Bitter divisions in the governmentâ€™s ruling coalition will stifle policy making and slow reform, but the countryâ€™s strong fundamentals, founded on robust domestic demand, should prevent asset prices from suffering much for the moment.
Three coalition parties crossed the floor and voted with the opposition on Wednesday to demand a criminal investigation of two key reformist technocrats in President Susilo Bambang Yudhoyonoâ€™s cabinet over a controversial bank rescue.
Analysts expect Yudhoyono to defy pressure to fire Vice President Boediono and Finance Minister Sri Mulyani Indrawati.
But he is unlikely to expel his recalcitrant coalition partners from the government - even though their attempt to exploit the Bank Century scandal signaled strong opposition to the pro-market economic reforms that investors want Yudhoyono to spearhead in his second term.
â€śThis does put the coalition under great stress. This will mean reduced functioning of the cabinet. This makes reform much more difficult,â€ť said Greg Fealy at the Australian National University. But he saw little chance Yudhoyono would break up the coalition, â€śbecause he is usually a safe player politically.â€ť
Beside the staunch opposition to reform from some coalition members - in particular the Golkar Party that dominated politics for decades during the rule of authoritarian former President Suharto - pro-market policy making will also suffer if Sri Mulyani and Boediono are distracted from their jobs by a criminal probe.
The governmentâ€™s efforts to boost tax collection and drive reform in the civil service, labor law and land acquisition could be threatened - with negative implications for the stock market, bonds and the rupiah.
Expectations that last yearâ€™s decisive election victory for Yudhoyono would mean a faster pace of reform were a key factor in making Indonesia one of 2009â€™s star emerging markets, with stocks up nearly 90 percent, government bonds rising 20 percent and the rupiah up 17 percent against the dollar.
Those hopes are now at risk. Yet sentiment remains bullish.
â€śWe do recognize that following last yearâ€™s positive electoral outcome, expectations may be set too high by some foreign investors and there may be some disappointment in the pace of reform,â€ť HSBC said in a recent report. But it added that â€śreform will come surely if slowly, and near-term political volatility is not a substantial threat to local markets.â€ť
Finance Ministry data shows that net foreign investment in local bonds stood at a record Rp 121.5 trillion ($13.12 billion) this week, with inflows of Rp 6 trillion since the end of January despite the fractious political climate.
ING said capital inflows would bring the 10-year bond yield down to 9 percent in the next three months from 9.54 percent at the last close.
HSBC said Indonesiaâ€™s benign inflation, manageable fiscal deficit and low borrowing gave its sovereign bonds a â€ścredibility premium,â€ť but warned this would be tested in coming months â€śdue to uncertainty over ... Sri Mulyaniâ€™s future in the cabinet and whether SBYâ€™s reform agenda has been permanently weakened.â€ť
Stocks are up 1.29 percent since the start of 2010, despite broad selling of emerging market assets seen as overbought, and ahead of regional peers Thailand, Malaysia and the Philippines.
A central figure in machinations to undermine Sri Mulyani and Boediono is Golkar leader and tycoon Aburizal Bakrie, whose conglomerate prospered under the rule of Suharto.
Golkar has close links with the countryâ€™s traditional business elites who could be threatened by reform.
Tensions between Aburizal and Sri Mulyani erupted in 2008 during the height of the global financial meltdown as concerns about the financial health of the tycoonâ€™s companies battered their share prices. During the worst of the storm Aburizal helped engineer the shut-down of the stock market and Sri Mulyani ordered it reopened.
They have clashed again over her tax-collection drive - the tax office says Bakrie group firms owe hundreds of millions of dollars, knocking shares in its mining firm PT Bumi Resources.
Plenty more established tycoons are equally reluctant to see tax collectors pursue them too vigorously.
Fealy said that despite Aburizalâ€™s behavior, Yudhoyono would probably rather keep Golkar within the coalition, where he could at least exert limited control over it. He said he expected the tax department and Corruption Eradication Commission (KPK) to press on with their work despite the opposition of powerful figures.
Also, even if Yudhoyono caves in to pressure to allow a criminal probe of his reformers, many expect them to be exonerated - potentially strengthening their hand longer-term.
â€śIt would be very difficult to prove they gained some personal benefit from this bailout. So the Democrats should be optimistic that even if there is an investigation, things will turn out OK for them,â€ť said Aleksius Jemadu, an analyst at Jakartaâ€™s Pelita Harapan University.
Yet while market fallout from the affair may be limited, and investor enthusiasm over Indonesia is set to continue, the reform struggle may slow gains by stocks and the rupiah this year, and even delay a sovereign upgrade to investment grade.
â€śNo one is going to want to make tough decisions now,â€ť said Jakarta-based analyst Kevin Evans. But he also did not expect troublesome coalition members to be thrown out. â€śIf it was just one party you might be able to exact some revenge but if an overwhelming chunk crossed the floor, itâ€™s not so easy,â€ť he said.
â€śThe removal of one or both [Sri Mulyani and Boediono] of such distinguished public servants would be perceived as a further backwards step for economic reform,â€ť said John Arnold, the founding chairman of the British Chamber of Commerce in Jakarta. â€śIf the president is perceived not to be inclined to strongly back key members of his team he risks criticism as being weak.â€ť
Singapore-based analyst Johanna Chua of Citigroup said in an email to the Jakarta Globe: â€śWe think it is unlikely Boediono will be impeached as this would require at least two-thirds of votes of the MPs, which we think can be blocked. We think Yudhoyono is under no pressure to remove Sri Mulyani, though she may remain under the cloud of investigations.â€ť
Still, if Boediono and Sri Mulyani are ousted, it doesnâ€™t â€śhave to necessarily spell disasterâ€ť for Indonesia, said James Van Zorge, a principal at Jakarta-based risk consulting company Van Zorge, Heffernan & Associates. Investors will continue to have an interest in the country if their successors are seen as capable, he said.
Standard Chartered analyst Fauzi Ichsan said the struggle over Bank Century had strained relations between the House of Representatives and the central bank and Finance Ministry, complicating fiscal policy and the establishment of an independent banking regulator.
More importantly, he warned, concerns that a lack of coalition unity would undermine the governmentâ€™s effectiveness â€śmay further delay a sovereign rating upgrade for Indonesia.â€ť
The title of his research note summarized a view of Indonesia shared by many investors: â€śBad politics, good economics.â€ť
While Indonesiaâ€™s rank in Transparency Internationalâ€™s annual corruption perception index rose to 111 last year from 126 in 2008, it remains in the category of nations perceived as deeply corrupt.