Why could the European Central Bank (ECB) not simply hike rates to fight inflation and match the Fed? There is a danger that in doing so, yields for southern European countries would increase much faster compared to northern European ones. In fact, this has already begun to happen, as the spread between the Italian and German 10-year bonds has widened to 213 basis points (bps) by July 15 versus 132 bps at the start of the year.

Essentially, this is the same “original sin” that has bedeviled the euro since its inception. In a currency union without fiscal union, a sharp widening of yield spreads among member nations threatens to undermine the whole project. If it is much more expensive to obtain euro liquidity in Italy compared to Germany, then Italy will be left with two options: Either accept a sharp reduction in its economic output, or exit the currency union altogether.

This feels like a déjà vu from the Eurozone debt crisis in the early 2010s. Back then, Greece had to undergo debt restructuring, while Italy, Spain and Portugal were set for a prolonged period of austerity until the then-ECB chief Mario Draghi famously brought down yield spreads by convincing the market that he would do “whatever it takes” to tighten it.

This time, however, ECB chief Christine Lagarde does not have nearly the same leeway due to the unfavorable global backdrop. Her ECB is expected to increase rates for the first time on July 21, and pair it with a so-called “antifragmentation tool” to prevent further widening of yield spreads.

This will likely include some kind of bond-market intervention, which, however, would be tested by the market and may require the ECB to expand its balance sheet at least temporarily, defeating the purpose of the rate hike.

At a glance, this saga seems rather removed from Indonesia’s concerns, except perhaps for the fact that Indonesia is benefiting from Europe’s switch to coal as Russia threatens to cut off gas supplies. However, there is a concerning parallel between the crack in the Eurozone and the fissure that is emerging in the global US dollar system.

The dollar remains, by far, the most-used currency in international trade, as well as the dominant funding currency for cross-border capital flows. It thus knits the whole world (except for countries under US sanctions) into a giant currency system, albeit an informal one, unlike the Eurozone. Countries also have an additional safety valve during periods of tight dollar liquidity aside from accepting lower growth, namely by devaluing their currency.

Today we are living through precisely such a period, as stubbornly high inflation rates force the Fed to undo its balance sheet and hike rates much faster than anticipated. The ensuing drying-out of dollar liquidity has made it harder for countries to service their debt and import basic necessities.

In the aftermath of Sri Lanka’s default, analysts are actively pondering which emerging nations will be the next to fall. Topping such lists are countries that have mismanaged their fiscal or monetary policy (Argentina, El Salvador) and those that are massively dependent on food or fuel imports (Egypt, Pakistan).

Thankfully, Indonesia does not belong to either group, and is instead among the few that should remain resilient amid this global downturn, thanks to its status as a net food/fuel exporter as well as its large internal market.

But this does not mean we can rest easy. Indonesia still needs dollar liquidity to import some key commodities (such as petroleum, wheat and fertilizer) and to repay our external debt (with US$68.3 billion expected to come due over the next year). As such, we need to conserve the dollar liquidity that we have, and refrain from excessive intervention in the forex market.

Interest rates, particularly on dollar deposits, need to be increased to encourage retention, while unnecessary imports (such as luxury goods) will have to be discouraged.

Second, the government will have to pivot away from the current domestic market obligation (DMO) rules to a new system where producers can freely export but have to cross-subsidize local consumption. There have been some encouraging shifts among policymakers on this issue, but the new scheme needs to be implemented faster for both coal and crude palm oil. Each week the current DMO rules remain in place is a week when we leave sizable dollar inflows off the table.

Finally, we will have to diversify our use of foreign exchange so as not to rely exclusively on the US dollar. To this end, Bank Indonesia’s encouragement of local currency settlement (LCS) is a step in the right direction, as is its recent signing of the RMB Liquidity Arrangement. Indonesia needs to have robust bilateral backup systems in case the cracks in the “dollar-zone” widen.

There are still scenarios where the dollar -- and euro -- systems will return to normal. Perhaps inflation will calm down, or perhaps the Fed and the ECB will decide that fighting inflation is not worth upsetting the whole apple cart (and causing a global recession to boot), and thus go back to easy money policy.

But until this happens, Indonesia will need to stay vigilant.

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Barra Kukuh Mamia is an economist at Bank Central Asia and Suryaputra Wijaksana holds a Master of Public Policy from Lee Kuan Yew School of Public Policy. These views are personal.