With the economy slowing, monetary policy in Indonesia is becoming tangled in a trap that echoes the dark days of the Asian financial crisis in early 1998, when Indonesian policymakers faced a stark choice: the economy or the currency.
Unwelcome as it is, even depreciation the IMFs standard prescription to ward off a balance-of-payments crisis due to its effect of making exports cheaper and imports more expensive isnt working.
The rupiah has lost more than 11% of its value since July, overtaking India as the emerging markets (EMs) worst-performing currency, but has stabilized of late, recovering in recent trade to 11,203 to the dollar.
Whats more, consumer price inflation has doubled this year to a four-year high of 8.8%, with analysts predicting it could hit double digits, despite the central bank hiking interest rates twice in the past month.
Until Fed-tapering panic erupted in May, the country was able to finance its current-account deficit despite rising imports and falling commodities export prices, thanks to capital inflows chasing higher real rates in Indonesia.
However, that support from external liquidity conditions has dried up, placing the capital and financial account balance under pressure, forcing Indonesia to dip into its foreign-exchange reserves to fund the deficit and support the currency.
Among EMs, Indonesia is one of the most exposed to short-term external funding risks because it has a smaller foreign-exchange war chest.
Its foreign-exchange reserves which have dropped 17.5% this year from $112.8 billion to $93 billion are now sufficient to cover just five months imports and external debt payments.
The IMF, however, recently cut its 2013 growth forecast for Indonesia to 5.25% from 6.3% and raised its current-account deficit forecast to 3.5% of GDP.
Higher inflation compared to the rest of the world means that although the rupiah has come off a lot against the dollar on nominal basis, on a real effective exchange rate it has actually appreciated over the last two months, says Shweta Singh, EM economist at Lombard Street Research.
The competitive advantage that the weaker rupiah should give to Indonesia is not coming through because inflation is so high.
It has benefited tremendously from easy external liquidity conditions, which helped support domestic demand thereby worsening the current-account deficit. This deficit is difficult to adjust because imports are quite inelastic and exports are prone to downside risks to commodities prices from China.
Fuel imports have a lot of subsidy support, so even if they come down on domestic demand it may not necessarily impact imports overall because import oil demand is not market-determined.
Singh says rates will have to be raised a lot more to push down the non-oil component of imports sufficiently to compensate for oil imports than if oil was not so heavily subsidized.
And the central bank will have to continue raising rates to keep the real interest rate elevated to bring down domestic demand and moderate its impact on the current-account deficit. That will have ripple effects on domestic demand growth feeding into real GDP growth.
In common with other EMs, Indonesias appetite for tackling the structural reforms it neglected during the good times is being tested given the pressure on living standards and a presidential election next year.
The government has been behind the curve, putting off fuel price rises until June when its hand was forced by a sell-off in equities and government bonds, and deteriorating economic conditions.
And Bank Indonesia has been slow to react to rising inflation and the sell-off sparked by Fed-tapering fears, holding rates at its August 15 meeting only to raise them at an emergency meeting two weeks later. As recently as last year when the economy was in danger of overheating, it was still cutting rates.
Others see the situation as far less ominous, arguing the high inflation rate is a temporary spike and that Indonesias fundamentals and potential make it well placed to benefit from stronger global growth.
Clearly it hasnt been a good year for Indonesia, says Gareth Leather, Asia economist at Capital Economics. Inflation is very high, the balance of payments has deteriorated and the currency has fallen quite sharply this year.
But a crisis is still some way off, especially if you compare the situation to what it looked like on the eve of the Asian financial crisis. Inflation is very high but its pretty much entirely due to the governments decision in June to slash fuel price subsidies, which has pushed up transport costs.
Core inflation is much lower than the headline figure and this oil element will work its way out over the coming months so inflation should come down next year.
He adds: GDP growth remains strong, a significant chunk of the investment in Indonesia is FDI, which is not vulnerable to reversals in the way the portfolio investments are, and it has healthy foreign-exchange reserves and a strong, credible central bank that has taken resolute action.
The currency appears to be stabilizing and we believe the recent volatility is nearing its end.
Underscoring the optimism is evidence that in line with other Asian economies, after four months of surging bond yields, Indonesias borrowing costs are starting to fall.
The yield on the governments benchmark 10-year local currency bond was 8.03% in recent trade, down almost 100 basis points from its high on September 9, just before Bank Indonesia surprised markets with its second rate rise in 14 days.
Indonesia will surely navigate the storm and would be wise to heed lessons from the crisis: pro-cyclical monetary policy and a dependence on portfolio flows in the absence of FDI-boosting structural reforms is a recipe for a hard landing.