JAKARTA, June 5, Reuter - Indonesia's central bank is wringing rupiah out of the market in an effort to stop dollar buying, sending interest rates rocketing.

For the fourth day in a row, Bank Indonesia (BI) on Tuesday held rupiah back from a desperately tight market and private banks with rupiah charged between 20 and 28 pct to borrow overnight. "We want to stop all this dollar buying. So much money is coming to big companies from the capital markets and that is fuelling dollar demand. So we have stopped dropping rupiah into the market," a central bank dealer said.

For the first time in weeks dollar demand, which some say is propelled by an irrational fear of devaluation, all but dried up and banks on Saturday paid up to 40 pct to borrow rupiah.

All agree that it is a short-term squeeze, but the thought that it may be repeated will push rates up, some say.

"To keep money in rupiah without BI help with liquidity, interest rates would have to stabilise around 20 pct. Is that really what the government wants?" a foreign dealer said. "I thought they were pushing for lower interest rates."

Some banks are already charging clients more to borrow, slapping on an extra two percentage points to cover extra costs.

Other banks say they are carrying the loss themselves but can't afford to do so for much longer.

"We can't jack lending up to market rates. But how long can anyone keep lending at 17 pct and borrowing at 25?" a treasury manager said. He predicted prime rates would rise by at least one percentage point in the next few weeks. "If we charged market (rates) our clients would just do a runner," he said.

An international banker said the government recognised with rates rising around the world and devaluation fears hanging stubbornly over the market, rupiah interest rates could only fall so far before money started to rush out into dollars.

Although a lot of foreign money is coming into Jakarta for investment in projects and stocks, more is leaving, the banker said.

"If you give the domestic market too much money, the choices are to sell it for foreign exchange or foreign goods," he said.

The government hopes high rates will keep money at home while a newly energetic stock market provides cheap funds to make up for higher bank lending rates, an economist said.

Banks borrowing rupiah to cover long-dollar positions and meet exposure limits usually pay around 11 pct overnight.

The current crisis is caused partly by an automated trading system introduced on Monday which gives dealers just an hour to scramble for funds if they are overexposed.

Because of that, dealers said, many banks are buying up far more rupiah than they need early in the day and holding on to it.

"It creates a totally artificial rupiah demand. It's really a big step backwards," one commented.