In August 2013, three months after the U.S. Federal
Reserve triggered a sharp sell-off in emerging market assets by announcing
plans to scale back its quantitative easing program, Morgan Stanley issued a
research note in which it singled out several countries it believed were most
at risk from the fallout from a tightening in U.S. monetary policy.
The bank's "Fragile
Five" list is made up of South Africa, Brazil, Turkey, Indonesia and
India. The two Asian countries were, at the time, the focal point of investor
nervousness about developing economies because of the dramatic declines in
their currencies and concerns about the credibility of their policy makers.
Nearly two years on, it is
Brazil and Turkey that are deemed more vulnerable, mainly because of their
failure to attend to underlying economic weaknesses.
India and Indonesia are no
longer considered members of the Fragile Five. Yet, while market conditions in
India remain extremely buoyant, sentiment toward Indonesia is more fragile.
The question is whether it is
sufficiently fragile for it to be readmitted to the ill-famed club.
There are a number of worrying
signs.
The Indonesian rupiah has
fallen 15% against the dollar over the past year. While the benchmark Jakarata
Composite Index is at a record high, Indonesian equities are barely in positive
territory this year in dollar terms, compared with a 4% rise in emerging market
shares and a 6% increase in Indian stocks; foreign exchange reserves are the
lowest in Southeast Asia as a share of gross domestic product at a time when
the currency is under significant strain; and the current account deficit
amounts to 3% of GDP. Perhaps most worryingly, the political abilities and
judgement of Joko Widodo, Indonesia's new president, are being called into
question.
The stakes for Indonesia are
high given that the country is reliant on foreign portfolio inflows to finance
its current account shortfall, which is more than twice the size of India's as
a proportion of GDP. Foreign holding of the country's government debt (38%) is
also one of the highest among the main emerging markets.
The sharp fall in the rupiah,
although helping strengthen external competitiveness, is focusing attention on
two troubling aspects about Indonesia: The direction of its monetary policy and
the political skills of Widodo -- a key consideration, given the structural and
institutional reforms Indonesia's new president seeks to implement.
On Feb. 17, Indonesia's
central bank unexpectedly -- and almost certainly prematurely -- cut its
benchmark rate by 25 basis points to 7.5%. The rate cut suggests that the
central bank is more concerned about boosting growth than curbing the current
account deficit, thereby increasing Indonesia's vulnerability to a rise in U.S.
interest rates.
The rupiah continues to
decline, adding to a still-sizeable current account deficit. Although the
plunge in oil prices has helped lower inflation from 8.4% in December to 6.4%
in March, higher fuel prices due to subsidy cuts are keeping inflation
elevated. Business and consumer sentiment remains fragile.
More worryingly, Widodo has
stumbled.
On Feb. 18, he was forced to
withdraw his nomination of an allegedly corrupt official for police chief and
suspend the head of Indonesia's anti-graft agency, tarnishing his image as an
anti-corruption campaigner. Megawati Sukarnoputri, Indonesia's former president
and the head of Widodo's political party, the Indonesian Democratic Party
of Struggle, supported the allegedly corrupt official's candidacy, straining
Widodo's relations with her further and raises fear that his support in
parliament will weaken.
Laying
the groundwork
Still, Widodo has already undertaken some crucial
reforms since assuming the presidency in October. In late December, his
government capitalized on the plunge in oil prices by scrapping $18 billion of
fuel subsidies in one of the most important fiscal reforms undertaken by an
emerging market government in recent years.
This has allowed Indonesia to
free up funds for much-needed investment in infrastructure. According to Bank
of America Merrill Lynch, capital expenditures will exceed energy subsidies for
the first time in a decade, with the former increasing by a whopping 75% this
year to some $23 billion.
Widodo has, in the space of
just several months, laid the groundwork for a major shift in Indonesian fiscal
and economic policy that prioritizes investment, which grew by a paltry 4% last
year. In February, the government's infrastructure-focused budget received
strong parliamentary backing in a sign that Widodo's ruling coalition, despite
controlling less than half the seats in parliament, is able to push through
reforms.
The central bank, moreover,
gave itself some breathing room when it hiked interest rates aggressively in
the months following the Fed's decision to wind down, or "taper," its
asset purchases.
Make no mistake about it,
Indonesia is reforming under Widodo -- and making significantly more progress
than Brazil, to say nothing about Turkey.
While sentiment toward
Indonesia may not be as buoyant as it is toward India, it is by no means bleak.
In the country's high-yielding domestic bond market, foreigners have increased
their holdings by 32% since the end of 2013, compared with a reduction of 8% in
Turkey, according to BAML.
For the time being, Indonesia
is not at risk of being readmitted to the "fragile" club of emerging
markets.
Nicholas Spiro is the founder and managing
director of Spiro Sovereign Strategy, a London-based consulting company that
specializes in sovereign credit risk
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