W

e commend the decision of the monthly board of governors' meeting of Bank Indonesia (BI) on March 18 and 19 to cut its benchmark interest rate, the BI seven-day reverse repo rate (BI 7-DRRR), by another 25 basis points to 4.5 percent, while the rupiah is in turmoil. This measure simply undermines the theoretical construction that has long been built. BI also lowered deposit facility rates by 25 bps to 3.75 percent and lending facility by 25 bps to 5.25 percent.

On the one hand, the rupiah had depreciated by 11.3 percent against the US dollar just within less than a month after the revelation of the COVID-19 outbreak in Indonesia. On the other hand, the volatile food prices have shown signs of increasing. Theoretically, the two factors are sufficient to meet the requirements for BI to hoist the benchmark interest rate.

Raising the policy rate would attract foreign capital inflows and increase the supply of dollars. In line with the market mechanism, an increase in the supply of dollars would curb the exchange rate fluctuations and maintain stability in the financial market.

Conversely, cutting the BI 7-DRRR might encourage capital flight. The demand for the dollar would increase, the domestic currency depreciate and the foreign exchange reserves shrink. The reduction of foreign exchange reserves would set off fears of further rupiah depreciation, thereby causing stronger inflationary pressures.

However, all of the above arguments do not apply to BI now because of the shocks of the coronavirus spread. BI is convinced that the theoretical propositions underlying the formation of policy rates are built on the rationality of economic agents. When the assumptions of rationality are not met, the basic formula for determining the policy rate can be misdirected.

The above thesis seems to be close to reality. For example, consumers have started panic buying of various kinds of basic needs, but supply chains are being broken by the containment efforts such as social distancing and travel restrictions, while foreign portfolio investors have been selling their rupiah assets (stocks and bonds).

If BI maintained its policy rate it could signal caution for calmness. In contrast, cutting the rate twice in two consecutive months potentially generates the impression that BI is panicking dealing with the latest developments.

But the domestic pressure to maintain the policy rate is weak. During 2018, BI raised the rate by 175 basis points, while throughout 2019 BI cut it cumulatively by 100 basis points. With the 25 basis-point rate cut in February, BI actually had only a space of 50 basis points to return to its original position.

Furthermore, BI should have taken valuable lessons from market conditions in the second quarter of 2018. At that time, BI raised its benchmark rate twice just in a month (May 2018) to reduce wild foreign exchange rate fluctuations and sharp inflation expectations. The result at that time was not too optimal.

Under the above circumstances, BI cannot wait too long for all economic players to immediately return to rationality. In the BI scenario, the panic of economic actors must be addressed by cutting the policy rate, instead of raising it, as suggested by the established theory.

The “ahead the curve” strategy would be effective in reducing speculative behavior. If the change in rate always follows the conceptual predictions, it may make expectations of dollar skyrocketing, which drives speculators to massively buy dollars for resale in the future. If this happens, BI's efforts will not be effective.

For this reason, BI “played beautifully” in terms of liquidity by optimizing macroprudential policies. The further easing of the minimum reserve for the banking industry and interventions in the foreign exchange market strengthened BI's efforts to stabilize and create preconditions for economic growth.

The investment-grade status affirmation from Rating and Investment Information, Inc. supports the trust of foreign economic actors. The sovereign debt rating improvement would be able to maintain the international market confidence in the Indonesian economy.

BI, the central government and local governments need to ensure that the strong message of stability would help the market panic. The countercyclical fiscal stimulus programs are very crucial as they are directed to the productive economic sectors. The distribution of social assistance programs for poor households and other social-safety net programs in education, health and unemployment benefits (preemployment cards) will help strengthen the purchasing power of the poorest segment of the population.

Furthermore, BI and the government should see to it that the other groups (middle and high income) of the people remain rational and calm in coping with the escalated fight against the virus.

The bandwagon effect triggered by consumers’ irrationality could worsen the economic condition as the demand for goods would skyrocket while many supply chains and manufacturing plants have been hard hit by the containment efforts like social distancing and travel restrictions to slow the virus spread.

The central and local governments should be united in providing strong leadership for the nationwide fight against COVID-19 that its economic damages can be significantly minimized. Indeed, excessive fear is the biggest obstacle for all authorities to pursue economic stabilization during the COVID-19 outbreak.