Strong growth and political stability made Indonesia southeast Asia's most attractive investment destination last year, but the outlook is threatened by a struggle between reformers and powerful vested interests. For the moment, the reformers appear to have the upper hand, but a major setback could rattle Indonesia's financial markets and hurt prospects for a credit rating upgrade with Indonesia now rated just one notch below the coveted investment grade by Fitch.
The benchmark stock index .JKSE has surged 154 percent from its Oct. 28, 2008 low and is now close to setting an all-time high, while the rupiah IDR= has strengthened from 12,600 per dollar in November 2008 to trade at about 9,090. The sovereign credit default swap spread IDGV5YUSAC=R has tightened to around 161 basis points from 182 a month ago.
Following is a summary of key Indonesia risks to watch:
* GOVERNMENT EFFECTIVENESS IN DRIVING REFORM
President Susilo Bambang Yudhoyono, re-elected with a strong mandate in July last year, is widely seen as a progressive, market-friendly reformer. Many investors hoped the pace of reform would pick up in his second term after he chose Boediono, an economist, as vice president, kept two key technocrats -- Sri Mulyani Indrawati and Mari Pangestu -- in economic posts in his cabinet, and set up a presidential delivery unit headed by Kuntoro Mangkusubroto.
Instead, his government was distracted by a highly politicised inquiry -- driven by opponents of reform -- into the rescue of Bank Century, a small lender, that ended in March with parliament recommending a criminal investigation into the bailout decision. Yudhoyono stated his full support for Indrawati and Boediono, who had backed the bailout to avoid a collapse of confidence in the financial sector, signalling that their jobs are safe. Boediono in March announced a new team to oversee reform of the bureaucracy, a positive sign for foreign investors. Also, healthy fundamentals and a large and growing domestic consumer base still provide reasons to invest in Indonesia even if reform prospects dim.
What to watch:
-- Opponents of reform, including those within Yudhoyono's ruling coalition, will probably try to block pro-investment policies such as changes to the tough labour laws and cuts in energy subsidies.
-- The future of the coalition. The Bank Century inquiry strained relations between Yudhoyono's Democrats and coalition partners Golkar, tycoon Aburizal Bakrie's party which opposes much reform, and the Islamist PKS, which sometimes takes a
nationalist, anti-Western stance.
* CORRUPTION AND GOVERNANCE
Corruption emerged as a defining issue at the start of Yudhoyono's second term, with popular anger mounting over a power struggle between the respected Corruption Eradication Commission (KPK) and the attorney-general's office and police. The KPK has made significant progress in investigating corrupt officials, but this has stirred powerful opposition. Yudhoyono has vowed to back the anti-corruption drive but his slow response to the KPK scandal disappointed many Indonesians.
However under Kuntoro, the presidential delivery unit and legal task force has begun tackling legal reform, for example exposing graft in the prison system and investigating various officials suspected of perverting the course of justice.
What to watch:
-- How effective Kuntoro's presidential delivery unit is in tackling legal reform and other issues that deter investors.
-- Pace of reform of Indonesia's civil service, police and courts. Yudhoyono's cautious response to the power struggle over the KPK suggests he will move much more slowly than markets had hoped, confirming his reputation for preferring gradual change to bold, sweeping reform. Investors betting on more decisive reform during Yudhoyono's second term have had to adjust expectations.
* HOT MONEY AND CAPITAL CONTROLS
The rupiah was Asia's best-performing currency in 2009 with a gain of 17 percent against the dollar, threatening Indonesia's export competitiveness, and is up about 3 percent this year, making it one of the region's better performers. Memories are also still raw of the 1998 Asian crisis, which was widely blamed in Indonesia on foreign "hot money" being yanked from the country. The central bank says it will keep intervening to stem the rupiah's gains but seems comfortable with the steady appreciation as this helps to contain imported inflation.
Late last year the senior deputy governor said Bank Indonesia was studying the possibility of curbing foreign ownership of its short-term debt or SBIs, sparking speculation about tighter capital controls. Instead, in March, it started to reduce the frequency of the auctions for one-month SBIs, which has resulted in foreign investors shifting into three-month paper instead.
What to watch:
-- Data on exports and speculative inflows, and whether the central bank's measures for SBI auctions has the desired effect of reducing short-term volatile capital inflows. If problems arise, expect controls may be tightened. Draconian measures that send investors fleeing to the exits are unlikely -- measures would be aimed at directing flows, rather than halting them, so any negative impact on asset prices would be relatively muted. However, the issue can still spook markets -- the rupiah suffered its biggest one-day sell-off in nine months last November due to mixed signals on capital controls.
* SECURITY
Suicide bombings at two luxury hotels in Jakarta last July were the first major terror attacks in Indonesia since 2005 and raised concerns that the threat from militants was again on the rise. The killing of Noordin Mohammad Top and, more recently, the bomb-making expert Dulmatin, may have significantly reduced that threat, but the risk persists.
Police recently discovered a new network of armed Islamist militants operating a secret training base in Aceh, Sumatra province. Analysts have warned that dangerous militants are using the prison system to recruit and spread their ideology, while recent trials of militants have shown that funding came from the Middle East.
What to watch:
-- Ability of militants to regroup and launch more attacks. Particularly if remaining militants are able to establish firm enough links with al Qaeda or allies in Southeast Asia to secure sustained funding, expertise and recruits, the threat may be far from over. But Indonesia's markets have proven highly resilient to bomb attacks. Unless there is a significant and sustained deterioration in security, any sell-off would be small and short-term. (Compiled by Andrew Marshall, Sunanda Creagh and Sara Webb)
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