The decision followed the BI's pronouncement late last year that it would maintain an accommodative policy stance throughout 2020 to support economic growth. Similar signals were given by the BI governor at the beginning of the year.

BI’s optimism in supporting economic growth came out when an agreement was reached in the first phase of trade negotiations between the United States and China. Although negotiations continue, what has already been achieved can reduce the tension of global uncertainty.

However, optimism suddenly dimmed when the coronavirus disease (COVID-19) began to make headlines at the end of January. Therefore, the benchmark rate cut is described by BI as a preemptive step to maintain the momentum of domestic economic growth amid the prospects of a weakening world economy.

The impact of COVID-19 has begun to be felt. Export and import activities with China have taken a hit, as China is Indonesia’s largest market for non-oil and gas trade and tourism. Should the accumulated impact of COVID-19 reduce China’s growth by one percentage point (100 basis points), it would lower Indonesian growth by between 0.30 and 0.60 percentage points, according to an estimate by Finance Minister Sri Mulyani Indrawati.

As a result, the easing of monetary policy is of strategic significance. From a psychological aspect, BI continues to signal responsiveness. Although economic growth is not BI’s main task, the central bank still shows its concern. This is expected to boost the confidence of all economic actors.

From a conceptual aspect, lowering the policy rate will reduce bank lending rates. With cheaper loans, economic actors are more likely to be expansive in developing their businesses. Expanding employment opportunities is another benefit that may be derived from the lowering of the benchmark interest rates.

Such expectations make sense. The loan-to-value (LTV) ratios for motor vehicles and property, as announced in December, account for most bank lending.

In addition, the reserve requirement (GWM) was cut from 5 percent to 4.5 percent on Feb. 2. The GWM relaxation will inject Rp 40 trillion (US$2.87 million) of additional liquidity into the money market. A lack of money market liquidity was the main reason for the reserve requirement change.

The same expectation applies to households. With lower deposit interest rates, consumers are more likely to use their bank savings for household spending. The result is a multiplier effect in the output market and in the input market, which amplifies the circular flow of income.

However, not all of the above scenarios will play out as hoped without an adequate response from commercial banks as BI policy agents. The banking sector is still hesitant to cut lending rates, but it is very fast in cutting deposit rates when the benchmark interest rate falls.

This response in the short term is indeed beneficial for banks. The reduction in loan interest rates as the ‘selling price’ of funds is smaller than the decrease in deposit rates as the ‘purchasing price’ of funds. The difference between the two interest rates is the motive behind the slow transmission of the benchmark interest rate policy.

But in the medium to long term, this strategy can backfire. Banks will have trouble raising third-party funds, because deposit interest rates are no longer attractive. Banks must look for funds from other sources with higher fees. Consequently, the easing of the reserve requirement and LTV is not working as it should.

Even if banks respond immediately to a cut in benchmark interest rates, the problem does not end there. Another effect that must be anticipated by BI is the possibility of capital flight. The shrinking yields due to the lower policy rate may prompt fund owners to move their funds abroad. As a result, foreign exchange demand increases, foreign exchange reserves shrink and the rupiah fluctuates.

Such fluctuation of the rupiah has recently been felt. Therefore, it should not be seen as a temporary effect of COVID-19. Blaming the rupiah problems solely on COVID-19 rather than looking at the issue with a longer time frame makes it harder to withstand external pressures once the COVID-19 outbreak subsides.

Accordingly, BI must be alert to all of the possible risks outlined above. For this reason, BI needs to prepare a surefire stance to protect the weakening rupiah. Intervention in the spot market would appear like a reactive response, resulting mostly in “burning money”, and such a measure could be seen as a panic reaction and create the impression that BI is panicking in controlling the exchange rate.

The use of mixed monetary instruments conducted on the domestic non-deliverable forward (DNDF) market is of limited effect. The DNDF instruments can to some extent anchor the rupiah in overseas markets, but a tendency for fluctuation in the domestic market will persist.

Furthermore, BI’s intervention in the debt market must also be selective. Risk mitigation needs to be focused more on the possibility of a big bonds sell-off, especially by foreign investors. Consequently, BI foreign exchange reserves could be eroded as an unanticipated side effect of its own policies.

Stability is an important factor in supporting growth, especially in an open economy. Without a comprehensive approach to mitigate rupiah volatility, the growth target of 5.3 percent could be missed and the 5 percent-growth stigma continues to loom over the economy and thereby trap the country in the middle-income country group.

Put briefly, COVID-19 is closely interrelated with the policy rate and economic growth.

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Research director at the Socio-Economic and Educational Business Institute (SEEBI) Jakarta and professor in economics at State University of Jakarta’s School of Economics. The views expressed are his own.

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