In a move that caught markets off guard, Bank Indonesia (BI) announced an emergency interest rate hike of 25 basis points on Tuesday, lifting its benchmark rate to 5.50%.

The central bank stated that the decision to act ahead of its scheduled monetary policy meeting was prompted by a sharper-than-expected depreciation of the rupiah. The move aims to counter severe volatility in global financial markets stemming from Middle East tensions, stabilize the local currency, and ensure inflation remains within the target band for 2026-2027.

Influenced by factors including escalating geopolitical conflict in the Middle East, the rupiah has depreciated by 8% against the US dollar so far this year, ranking among the world's worst-performing currencies. Following the rate announcement, the rupiah recovered slightly to 18,075 per dollar, after having earlier hit a record low of 18,190, marking its largest monthly decline since 2020.

To curb the currency's slide, the central bank has persistently intensified market interventions, leading to a significant drain on the nation's foreign exchange reserves. Data shows Indonesia's forex reserves fell by $1.3 billion in May to $144.9 billion, reaching their lowest level in nearly two years. Although the government issued $3.5 billion in dollar and euro bonds last month, it was insufficient to fully reverse the reserve outflow. Furthermore, market concerns over the new government's fiscal spending expansion, rising fuel subsidy budgets, and commodity export policies continue to exert persistent pressure on the rupiah.

Beyond adjusting the benchmark rate, Bank Indonesia also announced it will implement comprehensive measures to attract foreign capital inflows. The central bank stated it will enhance the appeal of Indonesian financial assets by increasing yields on rupiah-denominated securities (SRBI) and reducing the hedging cost for foreign investors by 10%. David Sumual, Chief Economist at Bank Central Asia (BCA), noted that given the high sovereign bond yields in peer emerging economies like Mexico, India, and the Philippines, Indonesia requires more aggressive monetary tightening to maintain its interest rate differential advantage.

Financial institution Barclays released a report predicting that given the current exchange rate pressures, Bank Indonesia could potentially raise rates by another 25 basis points to 5.75% at its policy meeting next week, with a 50-basis-point hike also a possibility. The report further indicated that once the rupiah stabilizes, the central bank may eventually transition into a rate-cutting cycle.