominated total exports with a share of 62 percent.

In sum, the government should encourage the development of export-oriented industries by expediting the business licensing process, providing fiscal incentives, lowering domestic logistics costs through better connectivity and expanding Indonesia’s industrial export market through bilateral or regional trade agreements.

More importantly, the capacity of human capital should be improved to support the provision of skilled manpower in line with the need for technological development and production automation.

That way, the government can kill two birds with one stone; preventing a current account deficit and reducing income equality.

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Both writers are economic analysts at Bank Indonesia. The views expressed are their own.