Analysis - Indonesia's investment stature under siege, further pain seen

JAKARTA Tue Aug 27, 2013 10:07pm BST

A street vendor walks past a billboard advertising luxury apartments in Jakarta August 27, 2013. REUTERS/Beawiharta

A street vendor walks past a billboard advertising luxury apartments in Jakarta August 27, 2013.

Credit: Reuters/Beawiharta

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JAKARTA (Reuters) - From a tumbling currency to a crippling current-account shortfall, slowing economic growth, high inflation and retreating investors, Indonesia's stature as emerging-market superstar is under siege.

The immediate prospects look forbidding. Measures imposed by the government and central bank on Friday are no panacea for a near-record current-account deficit that has torpedoed the rupiah currency and spooked foreign investors who own nearly a third of its government debt.

Expected further interest rate increases and a possible rise in bank reserve deposit requirements, along with fiscal-stimulus measures announced on Friday, could stabilise Indonesia's markets in the longer term and ultimately restore the allure of Southeast Asia's biggest economy.

But the cost, say economists, will be more short-term pain both to an already-slowing economy and to the vulnerable rupiah, as foreign capital dwindles ahead of an expected end to the U.S. Federal Reserve's policy of ultra-cheap money that had propelled investors into higher-yielding markets, from Brazil to Indonesia.

"There is still an investment party ... But it won't (any more) be caviar, foie gras and vintage wine," said Standard Chartered senior economist in Jakarta, Fauzi Ichsan. "It'll be gado-gado," he added, a reference to a popular, but cheap, Indonesian vegetable dish.

Less than a year ago, Indonesia was feted by investors clamouring to tap a booming middle class in the world's fourth-most populous country and its vast reserves of coal, natural gas and other resources. Annual economic growth raced ahead at more than 6 percent. But demand growth, especially from China, weakened, commodity prices fell and easy global capital started to dry up.

Gordon Ip, manager of Hong Kong-based Value Partners Ltd, sees a bottom approaching after a turbulent two weeks that has sliced 14 percent off Jakarta's benchmark stock index since August 12 and driven the rupiah to four-year lows of 10,900 per dollar - a drop of nearly 11 percent this year that has made it one of Asia's worst-performing currencies. To some, a test of 11,000 per dollar is now on the cards.

Ip notes that the rupiah is not far from the 15,000 per dollar level reached during Asia's 1997/98 financial crisis, a period when Indonesia was far more vulnerable with reserves only amounting to about half of its short-term external debt. Today, its foreign-exchange reserves cover about 170 percent of short-term external debt, reducing the risk of a balance of payments crisis.

"I don't believe the country is like what it was in the past," said Ip. "At the end of the day, Indonesia is a country with massive natural resources, one of the most populous countries so that it can provide a lot of labour and its demographic is also one of the youngest in the world. All these will be positive drivers for future growth."

Ip invests 10-15 percent of his $500 million fund in Indonesia and sees opportunities in government bonds where 10-year yields have shot up 300 basis points since May to 8.5, their highest since March 2011. "I would say we are likely at or near the bottom right now," he said. "Nonetheless, even if we argue the selloff has been overdone, I don't see it will come back very soon."

WIDENING SHORTFALL

Central to Indonesia's problems is its current account.

The widest measure of the flow of goods, services and money in and out of Indonesia has remained in deficit for seven quarters, driven by price declines for its most lucrative commodity exports - from coal to tin and palm oil. The shortfall reached an unexpectedly large $9.8 billion in the quarter ended June 30, the biggest since before the 1997/98 Asian financial crisis and equivalent to 4.4 percent of GDP.

A stimulus package unveiled Friday sought to mend that deficit by shoring up exports, in part by offering tax breaks to companies in labour-intensive industries, such as garments and textiles, that export at least 30 percent of their production. A luxury tax on certain domestic products would be phased out, meanwhile, to reduce imports.

Some measures, say economists and business leaders, could accelerate growth, curb inflation and lift foreign-direct investment over the longer-term, but their short-term impact on the current account looks negligible.

A stubborn current-account deficit makes Indonesia heavily dependent on increasingly scarce foreign capital. And further losses in the rupiah will make imported goods more expensive, adding to already strong inflationary pressures. The central bank projected on Friday that the annual inflation rate could exceed 8.9 percent in August, the highest since January 2009 and above July's already lofty 8.61 percent.

That keeps the spotlight on Bank Indonesia (BI), the central bank, which faces growing pressure to raise interest rates to shore up the currency and curb inflation. It surprised financial markets on Tuesday by calling a board meeting on Thursday, prompting speculation it might raise interest rates again instead of waiting for its next scheduled policy meeting on Sept 12.

"An imminent hike of at least 50 basis points in the reference rate to 7 percent would not be out of order," HSBC's Singapore-based Southeast Asian economist Su Sian Lim said before news broke of the surprise meeting. "It may not turn markets around, but it should at least bring back some stability."

Geoff Lewis, a Hong Kong-based global market strategist at JPMorgan Asset Management, said the recoiling of global capital that has wiped $45 billion off the value of Indonesian stocks since Aug 12 could be followed by more selling. He warned economic growth will slow and corporate earnings may have to be downgraded in the short term.

"Indonesia was late to see that circumstances had changed for emerging markets with large external deficits, and should have started to tighten monetary policy earlier. Another rate hike looks inevitable," he said.

QUESTIONS OVER RATE RISE

But raising the benchmark reference rate is no sure bet.

Some economists say Bank Indonesia may resist a further increase for fear that higher credit costs will steepen the economic slowdown - an especially unpalatable prospect ahead of national elections next year with President Susilo Bambang Yudhoyono's Democratic Party already struggling in opinion polls.

State-controlled Bank Mandiri calculates that every 1 percentage point decrease in economic growth translates into a loss of 300,000-400,000 jobs.

"Perhaps with an election looming ahead, politicians may be less willing to accept slower economic growth. But that, hopefully, will prove to be of secondary concern to BI policymakers," Lim at HSBC said in a note to clients.

The government is tempering expectations. New Finance Minister Chatib Basri said on Friday the government expects the economy to grow 5.9-6.0 percent this year, down from a previous target of 6.3 percent. Growth in the second quarter of 5.8 percent was the slowest since 2010.

Instead, Bank Indonesia could try to support the rupiah by further raising the rate it pays lenders on overnight deposits. The deposit facility rate, known as the FASBI, has already been raised 75 basis points this year to 4.75 percent. Economists at Standard Chartered say it could go up another 50-75 basis points.

Still, much of the recent turbulence looks temporary. For instance, surging inflation largely reflects the recent removal of fuel subsidies. And despite $1.4 billion in foreign selling of Indonesian government bonds since end-May, foreigners remain overall net buyers this year - to the tune of $1.7 billion.

But economists fault Yudhoyono and Southeast Asian leaders for failing to make structural economic reforms while investment was booming. Indonesian infrastructure remains woeful, corruption rampant and economic nationalism is on the rise, disadvantaging foreigner investors in lucrative resources industries.

"Difficult times like now require good policies from emerging markets and provide a wake-up call for Indonesia, Thailand and Malaysia to push through with structural reforms," said Lewis at JPMorgan.

($1=10,780 rupiah)

(Additional reporting by Jonathan Thatcher and Randy Fabi Jakarta, Umesh Desai in Hong Kong and Viparat Jantraprap in Bangkok. Editing by Jason Szep and Neil Fullick)

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