Indonesia's stock market bounced back nearly 3% on Tuesday after a brutal selloff wiped approximately $82 billion off equities, but investors aren't celebrating just yet.
But the real test is coming on Wednesday, when Bank Indonesia decides whether another interest rate hike is necessary to defend the country's battered currency and restore confidence in its financial markets.
The trouble began Friday when MSCI, one of the world's biggest index providers, warned that Indonesia could lose its emerging-market classification and become a standalone market. The announcement triggered the Jakarta Composite Index's worst two-day collapse on record.
Indonesian officials responded with proposals to improve trading transparency, including removing companies with tightly concentrated ownership from the main index. Those measures helped stocks recover Tuesday, although the rupiah remained under pressure.
Indonesia's central bank faces pressure to raise interest rates again
The rupiah weakened to 18,030 against the US dollar on Tuesday, approaching its June record low. The currency has already lost approximately 8% this year, making imported goods more expensive and putting additional pressure on inflation.
Economists are now scrambling to change their interest rate forecasts.
Citibank expects a 50-basis-point increase to 6.25%, abandoning its previous prediction that borrowing costs would remain unchanged. Meanwhile, Capital Economics and Permata Bank expect a smaller 25-basis-point hike to 6%.
The central bank's benchmark rate currently stands at 5.75%, following a combined 100 basis points of tightening since May.
September inflation reached 3.28%, its highest level in three months, although it remained within the official 1.5% to 3.5% target range. Core inflation, which removes volatile items, eased to 2.84%.
Governor Destry Damayanti has maintained that Indonesia's $146.3 billion in foreign-exchange reserves, recorded at September's end, provides enough firepower to support the rupiah.
But currency weakness isn't the economy's only headache.
A decade ago, Indonesia, home to nearly 290 million people, was considered relatively stable while other developing economies struggled with collapsing currencies and runaway inflation. Economic growth remains strong, but household finances tell another story.
The country's middle-class population has contracted roughly 19% from its peak, poorer households are saving considerably less, and youth unemployment stands near 17%, among Asia's highest.
Japan's bond market adds another twist to Asia's financial outlook
Meanwhile, investors in Japan are dealing with their own interest rate uncertainty.
Tuesday's auction of 20-year Japanese government bonds attracted record demand, supported by unusually high yields.
The bid-to-cover ratio reached 5.84, compared with 4.01 previously and a 12-month average of 3.73.
The auction's tail, measuring the difference between average and lowest accepted prices, narrowed to 0.07 from 0.15, signaling stronger demand.
Japanese borrowing costs have climbed amid Middle East tensions, expensive oil, and inflation worries. Earlier this month, 20-year yields reached a roughly 30-year high, while 30-year yields hit a record.
Prime Minister Takaichi Sanae’s proposed consumption tax cuts on food and soft drinks have also raised questions about government financing.
Takaichi has pledged to maintain fiscal discipline and manage bond issuance carefully in next year's budget.
Investors are now watching next week's Bank of Japan meeting, where markets assign only a 6.2% probability of another rate hike. Most expect unchanged rates, with Governor Kazuo Ueda's subsequent press conference expected to offer clues about future tightening.