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The rupiah is likely to strengthen further in the coming weeks as “hot money” continues to flow into the country’s financial markets but a correction is likely before the end of the first quarter, analysts said.

Hartadi A Sarwono, a deputy governor of Bank Indonesia, said on Friday that during the first week of this year Rp 8.1 trillion ($883 million) of foreign funds flowed into Bank Indonesia Certificates (SBIs) and government bonds due to increasing confidence in the domestic economy.

“Foreign holdings in SBIs rose from Rp 44.1 trillion [at the end of 2009] to Rp 49 trillion, a 19.4 percent increase for the year to date,” Hartadi said. “This was due to the good prospects for the domestic economy.” He added that sentiment about emerging markets in Asia remained positive.

In its monthly monetary publication released last week, Bank Indonesia said the high interest-rate differentials between Indonesia and developed countries was a key factor strengthening the currency. Interest rates here are as high as 6.5 percent for one-month SBIs, compared to rates approaching zero percent in developed countries such as the United States and Japan.

The difference encourages the “carry trade,” when investors borrow money in one country and invest it in another to take advantage of the higher interest rates in the latter.

Investment is also flowing into the Indonesia Stock Exchange (IDX). The Jakarta Composite Index gained 87 percent in 2009.

Asia’s best performer ahead of the South Korean won, the rupiah climbed 16 percent in 2009 after diving more than 20 percent the previous year. It has continued its rally in 2010, posting a 2 percent increase to Rp 9,222 per dollar at Friday’s stock market close, according to Bloomberg.

However, analysts are warning of a likely correction for the rupiah in the first quarter, which they say could see the currency weaken significantly.

Eric Sugandi, an economist at Standard Chartered Bank, said the strengthening rupiah was spurred by the improving share market in 2009 and expectations of good economic growth this year.

However, he warned that the flows could reverse if sentiment sagged in developed countries.

“The US unemployment numbers remain high, reflecting a slow economy in the first quarter of this year, while developed countries are also expected to announce their exit policies from fiscal and monetary stimulus [packages],” he said.

Such exits could cause investors to retreat to safe havens. Standard Chartered expects the rupiah to fall to Rp 9,700 per US dollar by the end of the first quarter, before strengthening to Rp 8,900 by the end of the year on a stronger global economy.

Finance Minister Sri Mulyani Indrawati has warned of the risks as developed nations withdraw their stimulus packages.

“Please, always anticipate the possibility of policy changes in 2010,” she said.