From: ReutersBy Sara Webb and Sunanda Creagh
JAKARTA, May 3 (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.
For the moment, the reformers appear to have the upper hand, but a major setback could rattle Indonesia's markets and hurt prospects for a credit rating upgrade with Indonesia now rated just one notch below the coveted investment grade by Fitch.
The benchmark stock index .JKSE has surged 155 percent from its Oct. 28, 2008, low and reached an all-time high on April 30, while the rupiah IDR= has strengthened from 12,600 per dollar in November 2008 to trade at about 9,010.
The sovereign credit default swap spread IDGV5YUSAC=R has tightened to around 161 basis points from 182 two months ago. Following is a summary of key Indonesia risks to watch:
* GOVERNMENT EFFECTIVENESS IN DRIVING REFORM
President Susilo Bambang Yudhoyono, re-elected with a strengthened mandate last 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 was distracted by a highly politicised inquiry -- driven by opponents of reform -- into the rescue of a small bank, which led in March to parliament recommending a criminal investigation into the bailout decision. Yudhoyono expressed full support for Indrawati and Boediono, who had backed the bailout to avoid a collapse of confidence in the financial sector, signalling their jobs are safe. [ID:nJAK443320]
Yudhoyono has shown a preference for incremental reforms rather than bold and controversial action, disappointing some investors. However, progress is slowly being made. In March, Boediono announced a new team to oversee reform of the bureaucracy, a positive sign for foreign investors.
Also, healthy fundamentals and a large and growing domestic consumer base still provide reasons to invest in Indonesia even if reform progress is slower than had been hoped. [ID:nJAK152181]
What to watch:
-- Opponents of reform, including those within Yudhoyono's ruling coalition, will probably try to block pro-investment policies such as changes to the tough labour laws and cuts in energy subsidies. [ID:nJAK427204]
-- The future of the coalition. The Bank Century inquiry strained relations between Yudhoyono's Democrats and coalition partners Golkar, led by tycoon Aburizal Bakrie and frequently opposed to reform, and the PKS, an Islamist party which sometimes takes a nationalist, anti-Western stance. If tensions deepen, there could be a realignment in parliament, with other parties being brought in to the coalition to maintain its majority.
* 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 stirred powerful opposition. Yudhoyono has vowed to back the anti-corruption drive but his slow response to the KPK scandal disappointed many Indonesians who wanted bolder steps.
However under Kuntoro, the presidential delivery unit and legal task force has begun tackling legal reform, for example exposing graft in the prison system and investigating officials suspected of perverting the course of justice. [ID:nJAK470187]
What to watch:
-- Effectiveness of Kuntoro's presidential delivery unit 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 4.4 percent this year, making it one of the region's better performers. Memories are 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 but seems comfortable with steady appreciation as this helps to contain imported inflation.
Late last year the senior deputy governor said Bank Indonesia was studying the possibility of curbing foreign ownership of its short-term debt, or SBIs, sparking speculation about tighter capital controls. Instead, in March, it began reducing the frequency of auctions for one-month SBIs, which has resulted in foreign investors shifting to three-month paper. [ID:nJAK197199]
What to watch:
-- Data on exports and speculative inflows, and whether the central bank's measures for SBI auctions has the desired effect of reducing volatile short-term capital inflows. If problems arise, 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 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. Since then, the killings of Noordin Mohammad Top and, more recently, the bomb-making expert Dulmatin, have significantly reduced that threat. But some risk persists.
Police recently discovered a new network of armed Islamist militants operating a secret training base in Aceh in Sumatra province. Also, analysts have warned that militants are using the prison system to recruit and spread their ideology, while recent trials of militants have presented evidence that funding came from the Middle East -- a worrying trend as it show militants are managing to establish international links. [ID:nJAK486152]
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 or allies in Southeast Asia to secure sustained funding, expertise and recruits, the threat may be far from over. But Indonesia's markets have proven highly resilient to militant attacks. Unless there is a significant and sustained deterioration in security, or militants reignite sectarian unrest, any sell-off would be small and brief.