Otherwise, it is difficult to explain why, earlier this week, Bank Indonesia cut interest rates by 25 basis points to 7.5%. Indonesia is one of the countries with the greatest dependence on foreign capital, due to a deficit on the current account of some 3% of GDP, but primarily because banks have major problems financing themselves in the domestic market as a result of structural mistrust amongst Indonesian savers. For that reason, but also to maintain pressure on the government in Jakarta to continue with reforms, the Indonesian central bank has been highly cautious in recent years. The fact that the bank has decided to cut interest rates now, in a month in which most EM currencies are under considerable pressure, is striking.

Indonesia is no exception, though. Of the sixteen major emerging countries, twelve have started cutting interest rates over the past few months. Not all those countries necessarily have a healthy economy in which foreign investors have a great deal of trust either. On the contrary, capital flows have been negative since the summer, despite the large interest rate differential in relation to the U.S. and Europe. The main reasons why investors have withdrawn their money are declining economic growth, the deteriorating investment climate in a number of emerging markets, the lack of convincing reforms, and the fear of capital flight as soon as the U.S. starts hiking interest rates.

These points remain valid and will perhaps become even more relevant if central banks allow their interest rates to fall below the economic basis and can justify any reforms. With each interest-rate cut, the risk of more exchange-rate correction in the emerging world increases. This may be what many policymakers are aiming for, enabling a growth recovery without burning their fingers on awkward reforms. Investors in emerging markets should remain critical. They would be better off investing in a country where interest rates are being cut because reforms have reduced economic imbalances, than in a country where interest rates are being lowered because they would be justified by future capital flows or to weaken the currency.


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