Indonesia losing status as Asia’s market darling

Emerging Markets ADB editions, May 4 2013

Is Indonesia losing its status as Asia’s market darling? Though the country continues to attract considerable inflows from international debt and equity investors, there are signs the country may be losing steam.

“Indonesian optimism is past its highs,” said UBS analyst Duncan Wooldridge. “Although the investment cycle is still on, diminishing returns may be setting in.”

This week Standard & Poor’s, the only one of the three international rating agencies that has not upgraded Indonesia to investment grade, instead downgraded its outlook on the country from positive to stable BB+.

The decision “reflects our assessment that the stalling of the reform momentum and a weaker external profile have diminished the potential for an upgrade over the next 12 months,” said Standard & Poor’s. It bemoaned the low per capita GDP of US$3,800 despite a decade of strong growth, and noted slow progress in improving critical infrastructure, legal and regulatory uncertainty, and bureaucracy. “The political considerations related to next year’s parliamentary and presidential elections appear to increasingly shape policy formulation,” the rating agency said. “This weakening policy environment may ultimately affect growth prospects and the generally sound economic conditions.”

Although the election may be over a year away, there are already signs of policy paralysis, notably around fuel subsidies, where reform had been expected and appears to be becoming more necessary than ever given high oil prices and structural shifts in the domestic oil market. “The government has been reluctant to deal decisively with the fuel subsidy problem,” S&P said.

The Indonesia outlook change came on the same day S&P upgraded the Philippines to investment grade. Deutsche Bank said “the contrasting rating actions on Philippines and Indonesia were a stark reminder of their diverging fundamental fortunes.” While the Philippines has enjoyed improving current account surpluses, “Indonesia’s current account has moved into a stubborn deficit,” the bank said. Deutsche is “modestly underweight” the Indonesian currency, “given our concerns both about misalignment in policy settings, and state of market liquidity under stress.”

Wooldridge at UBS drew parallels with India, given that both countries had deficits at historical extremes by the end of 2012. “Current account deficits are constraining policy makers in India and Indonesia, forcing them to limit the availability of policy stimulus demand despite weak exports,” he said. He also noted that although Indonesia’s investment to GDP ratio was up two fifths since 2005-7, real growth has not improved commensurately.

Nomura’s strategist Craig Chan said the downgrade “validates what we have been arguing for a while: that reforms have been put on the backburner and will continue to stay that way as the 2014 elections get closer.”

That said, Indonesia still has a lot going for it. With an economy based largely on domestic demand it has avoided the worst shocks of the financial crisis through limited exposure to exports; it is in a demographic sweet spot; and the government has reduced external leverage to a forecast 22% of GDP this year from a peak of 110% in 1999.