When the Fed for the first time announced to begin scaling back its quantitative easing in summer 2013, emerging economies underwent a sudden massive capital outflow, resulting in depreciation of their currencies. The graph below pictures how Indonesian rupiah, one of the five emerging economies’ currencies in 2013 so-called the fragile five, had behaved right after the beginning of tapering off issues until the end of the year.
If we use short run international finance diagram, this capital outflow is represented by the shifted-to-the-right NCO curve. People started to get rid of Indonesian assets and went back to the U.S. assets in the hope that interest rate in the U.S. will increase. This situation is described clearly by the data. Indonesian rupiah depreciated significantly against the U.S. started in May 2013.
In the case like this, at least there are two measures that can be adopted to reduce the volatility and to ensure that the currency not to slump down persistently: increasing domestic interest rate and sterilized sales of foreign (U.S.) assets.
First, the central bank might increase interest rate to deter foreign investors from pulling out their money from the country and attracting others to bring their money in. During the year of 2013, the central bank gradually increased its benchmark interest rate five times: on June 13 by 25 bps (basis points) to 6 percent, July 11 by 50 bps to 6.5 percent, August 29 by 50 bps to 7 percent, September 12 by 25 bps to 7.25 percent, and November 12 by 25 bps to 7.5 percent. As can be seen from the graph above, the interest rate tied closely to the exchange rate pattern, the more the currency depreciates the more the central bank will increase its interest rate.
Second, since the initial problem of this volatility is because NCO curve shifted out, then it requires that we bring back the curve in by sterilized sales of U.S. assets and buy domestic bonds. If it does work, the currency will start to appreciate. It is hard though to find such data in order to verify whether the central bank had done this option. Thus we will just look at the data on the official reserves and look at to the pattern.
As can be seen, Indonesian official reserves had been depleting in around May 2013 and hit the lowest point on July 1, 2013 at 92,671.06 million dollars. If we look at the graph deeper, this pattern seems to confirm that around these months, the central bank used the reserves to intervene rupiah in the market for a while and then abandoning this measure and starting to pile up reserves again.
I believe that Indonesian central bank used both interest rate increase and intervention in the market to response to the Fed stimulus reduction last year though the efficacy of this policy is in question since rupiah often regarded as one of the worst performing currencies in the region in 2013. I reach to the conclusion that the central bank had intervened in the market since a high official in the office had also confirmed that they were ready to take that measure in case of needed to smooth the volatility rather than to strengthen the currency.