JAKARTA, March 2 (Reuters) - 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.
The outcome could well hit markets, erasing gains notched up since the 2008 crisis. Stocks have surged 134 percent from the index .JKSE low on Oct. 28, 2008, while the rupiah IDR= has strengthened from 12,600 per dollar in the November 2008 crisis to trade at about the 9,300 level. The sovereign credit default swap spread IDGV5YUSAC=R has tightened to 182 basis points, and now trades consistently below the Philippines, which is at 194.
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, 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 has been distracted for months by a controversy over a small bank, rescued at the height of the 2008 credit crisis. The bailout, backed by Indrawati and Boediono to avoid a collapse of confidence, is now under investigation by a parliamentary committee.
So far, Yudhoyono has given the pair his backing, and their supporters say the controversy is being exploited by Indonesia's corrupt old guard whose privileges are threatened by reforms. How the struggle plays out will be crucial in determining the pace of reform. [ID:nJAK205282] [ID:nJAK80953]
What to watch:
-- Will Boediono and Indrawati keep their jobs? If not, and particularly if the technocrats are replaced by politicians linked to the old business elites, it will be a strong signal that reform prospects are evaporating. [ID:nJAK477288]
That would spark some capital outflow, hitting the rupiah, stocks, and bond prices in the short-run, and could make Indonesia less attractive to long-term investors. However, healthy fundamentals and a large and growing domestic consumer base would still provide reasons to invest in Indonesia even if reform prospects are dimming. [ID:nJAK152181]
* 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 has begun tackling legal reform, for example exposing graft in the prison system and pushing ahead with investigations of powerful tycoons. [ID:nJAK470187]
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 1 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. [ID:nJAK346407]
Late last year the senior deputy governor said Bank Indonesia was studying the possibility of curbing foreign ownership of its short-term debt, sparking speculation about tighter capital controls. While those fears have abated somewhat, this remains a risk. With Indonesia attracting increasing interest from foreign investors -- and with prospects of further credit rating upgrades over the next couple of years likely to give inflows a further boost -- it may decide it has to impose controls.
What to watch:
-- Data on exports and speculative inflows. If problems seem likely, 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. [ID:nHKG263506]
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 other key figures -- including the man who recruited the two suicide bombers for the attacks in July -- may significantly reduce that threat.
Analysts warn, however, that other dangerous militants remain at large and further attacks cannot be ruled out, while recent trials of militants have indicated that funding for the attacks came from the Middle East.
With President Barack Obama due to visit Indonesia in late March, security will be increased. The head of the anti-terror unit told Reuters that police have stepped up their monitoring of Islamist networks but have not seen any signs of a security threat to Obama. [ID:nJAK402324]
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 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. [ID:nSP545301]
(Compiled by Andrew Marshall and Sara Webb)